What is Transfer Pricing?

What is transfer pricing?

Transfer pricing is all about setting the price for goods / services sold between companies that are part of the same group. For instance, if a subsidiary sells products or provides services to its parent company or another subsidiary, the price they charge is called the transfer price. 

These companies are all controlled by one parent corporation. Multinational corporations use transfer pricing to distribute their profits (earnings before interest and taxes) among their different subsidiaries. 

While transfer pricing can be beneficial for a company, especially in terms of taxes, authorities often keep a close watch to prevent tax avoidance through manipulative transfer pricing. Legally savvy transfer pricing can take advantage of varying tax rates in different countries by increasing transfer prices for goods / services produced in low-tax regions. 

Sometimes, companies can also save on costs by avoiding tariffs on international transactions between their related entities. International tax laws, governed by the Organization for Economic Cooperation and Development (OECD), ensure that multinational corporations' financial statements are audited and compliant.

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How transfer pricing works

Transfer pricing is an accounting plus tax practice that sets prices for transactions within a business, especially between subsidiaries that share common control or ownership. This practice applies to both cross-border and domestic transactions.

A transfer price determines what one division, subsidiary, or holding company charges another for goods or services. Usually, these prices reflect the market rate for the goods or services. Transfer pricing can also cover intellectual property like research, patents, and royalties.

Multinational corporations (MNCs) can legally use transfer pricing to allocate earnings among their subsidiaries and affiliates within the parent organization. However, some companies might misuse this practice to alter their taxable income and lower their overall tax bill. Essentially, transfer pricing allows companies to shift tax liabilities to regions with lower tax rates.

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Understanding transfer pricing and taxes

To see how transfer pricing affects a company's tax bill, let’s look at a simple example.

Transfer pricing and the IRS

Transfer pricing is a big deal for the IRS because it directly impacts how much tax multinational companies pay in the U.S. The IRS has set up specific rules / guidelines to ensure that transfer pricing practices are fair and don’t lead to tax avoidance. Let’s break down how the IRS handles transfer pricing:

1. Arm's length principle: The foundation of the IRS’s transfer pricing rules is the arm's length principle. This principle says that transactions between related companies (like subsidiaries) should be priced as if they were between independent companies. In other words, the prices should be similar to what unrelated companies would charge each other.
2. Transfer pricing methods: The IRS provides several methods to determine arm's length prices:

• Comparable uncontrolled price (CUP) method: This methodology compares the price of goods / services in a controlled transaction to the price in a comparable uncontrolled transaction.
• Resale price method (RPM): This method focuses on the price at which a product is re-sold to an independent party, subtracting an appropriate gross margin.
• Cost plus method: This method adds an appropriate markup to the costs incurred by the supplier of goods / services in a controlled transaction.
• Profit split method: This method divides the combined profits from inter-company transactions according to the relative value of each party’s contribution.
• Transactional net margin method (TNMM): This methodology examines the net profit margin relative to an appropriate base (like costs or sales) that a taxpayer realises from a controlled transaction.

3. Documentation requirements: The IRS requires companies to keep detailed records to support their transfer pricing practices. This documentation must show that the prices charged in inter-company transactions are in line with the arm's length principle. The required documentation includes:

• A detailed description of the organisational structure.
• Information about the controlled transactions and the parties involved.
• An analysis of the comparability of the controlled transactions to uncontrolled transactions.
• An explanation of the selection + application of the transfer pricing method.

4. Penalties: If the IRS finds that a company’s transfer pricing practices don’t comply with the arm's length principle, the company can face significant penalties. These can include adjustments to taxable income, interest on underpaid taxes, and additional penalties for negligence or fraud.
5. Advance pricing agreements (APAs): To avoid disputes, companies can enter into Advance Pricing Agreements with the IRS. An APA is an agreement between a taxpayer & the IRS on the transfer pricing method to be used for specific transactions over a fixed period. This helps companies avoid potential conflicts and penalties by getting IRS approval in advance.
6. Audits and disputes: The IRS conducts audits to ensure compliance with transfer pricing regulations. If they find discrepancies, they can make adjustments to the taxable income of the related parties. These adjustments can lead to disputes, which may be resolved through administrative appeals or litigation.

