The transfer price – in German Verrechnungspreis – is the amount that is charged when services are rendered or procured within a company. Transfer pricing therefore describes the monetary valuation of goods and services exchanged internally.
Recently, transfer pricing has been increasingly scrutinised by tax authorities and others. Here you will learn when transfer pricing is applied, how transfer prices are determined, and why tax authorities in Switzerland are critical of current accounting practices.
When is transfer pricing used?
Transfer pricing is used when services are exchanged between independent divisions of a company. Such an “exchange” can look as follows:
- Exchange of assets
- Granting the use of tangible assets
- Granting the use of intangible assets
- Services
- Capital
Transfer pricing receives particular attention in multinational companies.
Why is transfer pricing important?
Transfer prices are not only used to quantify the exchange of goods and services in monetary terms; they are increasingly used to monitor efficiency and profitability and to achieve tax advantages. Because they are not influenced by market supply and demand, they offer extremely efficient cost control for individual parts of a company.
In companies operating across borders, the transfer price can have a significant impact on profits and losses. Within large companies, profits are preferentially shifted to those parts of the business where the tax burden is lowest.
Legal regulations in Switzerland
Currently, the Swiss legislator refrains from including specific legal provisions on transfer prices in tax law. However, there are a number of administrative guidelines that refer implicitly or explicitly to the calculation of the transfer price. Among other things, cantonal tax authorities are called upon to follow the OECD Transfer Pricing Guidelines when assessing transfer prices.
Because Switzerland is an OECD member state, it is also obliged to implement the OECD BEPS minimum standards (e.g. Country-by-Country Reporting). Essentially, Switzerland aims to establish arm’s length transfer prices.
Swiss tax law does not provide for specific obligations for companies to prepare transfer pricing documentation. However, taxpayers must ensure that a complete and accurate assessment is possible. They are also obliged, upon request by the assessment authority, to provide written or oral information on business transactions or to present the relevant accounting records and other documents.
When designing this documentation, the Local File and the Master File documentation approach as set out in the OECD Transfer Pricing Guidelines are frequently used.
Excursus: Transfer pricing documentation
With transfer pricing documentation, taxpayers report on the nature and content of their business relationships with other divisions within the same company or with related parties. Companies must submit the transfer pricing documentation within 30 days of being requested to do so or of receiving notification of an audit order, if they conduct transactions with affiliated companies.
Determining the transfer price
Although there is no regulation stipulating how the transfer price must be determined, there are a number of approaches intended to help. These include the so-called arm’s length principle and the tax transfer pricing methods.
Arm’s length principle
Both nationally and internationally, the arm’s length principle – or “dealing at arm’s length principle” – is used as the central starting point for determining the transfer price. This OECD principle was enshrined in the 2010 OECD Model Tax Convention. The principle requires that the price of a good or service must be the same as it would have been in a sale to third parties. The transfer price must therefore withstand the arm’s length or third-party comparison. There are different variants of the arm’s length comparison:
Internal vs. external comparables
- Internal comparables – A transaction between two divisions belonging to the same company is compared with a transaction between the company and an unrelated company.
- External comparables – Here, a transaction between two divisions belonging to the same company is compared with a transaction between two unrelated companies.
Concrete vs. hypothetical comparables
For a concrete comparable, there must be transactions both within the company and between independent third parties that have actually taken place. If there are no real transactions, a hypothetical comparable is used.
Direct vs. indirect comparables
- Direct comparable – The key factors of the transactions being compared must be identical.
- Indirect comparable – If similar business transactions are used as a basis and then adjusted to reflect actual transactions, this is referred to as an indirect comparable. Central to all comparables is always the comparability analysis. The OECD provides a nine-step process for this. Because applying the arm’s length principle is not a trivial task and often poses challenges for companies, so‑called Advanced Pricing Agreements (APAs) are frequently used.
Excursus: APA – Advanced Pricing Agreement
APAs, or advance pricing agreements, are arrangements between one or more taxpayers and one or more tax administrations. These time-limited agreements set out which transfer pricing methods and which prices or margins will apply to internal transactions and be accepted by the relevant tax authorities. This results in legal certainty and planning reliability.
Tax transfer pricing methods
The arm’s length principle alone does not determine the transfer price – instead, each company must individually identify the appropriate calculation method. In principle, a distinction is made between five transfer pricing methods that are used to determine an arm’s length price. Within these five methods, a distinction is made between transaction-based standard methods and profit-based methods.
- Transaction-based standard methods
- Comparable uncontrolled price method – The comparable uncontrolled price method (CUP) is based on prices agreed for comparable transactions between unrelated companies in the market. It ideally implements the arm’s length principle because it relies on a direct price comparison.
- Cost plus method – The cost plus method (CPM) starts from the production or service costs and adds a market-standard profit markup.
- Resale price method – The resale price method (RPM) is based on the resale price minus a gross margin such as would also apply in comparable transactions between independent third parties.
- Transaction-based profit methods
- Transactional net margin method – The transactional net margin method (TNMM) compares net margins from one or more internal transactions of the company with those of comparable companies.
- Profit split method – The profit split method focuses not solely on determining the transfer price, but rather on the allocation or distribution of profits.
Which transfer pricing method is appropriate depends on the allocation of functions, risks and key assets, as well as on the availability of comparable data.
Why is transfer pricing viewed critically?
As mentioned earlier, this accounting practice can have a significant impact on operating results. There are essentially two recurring criticisms of transfer pricing:
- The first allegation is that transfer prices are often set arbitrarily low in order to reduce the tax burden.
- The second is that profits are shifted to low-tax countries for the same purpose (international transfer prices).
Both issues are problematic not only from a market economy perspective but can also lead to internal conflicts. Since divisions of a company often focus primarily on their own success, this practice can cause major discrepancies, which in turn complicates performance evaluation and coordination.
If the recommendations or requirements that exist for calculating transfer prices are not followed, this can lead to the tax authority determining prices at its own discretion and making a corresponding adjustment to taxable profit. In cases of manipulation, the Swiss state can also impose substantial fines on the companies concerned.