Categories of inter-company transfer

Inter-company transactions take place through transfers of tangible and intangible property, the provision of services, as well as inter-company financing, rental and leasing arrangements, or even an exchange of, for example, property for services or the issue of sweat equity. It is important to note that it is the substance of the situation that always determines whether a transaction has taken place, rather than whether an invoice has been rendered. For instance, management services may be delivered through the medium of a telephone call between executives of a parent company and its subsidiary. In this example, a service has been performed that the provider had to finance in the form of payroll costs, phone charges, overheads, etc and the service itself is of value to the recipient in the form of the advice received. As a result, a transaction has taken place for transfer pricing purposes even though, at this stage, no charge has been made for the service. Transfer pricing rules typically require related entities to compensate each other appropriately so as to be commensurate with the value of property transferred or services provided whenever an inter-company transaction takes place. The basis for determining proper compensation is, almost universally, the arm’s- length principle.

The arm’s-length principle

Simply stated, the arm’s-length principle requires that compensation for any inter- company transaction conform to the level that would have applied had the transaction taken place between unrelated parties, all other factors remaining the same. Although the principle can be simply stated, the actual determination of arm’s-length compensation is notoriously difficult. Important factors influencing the determination of arm’s-length compensation include the type of transaction under review as well as the economic circumstances surrounding the transaction. In addition to influencing the amount of the compensation, these factors may also influence the form of the payment. For example, a given value might be structured as a lump-sum payment or a stream of royalty payments made over a predetermined period. This chapter summarises the various types of inter-company transfers and the principles that may be applied to determine the proper arm’s-length compensation for these transactions. The application of the arm’s-length principle is discussed in detail in Chapters 3 and 4. ‘sales of tangible property’ can include all the machinery and equipment employed by businesses in their day-to-day activities as well as the goods they produce.

Sales of machinery and equipment

Machinery and equipment is frequently provided to manufacturing affiliates by the parent company. For example, this may be a means of providing support to an existing subsidiary or it may be in the form of the sale of complete manufacturing lines to a new company in a ‘greenfield’ situation. The equipment may have been purchased from an unrelated company, manufactured by the parent or might be older equipment that the parent (or another manufacturing affiliate) no longer needs. Tax rules generally require that the transferor of this equipment (whether new or used, manufactured or purchased) should receive an arm’s-length consideration for the equipment. This is generally considered to be the fair market value of the equipment at the time of transfer. While the tax treatment of plant and machinery transfers is generally as described above, there can be circumstances where an alternative approach might be adopted. Such circumstances usually arise in connection with general business restructuring or, perhaps, when a previously unincorporated business (or an overseas branch of a company) is transferred into corporate form. A number of countries offer arrangements in their domestic law or under their treaty network to defer the tax charges that might otherwise arise as a result of an outright sale of assets at their fair market value. Another possibility to consider is whether there are any tax implications arising from the transfer of business as a whole, which is to say, the bundling of assets, related liabilities and goodwill or intangibles, as against the transfer of assets such as plant and machinery on a piecemeal basis.

Sales of inventory

Sales of inventory generally fall into three categories: sales of raw materials, sales of work in progress and sales of finished goods. Goods in each of these categories may be manufactured by the seller or purchased from third parties. Tax rules typically require that arm’s-length prices be used for sales of inventory between affiliates. Ideally, arm’s-length compensation is determined by direct reference to the prices of ‘comparable’ products. Comparable products are very similar, if not identical, products that are sold between unrelated parties under substantially similar economic circumstances (i.e. when the market conditions affecting the transactions are similar and when the functions performed, risks borne and intangible assets developed by the respective unrelated trading parties coincide with those of the related parties).


Assume that Widgets Inc. (WI), a US company, manufactures and sells in Europe through a UK subsidiary, Widgets Ltd. (WL). WL manufactures one product, Snerfos, using semiconductor chips that are produced by WI, transistors purchased by WI through a worldwide contract and packaging material that WL purchases locally from a third party. In addition, a testing machine, which is proprietary to WI, is supplied by WI.


Source: PWC