What is Transfer Pricing? and why should SAIs care about it?

An estimated 60 % of world trade is transactions between branches and subsidiaries of multinational enterprises (MNE). The way prices are set for these transactions (transfer prices) can greatly influence the overall taxes paid by the enterprise, as costs are shifted to high tax jurisdictions, and profits move to jurisdiction with less or no profit tax. This article explains what is meant by transfer pricing, and why it should be high on the agenda of SAIS looking to audit the extractive industries.

By August Schneider and Anders Pilskog, OAGN

What is transfer pricing (TP)?

Transfer prices are the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises (subsidiaries and other related/affiliated companies). Transfer prices are important for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.

An estimated 60 % of world trade is transactions between subsidiaries within multinational enterprises (MNE).[1] In principle, the prices charged for these transactions should equal those of the free market. This means that the transfer price within the company should correspond to the price a seller would charge an independent, “arm’s length” customer, or what the buyer would pay an independent, “arm’s length supplier”. In practice however, it can be hard to determine the market price, and multinational entities often set internal transfer prices that differ from free market prices (arm’s length). This ability opens for profit shifting between countries and thus tax base erosion in any particular country, commonly known as aggressive tax planning or corporate tax evasion.

When working with transfer pricing, we are looking for commonly accepted methodologies to determine market prices (arm’s length), or acceptable deviation from those prices. Use of the methodology is applicable for both authorities and private companies. For tax authorities these methods can help in their effort to reduce tax base erosion. For multinational entities (MNE), appropriate transfer pricing can help avoiding double taxation. It will also help the MNE leadership establish the accurate level of costs in different parts of the company and in this way determine which are performing well and not so well.

The arm`s length principle is set forth in Article 9 of the OECD Model Tax Convention, and basically states that any additional profits gained as a result from “favorable” transfer pricing between related enterprises should indeed be taxed:

Where “conditions are made or imposed between the two 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”.[2]

Why is Transfer Pricing within extractive industries important for SAIs?

As some jurisdictions in the world have low or no income tax for companies (tax havens), there are economic incentives for MNEs to shift profit between their companies: Moving costs to high tax jurisdictions and profits to low tax jurisdictions respectively. Such profit shifting can be done by letting the subsidiary in the low tax jurisdiction charge another subsidiary or the mother company in a normal tax-rate country a price that is higher than market price on services and goods, captives (insurance) or intangibles. The abnormal high price can then be deducted for tax purposes in the latter country and thus reduce the legal tax base in this particular country. This is commonplace, and not necessarily illegal.

A survey of 10 of the world’s most powerful extractive industries giants showed that 34 % of their 6 038 subsidiaries were situated in tax havens[3], giving an indication of the opportunities that exist for profit shifting within the sector. Audit has also revealed some rather stunning examples of creative transfer pricing: A company charging USD 973 USD for a plastic bucket[4], but only USD 52 for a rocket launcher[5] or USD 13 for a camera recorder[6] for example.

It is important to note that the invoicing country do not have to be a tax haven to play a part in transfer pricing or an aggressive tax planning scheme. Some seemingly normal tax-rate jurisdictions have special regulations that allow cash flow through their jurisdiction without taxation, and the profit might eventually end up in a tax haven, making it attractive for companies to shift profits here.

Transfer pricing is a high risk area in countries with extractive industries due to the nature of the business. The industry is characterized by several multinational entities, advanced technical expertise and knowledge, large investments, valuable assets and much intangible property for which prices are hard to determine. Within Production Sharing Agreements (PSA’s), transfer pricing will play a key role in the calculation of a company’s recoverable costs, and considerations of ring fencing[7]. Cost recovery statements, that is the amounts the companies intend to deduct from revenues before calculating profit, will normally contain costs incurred through services performed by an associated enterprise. Since the associated enterprise and the company have the same owner, the companies have incentives to exaggerate the cost incurred as to be able to deduct more costs through the cost recovery. For other than tax purposes, it should make little difference to the company as a whole where income and costs are placed.

