Transfer Pricing Basics for SMEs

What transfer pricing is

Transfer pricing refers to the prices charged in transactions between related parties — a parent company and its subsidiary, two subsidiaries of the same group, or a company and its shareholder.

When two independent companies transact, the market determines the price. When two related companies transact, they can, in theory, set any price — creating an opportunity to shift profits from high-tax to low-tax jurisdictions.

Tax authorities are aware of this. Transfer pricing rules require that transactions between related parties occur at the "arm's length" price — the price that unrelated parties dealing at arm's length would charge for the same transaction.

Why transfer pricing matters to SMEs

Transfer pricing is often seen as a "big company" issue — and the most complex rules (CbCR, APAs, OECD documentation requirements) do primarily apply to large multinationals. But SMEs with international structures are also affected in some circumstances:

Intercompany loans: If your UK holding company loans money to your UAE subsidiary, the interest rate on that loan must be at arm's length — the rate an unrelated lender would charge for the same loan.

Management fees / service charges: If your holding company provides services to subsidiaries (management, IT, administration), the fee charged must reflect the market price for those services.

Royalties: If an IP holding company licenses IP to an operating subsidiary, the royalty rate must be at arm's length — what an unrelated licensor would charge.

Sales between group entities: If one group company sells goods or services to another, the price must reflect market rates.

The arm's length principle in practice

The OECD Transfer Pricing Guidelines (recognised by most countries as the reference framework) describe several methods for determining arm's length prices:

Comparable Uncontrolled Price (CUP): Find the price charged in an identical or similar transaction between unrelated parties. Most reliable but often no perfect comparable exists.

Cost Plus: Start with the costs of production and add an appropriate markup. Common for manufacturing and services.

Resale Price: Start with the price at which the product is resold to an unrelated customer and subtract an appropriate margin. Common for distribution.

Transactional Net Margin Method (TNMM): Compare the net profit margin of the tested party (one of the related parties) to the margin earned by comparable independent companies. Most commonly used method in practice — benchmarking studies using commercial databases (TP Catalyst, Orbis) provide comparables.

Profit Split: Split the combined profit of related parties based on their respective contributions. Used where both parties make unique contributions and a one-sided method is not appropriate.

Documentation requirements

Countries increasingly require formal transfer pricing documentation. At the OECD BEPS level, the three-tier documentation structure includes:

Master File: Overview of the MNE group's business, organizational structure, intangibles, financial activities, and tax positions.

Local File: Specific information for each country — intercompany transactions of the local entity, benchmarking analysis supporting arm's length prices.

Country-by-Country Report (CbCR): Data on revenues, profits, taxes paid and accrued, employees, and assets by country. Required for MNE groups with consolidated revenues ≥€750M.

For SMEs: Full three-tier documentation is only required above specific revenue thresholds (typically €750M for CbCR). But many countries require some level of contemporaneous documentation for intercompany transactions even below these thresholds. And in a tax audit, having documentation ready is far better than trying to reconstruct it afterwards.

Common SME transfer pricing scenarios

Scenario 1: UK holding company charges management fee to UAE subsidiary UK parent provides management services to UAE subsidiary. What's the right fee?

Approach: Document the services provided (what, how much time, what value). Research comparable management service fees in the market. Apply a cost-plus methodology: actual costs + reasonable markup (5–15% is common for service entities).

Keep records: service agreements, timesheets, evidence of services actually provided.

Scenario 2: Singapore company licenses software to Indian subsidiary Software developed in Singapore licensed to the Indian subsidiary for use in India.

Approach: The royalty rate should reflect what an unrelated company would pay to license equivalent software. Comparable royalty rates for software licenses can be found in royalty rate databases (ktMINE, RoyaltySource) or can be derived from industry benchmarks.

India imposes withholding tax on royalties paid to non-residents — the India-Singapore DTAA reduces the rate from 15% (domestic) to 10%.

Scenario 3: Netherlands BV lends €1M to German subsidiary Intercompany loan — what interest rate?

Approach: The interest rate must reflect what the German subsidiary would pay to borrow €1M from an unrelated bank, at the same terms, given its creditworthiness at the time of the loan.

Comparable rates can be determined using the company's credit rating (calculated using a credit rating tool or based on the group's rating), the market rate for similar debt (Bloomberg, Thomson Reuters), and the loan term and currency.

Keep documentation: loan agreement, credit analysis, benchmark analysis.

Consequences of non-compliance

Transfer pricing adjustments are one of the most common results of tax audits of international businesses. If a tax authority finds that related-party transactions were not at arm's length:

• Primary adjustment: Recharacterise the income — increase the profits of the entity in the tax authority's country and impose additional tax on the difference.
• Secondary adjustment: In some countries, the adjustment may also be characterised as a deemed dividend, management fee, or capital contribution — triggering withholding tax or other tax obligations.
• Interest and penalties: Applied on the underpaid tax, often from the date it should have been paid.
• Double taxation risk: If Country A increases Company A's profits, Company B's profits in Country B should decrease by the same amount. But Country B may not automatically make the corresponding adjustment — potentially resulting in the same income being taxed in both countries. A Mutual Agreement Procedure (MAP) between the two countries' competent authorities can resolve this, but it is time-consuming.