USASBE 2008 Proceedings - Page 0565
Cost of sales
Transfer pricing transaction (Transactions between cooperating companies):
Sales Cost of sales
Co. A 200 50
Co. B 200 200
Combined 400 250
Gross margin Tax
Arm’s length transaction:
The effect of the arrangement is to reduce the taxable income of Company A and to increase the taxable income of Company B; thereby, providing a decrease in the combined tax rate of the two enterprises.
A transfer pricing arrangement of this kind is deemed an illegal avoidance of tax. It creates an unrecorded and undisclosed liability for the unpaid taxes and related penalties that may be assessed against both companies.
A different (but not arm’s-length) transfer pricing arrangement is sometimes entered into to provide window-dressing for the benefit of prospective investors or out-of-country partners. This arrangement involves the sale of products to a controlled enterprise at inflated prices to overstate net income and thereby increase the stockholders’ equity in the firm. This kind of arrangement may also involve the sale of non-existent goods or goods not delivered to the buyer. Another form of transfer pricing involves selling products to a controlled firm at discounted prices to enhance the profits of the transferee firm.
Unfortunately, unethical and illegal transfer pricing has been and continues to be a significant problem in China because of its history of overlapping ownership by the government and by businessmen.
Historically, the focus has been on ensuring that the transfer pricing arrangements is compliant with the arm’s length principle. PriceWaterhouseCoopers recommends that taxpayers will need to be increasingly vigilant regarding their transfer pricing arrangements further down the supply chain, e.g. distribution and retail processes (PriceWaterhouseCoopers, 2007).