Say a company makes motor cars in country A and then sells them via its subsidiary in country B. The profit which the B‑company reports for its selling operation will depend on the amount charged by the group per car transferred to it. The lower this transfer price, the more of the overall profit will be allocated to the B‑company. (See figure below for an example.)
Some groups may try to bias profit allocation towards countries with a lower tax rate by adjusting the transfer price. If country B has a higher tax rate than A, it is in the group's interests to minimise profits in B by setting a relatively high transfer price per car.
Governments are of course aware of this ruse. B's tax authority is likely to reject the company's calculation of profit if it considers the transfer price unreasonably high. Conversely, country A may object if it considers the price to be artificially low, so that too little of the profit is taxed in A. Disagreement about whether transfer prices are reasonable can result in long-drawn-out disputes.
The principle which guides authorities' decisions about whether a transfer price is reasonable is the arm's length rule. This states that transfer prices should approximate to what would happen in transactions between unconnected parties. Unfortunately, the interpretation of this is often anything but straightforward. There may be little or no market data to help answer the hypothetical question: what transfer price would be set if the two divisions were independent?
In the case of relatively homogeneous industries like motor cars it may be possible to look at mark-ups on cost charged by rival manufacturers to independent distributors, take an average, and adjust for any special factors. Alternatively one can look at the profit margins of independent distributors, and argue that the transfer price should result in a similar level of profit margin for distribution companies within a group. These are some rough and ready methods used in simple cases.
At the other end of the spectrum, if what is being transferred within the group is the use of intellectual property ("IP") — say from a technology company to one of its subsidiaries — there may be little or no basis for calculating an arm's length price.
A method often used in market-based transactions involving IP is to charge the IP user a percentage of the revenue he obtains from selling products that make use of the IP; in other words, a royalty. This suggests that the IP holder within a group should charge a royalty to other group companies. But royalty rates used in market transactions range from less than 1 percent to more than 20 percent, so this does not necessarily get one very far.
The above is an extract from the forthcoming article 'EC v Apple (part 3)' which is scheduled for publication in October.