Paper presented on
“E-commerce: triggering a revaluation of Global Transfer Pricing”
in Seminar on Accounting Issues
Research Scholar, UCCMS, Mohan Lal Sukhadia University, Udaipur
E-commerce: an insight
The fast development of technology has revolutionized the entire concept of business and commercialization since the last two-three decades. World is shrinking with the expanding electronic culture encompassing the business community. E-commerce enables the cross-border business transactions in real time, making the users more contented through effortless dealings from their own work stations or homes. Be it exchange of information, filling the shopping cart, orders processing, making payments or receiving invoices; everything has now been made electronic. No more has a housewife to rush to the nearest kirana store or drive 10 kms from her home to the shopping mall in the city to fetch the household items. All she needs to ease herself from these time consuming visits is to get an access to the internet and shop every listed item sitting comfortably at her home! And this is what the present day shopping culture is. The whole metrics of the stores have now transformed drastically. The small mismanaged store at the end of the street has now been replaced by the online stores, and the shopkeepers by the customer care cell guiding the virtual customer to shop well.
E-commerce is gaining the popularity very fast
Low set up cost: The online services provided by the organizations do not call for any huge investments and not even physical merchandise in many cases. The large retail showrooms simply display the products on the site.
Free market: The market of e-commerce is not having any restrictions on entry of the sellers of goods or services. It is limitless and hence serves as a good platform for the budding and small players too.
Global access: Same as for the number of sellers in the market, there is no restriction to the buyers of the commodities. E-commerce has a much wider customer base than a physically operated store or service station.
Technology: With the rapidly growing avenues in e-commerce, the newer technologies are mushrooming day-by-day to make it more effective and user friendly.
Real time transactions: Transaction via electronic carriers is less time consuming and more effective.
Cost effectiveness: With the shortening supply chains, the direct effect is on prices of the final products.
Ease of payments: many services make payments easy via the internet. Smart cards and credit cards services provided by internet shopping are assured of security and hence improvise the standards.
Personalization: The websites keep a track of past orders made by a particular customer, so that when he returns at a later stage, he is guided to those links he visited earlier.
Globalization of the economy, shorter product life cycles, hard-hitting competition and frequent changes in technology are some of the many factors giving rise to the emergence of e-commerce. Keeping up with the Darwin’s theory of “survival of the fittest” every organization is trying hard to board the new age band-wagon.
The concept of Transfer Pricing
Transfer pricing refers to the pricing of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions.
Transfer pricing is the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division’s profit (or loss) separately. Transfer pricing provisions primarily require any income arising out from an International transaction between two or more associated enterprises to be at arm’s length price and comparable to similar transactions between unrelated enterprises.
In order to discover the correct profitability, the firm should be sure that interdivisional transfer prices are the prices that would have been paid had the transactions been independent companies, so-called “Arm’s length prices”. Transfer pricing assumes greater significance in case of entities with a number of affiliates and subsidiaries located in different currency areas and under different legal and political systems. In overseas operations the MNCs may be confronted with many complicated variables such as differential taxes, tariffs, exchange controls, government regulations, inflation, political systems, etc.
Relevance of Transfer Pricing methods in E-commerce
In the age of IT enabled transnational exchanges of commodities, the concept of transfer pricing holds a major significant role. To ease the commodity and service transfers, the new international transactions, policies and protocols are getting moderated accordingly. Now, the MNCs have awakened to the fact that international accepted transfer pricing methods are no longer applicable to e-commerce cross-border activities. Also, they are aware that their corporate financial officers and accountants must help reduce the risk of transfer pricing tax audits of either Internal Revenue Service or host countries’ tax authorities. As multinationals manage their cross border global business transactions, traditional transfer pricing for e-commerce transactions may be more difficult to apply to reduce their worldwide tax liabilities and globally integrate their production and marketing strategies.
