When a company sells goods or services to another company, it charges a price for those goods or services. But what if the company is a large enterprise and wants to transfer goods and services from one of its divisions, subsidiaries, or affiliates to another? What price should it charge, and how should that price be accounted for? The answer to these questions lies in an accounting practice known as transfer pricing.
Companies use transfer pricing to determine the cost of goods, services, and intangible assets (such as royalties or intellectual property) transferred between divisions, subsidiaries, or affiliates. This practice can occur in domestic as well as international transactions, and many companies use transfer pricing to better understand the profits and losses of individual divisions.
Multinational companies (MNCs) may also use transfer pricing for cross-border transactions in an attempt to reduce their taxable profits. To discourage companies from using transfer pricing to dodge taxes, many countries maintain specific regulations that govern how transfer prices are set. Companies that violate these regulations or manipulate prices artificially can be pursued and penalized by tax authorities.
In this article, we’ll take a deeper look at transfer pricing and explain how this accounting practice works for international businesses.
What is transfer pricing and how does it work?
When two unrelated companies transact, they negotiate to get the best rate possible. This typically results in a number close to the market price for the goods or services in question. The same market forces don’t necessarily apply to intra-company transfers, so a company may use transfer pricing to set the price in such transactions.
To illustrate this point, let’s use an example:
Company ABC owns two subsidiaries: S1, which manufactures microchips, and S2, which assembles cell phones.
S1 typically charges third-party companies $10,000 for one shipment of microchips. Though it would probably like to charge even more, $10,000 is close to the current market price for a shipment of microchips. If S1 charged any more for its microchips, it likely wouldn’t find as many buyers.
Now let’s say S2 needs a shipment of microchips to assemble its new phones. It makes sense for S2 to obtain those microchips from S1—but without market forces dictating the price, how should the company account for this transaction? One way of doing so would be to simply use the market price of $10,000 to set the transfer price. Another way could be to set a transfer price of $7,000, which eats into the profits of S1 but saves S2 from paying the current market price.
The tax implications of transfer pricing
What would be the benefit of a company setting a higher or lower transfer price? The profits or expenses from an intra-company sale ultimately find their way to the same bottom line, right? Well, yes, but that’s not the whole story. Since profits are typically taxed according to local regulations, companies may attempt to use transfer pricing to:
- Transfer profits to divisions operating in jurisdictions with lower taxes
- Transfer costs to divisions operating in jurisdictions with higher taxes
Let’s return to the previous example of Company ABC and assume it operates an international business. S1 (the microchip manufacturer) is in a higher tax country than S2 (the phone assembler). Theoretically, Company ABC could reduce its overall tax liability by reducing S1’s profits and increasing S2’s profits. Setting a transfer price of $7,000 (instead of the market price of $10,000) for a shipment of microchips accomplishes this goal.
If this sounds a bit like tax evasion, you aren’t the only one who thinks so! Tax authorities know the significance of transfer pricing on a company’s overall tax bill, and they may attempt to penalize enterprises that charge unfair transfer prices.
How transfer pricing is determined
Transfer pricing guidelines allow governments to collect their fair share of taxes from profitable companies. However, there can be some contention between governments and businesses on how to calculate transfer prices.
Below are some of the common methods used to determine transfer pricing.
The arm’s length principle in transfer pricing
This widely held international principle states that transfer pricing should be calculated based on the rate a company would charge an unrelated company (one held “at arm’s length”) for products or services sold.
The arm’s length principle, which is described in U.S. Treasury Code Section 482 and applied in many other countries as well, helps ensure that related entities pay their fair share to the jurisdictions they conduct business in.
Still, this isn’t a perfect method. If apples-to-apples value comparisons aren’t available, companies may need to make some adjustments to make them more accurate. And in situations such as the purchase of intellectual property, making comparisons to similar transactions between unrelated companies can be difficult—if not impossible.
So, perhaps unsurprisingly, some companies favor other transfer pricing methods.
