Understanding Transfer Pricing: Importance, impact and compliance

Transfer pricing rules play a crucial role due to the following reasons:

They help prevent the shifting of profits from one tax jurisdiction to another.
These rules ensure that the appropriate amount of income is subject to taxation in each jurisdiction.
If payments are excessively high in one country, profits may be shifted to another country.
Conversely, if profits are too low, they may be shifted from one country to another.
In the absence of transfer pricing rules, multinational enterprises (MNEs) could intentionally or unintentionally exploit transfer pricing to shift substantial amounts of profits between countries.

Impact of Transfer Pricing on the Financial Statements of MNEs:

Transfer pricing significantly affects various areas of an MNE's financial statements. The following sections outline how intercompany transactions influence each financial statement:

(a) Income statements:

Sales of intangible property, raw materials, finished goods, and traded goods.
Service fees covering payroll, legal, technical and advisory, tax, insurance, training, marketing, sales, research and development, management services, creativity and innovation, strategic intent, and direction, among others.
Rents and leases of intangible and real property.
Royalties for intangible assets, licenses of patents, trademarks, and technical know-how.
Dividends and loans.

(b) Cost of sales:

Purchases of tangible property, raw materials, work in progress, and finished goods.
Service fees encompassing payments for assembly or manufacturing services.
Production and machinery installation services.
Quality control and assurance services.
Maintenance and repair costs.

(c) Sales, general & administrative expenses:

Expenses related to human resources, marketing, sales, and research and development.
Rental payments for real property.
Royalties for intangible property and trademarks.
Service fees such as headquarter allocations for management, accounting, legal, tax, insurance, etc.
Interest income and expense on intercompany loans and lending.

(d) Balance sheet - Current assets & liabilities:

Intercompany accounts payable and receivable.
Short-term and long-term borrowings, loans, and lending.

(e) Intangible assets:

Use of brands, patents, trademarks, and goodwill.

(f) Long-term borrowing:

Intercompany borrowings.
External borrowing with the parent company as guarantors.

Laws Governing Transfer Pricing in Uganda (The Legal Framework):

Section 90 of the Income Tax Act and the Arms Length Principle form the legal framework governing transfer pricing in Uganda. This section ensures that transactions between related parties are conducted on an arms-length basis. It empowers the commissioner to distribute, apportion, or allocate income, deductions, or credits between or among related taxpayers to accurately reflect the income.

The commissioner also has the authority to adjust the income arising from the transfer or licensing of intangible property between associates so that it aligns with the income attributable to that property.

Article 9 of the OECD/UN Model Convention: The arms-length principle, the foundation of transfer pricing, is defined in paragraph 1 of Article 9 of the OECD/UN Model Convention. This principle serves as the basis for bilateral tax treaties. Its purpose is to ensure that if a taxpayer receives a transfer pricing adjustment in one country without obtaining correlative relief in the other country, double taxation on the adjustment amount is avoided.

Uganda has nine tax treaties with countries such as Denmark, India, Italy, Mauritius, Netherlands, Norway, South Africa, the United Kingdom, and Zambia. Additionally, Uganda has negotiated two tax treaties with Belgium and a tripartite tax treaty involving Kenya and Tanzania.

The Critical Role of Advance Pricing Arrangement (APAs) in Resolving Transfer Pricing Controversies:

Advance Pricing Arrangements (APAs) are formal arrangements on transfer prices made between taxpayers and tax authorities.
APAs facilitate the resolution of transfer pricing disputes by allowing taxpayers to negotiate with tax authorities.
APAs are particularly useful in avoiding transfer pricing disputes for complex issues, such as high-value intangibles (HTVI).
APAs provide certainty for a fixed period, mitigating the risk of double taxation in the future.
However, APAs involve costs and should consider the time value of money.

Potential Triggers for a Transfer Pricing Audit:

Various factors can trigger a transfer pricing audit, including:

Consistent loss-making or low-profit entities.
Significant advertising and marketing expenditures by manufacturing or distribution companies.
Non-maintenance of transfer pricing documentation or undocumented price setting mechanisms.
Business restructuring.
Transactions with related parties in low-tax jurisdictions.
Non-compliance with the global transfer pricing policy.
Specific transactions like management fees, financial transactions, royalty payments, cost-sharing agreements, among others.

The Arm's Length Principle is crucial for managing transfer pricing effectively. Companies should be aware that factors such as high interest rates, levels of related-party transactions, substantial related-party debt, insufficient or inappropriate attribution of profits to permanent establishments, and inconsistencies between the financials of legal entities and transfer pricing policies can lead to transfer pricing disputes with tax authorities.

It is essential to adhere to transfer pricing regulations and maintain accurate documentation to avoid transfer pricing audits and potential adverse effects on organisations.