What is transfer pricing?
Transfer pricing in accounting denotes the price at which one unit in a company charges another for its products and services. It’s also known as transfer cost.
Transfer pricing is commonly encountered during intercompany transactions, such as between a company and its subsidiaries or between different units in the same company in other regions or countries. It has a serious impact on a company’s valuation. Businesses can track transfer pricing by using financial risk management software.
Examples of transfer pricing
Two units, X and Y, exist within the same company.’ While X builds the components required for a smartphone, Y assembles these components to sell the entire smartphone. If unit X offers the parts to unit Y at a rate lower than the market value, unit Y incurs a lower cost of goods sold (COGS) and higher revenue, but it also lessens unit X’s overall revenue. Unit X would incur higher income and higher COGS in the reverse situation.
Another example is when there are two units in different countries. If team X is in a high-tax country and another branch and Y is in a developing country, the parent organization would try to shift the revenue from unit X to Y for lower tax rates. The transfer pricing practice benefits the company as a whole.
International tax authorities and administrations in major countries have rules, known as advance pricing agreements or arrangements (APA), to set related party prices. Under these conditions, a taxpayer and a government entity must agree on the methods used to test prices. APAs are based on the transfer pricing documentation prepared by the two parties. The Organization for Economic Cooperation and Development (OECD) sets and regulates these international tax laws.
The arm's length principle
Many countries adopt the arm’s length principle. According to this deal, the buyer and the seller act independently without one party influencing the other. It urges both parties to consider their own interests and not be affected by the other. Both parties have equal access to the deal information.
Brazil is one example of a country that has not adopted this principle.
The arm’s length standard is a vital transfer pricing guideline because it has legal implications. When multinational corporations (MNCs) conduct a transaction with affiliated companies in other countries, it needs to ensure that the transactions are made at fair market values so the right amount of tax is paid in each jurisdiction.
These affiliates face challenges if the companies in their companies don’t deal with one another based on the arm's length principle stated under the relevant transfer pricing documentation. These transactions are intended to encourage fair and reasonable business practices, and companies shouldn’t make transfer pricing adjustments to transactions within arm’s length.
How does transfer pricing work?
Transfer pricing is an accounting practice that allows for internal transactions within businesses and between subsidiaries that operate under common control or ownership. This practice applies to cross-border and domestic transactions.
This concept helps determine the charging cost between a company and a subsidiary or between divisions within the same company.
Companies with global offices can use this method to allocate their earnings among different divisions. This could also pose a major challenge since it could cause companies to alter their taxable income.
In terms of how it works, five methods can be split into two groups: traditional and transactional.
Here are five methods of transfer pricing analysis:
- Resale price takes a product's or service's selling price and reduces it with a gross margin. It compares the gross margins in similar transactions in different organizations. Costs such as import, export, or customs duties get deducted from this total. The final value is an arm’s length price for a controlled transaction.
- Cost plus compares a company’s total profits to the cost of selling. The supplier costs are determined first, followed by market-based markup costs in comparable transactions between unrelated organizations. This is the “plus” under cost plus. It gets added to the total costs to account for profits. The unavailability of comparable data and consistent accounting information are the downsides to this method.
- Comparable uncontrolled price, or CUP, compares the price and conditions of products and services in a controlled transaction with those from an uncontrolled transaction between unrelated parties. CUP requires access to comparable data, and the transactions need to be similar to be considered identical.
- Profit split is used by companies operating under the same brand. When these companies engage in related transactions, they cannot be observed separately and therefore agree to split the profit. This method helps companies gauge their financial performance better and is helpful when dealing with intangible assets.
- Comparable profits, also known as the transactional net margin method, helps determine the transfer price through net profits between associated companies. This is then compared with the net profits in uncontrolled transactions between independent companies. This method is one of the most used transfer pricing methods and is easy to implement since it requires only financial data.
Revenue authorities focus more on transfer pricing issues, and an approach that includes digital transformation policies is necessary for companies that operate globally.
Benefits of transfer pricing
- Transparent transactions: Without transfer pricing, different departments can charge random product prices, resulting in market exploitative practices and uncompetitive products. It also creates unnecessary animosities between teams that, if left unattended, can prove irreparable.
- Income tax savings: Transfer pricing can help save income tax money. When the division of a company supplies a product to another in a different tax jurisdiction where the tax rates are lower, the organization would price the goods higher while sending them. This means the company would get more tax returns and generate more profits.
- Cost saving: Since the prices of the products supplied to different divisions within the same company are lower than the actual market price, it poses a significant cost advantage. If a car company has a tire division and supplies tires to the assembly division, the division would be able to acquire them easily. Since they also get the tires at lower costs than the market, they generate more profits.
- Lower duty costs: Any multinational enterprise has to face the challenge of duty costs while dealing with imports and exports. Since transfer pricing allows selling products among divisions at a low rate, this reflects in the overall price of the product. When the overall cost of the product goes down, it benefits the organization in other jurisdictions and helps save on import and export duties.
- Easier access to products: When supply chains face troubles, transfer pricing helps because it allows interdepartmental buying and selling. It also saves lowers costs and removes the dependency on third-party vendors.
The IRS and transfer pricing
The internal revenue service (IRS) dictates that transfer pricing for intercompany transactions should be the same as third-party ones in a relevant tax year.
Section 482 under the IRS states that the prices charged by one division in a company to another should yield results that are consistent with the ones that would have been realized if a common taxpayer had engaged in the same transaction.
Financial reporting for tax transfer pricing has strict guidelines. Tax auditors and regulators need access to detailed documentation to ensure the practice has been carried out correctly. They must also check for double taxation of the same income in two jurisdictions. If this is the case, it could result in penalties due to improper income allocation.
Adithya Siva
Adithya Siva is a Content Marketing Specialist at G2.com. Although an engineer by education, he always wanted to explore writing as a career option and has over three years of experience writing content for SaaS companies.
