You can always find a lot of relevant information in the history of transactions between related parties. If we know there will probably be related-party transactions, we need to think about pricing in advance. This briefly sums up the content and essence of our article, focusing on the importance and relevance of TP policy.
In our previous article we looked at transfer price documentation, which companies have a statutory obligation to prepare. Ideally, however, TP policy or directives are prepared much earlier along with intercompany policies, in which we can define the pricing principles and methods within the group.
Why is TP policy useful?
Planning is a key element in the life of a company: when preparing business plans the owners and the management “dream up” what they would like to achieve within a few years, including levels of sales revenues and profit. If a group consists of several related companies doing business with each other, it is worth looking at the pricing applied in their transactions. Depending on the size of transactions between the parties, pricing can have a significant impact on the sales revenues and profits of subsidiaries. If we plan the pricing of related-party transactions, we can then apply the rules consistently and refer to them during price negotiations.
What should the principles contain?
If TP policy is prepared, the most important chapter should definitely be a detailed breakdown of the various types of transaction. For example, financing (e.g. loans, cash-pool agreements), purchasing raw materials and selling semi-finished and finished products within the group are key aspects for a manufacturing group. We should not forget about services provided at group level either that do not fall directly under the main profile, and in many cases come from the “head office”, but they facilitate day-to-day operations (e.g. SAP subscriptions).
Once we have identified each type of transaction, we should set prices for each of them. Pricing can be based on generally accepted principles, for example, in the case of loans, connecting transactions to the variable interest rate determined by market mechanisms (such as the EURIBOR). For raw materials used during manufacturing as well as semi-finished / finished products, prices should be set in line with market trends at arm’s length prices. This can be determined based on a price list used for independent parties, revenues defined on a cost basis, or even based on profitability ratios that take particular market features into account.
How can TP policy be useful for us later on?
At the end of the financial year, when we prepare the transfer pricing documentation before filing our corporate tax return, we need to analyse a great deal of data and information. The rules can be really useful during this brief period covering a few months, where we have already set the prices to be applied within the group. If the planned transfer prices are close to the market prices during the preparation of the principles, we can simply copy a significant part of the rules into the transfer pricing documentation. The documentation, of course, needs to be completed with the statutory content.
Based on the above we recommend that the competent people in the group should prepare TP policy, since they can be used as a preliminary checkpoint for transfer pricing as well. We can identify pricing problems during the planning process and correct them, thereby avoiding the need for an ex post tax base correction that may be required for the sole reason that we failed to revise prices properly in advance.