Transfer pricing in international operations

In a globalized world, multinational companies carry out business operations between their different subsidiaries located in various jurisdictions. In this context, the correct setting of prices in transactions between related entities, known as “transfer pricing“ or “transfer prices”, is fundamental to ensure fair taxation and avoid practices that could be considered tax avoidance or evasion. On paper, this would be the universal legal concept of transfer pricing, although in practice each person and state applies their respective ideologies and economic policies.

The main objective of transfer pricing regulations is to ensure that transactions between related companies are conducted under the “Arm’s Length Principle”, commonly referred to in English as “arm’s length”, meaning under conditions equivalent to those that would be present between independent companies in similar circumstances. The correct application of these regulations not only allows compliance with the tax obligations of each country but also reduces legal risks and avoids significant penalties from tax authorities.

In this article, we will explore together the international regulatory framework, documentation obligations in Spain and globally, as well as a practical and hopefully educational example that illustrates the importance of proper compliance with transfer pricing.

International regulatory framework

Transfer pricing rules are regulated internationally by:

OECD Guidelines: The Organization for Economic Cooperation and Development (OECD) sets the governing principles, especially the “Arm’s Length Principle” (Arm’s Length Principle).
BEPS Actions (Base Erosion and Profit Shifting): An OECD and G20 initiative aimed at preventing tax avoidance through transfer pricing manipulation strategies.
National regulations: Each country adopts its own legislation, generally based on OECD guidelines.
UN Regulations: Includes specific recommendations for developing countries.

Arm’s length principle and applicable methods

The arm’s length principle establishes that transactions between related companies must be conducted under conditions similar to those between independent companies. To determine whether a transaction complies with this principle, recognized methods are applied, including:

Comparable Uncontrolled Price Method (CUP – Comparable Uncontrolled Price Method): Compares the price of the controlled transaction with the price of comparable transactions between independent parties under similar circumstances.
Resale Price Method (RPM – Resale Price Method): Based on the price at which a product is sold to an independent third party, deducting an appropriate profit margin to determine the purchase price between related companies.
Cost Plus Method (CPM – Cost Plus Method): Adds a profit margin to the production cost of a good or service, ensuring the margin reflects that which would be applied in transactions between independent parties.
Profit Split Method (PSM – Profit Split Method): Distributes profits generated by a transaction between the involved parties based on the value each has contributed.
Transactional Net Margin Method (TNMM – Transactional Net Margin Method): Assesses the net profitability of the transaction relative to an appropriate base (such as sales, costs, or assets) and compares it to that of independent companies.

Documentation and compliance obligations

Multinational companies must comply with strict documentation requirements, including:

Master file: Describes the corporate group structure and its transfer pricing policies.
Local file: Details the operations of the resident entity and the application of transfer pricing.
Country-by-Country Report (CbC Report): Requires detailed financial information from all entities within the group.
Specific filings with the Spanish Tax Agency: Forms such as Model 232 must be submitted. Obligations under Corporate Tax (IS) and VAT.

Model 232 covers the following operations:

Specific transactions: Related operations exceeding 100,000 euros, including sales of properties, shares, or intangible assets.
Significant transactions: Related operations that, applying the same valuation method and category, represent more than 50% of the company’s turnover, regardless of the individual amount of each.
Patent box incentive: Operations where the tax reduction for the transfer of patents or other intangible rights has been applied, regardless of the transaction amount.
Operations in low-tax jurisdictions: Transactions conducted with entities located in countries or territories classified as tax havens, regardless of amount and regardless of whether there is a relationship between parties.
Transfer pricing justification: Demonstrate that prices comply with the arm’s length principle.

Obligation to report to the AEAT in Spain

In certain cases, it is not enough to just properly value transactions, following the arm’s length principles and OECD guidelines; it is mandatory to prepare a detailed dossier covering the nature and valuation assigned to these transactions, justifying that this valuation corresponds to what independent parties would pay under similar conditions, when the amount of related-party transactions exceeds 250,000 euros in total.

In the case of corporate groups or large companies, if turnover exceeds 45 million euros, the country-by-country report is required.

For specific transactions considered high risk, such as those conducted with tax havens or high-value intangible assets, documentation requirements are stricter regardless of amount.

Globally, although each country imposes its own regulations, most follow OECD guidelines, requiring exhaustive documentation and reporting of intercompany operations, the well-known “intercompany agreements.”

