Transfer Pricing: Definition, Example, and Impact

Transfer pricing is a financial and taxation technique multinational corporations use to allocate earnings to their subsidiaries to gain a better tax rate. Transfer pricing practices occur between divisions of the same company, locally and cross-border with other countries. Though technically legal, transfer pricing methods risk abuse when companies change their taxable income through controlled transactions and move liabilities to lower tax jurisdictions (a practice known as BEPS or Base Erosion and Profit Shifting).

Many countries’ tax authorities, including the Internal Revenue Service (IRS) in the United States, have transfer pricing regulations that follow the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. The Organization for Economic Cooperation and Development (OECD) recommends that multinational companies follow the arm’s-length principle. Outlined in the United Nations Model Double Taxation Convention Between Developed and Developing Countries, the arm’s-length transfer pricing policy asserts that the price for a service or product exchanged between two unrelated parties should be the same as the price charged in a comparable transaction between related entities.

For example, if you own a business with subsidiaries, you should base the transfer pricing rules between your company and its related parties on the profit margin comparison of non-arm’s-length entities with those of arm’s-length entities in the same kinds of transactions. In simpler terms, transfer pricing should be the same between intercompany transactions as with transactions outside the company.

Let’s say you own a multinational company with a subsidiary (Business A) located in a higher-tax country than your other subsidiary (Business B) in a lower-tax country. Your corporation can save on income tax by making Business A (which will owe higher taxes in the higher-tax country) seem less profitable on financial statements than Business B in the lower tax country.

You have Business A offer a transfer price lower than the market price to Business B when selling them items they need for their business. That way, you pass the lower price on to Business B, boosting their profits and pushing them to a lower rate on their tax return in their home country. By not charging market pricing through transfer pricing adjustments, your company avoids a higher corporate tax bill through technically accurate financial reporting that follows local tax laws.

There‘s a reason multinational corporations like transfer pricing and transfer pricing analysis: profits. The advantages include it:

1. 1. Avoids tariffs and lowers duty costs: Transfer pricing helps your company move goods internationally without paying high tariffs and significantly lowers duty costs.
2. 2. Lowers tax rate: Transfer pricing ensures your company benefits from lower tax rates from cross-border countries and international tax laws.
3. 3. Provides tax relief: Transfer pricing qualifies your organization for tax benefits, provided you have the proper transfer pricing documentation.
4. 4. Reduces income tax: Perhaps the most attractive of all the advantages, transfer pricing significantly lowers your income tax, which means you keep more of your profits.
5. 5. Saves on costs: Transfer prices save you money as they are generally lower than market prices when buying a product.

Several disadvantages crop up when examining transfer pricing issues, such as it:

1. 1. Deprives countries of tax revenue: When you employ transfer pricing valuation, profits shift to low-tax jurisdictions, which can deprive higher-tax jurisdictions of tax revenue.
2. 2. Requires investment: Transfer pricing poses a complex challenge and may take time, money, and a unique team of employees to set up your accounting system and keep track of international laws.
3. 3. Risks double taxation: If two tax authorities have opposing views on the arm’s-length price or your product, double taxation can occur, burdening taxpayers over time.
4. 4. Risks tax disputes: The IRS and international tax authorities go to great lengths to prosecute unlawful or legally muddy transfer pricing. International transfer pricing disputes can go on for years and have affected high-profile companies, costing them millions in tax bills.

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