A transfer price is a price set by a taxpayer when selling to, buying from, or sharing resources with a related person. For example, if ACo manufactures goods in Country A and sells them to its foreign affiliate, BCo, organised in Country B, the price at which that sale takes place is called a transfer price. A transfer price is usually contrasted with a market price, which is the price set in the marketplace for the transfer of goods and services between unrelated persons.
Multinational companies use transfer prices for sales and other transfers of goods and services within their corporate group. These intercompany prices are the most important category of transfer prices. Transfer prices are also used by individuals dealing with corporations or other entities under their control and by individuals dealing with close family members.
Unless prevented from doing so, related persons engaged in cross-border transactions can avoid the income taxes of a country through their manipulation of transfer prices. For example, in the example above, ACo might avoid paying income taxes in Country A by setting a price on the sale of its manufactured goods to BCo that results in its earning little or no profit. If the effective tax rate in Country B is lower than the effective tax rate in Country A, then the total tax burden of the affiliated companies ACo and BCo would be reduced through the use of inappropriate transfer prices. If Country B is a tax haven, then the affiliated companies would pay little or no tax on their combined profits.
While studying different aspects of transfer price, an interesting study is that of the contract manufacturer. Contract manufacturing is becoming important in the international trade and it has bearings on international taxation, particularly with reference to transfer pricing.
The main focus to study contract manufacturing is to know about controlled transaction between associated parties. Where in terms of contract conditions governing transaction is established, it becomes less complex for taxation authorities to determine the nature of transaction, but where the circumstances show a relationship not identified in the contractual terms, the taxing authorities can probe the issue from transfer price perspective in order to determine whether or not the price charged is fair or unfair.
Thus the role of the contractor from the transfer pricing perspective becomes very important and calls for review of the contracts, correspondence and communication exchanged between the parties. It may be understood that a contractor is a person who contracts to do work or provide or makes supplies for another. Contractors are of two types: competent contractor and general contractor. A competent contractor is one who possess skills or some special qualities, whereas a general contractor is one who undertakes to compete a project including the purchase of all materials hiring and paying sub-contractors. All these transactions are relevant from the taxation perspective as they create rights and obligations. This paper examines the role of contract manufacturers and defines the perspective of international taxation.
ROLE OF CONTRACT MANUFACTURER The role of contract manufacturers is important from the perspective of comparability and risks. The important factor here is the independence of contractual parties. In order to establish the degree of actual comparability and then to make appropriate adjustments to establish arm's length conditions (or a range thereof), it is necessary to compare attributes of the transactions or enterprises that would affect conditions in arm's length transactions. Attributes or "comparability factors" that may be important when determining comparability include the characteristics of the property or services transferred, the functions performed by the parties (taking into account assets used and risks assumed), the contractual terms, the economic circumstances of the parties, and the business strategies pursued by the parties.
An examination of the contractual terms between the parties is of primary importance, as those generally define how risks are to be divided between the parties.1 Contractual arrangements are the starting point for determining which party to a transaction bears the risk associated with it. Accordingly, it would be a good practice for associated enterprises to document in writing their decisions to allocate or transfer significant risks before the transactions with respect to which the risks will be borne or transferee occurs, and to document the evaluation of the consequences on profit potential of significant risk reallocations.
The terms of a transaction may be found in written contracts or in correspondence and/or other communications between the parties.2 Where no written terms exist, the contractual relationships of the parties must be deduced from their conduct and the economic principles that generally govern relationships between independent enterprises.
A tax administration is entitled to challenge the purported contractual allocation of risk between associated enterprises if it is not consistent with the economic substance of the transaction.3 Therefore, in examining the risk allocation between associated enterprises and its transfer pricing consequences, it is important to review not only the contractual terms but also the following additional questions:
--- Whether the conduct of the associated enterprises conform to the contractual allocation of risks,4
--- Whether the allocation of risks in the controlled transaction is arm's length,5 and;
--- What the consequences of the risk allocation are.6
--- Can such an entity be used to circumvent transfer pricing rules?
Where contract manufacturer is an associated person, likelihood of circumvention of the Transfer Price Rules exist. However, where parties are independent and contractual terms exists, likelihood of circumvention of Transfer Pricing Rules diminish, the following characteristics of contractual agreements define the risk involved in these transactions:
--- Contract manufacturer is less complex and is a tested party in the transfer pricing analysis.
--- Contract terms define explicitly or implicitly how the responsibilities, risks and benefits are to be divided between parties.
--- Terms of transactions are verifiable.
--- Where no written terms exist, relationship is to be deduced from conduct and economic principles which generally govern such relationships.
--- Divergence of interest exists between independent enterprises.
--- Divergence of interest may not exist between associated parties.
--- External comparables provide basis for analysis.7
--- In IP right cases information regarding description of rights and obligations is critical and if not available in the contract, the same is to be deduced from comparables.
--- Contractual terms are challengeable if not consistent with the economic substance of the transaction.
1. Article 7 and 9 of the OECD Model Convention.
2. Paragraph 1.52 of the OECD Transfer Pricing Guidelines 2010.
3. Paragraphs 1.47 to 1.53 ibid.
4. Paragraph 9.13 ibid.
5. Paragraph 9.17 ibid.
6. Paragraph 9.39 ibid.
7. Paragraphs 1.38 ibid.
(The writer is an advocate and is currently working as an associate with Azim ud Din Law Associates)