Other transfer pricing methods used by companies
Cost-based transfer pricing
Companies using the cost-based method set prices based on the standard cost to produce the good or service, relying on only one party to cover this cost. Although this can allow one division to maximize its profit on a transaction, it may drastically hurt the other division’s bottom line.
Negotiated transfer pricing
With this method, the parties involved in the transaction negotiate on the price of the good or service. It’s generally used when the cost of a good or service is too difficult to accurately determine using other methods.
Abusive transfer pricing
Abusive transfer pricing isn’t really a “method,” but it’s an issue worth mentioning. It takes place when a company intentionally manipulates its internal transfer prices to avoid paying taxes. This practice can sometimes be difficult for tax authorities to detect and prosecute, especially when it comes to intangible assets.
Is transfer pricing illegal?
Transfer pricing, in and of itself, is not illegal. But the way some companies calculate transfer pricing can lead to heightened scrutiny and potential penalties.
To reduce abusive transfer pricing, tax authorities throughout the world have created strict regulations to crack down on transfer pricing manipulation. These include Section 482 of the U.S. Internal Revenue Code as well as the international Base Erosion and Profit Shifting (BEPS) initiative.
Many enterprises, including huge multinational corporations ranging from Amazon to Microsoft, have since gone to court over their transfer pricing practices. Let’s look at one well-known lawsuit—the Coca-Cola transfer pricing case—as an example.
Transfer pricing case study: Coca-Cola v. Commissioner
After auditing the company’s 1987–1995 tax years, the IRS established a set of transfer prices for Coca-Cola to use for certain licensing arrangements with its foreign affiliates. The company continued to use those guidelines for later transactions.
Following an audit of Coca-Cola’s 2007–2009 taxes, the IRS claimed that the transfer pricing for certain transactions in those years should have been calculated with a different method than the one used previously. In November 2020, the U.S. Tax Court sided with the IRS in ruling that Coca-Cola owes an additional $3.3 billion in taxes due to transfer pricing that undercharged affiliates for the right to use intangible property.
This decision shows that enterprises must regularly update their transfer pricing, as well as the analysis and methodologies used, to account for new circumstances.
Transfer pricing documentation
As seen above, tax authorities may penalize companies for outdated transfer pricing methods requiring adjustment. However, this can be avoided by thoroughly documenting the methods and analyses that support and validate these accounting decisions.
Many countries require some or all of the following types of transfer pricing documentation, while some have additional requirements that are specific to them:
- Master file. This is a comprehensive record of the company’s global transfer pricing policies, operations, and financial activities.
- Local file. This is a document outlining the company’s transactions in a specific country.
- Country-by-country reports. These reports summarize the financial activities of the company’s related entities in a specific country. Country-by-country reports can draw information from the master file and the local file pertaining to the country.
Transfer pricing documentation in the US
Enterprises making intra-company transactions in the U.S. must maintain comprehensive documentation. This documentation should include descriptions and analyses of controlled transactions; an explanation of why the method used to calculate transfer pricing provided the most reliable and reasonable result; and a record of any alternative methods considered (and why those methods weren’t used).
Companies must also have this documentation in place when filing their taxes, and be able to provide a copy of it within 30 days if requested by the IRS. For more information on U.S. transfer pricing documentation and best practices, review this IRS FAQ page.
Transfer pricing documentation in the EU and other countries
Documentation requirements vary widely between countries, so MNCs will benefit from reviewing and following the guidelines of the jurisdictions they plan to do business in.
Similar to the U.S., the European Union uses the arm’s length principle to determine transfer pricing for MNCs. It also requires two forms of documentation: a master file and country-by-country reports (described as “country-specific documentation” here).
For a detailed look at transfer pricing principles across 69 countries, review this list of profiles compiled by the Organization for Economic Co-operation and Development (OECD).
The risks and benefits of transfer pricing for international businesses
On the one hand, transfer pricing can help companies better understand their finances and possibly reduce their tax liability. However, transfer pricing is a complex and time-consuming accounting process. It takes a large amount of resources to properly track and document transactions and methodologies—especially across multiple countries.
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