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Transactions covered by transfer pricing rules

Transfer pricing rules apply to a variety of international transactions. Here are some common examples:

1. Selling finished goods
2. Buying raw materials
3. Purchasing fixed assets
4. Buying or selling machinery
5. Dealing with intangibles like patents or trademarks
6. Reimbursing expenses paid or received
7. IT-enabled services
8. Support services
9. Software development services
10. Paying or receiving technical service fees
11. Management fees
12. Royalty fees
13. Corporate guarantee fees
14. Receiving or paying loans

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The purpose and importance of transfer pricing

Why transfer pricing matters

Transfer pricing has a few key goals:

• It allows each division of a company to generate its own profit and enables separate performance evaluations for each division.
• Transfer prices affect not only the reported profits of each division but also the allocation of a company’s resources. Costs incurred by one division are seen as resources used by that division.

Why transfer pricing is important

For management accounting and reporting, multinational companies (MNCs) have some flexibility in how they distribute profits and expenses among subsidiaries in different countries.

Here’s why transfer pricing is important:

• Accurate Allocation: Helps correctly allocate revenue and expenses to subsidiaries, especially when they are divided into segments or treated as standalone businesses.
• Profitability Impact: The profitability of a subsidiary depends on the prices of inter-company transactions.
• Government Scrutiny: Inter-company transactions are under increased scrutiny by governments, making compliance crucial.
• Shareholder Wealth: Transfer pricing can impact shareholder wealth by influencing taxable income and after-tax, free cash flow.
• Compliance: Understanding transfer pricing is essential for meeting legal compliance requirements and avoiding the risks of non-compliance.

Similar reading: Effortlessly track your global transactions.

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Transfer pricing: Common methodologies

Comparable uncontrolled price (CUP) method

Let’s say you run a multinational coffee company, "Global Brew Co." This company has two main divisions: one in Colombia, that grows and processes coffee beans (Division A) and another in the United States that roasts and sells coffee (Division B).

Using the CUP method

Division A in Colombia sells coffee beans to Division B in the United States. To make sure the price Division A charges Division B is fair and complies with transfer pricing rules, you decide to use the Comparable Uncontrolled Price (CUP) method.

Here’s how you do it:

1. Find comparable transactions: You look at what Division A charges independent third-party coffee roasters for the same quality of coffee beans. Let’s say Division A sells to other U.S. roasters for $5 per pound.
2. Make adjustments: Sometimes, the circumstances between the transactions might not be identical. For instance, if the third-party roasters buy in smaller quantities than Division B, you might need to adjust the price slightly to reflect bulk purchase discounts. If Division A offers third-party roasters credit terms but charges Division B upfront, adjustments might be necessary for these differences as well.
3. Set the transfer price: After considering any necessary adjustments, you set the transfer price for Division B. In this example, if the adjustments lead to a 10% discount for bulk purchases, the adjusted transfer price might be $4.50 per pound instead of $5. This ensures that the price Division A charges Division B is consistent with the arm's length principle, meaning it’s what independent companies would agree upon under similar conditions.

Resale price method

Imagine you run an international electronics company called "TechWorld." This company has two main divisions: Division X, located in South Korea, manufactures high-end smartphones, and Division Y, based in Germany, handles the sales and distribution of these smartphones across Europe.

Using the resale price method

Division Y buys smartphones from Division X and then sells them to retailers and customers in Europe. To set a fair transfer price between Division X and Division Y, you decide to use the Resale Price Method (also known as the Resale Minus Method).

Here’s how you do it:

1. Determine the resale price: Start by looking at the price Division Y charges when it sells the smartphones to retailers. Let's say Division Y sells the phones for $1,000 each.
2. Calculate the gross margin: Next, determine a reasonable gross margin for Division Y. This is the profit margin after accounting for the COGS but before deducting operating expenses. Based on market data and similar independent distributors, you decide that a 20% gross margin is appropriate for Division Y.
3. Calculate the transfer price: Subtract the gross margin from the resale price to determine the transfer price. So, if Division Y sells the phones for $1,000 and needs a 20% gross margin, you calculate the transfer price as follows:

Transfer price = Resale price - (Resale price x Gross margin)

Transfer price = $1000 - ($1000 x 0.20) = $1000 - $200 = $800

Therefore, Division X should charge Division Y $800 per smartphone.

Cost plus method

Let’s say you run a global furniture company called "EcoFurn." Your company has two main divisions: Division A, located in Vietnam, manufactures high-quality wooden furniture, and Division B, based in Canada, sells this furniture in the North American market.

Using the cost-plus method

Division A in Vietnam makes furniture and then sells it to Division B in Canada. To set a fair transfer price between these divisions, you decide to use the Cost Plus Method.

