Posted by Dennis Jao

What Is Transfer Pricing?

What Is Transfer Pricing?

Transfer pricing is an accounting practice that represents the price that one division of one company charges another division for the goods and services provided.

Transfer pricing is a way to fix the prices of goods and services traded between an affiliate, subsidiary, or normally controlled company that is part of the same larger company. Transfer pricing can generate tax savings for businesses, although tax authorities can dispute their claims.


How transfer pricing works

Transfer pricing is an accounting and tax practice that allows you to set transaction prices within companies and between branches that operate jointly or under control. The practice of transfer pricing extends to national and international transactions.

A transfer price is used to determine the cost of invoicing another division, subsidiary, or parent company for the services provided. Transfer prices are usually set based on the current market price for that good or service. Transfer pricing can also apply to intellectual property, such as research, patents, and royalties.

Multinational enterprises are legally allowed to use the transfer pricing method to allocate profits among their affiliates and subsidiaries that are part of the parent organization. However, companies can sometimes use (or abuse) this practice by altering their taxable income, thereby reducing total taxes. The transfer pricing mechanism is a way for businesses to transfer their tax obligations to tax jurisdictions at a low cost.


Taxes and Transfer Pricing

To better understand how transfer pricing affects a company's tax account, consider the following scenario. Suppose an automobile manufacturer has two divisions: Division A, which produces software, while Division B produces bikes.

Division A sells software to other bike manufacturers as well as to its parent company. Division B pays Division A for software, usually at the prevailing market price that Division A charges other bike makers.

Suppose Division A decides to charge a lower price than Division B instead of using the market price. Therefore, division A sales or revenue is lower due to lower prices. In contrast, the cost of goods sold (COGS) in division B is lower, increasing the division's profit. In short, Division A's revenue is less than the same amount as Division B's cost savings, so there is no financial impact on the business as a whole.

However, suppose Division A is in a country where taxes are higher than Division B. The company can save taxes by making Division A less profitable and Division B more profitable. By collecting lower prices from Division A and transferring the savings to Division B, increasing their profits through a lower cost per goods sold, Division B will pay taxes at a lower rate. In other words, Division A's decision not to charge Division B's market prices allows the business as a whole to avoid tax.

In short, when prices are above or below the market price, companies can use transfer pricing to shift profits and costs to other national divisions to reduce their tax burden. Tax authorities have strict transfer pricing rules to try to prevent companies from using them to avoid taxes.


The IRS and Transfer pricing 

The IRS says transfer prices should be the same between business-to-business transactions that would otherwise have taken place if the business had negotiated with a party or client outside the business. According to the IRS, transfer prices are defined as follows:

Section 482 regulations generally provide that the prices charged by one affiliate to others in a business-to-business transaction involving the transfer of goods, services, or tangible fixed assets produce results consistent with the results that would have been obtained if uncontrolled taxpayers had participated in the same transaction under the same circumstances.

As a result, financial information on transfer pricing follows strict guidelines and is closely monitored by the tax authorities. Auditors and regulators often need full documentation. If the transfer amount is incorrect or incorrectly made, the balance may need to be restated, and charges or penalties may apply.

However, there is a lot of debate and ambiguities about how transfer pricing is accounted for between divisions and which division should bear the brunt of the tax burden.


Summary

  • A transfer price is based on market prices billed to another division, subsidiary, or parent company for the services provided.

  • Companies charge a higher price for divisions in high tax countries (reduced profits) while charging lower prices (increased profits) for divisions in low tax countries.

  • However, companies have used inter-company transfer pricing to reduce the tax burden on the parent company.

  • The IRS says transfer prices should be the same between intra-company transactions that would otherwise have occurred if the company had made the transaction outside of the company.

  • Transfer pricing is an accounting practice that represents the price that one division of a company charges another division for the goods or services provided.


FOR MORE INFORMATION ON HOW DENNIS JAO CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.


THANKS FOR VISITING.

Dennis Jao
Contact Member