Transfer pricing is how multinational companies with offices in different countries decide what to charge each other for products and services. For example, a US parent company might charge its office in Europe for using its software or developer resources.
Tax authorities scrutinize these deals carefully, because they want to ensure companies aren’t trying to evade taxes by moving their profits to countries with a lower tax rate.
Software as a service (SaaS) companies, especially, need to pay close attention to the fairness of their transfer pricing practices, because often the value of the company–such as intellectual property, research & development, or global support services–are concentrated in one country while serving customers globally.
This guide will explain what transfer pricing is and what SaaS companies need to know in order to stay compliant.
What Is Transfer Pricing? (Definition & Basics)
Transfer pricing refers to setting fair prices when different parts of the same company do business with each other. For example, say a US company pays its Dublin office for software development, or if that Dublin office pays the US headquarters for using their brand name. These aren’t transactions on the public market. Instead, they’re “transfers” between different parts of the same or a closely interrelated company.
Without rules, companies could easily set these prices too high or low and artificially shift the tax burden to a country or jurisdiction with lower taxes. To avoid this tax trouble, companies use the “arm’s length principle” when it comes to transfer pricing between related companies.
This is an internationally accepted standard that requires that prices charged between related parties reflect the standard pricing as if the transaction was between unrelated parties. In other words, if the US branch pays the Dublin branch for developer services, they should pay about the same as they would to an outside, non-related company for the same work.
Why the arm’s length principle? If a company sets prices artificially low or high, it can shift all its profits to countries with lower taxes. Tax authorities consider strategies like this to be manipulation, and have enacted internationally agreed-upon rules to prevent this and ensure each jurisdiction receives their fair share of tax money.
Why SaaS Teams Should Care
SaaS companies face more scrutiny than traditional manufacturers of goods because they mainly deal in intangible assets like:
- Intellectual property licenses - This includes platform IP, proprietary algorithms, and software licenses that may be used by workers in multiple countries
- Support or development services - Administrative functions, such as when a subsidiary in Asia provides marketing or customer support help in a related-party transaction for another subsidiary in Europe
- Intercompany recharges - This includes development and personnel costs and infrastructure expenses
While each country makes their own tax laws, most follow guidelines set by the Organisation for Economic Co-operation and Development (OECD) to apply careful scrutiny to these types of arrangements. They’re on the lookout for “profit shifting” schemes that may deprive a jurisdiction of their rightful tax revenue.
How Transfer Pricing Works (for SaaS)
Multinational SaaS companies generally work together in a few common ways.
Common SaaS Intercompany Flows
- Software licensing - A US-based company creates the platform then licenses it to a subsidiary in Brazil. The Brazilian subsidiary pays royalties back to the US.
- Development services - An engineering team in Colombia builds features for the whole company. They charge the other entities in the US, Brazil, South Africa a markup for using their work.
- Sales and marketing - Local specialist teams handle customers in their own regions. They keep most of the revenue, but may pay fees to use the company name, logo, or other marketing materials.
- Loans - One entity might loan another entity money in order to expand. In this case, the interest rate must be similar to what a bank would charge.
This is not an exhaustive list of how related entities work together across borders, but does represent common ways that SaaS companies work together. In order to apply the correct transfer pricing, you must understand who owns which assets, who performs which functions, and who takes what risks? Knowing this information is all crucial when determining transfer pricing.
Accepted Methods (Pick the “Best Method”)
There are five main ways to set transfer prices according to the arm’s length principal:
- Comparable Uncontrolled Price (CUP) – Compare your price to what other unrelated companies charge for similar things. This works for support services but is hard when it comes to unique assets like SaaS IP.
- Cost Plus Method – Take the cost of providing a service and add a reasonable profit. This works well for research, development, and support services.
- Resale Price Method – Start with the price charged to customers and subtract a fair amount. This might be used when selling to offices that don't add much value.
- Transactional Net Margin Method (TNMM) - This is usually the most useful for SaaS companies. It compares profit margins with other similar companies.
- Profit Split Method - Split profits based on how much each office contributed to creating the product or service.
In the US, businesses are required to use the “best method rule” i.e. the method that provides “the most reliable measure of an arm’s length result.”
A Simple SaaS Example
Say a US-based SaaS company has an office in Ireland. Here are some examples of how they might fall afoul of taxing authorities and how they can do transfer pricing right.
- Scenario 1: Pricing Too High – If the Irish office pays only 1% in royalties for software that creates 80% of its revenue, tax authorities would see this as unfair and an attempt to move profits to Ireland's lower tax rate.
- Scenario 2: Pricing Too Low – If the Irish subsidiary pays 15% in royalties for IP but also makes significant changes to that IP before bringing it to market, then they may actually be overpaying the US entity based on its relative contribution.
- Scenario 3: Arm’s Length Pricing – The Irish office looks at what other similar SaaS companies pay for licensing deals and pays 4% in royalties. Regulators see this as fair using the Transactional Net Margin Method (TNMM).
Scenario 3, arm’s length pricing, would pass muster with regulators. With this method, each country would get their fair share of tax revenue.
Transfer Pricing Rules by Region (What Changes Internationally?)
While OECD regulations provide a framework for transfer pricing, there are still country-to-country differences.