Here’s how you do it:

1. Calculate the production cost: First, determine the total production cost for each piece of furniture. This includes the cost of raw materials / labour / manufacturing overhead. Let’s say it costs Division A $200 to produce a dining table.
2. Determine an appropriate markup: Next, decide on a reasonable markup percentage for Division A. This markup should cover the cost of production and include a profit margin. Based on industry standards and comparable independent transactions, you decide that a 25% markup is fair.
3. Calculate the transfer price: Add the markup to the production cost to determine the transfer price. Here’s the calculation:

Transfer price = Cost of production + (Cost of production x Markup percentage)

Transfer price = $200 + ($200 x 0.25) = $200 + $50 = $250

So, Division A should charge Division B $250 for each dining table.

Here’s how 91Squarefeet scaled intercompany transactions with Inkle Introgroup.

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Starbucks and transfer pricing

Background

Let’s talk about Starbucks and how their transfer pricing practices got them into some hot water. Starbucks, the global coffee chain we all know and love, found themselves in the spotlight in the UK. People were questioning how they managed to sell so much coffee but report so little profit.

What happened?

Starbucks has different subsidiaries all over the world. In the UK, despite having busy stores, they showed very little profit on their books. Here’s what they were doing:

1. Royalty payments: Starbucks UK paid hefty royalties to a sister company in the Netherlands for using the Starbucks brand. These payments were marked as business expenses, which reduced their taxable income in the UK.
2. Buying coffee beans: Starbucks UK bought their coffee beans from another Starbucks subsidiary in Switzerland. The Swiss subsidiary charged high prices, which again lowered the profits reported in the UK.
3. Interest payments: Starbucks UK was also paying interest on loans from another Starbucks entity. These interest payments further cut down their taxable income.

The scrutiny

UK tax authorities and the public started asking questions. They suspected that these high prices for beans and big royalty payments were not at arm’s length – meaning, not the kind of prices you’d expect if these were independent companies dealing with each other. It looked like Starbucks was shifting profits out of the UK to countries with lower tax rates.

What Starbucks did

Faced with public outrage and pressure from tax authorities, Starbucks made some changes:

• Voluntary tax payments: Starbucks decided to pay more taxes in the UK, even though they stood by their original transfer pricing practices.
• Adjusting transfer pricing: They reviewed and adjusted their transfer pricing policies to better align with what would be considered fair market prices.
• Increased transparency: Starbucks promised to be more open about their tax payments and how they set their transfer prices.

Why It matters

This case with Starbucks shows a few important things:

1. Fair pricing: Setting prices that reflect what independent companies would charge each other is crucial to avoid getting in trouble.
2. Following the rules: Multinational companies need to follow tax laws closely to avoid fines and damage to their reputation.
3. Being open: Being transparent about tax practices can help reduce scrutiny from both the public and regulators.

The Starbucks case is a clear example of why it’s important to keep transfer pricing practices fair and transparent. It shows what can happen when a company’s tax strategies come under the microscope.

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FAQs

Why do multinational companies use transfer pricing?

Transfer pricing helps multinational companies allocate profits and expenses among their various subsidiaries to reflect fair market value and comply with international tax regulations.

How does transfer pricing affect a company's taxes?

Transfer pricing can significantly impact a company’s tax bill by shifting profits to subsidiaries in lower-tax countries, which reduces the overall tax burden.

What are the common methods for setting transfer prices?

Common methods include the Comparable Uncontrolled Price (CUP) Method, Resale Price Method / Cost Plus Method / Profit Split Method / Transactional Net Margin Method (TNMM).

Why is the arm's length principle important in transfer pricing?

The arm’s length principle ensures that transactions between related companies are priced as if they were between independent parties, helping to prevent tax avoidance and ensure fair tax reporting.

What documentation is needed to support transfer pricing practices?

Companies need to keep detailed records, including descriptions of the organizational structure, controlled transactions, comparability analysis, and how they chose and applied their transfer pricing methods.

What happens if a company doesn’t comply with transfer pricing regulations?

Non-compliance can lead to significant penalties, including adjustments to taxable income, interest on underpaid taxes, and extra penalties for negligence or fraud.

How can companies avoid disputes with tax authorities over transfer pricing?

Companies can avoid disputes by maintaining thorough documentation, following the arm’s length principle, and potentially entering into Advance Pricing Agreements (APAs) with tax authorities.

Can transfer pricing methods be applied to intangible assets?

Yes, transfer pricing methods can be used for intangible assets like patents, trademarks, and royalties to ensure fair and compliant pricing.

How does the OECD influence transfer pricing rules?

The OECD provides guidelines and frameworks for transfer pricing, which many countries adopt to ensure consistent and fair taxation of multinational enterprises.

What role do transfer pricing audits play in compliance?

Transfer pricing audits by tax authorities make sure companies comply with the rules and that inter-company transactions are conducted at arm’s length, helping to prevent tax avoidance.

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