Transfer Pricing

What Is Transfer Pricing?

A transfer price is a price charged by one sub-unit of a company to another sub-unit of the same company for the goods or services produced by the first sub-unit and "sold" to the second sub-unit. 

The product or service sold and purchased internally is called an intermediate product. It may be used as a product component sold to the final customer by the center that purchased it internally, or the center that purchased it may sell it outright to the last customer.

For example, if a subsidiary sells goods or services to an acting or sister company, the amount charged is called the transfer price.

Businesses under the same control are those that a single-parent company ultimately controls. International companies use transfer rates to distribute profits (interest before profits and taxes) between their various subsidiaries within the organization.

The accounting for a transfer price occurs when goods or services are exchanged between classes of the same company. The transfer price is based on market prices in the payment of another component, a subsidiary, or a company in charge of the services provided.

Companies use transfer prices to reduce the overall tax burden on the parent company. 

Companies charge higher rates in categories in high-tax countries (reduced profits) while paying lower interest rates (in growing profits) in installments in low-tax countries; this is known as price differentiation in different markets.

The IRS states that the transfer price should be commensurate with the value of the transaction between companies and commerce, as it would be in the case of a company operating outside the company.

How Transfer Pricing Works?

It is a calculation and tax practice that allows for transactions within businesses and between subsidiaries operating under the same control or ownership. The method of exchanging goods and services extends far beyond the border and domestic areas.

The transfer price determines the cost of charging another component, a holding company, or a company in charge of the services provided. Generally, transfer prices reflect the ongoing market price of that value or service. 

Transfer prices can also be applied to intellectual property such as research, patents, and benefits.

Multinational corporations (MNCs) are legally permitted to use these methods to allocate earnings between a parent organization's various subsidiaries and companies. 

However, sometimes, companies can exploit (or misuse) this practice by changing their taxable income, thus reducing their total taxes. The transfer price method allows companies to convert tax debts to less expensive tax havens.

It allows businesses to create a framework for transactions within a large structure of a multinational organization. 

But to ensure integrity on both sides and compliance with regulatory rules, these transfer price systems need to be managed by a business solution that can create high-quality strategic decisions regarding any transfer pricing method set by your tax advisers.

Example Of Transfer Pricing

Suppose your company is headquartered in more than one country and has divisions in different countries trading with each other. In that case, the amount charged from one Division to another will affect the profits earned by those divisions.

Since tax is based on the profit earned, a division will pay more or less tax based on the transfer price set. The transfer price set affects the profit generated by the segment. 

The profits made by an organization often become an integral part of the performance appraisal. This will be the case if the return on investment (ROI) or residual value (RI) is used to measure performance. 

Therefore, a division may, for example, be told by headquarters that it must buy components in another division, even though that component costs more than what an outsourced company would charge. 

This will lead to lower profits and make the performance of the buying phase look poorer than it would otherwise be. On the other hand, the sales segment will appear to be doing better. This can lead to the company making poor decisions.

Benefits of transfer pricing

The benefits of transfer pricing are:

1. Tax Benefits: Transfer prices provide tax benefits to international organizations. If an organization can produce reliable transfer documents, it will receive several tax deductions, which will help it avoid tax evasion. 
   • Reducing income and business taxes in high-tax countries by costly goods transferred to low-income countries helps companies acquire higher profit margins. 
2. Low Tax Rate: Another advantage of the transfer price is that it ensures the profitability of products and services in many countries with low tax rates, such as Malaysia. 
   • As a result, the organization will have no problem complying with international tax laws, ensuring continued growth at great profit.
3. Avoid High Prices: Suppose your organization is engaged in the international trade of goods and services. In that case, transferring prices helps you to move resources from one country to another through reliable channels and avoid high prices on such exchanges.
   • Transfer prices help reduce tax costs by shipping goods to high-tax countries by using lower transfer prices to reduce the tax base of such transactions. 
4. Avoid / Reduce Tax Debt: The transfer price document is the basis for determining the total cost of a transaction between the two parties, which helps to avoid or reduce tax liability. 
   • There are a number of principles that are used by accounting services to determine the arm's length price of the transaction performed between two companies.
5. Reduce Duty Costs: Duty costs are a significant challenge in international trade. If you run a global organization, you must deal with such costs daily. 
   • Transfer prices help organizations to reduce duty costs. In addition, organizations can export goods to high-tax countries with lower transfer prices.
6. Reduce Income Taxes: Organizations can also significantly reduce income taxes in countries with high tax costs. This can be done by overcharging the goods they export to countries with low tax rates. Therefore, businesses can generate higher profits.
7. Profit goals: It encourages profit center managers to pursue their profit goals while working for the company's success as a whole. 
   • The sales phase should be encouraged to keep costs down, and the purchasing phase should be encouraged to acquire and use inputs effectively.

Transfer pricing methods

Companies have several choices of methods for calculating the transfer price of a product or service. Generally, top management chooses the process of setting transfer prices, and the decision should consider the entire company's goals.

The most common methods are discussed below.

Market-Based Price

Market-based pay transfer price that is equal to the current or market price of the selling division's product in an "arms-length" transaction. 

In other words, the transfer price is set as if the selling division were selling to an outside customer, even though the selling division is selling to another division of the same company.