How to audit TP or What do auditors need to know?

Tax authorities and SAIs play a key role in preventing illicit profit shifting. SAIs in some countries have direct authority to audit cost statements according to Production Sharing Agreements (PSA), and therefore have tasks similar to a tax authority. Tax authorities and SAIs can for example prevent illicit profit shifting through TP risk assessments, comparability analysis, function analysis and tax audits. They may challenge the prices set by the companies through dedicated Appeals Board or Advisory Committees, or through the ordinary judiciary and/or application for prosecution in cases of tax evasion and fraud.

Where a SAI has no direct authority to audit cost statements, the SAIs could still play an important role in monitoring and auditing the tax authorities on their accomplishment on TP performance. This is normally done as a compliance audit.

There are different transfer pricing rules and regulations across the globe. Common for them all is that they contain rules on what kind of information companies should present to governmental bodies, in order to enable them to control the price set between affiliated parties. Further, they contain pre-approved methods of calculating an arm’s length price. For OECD countries there are five such pre-approved methods. Other jurisdictions may have more pre-approved methods as for example USA, which has seven pre-approved methods. Some countries oblige companies to use one of these methods to prove arm’s length, whilst other countries allow companies to also present alternative methods to prove arm’s length. Either way, the rationale behind all the methods used is to substantiate that the agreement is economically sound and could have been entered into by unaffiliated parties.

In order to do this, extensive amounts of documentation must be examined. The documentation should disclose the nature of the transaction, the amounts paid and a comparable price which can justify that the price agreed upon does not significantly diverge from what two unrelated parties could have agreed upon. Note that it is not necessarily the “market price” that should be identified, but the unexplained difference from the market price. It is still allowed to cut costs by streamlining services throughout the company, but again any divergence from the market price must be justified.

Examples of what audit has revealed

As mentioned before, audit has revealed several examples of illicit TP practice and profit shifting:

  • Reluctance or unwillingness to provide mandatory transfer pricing documents for audit
  • Restrictions to audit transfer pricing in clauses in PSA (terms in PSA)
  • Indiscriminate rate of services/consultancy fee charged regardless of staff experience or merit
  • Duplication of costs (often hard to detect in transfer pricing arrangements)
  • Insurance/captives overpriced from subsidiary in tax haven
  • Use of intangibles overpriced from subsidiary in tax haven
  • Loans and financing/funding from related companies/affiliates significantly above or below market rates
  • A mother company invoicing an affiliate for general assistance costs in a way that mixes the actual service costs with for example shareholder costs. Shareholder costs accumulate regardless of the affiliates and should therefor note be included in general assistance costs.

Where to learn more – tools and resources


OECD Transfer Pricing Guidelines. (needs Log In)







[1] Neighbour, J. (2002). Transfer pricing: Keeping it at arm’s length. OCED Observer. http://www.oecdobserver.org/news/fullstory.php/aid/670/Transfer_pricing:_Keeping_it_at_arms_length.html

[2] OECD (2014) Model Tax Convention on Income and capital: Condensed version. http://www.oecd-ilibrary.org/taxation/model-tax-convention-on-income-and-on-capital-condensed-version_20745419

[3] Mathiason, N. (2011). Piping Profits. Mapping the 6,038 subsidiaries owned by ten of the world’s most powerful Extractive Industry giants and the quest by Latin American journalists to find out more. Oslo: Publish What You Pay Norway. http://www.publishwhatyoupay.no/pipingprofits

[4] Pak, S. J., Zdanowicz, J. S. (2002). U.S. Trade with the World. Malvern/Miami: Trade Research Institute: http://www.oss.net/dynamaster/file_archive/040318/50b167ce2bb58f256cf8c2225aa4da82/OSS2003-01-09.pdf

[5] Ibid

[6] Ibid

[7] Ring fencing here refers to the segregation of different income streams for taxation purposes. A government may decide that companies must “ring fence” a given project or license, preventing companies from offsetting profits or losses against other projects and licenses and thereby reducing overall tax payments.

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