A substantial share of world trade happens between parts of the same company. The prices used in those transactions are set internally, and they decide which country taxes the profit.
Why internal prices determine where profit lands
A subsidiary in one country sells components to an affiliate in another. The price charged is revenue for the first and cost for the second.
Raising that price moves profit toward the selling country and away from the buying one. Nothing about the underlying business changes.
Where tax rates differ, the group has an incentive to set prices that place profit in the lower-rate jurisdiction. Transfer pricing rules exist to remove that discretion.
The standard the rules apply
The general principle requires related parties to transact as independent parties would in comparable circumstances. The internal price must approximate a market price.
Applying this requires finding comparable transactions between unrelated firms, which is straightforward for commodities and very difficult for specialised components or internal services. Much of the dispute concerns comparability rather than principle.
Several accepted methods exist, based variously on comparable prices, cost plus a margin, resale price or the division of overall profit. The choice of method frequently determines the outcome.
Why intangibles are the hardest case
Brands, patents and software have no obvious market price and can be held anywhere. Licensing them between affiliates moves large amounts of profit through royalty payments.
Rules have increasingly focused on where the functions creating and managing the intangible actually take place. Legal ownership alone is treated as insufficient to attract the return.
Establishing where development, enhancement and control genuinely occur is evidence-intensive. Documentation of decision-making has become as important as the contracts.
What companies must document
Groups above defined thresholds generally prepare a description of the global business, detailed local files for each entity and a summary of income and taxes by country. The requirement is to explain, in advance, why prices are defensible.
Country-level reporting is shared between tax administrations under exchange arrangements. Authorities therefore see the group's global picture rather than only their own slice.
Thresholds, formats and filing deadlines differ by jurisdiction and are periodically revised. Non-compliance carries penalties independent of any adjustment.
How disputes are resolved
If one country adjusts a price upward, the same profit is taxed twice unless the other country makes a corresponding reduction. Treaty procedures exist to negotiate that outcome between administrations.
These procedures can take years, during which the tax may be payable. Advance pricing agreements offer certainty prospectively by agreeing a method before transactions occur.
Availability and duration of such agreements vary between jurisdictions, and the underlying rules continue to develop through international coordination.