Transfer Pricing

What Is Transfer Pricing?

"Transfer pricing is an accounting practice that represents the price at which the Subsidiaries and Divisions transfer goods and services to each other within a group."

In other words, Transfer Pricing refers to the price that is charged by One Division/or, a subsidiary to transfer the goods or services to another Division/or Subsidiary within the group.

Key Points

Transfer prices that are different from the market value (market prices) will benefit one entity while hurting the other entity by lowering their profits.
Multinational companies can manipulate transfer prices to reduce the tax cost by shifting profits to regions where the tax rates are low by their tax laws.
To address this, regulations impose an arm's length principle rule, which requires pricing to be based on similar transactions made between unrelated parties.

How Transfer Pricing Works

Transfer prices are used when entities, subsidiaries, and divisions within the group report profits separately, pay tax on those profits separately and prepare financial statements separately.

Each entity, subsidiary, and division have their own objectives such as maximizing profit.

The transfer pricing practice applies to both cross-border and domestic transactions.

For example, Assume that Company ABC has 2 separate segments: entity A and entity B. Entity A manufactures and sells bicycles, while entity B assembles and sells wheels. In an intercompany transaction, entity A could also sell wheels to entity B. Entity B will have a lower cost of goods sold (COGS) and higher earnings than it would otherwise have if entity A offers a rate below market value. However, this would have a negative impact on entity A's sales revenue.

If entity A, on the other hand, offers entity B a higher rate than market value, entity A will generate more sales revenue than if it was sold to an external customer. Entity B would have a higher cost of goods sold but a lower profit margin. In either case, a transfer price that differs from market value benefits one party while hurting the other.

Regulations on Transfer Pricing

Transfer pricing regulations ensure that transfer pricing among related entities is fair and accurate. Regulations enforce the arm's length transaction rule, which states that companies must price their products and services based on similar transactions between unrelated parties. Within a company's financial reporting, it is closely monitored.

How Transfer Pricing is used to minimize the tax?

Companies can manipulate profits of goods and services through transfer pricing in order to book higher profits in a country where the tax rates are lower. In some cases, transferring goods and services from one country to another within an intercompany transaction can help a company avoid tariffs on international goods and services. The Organisation for Economic Cooperation and Development (OECD) regulates international tax laws, and auditing firms in each international location examine the financial statements in accordance.

For Example, XYZ company set up a fully owned subsidiary in a country where the tax rates are high at 30% and set up their head office in a country where the tax rates are low at 8% and made all their transactions from that country.

Head office purchases components from the subsidiary at cost plus 5% profit and after assembling it, sells to another market at a profit of 40%.

In a subsidiary country where the tax rate is high at 30%, the company will be paying tax on 5% profit whereas, in the head office from where that actual revenue is generated, the company will be paying tax of only 8% on its 40% profit.

Is transfer pricing legal?

It is a very complicated question and not easy to answer. Some say, It is legal and some keep silent on this question. But Transfer pricing is a normal and legitimate activity. Whereas the Manipulation of Transfer price is not legal nor ethical.

The transfer price manipulation exists when transfer prices are used to evade or avoid the payment of taxes and tariffs.

How is transfer pricing unethical?

In some circumstances, Even if ‘the transfer price is legal, it is not ethical.’

There was a very big and known company (sorry I cannot reveal their name), set up their head office in a country where the tax rates were low. The company opened its many franchises in a country where their demand was high and the tax rates were also high.

As the formula belongs to the Parent company and the parent company sold rights to use their formula to XYZ country franchises, The parent company started charging the royalty fee from XYZ country’s franchises for each of their products sold.

Due to this, the franchises started generating negative profits (losses) and therefore the franchises had to pay the ZERO Tax and Parent company’s started generating higher sales on which they were paying a low rate of tax.

Later it was investigated and issued a report where it was declared the ‘Unethical behavior of the company for not paying to a country to spend on their people from where they are generating sales revenue and earning profits.’

What is the Solution to control the Manipulation of Transfer Pricing?

The most common solution that tax authorities have adopted to reduce the probability of transfer price manipulation is to develop particular transfer pricing regulations based on the concept of the arm's length standard, which says that all MNC intra-firm activities should be priced as if they took place between unrelated parties acting at arm's length in competitive markets.

Arm's length standard:

This means that intra-firm trade of multinational corporations should be priced as if they took place between unrelated parties acting at arm's length in competitive markets.

Transfer Pricing Methods

There are three methods of transfer pricing.

Full Cost
Cost + Profit
Negotiation

1: Full Cost

In Full Cost Method, the One Entity, Division, or Subsidiary sold goods or services to another Entity, Division, or Subsidiary within a group at a full cost that occurs to manufacture that component/good. Hence the transferring company will be generating ZERO profit and therefore will be paying ZERO tax due to ZERO taxable income.

2: Cost + Profit

In the Cost + Profit method, the One Entity, Division, or Subsidiary sold goods or services to another Entity, Division, or Subsidiary within a group at a Full Cost + Profit that occurs to manufacture that component/good. Therefore, transferring companies will be generating some profit and will be paying tax on it.

3: Negotiation

In the Negotiation method, The Entities, Division, or Subsidiaries negotiate the Transfer price by themselves between each other. The goods or services will be transferred at a price that will be agreed upon by either the Entities, Divisions, or Subsidiaries that are transitioning with each other.

What is the Best, Unbiased and Fair method of Transfer Pricing?

The Best and Fair method of Transfer Pricing is, "Set up the Transfer Price At Market Price."

Setting the transfer price at market price should enable a fair assessment of the performance of both the buying and selling divisions. Both internal and external sales will be accounted for at the same price. Both the divisions will be happy with this approach.