Transfer pricing sits at the intersection of tax and accounting, but it serves different objectives in each discipline. For tax, the primary purpose is to ensure that intercompany transactions are priced on an arm’s length basis; for accounting, the focus is how the intercompany transactions are recorded in the accounts and presented in the financial statements.

What is transfer pricing?

Transfer pricing legislation requires that intercompany transactions are conducted on an arm’s length basis, so that group entities are remunerated in line with the value they contribute to the transaction.

In practice, this means that the profits arising from intercompany transactions should be consistent with those that would have arisen had the same transactions taken place between independent parties dealing at arm’s length.

In the UK, certain small and medium-sized enterprises (SMEs) may be exempt from preparing formal transfer pricing documentation, although they remain subject to the arm’s length principle and should retain sufficient records to support their intercompany arrangements.

For further information on transfer pricing, please see here.

How does transfer pricing work for tax purposes?

For tax purposes, the primary objective of transfer pricing is to ensure that profits are allocated between group entities as they would have been between independent parties dealing at arm’s length. In practice, this requires each group entity to be appropriately remunerated for the functions it performs, the assets it employs and the risks it assumes.

Where the pricing of intercompany transactions differs from the arm’s length standard, tax authorities may adjust taxable profits of the relevant entities to reflect the profits that would have arisen had the transaction taken place between independent parties under comparable circumstances.

In the UK, transfer pricing adjustments generally arise where a non-arm's length provision results in a UK tax advantage, leading to taxable profits being understated or tax losses being overstated.

A corresponding adjustment may also be made to a disadvantaged party, ensuring that the transfer pricing correction applied to one entity is appropriately reflected in the tax position of the counterparty, thereby mitigating the risk of double taxation.

Accordingly, transfer pricing analysis focuses on identifying the economic substance of intercompany arrangements – typically through a functional analysis of the parties involved - to determine which entity creates value within the group and to establish an arm’s length reward for those activities. The principles apply across a broad range of transactions, including the provision of goods, services, financing, intellectual property and management support activities.

How does transfer pricing work for accounting purposes?

For accounting purposes, the focus is on how intercompany transactions are recognised, measured and presented in the financial statements. This involves ensuring that transactions between group entities are recorded in the accounting records in accordance with the relevant accounting framework, such as UK GAAP or IFRS, and that any related balances, income, expenses, assets or liabilities are appropriately reflected in the statutory accounts.

Unlike the tax transfer pricing analysis, the accounting perspective considers how the actual transaction has been recorded and whether the resulting financial statement presentation is appropriate. This includes considering the nature of the transaction, the contractual position between the parties, the amounts recognised in each entity’s accounts, and whether any related party disclosures are required.

Importantly, a transaction is not automatically considered arm’s length simply because it has been recognised in the financial statements. Transfer pricing analysis may require the tax treatment of a transaction to be assessed separately from its accounting treatment. Accordingly, a transaction may be correctly accounted for under the relevant accounting standards but still require transfer pricing review to determine whether the pricing reflects arm's length conditions.

For example, a UK company may provide management support services to its overseas subsidiary and record a £100,000 service fee in its accounts. From an accounting perspective, the focus is whether the income and corresponding expense have been properly recognised and disclosed. From a transfer pricing perspective, the key question is whether £100,000 reflects an arm's length charge for the services provided. Even where the accounting treatment is correct, a transfer pricing adjustment may be required if the charge does not reflect market conditions.

Under IFRS, IAS 24 Related Party Disclosures requires entities to disclose material related party relationships, transactions and balances. Similar disclosure requirements also exist under UK GAAP.

Whilst intercompany transactions are recognised in the individual statutory accounts of each group entity, they are generally eliminated on consolidation to ensure the consolidated financial statements present the group as a single economic entity.

Client responsibilities and management decisions

In applying a transfer pricing policy, there are several key decisions that should be made and confirmed by management, albeit with guidance from transfer pricing tax specialists.

Management should first confirm the functions performed, assets used and risks assumed by each relevant entity. A functional analysis is therefore fundamental to characterising each entity for transfer pricing purposes, for example as a routine service provider, limited risk distributor or residual profit entity.

Management will also need to decide which transfer pricing methodology best reflects the commercial and economic substance of the group’s arrangements. The available methodologies include:

• Comparable uncontrolled price (CUP);

• Resale price method (RPM);

• Cost plus method (CPM);

• Transactional net margin method (TNMM); and

• Profit split method (PSM).

Once a methodology has been selected, management will need to decide the practical basis on which each entity is remunerated. This may include agreeing the relevant mark-up, margin, profit split percentage or other allocation mechanism.

Benchmarking compares prices or profit margins from related-party transactions against comparable transactions between independent parties. This helps establish an arm’s length range, which supports the group’s transfer pricing policy.

Governance of transfer pricing arrangements

Given the interaction between tax, accounting and commercial decision-making, transfer pricing should be viewed as part of the wider governance of a group’s intercompany arrangements. A clearly documented and regularly reviewed policy can help ensure that intercompany transactions are priced on an arm’s length basis, appropriately reflected in the accounts and supported by robust contemporaneous evidence, should HMRC seek to review the position.

How Buzzacott can help

Our Business Tax team can help you establish and maintain a robust governance framework around your group’s transfer pricing arrangements. Get in touch via the form below to discuss how we can support you.