Transfer Pricing

Transfer Pricing Meaning

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

Explanation

In the OECD Model Tax Convention, Article 9 describes the rules for determining the an arms-length transactionAn Arms-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. Such Arm’s length price is fairly a market price for such commodity or service in the market. 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.

Transfer Pricing

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Source: Transfer Pricing (wallstreetmojo.com)

How does it Work?

Transfer Pricing Examples

Let us take an example of two associated entities X and Y, where X is situated in a high tax country. 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 country by benefiting the country of source of generating such revenue.

Determining Transfer Pricing

Suppose 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 a total of 200,000 tires every year to arm’s length customers at $140 per unit. The capacity of the tire division is 300,000 batteries/year. The assembly division typically buys the tires from the 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 costs 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 is paying $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. This is because 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.

Now, on which legal entities should follow 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 to be 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.

Why is it Important?

Purpose of Transfer Pricing

Functions and Risks

  • This concept functions basically on the principles of determination of price that is available in the market for such commodity or service involved in the transaction.
  • Due to such 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, transactions that are not in financial nature. Even the exchange of goods and services, with other 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.

Objectives of Transfer Pricing

Benefits

Drawbacks

Conclusion

As a whole, 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. 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.

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