Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided.
Transfer pricing allows for the establishment of prices for the goods and services exchanged between subsidiaries, affiliates, or commonly controlled companies that are part of the same larger enterprise. Transfer pricing can lead to tax savings for corporations, though tax authorities may contest their claims.
Transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries that operate under common control or ownership. The transfer pricing practice extends to cross-border transactions as well as domestic ones.
A transfer price is used to determine the cost to charge another division, subsidiary, or holding company for services rendered. Typically, transfer prices are reflective of the going market price for that good or service. Transfer pricing can also be applied to intellectual property such as research, patents, and royalties.
Multinational corporations (MNC) are legally allowed to use the transfer pricing method for allocating earnings among their various subsidiary and affiliate companies that are part of the parent organization. However, companies at times can also use (or misuse) this practice by altering their taxable income, thus reducing their overall taxes. The transfer pricing mechanism is a way that companies can shift tax liabilities to low-cost tax jurisdictions.
Transactions Subject to Transfer Pricing
The following are some of the typical international transactions which are governed by the transfer pricing rules:
- Sale of finished goods
- Purchase of raw material
- Purchase of fixed assets
- Sale or purchase of machinery etc.
- Sale or purchase of intangibles
- Reimbursement of expenses paid/received
- IT enabled services
- Support services
- Software development services
- Technical Service fees
- Management fees
- Royalty fees
- Corporate Guarantee fees
- Loan received or paid
Purposes of Transfer Pricing
The key objectives behind having transfer pricing are:
- Transfer prices would affect not just the reported profits of every centre, but would also affect the allocation of a company’s resources (Cost incurred by one centre will be considered as the resources utilized by them).
- Generating separate profit for each of the divisions and enabling performance evaluation of each division separately.
Resale Price Method or Resale Minus Method
In this method, it takes the prices at which the associated enterprise sells its product to the third party. This price is referred to as the resale price.
The gross margin which is determined by comparing the gross margins in a comparable uncontrolled transaction is then reduced from this resale price. After this, costs which are associated with the purchase of such product such as the customs duty are deducted. What remains is considered as arm’s length price for a controlled transaction between the associated enterprises.
Cost Plus Method
With the Cost Plus Method, you emphasize on costs of the supplier of goods or services in the controlled transaction. Once you’re aware of the costs, you need to add a markup. This markup must reflect the profit for the associated enterprise on basis of risks and functions performed. The result is the arm’s length price.
Generally, the markup in the cost plus method would be calculated after the direct and indirect cost related to production or supply is considered. But, the operating expenses of an enterprise (like overhead expenses) aren’t part of this markup.
Problems Associated with Transfer Pricing
There are quite a few problems associated with the transfer prices. Some of these issues include:
- There could be differences in opinions among organizational divisional managers with respect to how to transfer price needs to be set.
- Additional time, costs and manpower would be required for executing the transfer prices and designing the accounting system to match the requirements of transfer pricing rules.
- Arm’s length prices might cause dysfunctional behaviour among the managers of organizational units.
- For some of the divisions or departments, for instance, a service department, arm’s length prices don’t work equally well as such departments don’t offer measurable benefits.
- The transfer pricing issue in a multinational setup is very complicated.