This paper reveals the transfer pricing methodology to be used setting the arm’s length prices between related parties applying the Berry ratio. The author provides cases when the Berry ratio is not reliable profit level indicator for transfer pricing purposes. The theoretical propositions are supported by the results of author’s research performed.
The multinational companies have the incentive to increase its after-tax profits by shifting taxable income from high tax countries to low tax countries by altering transfer prices, thus the transfer pricing is significant for both taxpayers and tax administration purposes, because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions. Setting transfer prices not under the arm’s length principle may lead to the transfer pricing adjustments and additional payable taxes and penalties. Thus, the proper transfer pricing determination is one of the most important tax issues for multinational companies.
Determining the transfer pricing that confirms to the arm’s length principle, i.e. the principle under which the prices set between related parties do not differ from market prices, various profit level indicators are used (e.g. gross profit, operating profit, return on assets, mark up on total costs, Berry ratio, etc.). The Berry ratio can be applied determining the transfer pricing of „pure“ distributors and services providers, however, the following criteria have to be met:
The correlation between operating costs and sales income is strong;
The gross profit is increasing proportionally to operating costs;
The accounting standards and composition of operating expenses and costs of goods / services sold of tested party is similar to that of the comparable companies.
However, the misapplication of this ratio would mislead a company into assuming that they are transacting at arm’s length while in actuality they may be concluding transactions not under the arm’s length standard. Such misapplication can occur mostuly in cases then the Berry ratio applied to integrated distributors (that is, distributors that also perform manufacturing functions) or comparing the ratios of companies from different countries.