Earlier, the transfer pricing tax regulations were written within the framework of national sovereignty in tax system before the discovery of e-commerce. Tax authorities consider ecommerce as a threat to revenues from traditional income tax systems and; therefore, they are pushed to ensure their tax system integrity by closing the loopholes for either tax avoidance or tax evasion through the use of ecommerce. On the other hand, corporate financial officers (CFO) and accountants who work for MNCs should ensure that their transfer pricing policies reduce the risk of audits. To protect their tax bases, tax authorities must ensure they collect a fair amount of corporate income tax from multinational corporations (MNCs) operating in their jurisdictions and have become more alert in enforcing the rules of transfer pricing. MNCs could face inconsistent and unfair treatment of cross-border transactions, double taxation and penalties for noncompliance with different tax regulations of different countries. The complexity of the issue might require MNCs to redefine and update their strategies to go with the new challenge of the information technology in the twenty-first century.
Maguire (1999) argue that e-commerce may not present new transfer pricing problems; it only magnifies exiting issues such as the valuation of intangibles and services, and compliance with documentation and information reporting requirements. Moreover, the Organization of Economic and Cooperation Development (OECD) still think that existing principles in dealing with e-transfer pricing transactions are adequate, and that e-commerce has not presented any fundamentally new problems for transfer pricing. However, due to rapid development in communications resulting in instantaneous transmission of information, tax administrations are concerned that it may become more difficult to identify, trace, quantify and verify cross border transactions, and there are difficulties in applying internationally accepted transfer pricing methods to e-commerce.
MNCs, tax authorities, and international organizations are at the crossroads of not being able to solve the complicated problems created by e-commerce and international transfer pricing transactions. As MNCs mange their cross border business transactions, transfer pricing methods and strategies for e-commerce may be more difficult to apply in reducing their tax liabilities and integrate their production and marketing strategies on a worldwide basis.
First, the issues of choosing the right transfer price that fits the nature of cross-border ecommerce activities will be investigated.
Second, taxation of products or services transferred through the Internet by tax authorities will be discussed. Finally, certain guidelines to protect MNCs and reduce their risk against transfer pricing audits by tax authorities will be recommended.
Methods of Transfer Pricing by E-commerce based MNCs:
It is presumed that the use of non-traditional business practices such as the web by online retailers should not theoretically result in generated income being treated differently for tax purposes. However, the nature of ecommerce business tends to mix up national borders and the source of income. Under Section 482 of IRC, the permissible methods for determining an arm’s-length price are: (a) comparable uncontrolled price method, (b) resale price method, and (c) cost-plus method.
The three methods are required to be used in order, and a fourth alternative method may be used for all other situations in which none of the first three are considered appropriate and reasonable. The fourth one can be based on profit-split approaches such as the comparable profits method and several split-profit methods.
The OECD transfer pricing guidelines were first issued in 1979 and have become internationally respected. They maintain the arm’s length principle of treating related enterprises within a multinational group and affirm traditional transaction methods as the preferred way of implementing the principle.
OECD’s definition of Arm’s length principle
Although there are discrepancies in the specifics of each country’s laws concerning the application of the arm’s length principle, the fact that they are primarily based in the OECD Guidelines means that, although such a strategy carries a greater taxation risk than solutions tailored to each country, global transfer pricing policies can be effectively used to determine an appropriate range representing the arm’s length price for transactions carried out across a global enterprise.
However, different countries may accept different methods of calculating the transfer price (i.e. Japan requires that the three “traditional” methods, outlined below, be systematically discounted before allowing the use of alternative methods, while the United States accepts the most appropriate method regardless), so care must be taken in such circumstances. In addition, some countries may have immature transfer pricing regimes or apply the arm’s length principle in different ways—Brazil, for example, does not apply the arm’s length principle despite the existence of transfer pricing legislation.
