Transfer pricing represents an important aspect of tax compliance for both businesses and tax authorities worldwide. Increased transparency, the exchange of data between tax authorities, and OECD guidelines have further raised the requirements placed on taxpayers. Consequently, transfer pricing documentation has become a key element of tax risk management, rather than merely a regulatory formality.

What is transfer pricing?

Transfer pricing refers to the prices at which a company transfers physical goods and intangible assets, or provides services, to related entities. This encompasses the pricing of products, services, and intellectual property, as well as other charges applied between related parties - including arrangements under which entities within a multinational group share common costs.

The fundamental principle applied is the "arm's length principle." This principle dictates that transactions between related parties must be conducted at market prices. In other words, the prices used must be the same as those that would be applied in dealings with independent, unrelated third parties.

Who are the obligated parties?

Obligated parties are all those who engage in transactions with related parties - that is, all those who meet the following criteria:

• related parties, one of which is a resident and the other a non-resident
• related parties that are both residents, where one of the parties has a preferential tax status (pays corporate income tax at rates lower than the prescribed rate, or is exempt from corporate income tax)
• related parties that are both residents, where one of the parties is entitled to carry forward a tax loss from previous periods

Legislative Framework

Article 13 of the Profit Tax Act mandates the application of transfer pricing to transactions between related parties and provides a definition for such parties. This article also addresses the methodology for substantiating transfer prices, specifying how to demonstrate that individual transactions comply with the arm’s length principle.

Article 40 of the Profit Tax Ordinance stipulates the obligation to submit transfer pricing documentation upon the request of the Tax Administration. This same article outlines the required content of such documentation and specifies the obligation to update the data in the event of significant changes to facts and circumstances.

It is also important to mention the OECD Transfer Pricing Guidelines, as they represent the international standard for determining transfer prices, serving as a reference for both multinational enterprises and tax authorities across various jurisdictions.

 The Importance of Application

The importance of this application lies primarily in the prevention of tax base erosion, as prices agreed upon between related parties create opportunities for:

• the artificial reduction of profits in a jurisdiction with a higher tax rate;
• the shifting of profits to a jurisdiction with a lower tax rate;
• the concealed distribution of profits – through non-arm’s-length interest, service fees, royalties, or similar mechanisms – rather than through transparent dividend payments.

Consequently, the preparation of documentation and the substantiation of the arm’s-length principle for transactions between related entities are imperative – both for businesses and within the framework of national legislation.

Should you have any questions regarding the application of the arm’s-length principle, or if you require assistance in preparing transfer pricing documentation, the experts from the tax department at Grant Thornton Croatia are at your disposal.