What are transfer prices and which companies do they apply to?

Companies often believe that transfer pricing does not apply to them, as it is only applicable to large multinational corporations. However, in reality, transfer pricing affects significantly more companies than it might initially seem.

Transfer prices are the prices at which related companies trade with each other. Transfer pricing regulation exists at the level of each country, as tax laws and revenues fall under the jurisdiction of each state. Countries must ensure that companies do not distort transaction prices to artificially shift profits to countries with lower tax rates, thereby eroding the local tax base. This control applies only to related companies because the market mechanism does not function fully between them – the transaction price may be determined based on internal group interests rather than market conditions. It is precisely this potential for profit shifting that is the reason why states regulate transfer pricing between related parties by applying the “arm’s length principle.” Transfer pricing affects not only the sale of goods but also services, loans, lease agreements, etc. If transfer prices are not set correctly, a company may face tax adjustments, penalties, and even reputational risks.

In today’s globalized economy, companies expand and restructure with the aim of achieving the highest possible profit, resulting in companies operating in several countries simultaneously. For instance, a company manufactures products in Latvia but sells them through its companies abroad – in Germany, Denmark, Great Britain, or elsewhere – while its management is located in yet another country. Such practice is a natural part of business development; however, it creates risks that income may “disappear” between several countries. It is in these situations that transfer pricing plays a significant role.

A transfer price is any value or terms applied in transactions between related parties – regardless of whether they relate to goods, services, or financial transactions. This is best illustrated by the example of the company SIA “Kociņš”.

Suppose there is a company, SIA “Kociņš”, which is a furniture manufacturer in the Aizkraukle region, but it has a subsidiary, KisFa Kft., which handles furniture sales to end customers in Hungary. When SIA “Kociņš” supplies furniture to KisFa Kft., SIA “Kociņš” issues an invoice to its subsidiary. So far, it would be simple – the furniture is produced in Latvia and sent to Hungary, but at what price?

However, this is exactly where the question arises – how to determine the price for such a transaction between related companies? Since both parties are related, there is no guarantee that the price reflects true market conditions. To ensure that the transaction is fair and that the distribution of profit between countries is not artificially influenced, the arm’s length principle is applied.

The arm’s length principle means that in transactions between related companies, the same conditions are applied as would exist between two completely independent companies in the market.

Namely, in this case, the selling price is not determined arbitrarily — it is also a transfer price. A price that would be the same as what an unrelated Hungarian company would pay to purchase furniture from the Latvian manufacturer.

If related companies engage in mutual transactions, then legal norms impose an obligation to prepare transfer pricing documentation. Transfer pricing documentation includes the master file, local file, and simplified documentation, as well as the country-by-country report for international corporate groups.

Transfer pricing documentation can include several parts, and the obligation to prepare a specific volume of documentation depends on the volume and structure of the company’s transactions. The master file (global documentation) summarizes information about the entire international group of companies as a whole — its structure, functions, risks, and transfer pricing policy at the group level. The local file, on the other hand, relates to the specific taxpayer and its controlled transactions, including detailed information on the pricing method and comparative data analysis.

In this context, the question often arises whether transfer pricing regulations also apply to cases where all companies involved in the transaction are Latvian residents. Even in such situations, transfer pricing principles are applicable, as the legislator’s goal is to ensure that any transactions between related parties are conducted in accordance with market conditions. Therefore, the obligation remains to control transaction prices and ensure that related companies interact with each other as two independent market participants would.

Why must the price comply with the arm’s length principle?

The aforementioned arm’s length principle is an internationally accepted criterion used to ensure that transactions between related parties occur under the same conditions as would exist between two independent companies. If SIA “Kociņš” sells to its related company at too low a price that does not comply with the arm’s length principle, then all profit from the furniture sales will remain in Hungary (any country could be inserted here; the focus is not on the specific country), where theoretically there may be a lower tax burden than in Latvia. Conversely, from the perspective of the Latvian tax administration, it will appear that furniture production is being carried out at a loss or with minimal profit, thus the taxes collected will also be minimal. This is not quite fair to the Latvian budget, and it must be acknowledged that recently, Corporate Income Tax (CIT) control has become the No. 1 priority for the State Revenue Service (SRS), which is why such and similar cases are carefully monitored.

In Latvia, several types of sanctions are applied for non-compliance with the arm’s length principle:

1. CIT adjustment. If the SRS concludes that the price applied in transactions does not fall within the market price level, the difference is added to the CIT taxable base. The CIT rate is 20/80 of the taxable amount; therefore, every unjustifiably “lowered” EUR 100,000 transaction can cost the company an additional EUR 25,000 in taxes.
2. Fines. For the application of inappropriate prices and non-compliance with the arm’s length principle, a fine of up to 1% of the value of the controlled transaction may be applied. For example, if transactions are carried out for EUR 5 million, the fine can reach up to EUR 50 thousand.
3. When a decision is made regarding a violation of the requirements for preparing transfer pricing documentation provided for in regulatory acts in accordance with Section 15.², Paragraph 14 of the Law “On Taxes and Duties”, the taxpayer’s obligation to submit transfer pricing documentation remains, as does the tax risk. The making of a decision does not deprive the SRS of the right to perform tax control or a tax audit to determine the amount of additional taxes to be paid, late payment interest, and fines.

Price?

When discussing transactions between related parties, the word “price” within the term “transfer price” often creates a misconception that it only applies to buy-sell transactions. However, this perception is incorrect. Buying and selling is only one type of transaction that can exist between related companies. Any transaction between related parties can be considered an object of transfer pricing if it affects the company’s profit or costs.

Who are related parties? A full list of related parties is set out in Section 1, Paragraph 18 of the Law “On Taxes and Duties”. However, in practice, transfer pricing issues are most often encountered by companies whose structure includes the following types of related parties:

1. parent and subsidiary companies, sister companies;
2. board members or owners who control more than 20% of the equity shares;
3. companies with common owners;
4. companies in which a natural person or their spouse or relative owns more than 50% of the value of the company’s share capital or has a decisive influence in the company.

Is a loan being issued to a board member who owns more than 20% of the equity shares? Such a transaction also qualifies as a related party transaction, and in this case, it is also necessary to justify and document the applied loan interest rate to prove its compliance with market conditions.

Renting premises from a subsidiary – a related party transaction. Providing management, IT, or other consulting services – a related party transaction. Purchasing goods between related companies – likewise a related party transaction.

Namely, all transactions carried out between related companies must comply with the arm’s length principle, or as it is also known – the market price principle. It will not always be specifically prices; it can be an interest rate, profit margin, markup, etc.

What to do?

If a company’s structure is designed such that transactions with related parties occur, it must be possible to prove that these transactions were carried out in compliance with the market price principle. In certain cases, there is an obligation to prepare transfer pricing documentation and submit it upon request from the State Revenue Service.

The table below summarizes the criteria under which the preparation of transfer pricing documentation is mandatory. However, even in cases where a company does not meet all the specified criteria, this fact does not exempt it from the obligation to conduct transactions with related parties at prices that comply with the arm’s length principle. In other words, even if there is no direct obligation to prepare documentation, it must still be ensured that transaction prices correspond to market levels.