Transfer Pricing

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Transfer Pricing?

Transfer pricing is the price determined for the transactions between two or more related entities within a multi-company organization. This price is also known as the cost of transfer which shows the value of such transfer between the related entities in terms of goods or even transfer of employees or labor across different departments.

Transfer Pricing

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The introduction of this concept has eliminated improper pricing of related party transactions between associate enterprises, making way for the elimination of tax evasion through such methods assisting the government and tax authorities. However, as this concept is relatively new, various changes need to be made to provisions over time based on its nature of the use to make it a globally accepted principle.

Transfer Pricing Explained

Transfer pricing at a corporate level refers to the transactions of goods and services between two entities owned by a single parent company. Multinational companies take advantage of different tax regimes in different countries of their operations and to allocate their profits at the end of a financial year to boost their retained earnings after tax.

Article 9 describes the rules for determining the arms-length transactionArms-length TransactionAn arm's length transaction is one in which two parties operate independently and the price agreed between them (also known as the transfer price) is free of any influence.read more prices for related party transactionsRelated Party TransactionsRelated party transaction is an arrangement between two related parties for the transfer of resources, services or obligations, irrespective of whether a price is charged or can affect the statement of profit or loss and the financial position of an entity.read more between associated enterprises in the OECD Model Tax Convention. Such an arm’s length price is fairly a market price for such a commodity or service. This price is widely accepted by tax authorities and users of financial statementsUsers Of Financial StatementsFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers.read more. It assists entities in determining their real income.

The transfer price agreement is vastly related to the market price of the product or service involved in such related party transactions. This will eliminate the entities purchasing or selling such products or services in the market as they can buy or sell them between the related parties at the market price itself; this is the reason it is more of an accounting conceptAccounting ConceptAccounting concepts are the principles, assumptions, and conditions that govern accounting's foundation. They ensure that the accounting is done in a way that the financial statements present a true and fair view.read more that accounts for the transaction between such related entities at a correct and fair price.

This is determined based on a few widely accepted methods such as comparable uncontrolled price, cost-plus pricingCost-plus PricingCost Plus pricing is the strategy of determining the selling price of a product in the market by adding a markup or profit premium to the actual cost of the product. This additional margin represents the entrepreneur's profit.read more, resale price, Transactional Net margin, and transactional profit split methods.

The above-listed methods are used based on the transaction, such as if there are comparable products or services in the market for which there is a market price determined, then such price could be used to determine Transfer Pricing. Similarly, if the product is resaleable and such resale price is determined along with profit on such sale, then the resale price method can be utilized. Related entities use other methods.

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Objectives

Let us understand the transfer pricing agreement through getting to know their objectives from the explanation below.

Examples

Let us understand different transfer pricing methods with the help of a couple of examples.

Example #1

Two associated entities X and Y, where X is situated in a high tax country. On the other hand, y is located in a Low tax country which is a tax haven destination; in this case, X would shift most of the revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more generated to Y through means of some associated transfers to avoid taxation or reduce the incidence of tax for the company, with the use of these provisions, such type of tax avoidance transactions could be eliminated. Similarly, due to this, there will not be the eradication of revenue from one country to another by benefiting the country of source of generating such revenue.

Example #2

The assembly division of an automobile company, ABC Company, offers to purchase 50,000 tires from the tire division of the same company for $100 per unit. The production costs per tire at a volume of 200,000 tires per year are as follows:

ItemProduction Cost ($)
Direct materialsDirect MaterialsDirect materials are raw materials that are directly used in the manufacturing process of a company's goods and/or services and are an essential component of the finished goods manufactured.read more50
Direct labor20
Variable factory overhead12
Fixed factory overhead42
Total124

The tire division typically sells 200,000 tires every year to arm’s length customers at $140 per unit. In addition, the capacity of the tire division is 300,000 batteries/year. The assembly division typically buys the tires from arm’s length suppliers at $125 per unit.

Now, the question is whether or not the tire division manager should accept the offer? If yes, how will the company benefit from this internal transfer?

The tire division has a surplus capacity of (300,000-200,000) = 100,000 tires per year. So the relevant costsRelevant CostsRelevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management's decision-making process. For example, businesses use relevant costs in management accounting to conclude whether a new decision is economical.read more to the tire division will be $82 / battery (total of $124 minus the fixed factory overheadFactory OverheadFactory Overhead, also called Factory Burden, is the total of all the indirect expenses related to the production of goods such as Quality Assurance Salaries, Factory Rent, & Factory Building Insurance etc. read more of $42).

And the increased margin to the tire division would be 50,000*$(100 –82) = $0.9 million.

Due to the above benefits to the tire division, its manager must undoubtedly accept the offer.

The assembly division pays $125 to external suppliers for a tire that could be purchased internally at an incremental costIncremental CostIncremental costs are the additional costs associated with the production of one additional unit, and it only considers costs that are likely to change as a result of a specific decision, such as replacing machinery or equipment or adding a new product, and so on.read more of just $82. So, the overall cost saved by the company would be 50,000 * $(125–82) = $2.15 million per year.

This is how the company will benefit from the internal transfer.

Now, what should be the price range in this case?

The transfer price should be kept between $82 and $125. If it goes below $82, the tire division will be at a loss, while if it goes beyond $125, the assembly division will be paying more than what it pays to the external suppliers.

On which legal entities should the practice of transfer pricing be applied?

The entities which can adopt this practice must be legally related entities. In other words, if two companies are owned wholly or with the majority by the parent corporation, then those companies can be considered to be under the control of a single corporation. And since they are under the control of a single corporation, they are also legally related entities, and hence, transfer pricing can be applied to them and can be practiced by them.

Under certain jurisdictions, entities are considered under common control if they share family members on their boards of directorsBoards Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals. read more even though they may not be related legally, as described in the above paragraph.

Importance

Transfer pricing methods prove to be extremely useful for individuals and multinational companies alike. Let us understand how through the discussion below.

Purpose

Let us understand the purpose of a transfer pricing agreement through the discussion below.

Functions and Risks

Regardless of transfer pricing methods being useful for individuals and MNCs, it also has its share of risks and intricate detailing to it. Let us understand them through the discussion below.

  • This concept functions basically on the principles of price determination that is available in the market for such commodities or services involved in the transaction.
  • Due to such a function, there are few risks involved, such as the valuation of those transactions that involve the use of intellectual property, services that are highly valued, and transactions that are not of financial nature. The exchange of goods and services with unrelated goods and services between associated enterprises, etc.
  • Also, there is a risk of mispricing a self-generated commodity or service that is not related to any other resource in the market due to limitations present in domestic pricing rules.

Benefits

Let us discuss the importance of inculcating transfer pricing methods through the points below.

Drawbacks

To understand the transfer pricing agreement completely it is important to understand its drawbacks as well. Let us do so through the explanation below.

Recommended Articles

This article has been a guide to what is Transfer Pricing. Here we explain its examples, objectives, purpose, benefits, and drawbacks in detail. Also, discuss its advantages, disadvantages, and how it works. You can learn more about it from the following articles –

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