king_pellinor | Tax ranting #5

Right, this one really annoys me.

According to the media, "transfer pricing" is the name of a sophisticated accounting technique used to avoid tax. For example, Margaret Hodge has been accused by one Priti Patel, who I understand is some sort of MP, of not being without reproach vis a vis tax dodging, and in an open letter on the subject Patel says Hodge's company Stemcor "admits to using 'transfer pricing' ".

To me, who's actually dealt with the stuff, transfer pricing is just an aspect of book-keeping: like stock-taking, invoicing, or accruals.

This takes me back to the rant about MP's not having a clue about that whereof they speak, but hey ho.

Let me run through the etymology of "transfer pricing" in this context.

When company A sells goods or services to company B, there has to be a way of coming up with a price. A few years ago, when A and B were in the same group, they'd simply agree on a price. If A pays tax at 30% and B pays tax at 20%, then (very broadly) the lower the price the less tax the group pays overall: if the price goes down by £100, then A has £100 less profit and so pays £30 less tax, and B has £100 more profit and pays £20 more tax. Net result: £10 less tax.

Governments have gradually cottoned on to this, and brought in rules to counter any abuse. Because we're talking about the price at which a transfer is made, the amount paid became known as the "transfer price". The tax rules about the pricing of such transfers have therefore become known as "transfer pricing rules".

Nearly every country uses the same basic transfer pricing rule: the price two connected parties pay each other should be the amount two unconnected parties would pay. That is, they should behave as if they were acting at "arm's length" - presumably this is the opposite of being in bed with each other.

If A and B don't act at arm's length, the normal thing to do in the tax world is to adjust the accounts to reflect the arm's length position. So in the example above, if A has charged B £100 less than it'd charge an independent company, you'd adjust A's profits up by £100. This adjustment made as a result of the transfer pricing rules is a "transfer pricing adjustment".

The trick is that it's really hard to work out what the arm's length position is. Very often there's no obvious way of pricing up the deal, because it's never happened before or you just wouldn't sell to someone unrelated. For example, Google wouldn't let anyone but a group company trade in the UK and call themselves "Google". So you have to have a discussion with the tax authorities and agree what the right rate is. This takes ages, because there's lots of tax at stake and there's no right answer. Five years would be pretty routine even if you end up with no adjustment.

So, if you see a company that includes a transfer pricing adjustment when calculating its tax, all that means is that the relevant authorities have checked the books and agreed that everything's OK. If someone says that the authorities are investigating the transfer pricing position, all that means is that they're checking the figures and they might agree everything's OK.

Incidentally, B would hope to be able to reduce its profits by £100 as well, but if B is in a different country it might find that the authorities there are fine with it paying the lower amount, no problem whatsoever. So you might then end up with both A and B paying tax on the same bit of profit, which would leave the group £20 worse off.

So international groups are generally very keen to make sure that they have a reasonable starting point, to minimise the risk of paying that extra £20. Deliberately getting your transfer prices wrong is a very risky strategy.

This also means that groups make allowances for the possibility that the authorities might not like what they've done, and over-estimate their tax bill to be on the safe side pending agreement. This also seems to confuse journalists: you put £100 million of tax in your accounts in case it's due, but don't actually pay it over because you're not sure it will be, and then a journalist accuses you of not paying all the tax you're supposed to.

So, to summarise: "transfer pricing" is all about getting the tax figures right. It's no more an abuse than "invoicing" is. It annoys people like HMRC, because whenever a compromise figure gets agreed both sides will thnk they've been done. Tax managers in industry hate it, because HMRC keep asking for more documents so they can challenge the figures even though they're ignoring the ones you sent them months ago. CEOs hate it, because they want a nice solid cashflow forecast but the Tax people are always saying we might have to pay more cash out but they can't be sure how much for five years.

And journalists and politicians love it, because they don't know what it is and neither does the public, so they can get all outraged for a while until they find a new bandwagon.