1. Comparable Uncontrolled Price method
The Comparable Uncontrolled Price (CUP) method compares the price at which a controlled transaction is conducted to the price at which a comparable uncontrolled transaction is conducted. This makes it the easiest to conceptually grasp, as the arm’s length price is, quite simply, determined by the sale price between two unrelated corporations. However, the fact that virtually any minor change in the circumstances of trade (billing period, amount of trade, branding, etc.) may have a significant effect on the price makes it exceedingly difficult to find a transaction–much less transactions–that are sufficiently comparable.
Should they exist, such comparable transactions fall into two categories: external comparables and internal comparables. The former is a comparable uncontrolled transaction in the purest sense of the term–if Company A, in France, sells widgets to its subsidiary A(sub) in Turkey, then an external comparable transaction would be the sale of widgets from French Company B to Turkish Company C (an unrelated enterprise) on identical terms as the trade between A and A(sub). An internal comparable transaction, then, would be either the trade of widgets between Company A and Company C, or the trade of widgets between Company B and Company A(sub), with the term “internal” referring to the fact that one of the parties involved in the tested transaction is also involved in the comparable uncontrolled transaction.
2. Cost Plus method
The Cost Plus (CP) method, generally used for the trade of finished goods, is determined by adding an appropriate markup to the costs incurred by the selling party in manufacturing/purchasing the goods or services provided, with the appropriate markup being based on the profits of other companies comparable to the tested party. For example, the arm’s length price for a transaction involving the sale of finished clothing to a related distributor would be determined by adding an appropriate markup to the cost of materials, labour, manufacturing, and so on. Cost based method calculates transfer price on the cost of the goods or services available as per the cost accounting records of the company. The method is generally accepted by the tax customs authorities, since it provides some indication that the transfer price approximates the real cost of item. Cost based approaches are how ever not as transparent as they appear. A company can easily manipulate its cost accounts to alter the magnitude of the transfer price. Companies that adopt the cost based transfer pricing method have to choose between alternative approaches : Actual cost approach Standard cost approach Variable cost approach Marginal cost approach
Apart from this, companies also have to decide on the treatment of fixed cost and research and development cost. These issues can prove problematic for the company that adopts a cost based transfer pricing method. Cost based method usually creates difficulties for the selling profit centre. As their incentives to be cost effective may fall, if they know that they can recover increased cost simply by raising the transfer price without an incentive. To produce efficiently the transfer price may erode the competitiveness of the final product in the market place.
3. Resale Price method
The Resale Price (RP), while similar to the CP method, is found by working backwards from transactions taking place at the next stage in the supply chain, and is determined by subtracting an appropriate gross markup from the sale price to an unrelated third party, with the appropriate gross margin being determined by examining the conditions under which the goods or services are sold and comparing said transaction to other, third-party transactions. In our clothing example, then, the arm’s length price would be determined by subtracting an appropriate gross margin from the price at which the distributor sold the products received from the manufacturer to third-party retailers–department stores, boutiques, etc.
In this example, both the CP and RP methods are being used to examine the same transaction–the one between the manufacturer and the distributor–meaning that the selection of one for use is ultimately dependent on the availability of data and comparable transactions. This flexibility is not available in other transactions, particularly those involving intangible goods (i.e. it is exceedingly difficult to determine the costs involved in developing technological know-how, and so the arm’s length price for the payment of royalties from one company to another is best determined by working backwards from the profits gained based on the usage of the know-how–in other words, the RP method).
Internal Revenue Service
Section 482 of the Code authorizes the IRS, (United States Department of Treasury) to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent evasion of taxes or to clearly reflect their income. The regulations under section 482 generally provide that prices charged by one affiliate to another, in an intercompany transaction involving the transfer of goods, services, or intangibles, yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.
Profit allocation will usually be according to the distribution of corporate sales, with the sales valued at the “correct” exchange rate. The advantages of preventing distortions in transfer prices must be balanced against the potential gains from using distorted transfer prices to reduce tariffs, taxes, political risks, and exchange losses. This balance can be a difficult problem for multinational corporations.