Practical case of transfer pricing

Consider a multinational group that I just made up, ElectroGlobal Holding, a really catchy name, headquartered in a country with a favorable tax regime. Under this holding company, the following operating entities exist:

ElectroGlobal Ireland (EG Ireland): Responsible for software and technology development.

ElectroGlobal USA (EG USA): Subsidiary that manufactures and sells the final products.

ElectroGlobal Spain (EG Spain): Responsible for distribution in the European Union.

The holding company, ElectroGlobal Holding, centralizes the group’s financial and strategic management, controlling transfer pricing policies. EG Ireland sells intellectual property to EG USA for €500 per unit, while EG USA sells products to EG Spain for $850 per unit. Due to currency conversion and the holding’s location in a low-tax jurisdiction, tax authorities may analyze whether profits have been artificially shifted to reduce the taxable base in the USA and Spain and scrutinize the holding’s billing policies.

For these operations to be fiscally correct and comply with the arm’s length principle, the following must be considered:

Use of Advance Pricing Agreements (APA): Obtain prior validation from tax authorities on the transfer pricing methods applied.
Fair determination of intellectual property value: In the case of selling software and other intangible assets, apply valuation studies to justify the transfer price.
Ensure adequate margins for the Holding: The holding company must receive fair compensation according to its real role in the group structure.
Avoid undercapitalization: Ensure subsidiaries do not excessively rely on internal loans with interest rates not aligned with the market or without interest.
Consistent application of comparison methods: Select the most appropriate method and apply it uniformly across all operations.
Preparation of transfer pricing reports to define market mark-ups.

Possible tax adjustment:

For example, if US tax authorities determine that the fair price of the software should be €200 instead of €500, they could make an adjustment and charge additional taxes on the €300 difference per unit and potentially impose additional penalties.

In Spain, if the Tax Agency considers EG Spain’s distribution margin artificially low to reduce its tax burden, it could make an adjustment and regularize its Corporate Tax obligations.

Currency Differences:
- Since EG Ireland invoices in euros (€) and EG USA and EG Spain in dollars ($), market exchange rates must be applied to ensure prices reflect the real value of transactions and do not generate artificial profits due to currency differences.

Non-compliance with transfer pricing regulations may result in:

Tax adjustments by tax authorities.
Significant fines for documentation non-compliance.
Double taxation in the event of tax disputes between jurisdictions.

In Spain, fines for lack of documentation can reach 15% of the adjustments made under Corporate Tax.

Additional fines for failure to submit required documentation on time and correctly can range from €1,000 to €10,000 per omitted or incorrect item in Model 232.

Transfer pricing: conclusions

Proper compliance with transfer pricing regulations is essential for multinational companies to operate within established legal frameworks and avoid tax risks.

Some key points are highlighted below:

Transparency and documentation: Proper preparation and maintenance of transfer pricing documentation is fundamental to justify pricing policies to tax authorities and minimize risks of tax adjustments.
Risk management: Non-compliance can lead to significant penalties, tax adjustments, and fines affecting company profitability and reputation.
Tax planning: Transfer Pricing should not only be seen as a legal obligation but as a business strategy to optimize the group’s tax burden and ensure equitable profit distribution among jurisdictions and avoid double taxation.
Importance of advance agreements: The execution of Advance Pricing Agreements (APA) and use of dispute resolution mechanisms such as Mutual Agreement Procedures (MAP) can help reduce tax uncertainty and avoid conflicts with tax authorities.
Since transfer pricing regulations are constantly evolving, it is key for companies to stay updated and adapt their policies to new regulatory requirements.

In conclusion, proper application of transfer pricing regulations is not only a legal requirement but also a good business practice to ensure financial stability, reduce tax risks, and apply fair taxation policies in today’s globalized environment.

At Metricson, we have a specialized team in transfer pricing that can analyze all your company’s related-party operations, ensuring compliance with all fiscal and regulatory obligations.

Our services include:

Evaluation and application of the most appropriate valuation methods for each type of transaction.
Preparation of mandatory documentation required by the Tax Agency and other international tax bodies.
Assistance in filing reports such as Model 232, Local File, Master File, and CbC Report.
Drafting of Intercompany Agreements.
Implementation of tax strategies to optimize tax burden within the legal framework.
Representation in tax audits and dispute resolution related to transfer pricing.

If you want to contact us, do not hesitate to write to us at contacto@metricson.com. We look forward to talking with you!

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