What is meant by transfer pricing explain the various methods used to determine the transfer pricing?

Setting prices for goods and services between related entities

What is Transfer Pricing?

Transfer pricing refers to the prices of goods and services that are exchanged between companies under common control. For example, if a subsidiary company sells goods or renders services to its holding company or a sister company, the price charged is referred to as the transfer price.

Entities under common control refer to those that are ultimately controlled by a single parent corporation. Multinational corporations use transfer pricing as a method of allocating profits (earnings before interest and taxes) among their various subsidiaries within the organization.

Transfer pricing strategies offer many advantages for a company from a taxation perspective, although regulatory authorities often frown upon the manipulation of transfer prices to avoid taxes. Effective but legal transfer pricing takes advantage of different tax regimes in different countries by raising transfer prices for goods and services produced in countries with lower tax rates.

In some cases, companies even lower their expenditure on interrelated transactions by avoiding tariffs on goods and services exchanged internationally. International tax laws are governed by the Organization for Economic Cooperation and Development (OECD) and the auditing firms under OECD review and audit the financial statements of MNCs accordingly.

Example

Consider ABC Co., a U.S.-based pen company manufacturing pens at a cost of 10 cents each in the U.S. ABC Co.’s subsidiary in Canada, XYZ Co., sells the pens to Canadian customers at $1 per pen and spends 10 cents per pen on marketing and distribution. The group’s total profit amounts to 80 cents per pen.

Now, ABC Co. will charge a transfer price of between 20 cents and 80 cents per pen to its subsidiary. In the absence of transfer price regulations, ABC Co. will identify where tax rates are lowest and seek to put more profit in that country. Thus, if U.S. tax rates are higher than Canadian tax rates, the company is likely to assign the lowest possible transfer price to the sale of pens to XYZ Co.

Arm’s Length Principle

Article 9 of the OECD Model Tax Convention describes the rules for the Arm’s Length Principle. It states that transfer prices between two commonly controlled entities must be treated as if they are two independent entities, and therefore negotiate at arm’s length.

The Arm’s Length Principle is based on real markets and provides a single international standard of tax computation, which enables various governments to collect their share of taxes and at the same time creates enough provisions for MNCs to avoid double taxation.

Case Study: How Google Uses Transfer Pricing

Google runs a regional headquarters in Singapore and a subsidiary in Australia. The Australian subsidiary provides sales and marketing support services to users and Australian companies. The Australian subsidiary also provides research services to Google worldwide. In FY 2012-13, Google Australia earned around $46 million as profit on revenues of $358 million. The corporate tax payment was estimated at AU$7.1 million, after claiming a tax credit of $4.5 million.

When asked about why Google did not pay more taxes in Australia, Ms. Maile Carnegie, the former chief of Google Australia, replied that Singapore’s share in taxes was already paid in the country where they were headquartered. Google reported total tax payments of US $3.3 billion against revenues of $66 billion. The effective tax rates come to 19%, which is less than the statutory corporate tax rate of 35% in the US.

Benefits of Transfer Pricing

1. Transfer pricing helps in reducing duty costs by shipping goods into countries with high tariff rates by using low transfer prices so that the duty base of such transactions is lowered.
2. Reducing income and corporate taxes in high tax countries by overpricing goods that are transferred to countries with lower tax rates helps companies obtain higher profit margins.

Risks

1. There can be disagreements within the divisions of an organization regarding the policies on pricing and transfer.
2. Lots of additional costs are incurred in terms of time and manpower required in executing transfer prices and maintaining a proper accounting system to support them. Transfer pricing is a very complicated and time-consuming methodology.
3. It gets difficult to establish prices for intangible items such as services rendered, which are not sold externally.
4. Sellers and buyers perform different functions and, thus, assume different types of risks. For instance, the seller may refuse to provide a warranty for the product. But the price paid by the buyer would be affected by the difference.

Related Readings

Thank you for reading CFI’s guide to Transfer Pricing. To continue learning and advance your career, see the following free CFI resources:

• Tax Shields
• Economies of Scale
• Law of  Supply
• Consumer Surplus Formula