Transfer Pricing: Guide for Cross-Border Businesses in Europe

Navigating the complex world of international business taxation can be a daunting task for entrepreneurs, startups, and established businesses alike. One particularly challenging aspect is transfer pricing, a concept that plays a crucial role in determining the taxable profits of companies operating across borders. This guide will provide a comprehensive overview of transfer pricing, its implications for businesses operating in Europe, and the diverse approaches to transfer pricing adopted by various European countries.

What is Transfer Pricing?

Transfer pricing refers to the prices charged for goods, services, and intangible property transferred between related entities within a multinational enterprise (MNE) group. These “related entities” can be parent companies and subsidiaries, or companies under common control (as defined in Article 9 of the OECD Model Tax Convention). The challenge arises because, unlike transactions between independent enterprises, where market forces determine prices, related entities have the potential to manipulate transfer prices to shift profits to low-tax jurisdictions.

Why is Transfer Pricing Important?

Transfer pricing is critical for both taxpayers and tax administrations because it significantly impacts the income and expenses, and consequently taxable profits, of associated enterprises in different tax jurisdictions. When transfer pricing does not reflect market forces and the arm’s length principle (as outlined by the OECD), the tax liabilities of associated enterprises and the tax revenues of the host jurisdictions can be distorted. This can lead to:

• Base Erosion and Profit Shifting (BEPS): Companies may shift profits to low-tax jurisdictions, eroding the tax base of higher-tax countries.
• Double Taxation: Conflicting interpretations of transfer pricing rules by different tax administrations can result in the same income being taxed twice, creating a significant burden for MNEs.
• Increased Scrutiny and Audits: Tax administrations are increasingly scrutinizing transfer pricing arrangements, leading to more frequent and extensive audits.

The Arm’s Length Principle

The foundation of transfer pricing regulations is the arm’s length principle, which states that the pricing of transactions between related entities should be consistent with the prices that would have been agreed upon between independent enterprises in comparable transactions under comparable circumstances. In essence, this principle seeks to ensure a level playing field between MNEs and independent enterprises.

Transfer Pricing Methods

To determine whether transfer prices comply with the arm’s length principle, several methods are employed, as detailed in Chapter II of the OECD Transfer Pricing Guidelines. These methods can be categorized as:

1. Traditional Transaction Methods:

• Comparable Uncontrolled Price (CUP) Method: This method directly compares the price charged for goods or services in a controlled transaction to the price charged in a comparable uncontrolled transaction.
• Resale Price Method: This method starts with the price at which a product purchased from an associated enterprise is resold to an independent enterprise and deducts an appropriate gross margin to arrive at an arm’s length price for the original transfer.
• Cost Plus Method: This method starts with the costs incurred by the supplier of property or services and adds an appropriate mark-up to arrive at an arm’s length price for the controlled transaction.

2. Transactional Profit Methods:

• Transactional Net Margin Method (TNMM): This method compares the net profit margin of a taxpayer from a controlled transaction to the net profit margins realized in comparable uncontrolled transactions.
• Transactional Profit Split Method: This method identifies the relevant profits from controlled transactions and splits them between the associated enterprises based on an economically valid basis.

The choice of the most appropriate method depends on the specific facts and circumstances of the case, the availability of reliable data, and the degree of comparability between the controlled and uncontrolled transactions (paragraphs 2.1 to 2.12 of the OECD Transfer Pricing Guidelines).

Transfer Pricing in Europe: Country-Specific Approaches

Transfer pricing legislation and practices vary across different European countries, reflecting the unique characteristics of their tax systems and economic environments. Here’s an overview of the key differences in the way transfer pricing is treated in some of the major European economies, displayed in a table for easy comparison:

Practical Examples of Transfer Pricing

Here are a few practical examples of transfer pricing scenarios to illustrate how the concept applies to cross-border businesses:

Example 1: Manufacturing & Distribution

A German parent company manufactures goods and sells them to its Irish subsidiary for distribution in the Irish market. The German tax authorities might scrutinize the transfer price charged by the parent company to its subsidiary to ensure that it reflects an arm’s length price. If the price is found to be too low, the profits of the German parent company might be adjusted upward, resulting in higher German taxes.

Example 2: Intangible Property Licensing

A Swedish software company licenses its intellectual property to its Danish subsidiary. The Danish tax authorities might examine the royalty rate charged by the Swedish parent company to its subsidiary to ensure that it reflects an arm’s length royalty rate. If the royalty rate is deemed too low, the profits of the Danish subsidiary might be adjusted upward, resulting in higher Danish taxes.

Example 3: Intra-Group Services

A French parent company provides management services to its UK subsidiary. The UK tax authorities might examine the charges for those services to ensure that they are consistent with arm’s length prices. If the charges are deemed excessive, the UK subsidiary’s profits might be adjusted downward, resulting in lower UK taxes.

Transfer Pricing Enforcement in Europe

Further reading

• OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations: https://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-20769709.htm
• OECD Model Tax Convention on Income and on Capital: Condensed Version: https://www.oecd.org/tax/treaties/model-tax-convention-on-income-and-on-capital-condensed-version-20743246.htm

Where to go from here?

Transfer pricing is a complex and evolving area of international taxation. For businesses operating across borders, it is crucial to understand the principles of transfer pricing, the different methodologies used to determine arm’s length prices, and the specific approaches adopted by the various European countries in which they operate. Careful planning, comprehensive documentation, and a willingness to engage with tax administrations can help to mitigate the risks of transfer pricing adjustments and ensure compliance with the arm’s length principle.

NordicHQ’s network can help you become compliant. We can set up a preliminary call to get started on your transfer pricing challenges. Contact you network of transfer pricing and tax advisors by filling out the form below.