Why transfer pricing is critical for the world’s premier tech hubs

The foundations of global tax systems are in flux, changing companies’ risk profile – especially where transfer pricing is concerned.

In a deep-dive insight article, BDO’s Laurie Dicker and Dan McGeown detail how transfer pricing tops the complexity scale for tax issues:

Source: Spotlight on Transfer Pricing - Identifying complexity and areas of risk/Global MNC Tax Complexity Survey. Table: BDO Global

Furthermore, BDO’s latest Tax Outlook Survey in the US shows that 73% of tax executives have seen total tax liabilities have increased in the last 12 months. 70% expect liabilities to rise in the coming 12 months.

Transfer pricing is especially challenging for many technology start-ups and companies found in the world’s premier tech hubs, influencing companies’ ability to pursue growth opportunities, build out company structures, and their attractiveness to prospective investors.

What is transfer pricing?

Transfer pricing refers to the rules and regulations that govern the pricing of goods, services, loans, or intellectual property (IP) (for example, technology licenses or marketing intangibles) between related entities.

Authorities look to protect such exchanges against tax-base erosion and expect the transfer prices to adhere to the so-called arm’s length principle. This means that exchanged goods, services, or IP should be priced in a way that matches what an independent third party would charge.

Individual jurisdictions have different tax rates and rules that govern transfer pricing. The differences can include documentation requirements. Furthermore, the related parties are treated as legally separate, complicating tax liabilities and audit requirements – especially if the companies operate in different countries with different tax rules and rates.

Transfer pricing and IP

For technology start-ups, scaleups, and mature entities, transfer pricing will likely be an issue that arises in connection with expanding into new territories, raising growth capital, or related to M&A activities.

As detailed in BDO’s Spotlight on Transfer Pricing - Identifying complexity and areas of risk, transfer pricing creates complexity across many tax-related business processes.

Source: Spotlight on Transfer Pricing - Identifying complexity and areas of risk/Global MNC Tax Complexity Survey. Table: BDO Global

One of the prime concerns and challenges will likely be calculating the IP’s transfer price.

IP generally refers to patents, trademarks, copyrights, and trade secrets. It is often sold or transferred between parties in licensing agreements.

There are several methods to calculate the value of a transfer between related entities, also covering IP, including:

  • The Comparable Uncontrolled Price Method (CUP): compares the cost of a transaction between two related entities with comparable transactions between two unrelated parties.
  • The Resale Price Method (RPM): uses the resale price of a product or service, reduced with a calculated gross margin.
  • The Cost-Plus Method (CPLM): compares gross profits to the overall sales costs with an added, market-based markup.
  • The Comparable Profits Method (CPM): looks at the net profit of a controlled transaction between associated enterprises, which is compared to net profits of comparable uncontrolled transactions between independent enterprises.

Each method has its advantages and applications. Therefore, the advice is to consult with transfer pricing experts on which may be best for a company’s situation.

How transfer pricing influences M&A and growth capital

For tech hubs and the companies within them, transfer pricing directly influences growth ambitions.

Transfer pricing rules will directly influence new ventures outside of the company’s national market in the different legislations.

Suppose a company is looking to secure growth capital from outside investors. In that case, the investors will also want to know how said growth will be influenced by growing financial complexities, including transfer pricing.

Investors looking to acquire one or more companies located in a tech hub may view complications due to transfer pricing structures as a reason to lower their offering price – or call off the potential deal.

For example, if a private equity (PE) investor is interested in a scaleup company looking to combine it with several other companies located elsewhere in a bolt-on deal, the PE may look at the applicable transfer pricing rules and regulations – or the company’s transfer pricing setup - and decide the investment will be complicated or likely to miss the desired economic upsides due to transfer pricing issues.

One lesson is that creating clear, easy-to-navigate transfer pricing structures is pivotal for a region’s ability to create a national, regional, or international tech hub.