What is Transfer Pricing?
By Corporate Finance

Transfer pricing is an accounting practice that captures the price that one division within a company charges another division within the same company for goods and services provided.

By incorporating transfer pricing, companies establish prices for the goods and services exchanged between their various affiliates and subsidiaries or commonly controlled companies that are within or part of the same larger enterprise. The benefit of transfer pricing can lead to tax savings for corporations, however, tax authorities will sometimes contest these claims.

KEY POINTS TO REMEMBER

    • It’s important to note that a transfer price should be based on market prices when charging another division, subsidiary, or holding company for goods or services rendered.
    • The main benefit for Companies that use transfer pricing is the reduction in the overall tax burden of the parent company.
    • Common practice involves Companies charging a higher price to divisions in high-tax countries (thus reducing profit) while charging a lower price for divisions in low-tax countries (thus increasing profits).
    • When goods or services are exchanged between divisions of the same company transfer pricing accounting is required.
    • It is commonly understood that transfer pricing should be the same between intercompany transactions as it would have been had the company done the transaction with a party (client/customer) outside the company.

Transfer Pricing, How it Works

Transfer pricing is an accounting and taxation practice that captures pricing transactions within businesses and between subsidiaries and affiliates that operate under the same ownership or common control. Transfer pricing practice includes both domestic and cross-border transactions.

In order to determine the cost to charge another division within the company, transfer pricing is used. Generally speaking, transfer prices should be reflective of the going market price for that good or service. In addition to goods and services, transfer pricing can also be applied to patents, royalties, and intellectual property.

Multinational companies are allowed to use transfer pricing methods for allocating their earnings among their various subsidiary and affiliate companies that form the parent company. It’s important to note that sometimes companies may use (or misuse) this practice by altering their taxable income, thus reducing their overall taxes. In this way transfer pricing can be used as a way for companies to shift tax liabilities to lower-cost tax jurisdictions.

Transfer Pricing and the impact on Taxes

A good way to demonstrate how Transfer pricing can impact a company’s tax bill is by presenting the following scenario.

Let’s imagine that an aeronautical company has two divisions: Division A, manufactures flight software, and Division Z manufactures airplanes. Division A sells its software to other aeronautical companies in addition to selling its software to Division Z. In other words Division Z pays Division A for the software at the prevailing market price that Division A would charge to other aeronautical companies.

Let’s say that Division A decides to charge a lower price to Division Z instead of using the market price. As a result, Division A’s revenues or sales are lower because of the lower pricing. In conjunction with this, Division Z’s costs of goods sold (COGS) are also lower which would result in an increase in the division’s profits. Simply put, Division A’s revenues are lower by the same amount as Division Z’s cost savings—so in theory there would be no financial impact on the overall corporation.

Now let’s look at another scenario using the above example whereby Division A is located in a higher tax jurisdiction (country) than Division Z. Overall the company would be able to save on taxes by making Division A less profitable and Division Z more profitable. If Division A charges lower prices and passes those savings on to Division Z, this would boost profits through a lower COGS, as Division Z (located in a lower tax jurisdiction) will be taxed at a lower rate. In effect Division A’s decision to charge below-market pricing to Division Z allows the overall company to minimize taxes.