Comparable Uncontrolled Pricing Method

A comparable uncontrolled pricing method (CUP) compares the price and conditions of products or services in regulated transactions with those of rampant transactions between non-affiliated organizations. 

To perform this comparison, the CUP method requires what is known as comparable data. To be considered equal value, uncontrolled transactions must meet similar standards.

In other words, the transactions should be very similar and comparable under this method. The OECD recommends this approach whenever possible.

Retail Price Method

Retail Price Rate (RPM) uses the selling price of a product or service, otherwise known as a retail price. 

This number is then reduced by the gross margin, which is determined by comparing the gross margins to comparable transactions performed by similar but unrelated organizations. 

Then, the costs associated with purchasing the product — such as taxes — are deducted from the total amount. The latter number is the arm's length price of the controlled transaction performed between sub-companies.

Comparable Profit Method

The Comparable Profit Method (CPM), also known as the transactional net margin (TNMM) method, helps determine the transfer prices by considering the net profit of controlled transactions between related entities. 

These profits are compared to the remainder of earnings in comparable uncontrolled trading of private businesses.

Cost Of Production Plus The Opportunity Cost

The cost of production plus opportunity cost includes the cost of the production (outlay cost) and the profit margin that the selling division is giving up by selling the product internally rather than externally. 

Negotiated Price

Negotiating a transfer price between subsidiary companies may be necessary without using any market price as a basis. 

This situation arises when no visible market price is available because the market is either too small or the goods are too customized. This results in values ​​based on group-related negotiating skills.

Cost-Plus Price

If there is no market price to base the transfer price, you may consider using a system that creates a fee based on the cost of the components to be transferred.

The best way to do this is to add a profit margin to the cost, add up the average cost of the component, add the standard profit margin, and use the result as a transfer price.

Variable Cost

The variable cost method of setting the transfer price uses only the selling division's variable costs as the transfer price. 

This method works well if the selling division has the excess (unused) capacity and if the main objective of the transfer price is to satisfy the internal demand for goods. 

Here, fixed cost per unit is ignored because fixed charges will be incurred regardless of whether the sale is made.

Full Cost

This method includes all material, labor, and a total allocation of overhead in determining a transfer price. In other words, the transfer price is the inventory cost of the item, calculated using absorption costing. Nothing is added for a markup.

Transfer Pricing and Taxes

Transfer price is the first tax issue many international companies face. A significant increase in global trade, especially in international cooperation, has led to increased government concerns over possible tax losses. 

Tax authorities around the world are increasingly aggressive in defending their tax base. To better understand how price transfers affect corporate taxes, let us consider the following scenario: 

Suppose a car manufacturer has two divisions: Division A, which produces software, and Division B, which makes cars. 

Division A sells software to other car manufacturers and its parent company. Division B pays for Division A software, usually at the existing market price that Division A charges other car manufacturers.

Suppose Division A decides to charge a lower price to Division B instead of using the market price. As a result, Division A's revenues are lower due to the lower fees charged. 

On the other hand, the cost of Division B of commodities (COGS) is lower, increasing the profitability of the Division. In short, Division A's revenue is less by the same amount as the cost of Division B's — so there is no financial impact on the whole organization.

However, suppose that Division A is situated in a country with higher taxes than Division B. The company can save taxes by making Division A less profitable and Division B more profitable. 

By making Division A charge lower rates and transferring savings to Division B, increasing its profits with lower COGS, Division A will be taxed at a lower rate. In other words, Division A's decision not to charge market prices from Division B allows the company to avoid taxes.

In short, by charging above or below the market price, companies can use transfer rates to transfer profits and costs to other categories internally to reduce their tax burden.

Examples of Transfer Pricing

Suppose a division of a car company, ABC Company, promises to buy 50,000 tires from the same company's tire division for $100 per unit. The cost of producing each wheel with a volume of 200,000 revolutions per year is as follows:

The tire division sells 200,000 tires annually to customers for up to $140 per unit. In addition, the battery capacity of the Division is 300,000/year. The assembly division usually buys tires from arm's length suppliers for $125 per unit.

Now, the question is whether the manager of the tire unit should accept the offer or not. If so, how will the company benefit from this internal transfer?

Part of the wheels have an additional capacity 

(300,000-200,000) = 100,000 tires per year. 

So, the relevant cost in the tire segment will be 

$82 / battery ($124 priced out on top of a fixed factory overhead of $42) 

And the additional margin on the tire division would be 

50,000 * (Given= $0.9 million)

In view of the above benefits of the tire unit, its manager should undoubtedly accept the offer.

The assembly section costs $125 for external suppliers, with a tire that can be purchased internally at an incremental cost of $82. 

Thus, the total cost saved by the company is approximately 

50,000 * (125 – 82) = $2.15 million per year

This is how a company will benefit from internal transfers.

The transfer price should be between $82 and $125 in this case. If it is less than $82, the tire division will incur a loss, while if it exceeds $125, the assembly division will pay more than what we pay outside suppliers.

Researched and Authored by Sakshi Uradi | LinkedIn

Edited by Aditya Murarka | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Black Market
• Demand Theory
• Economic Profit
• Open Market
• Trade Wars