United States (IRS)
Transfer pricing in the US is regulated by Internal Revenue Service (IRS) Code Section 482. This allows the IRS to move income between related companies to prevent tax avoidance. These regulations require the arm’s length principle and impose penalties of up to 40% for substantial variations from what they see as fair allocation.
In the US, companies must provide documentation of their transfer pricing as well as detailed benchmarking studies supporting the method selected and showing why their pricing was fair.
Note that the IRS has been especially tough on technology companies, so SaaS companies should prioritize following the rules.
Canada (CRA)
The Canada Revenue Agency abides by OECD rules, but with some country-specific requirements such as filing Form T106 annually to disclose transactions with non-Canada related companies.
There is also no small business exemption for transfer pricing in Canada’s tax laws and regulations. Penalties for non-compliance can be up to 10% of the transfer pricing adjustment, so companies should pay careful attention to requirements.
Europe/UK (OECD-based)
Most European jurisdictions, including the UK, follow the OECD Transfer Pricing Guidelines.
They are required to keep documentation explaining their transfer pricing in two forms:
- Master File - High-level documentation of all transfer pricing practices across the whole company
- Local File - Specific documentation about transfer pricing policies for one individual company within the larger group
Further, companies with more than €750 million in revenue must file detailed reports showing how exactly they allocated their income globally.
Europe also requires safeguards against “base erosion and profit sharing” (BEPS). BEPS is a part of the OECD framework that covers more than 140 countries and helps ensure fair transfer pricing between countries.
Benefits of Getting Transfer Pricing Right
Compliance & Risk Reduction
Getting transfer pricing right from the start protects your business from headaches and tax disputes with multiple countries. You'll avoid audits, sudden pricing adjustments, and penalties that can reach 40% of underpayments. Most importantly, proper transfer pricing protects your company from double taxation, where two countries fight over where income should be taxed - with your company caught in the middle.
Financial & Strategic Upside
Aside from staying out of trouble and avoiding paying steep penalties, standardized transfer pricing creates predictability in your business, both internally for your employees and the employees of related businesses, and when it comes to planning for tax liability. This is especially valuable during an acquisition or merger when investors or buyers want to see pristine financial records.
Risks & Things to Watch Out For
Common Pitfalls
It’s easy for SaaS companies to fall into some common transfer pricing pitfalls:
- Pricing without proper documentation - Under OECD regulations, most taxing authorities will require documentation regarding your transfer pricing and the method you used
- Using weak comparables - It's hard to compare SaaS offerings with other companies, but weak comparisons can lead to transfer pricing that tax authorities reject
- Incorrect reporting - Different countries require different reporting methods and paperwork on different dates. Make sure you follow each country's guidelines
- Stagnant pricing - Many companies set transfer pricing once and never update it, even when business models or market conditions change. Be sure to review transfer pricing regularly
Consequences
The consequences for incorrect transfer pricing range from administrative and financial penalties to allegations of profit shifting and reputation damage. Penalties can reach 40% of underpayments in the US and similar amounts elsewhere. You may also face double taxation if countries can't agree on where profits should be allocated.
How to Implement Transfer Pricing (SaaS Playbook)
Set Policies & Agreements
Start by drafting clear intercompany agreements for any transactions between entities, such as IP licenses, development services, marketing and customer support, etc. Include which pricing method you chose and why it complies with the arm’s length principle. Review pricing and policies annually as your business grows and relations between interconnected companies evolve.
Build Defensible Documentation
Understand what documentation each country requires, such as Master Files and Local Files in Europe and the similar requirements in the US. Include supporting facts like price comparisons to other similar companies and market rates. The key is creating this documentation early, and not after an audit has already started.
Solutions to Help with Transfer Pricing
Transfer pricing is complicated, and every business is different. Many companies choose to consult with a specialist who can design pricing policies, conduct benchmarking studies, and adhere to each country’s documentation requirements. Since governments are aggressively looking for tax avoidance in the SaaS space, look for advisors with SaaS-specific experience.
Software (Automation & Scale)
As your business grows, consider transfer pricing solutions like Caribou that automate pricing policy, documentation, benchmarking, and reporting. These tools integrate with your business’s billing and financial systems and centralize your transfer pricing policies, simplifying a complex process. Platforms like Caribou also handle multiple countries’ requirements, meaning they can scale with your business.
Where Sphere Fits
Transfer pricing and indirect taxation share the same underlying challenge: figuring out which entity does what across your global operations.
Sphere connects directly to your ERP system to calculate VAT/GST and other indirect taxes on invoices between offices and apply the correct tax treatment. Your ERP system remains the main record-keeper while Sphere's AI-powered tax engine ensures the indirect tax side is accurate and consistent. This creates clean transaction data that supports your transfer pricing documentation and makes both indirect tax and transfer pricing compliance manageable as you grow.
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Staying Compliant Means Staying Scalable
Staying compliant with transfer pricing best practices boils down to one thing: price transactions between your entities as if the companies were totally unrelated. This satisfies taxing authorities that you are not using tax schemes to shift your profit margins to low-tax jurisdictions.
For SaaS companies, this means to thoroughly document your intercompany arrangements, review and update pricing annually and as your business evolves, and consider automation tools as you scale. Paying close attention to transfer pricing from your business's start means reduced audit risk, predictable costs, and smoother expansion as your business grows.
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