Understanding the Implications of Related Party Transactions and Transfer Pricing
Many multinational organizations are embracing tax-effective supply chain management to reduce costs and increase margins. Supply chain managers need to understand the ramifications of these tax-based strategies when it involves the transfer of tangible goods to their own foreign subsidiaries or parent companies. Reducing taxes is a desirable outcome, but not when it runs afoul of related party transaction regulations from tax and Customs authorities.
Doing cross-border business with a related party, which includes foreign subsidiaries and parent companies, can be complicated. A related party is any entity that can exercise control or significant influence over the operating policies of another entity. In global trade, it’s an individual or business that exercises a 10 percent interest in both the exporter and the ultimate consignee.
A related party transaction occurs during the transfer of resources, services, or obligations between related parties—regardless of whether a price is charged. The term "transfer price" refers to the price at which one company sells goods or services to a related affiliate in its supply chain. While the transfer price may be negligible, the tax obligations, Customs declaration and reporting requirements that go along with the transaction are not.
Countries have adopted various laws and practices to ensure transferred goods and services are appropriately priced based on market conditions. The goal of this legislation is to ensure that revenue generated within a country, and thereby taxable by that country, is not inappropriately transferred to a related party outside that country to avoid taxes. Therefore, in a related party transaction, taxes are assessed on transferred goods regardless of whether money changes hands. In any related party transaction, disclosing the relationship, reporting the transactions and conducting business "at arm’s length" are important ways to mitigate audit risks and satisfy tax authorities.
The Organization for Economic Cooperation and Development (OECD) has promoted the acceptance of "the arm’s length principle" as the international standard to guide transfer pricing. The arm’s length principle is defined as "where conditions are made or imposed between two affiliated enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly."
Multinational organizations can face significant compliance challenges with the regulations and administrative requirements around transfer pricing, since they differ from country to country. Tax authorities are increasingly sophisticated in the way they operate, and are focusing more closely on transfer pricing activities. However, Customs authorities are also concerned with related party transactions and any difference between the transaction value and the Customs valuation that might affect duties collected.
Imported goods are appraised for the payment of duties. In the case of non-related party transactions, the transaction value is typically used for this appraisal under the assumption that it reflects prevailing market conditions and is comparable to similar goods.
However, in a related party transaction, there is no such assumption. Therefore, Customs authorities must determine the value of the goods on which to base import duties. Under the "circumstances of sale" test, the transaction value between a related buyer and seller is acceptable if an examination of the circumstances of the sale of the imported merchandise indicates that the relationship between the buyer and the seller did not influence the price actually paid or payable.
An importer must use reasonable care to determine whether transaction value is acceptable according to the circumstances of sale or test value conditions (where the transaction value is close to identical or similar goods exported at or about the same time as the imported merchandise under review). The importer must also have sufficient information available to demonstrate how it meets the particular test conditions before a related party transaction value declaration is made.
Supply chain managers need to be aware that although there may be legitimate tax benefits involved with conducting related party transactions, there may still be tax and duty implications to consider. Both tax and Customs authorities must be satisfied that the transaction was conducted according to the arm’s length principle.
Therefore, supply chain managers should work closely with compliance professionals and corporate tax specialists when making decisions about related-party transactions. And keep in mind it is the importer’s responsibility to provide information and evidence regarding the transaction value to tax and Customs authorities.