Transfer Pricing

Transfer pricing can be defined as the value which is attached to the goods or services transferred between related parties. In other words, transfer pricing is the price which is paid for goods or services transferred from one unit of an organization to its other units situated in different countries

Transfer pricing refers to value attached to transfer of goods or services between related parties.

Thus, transfer pricing can be defined as the price paid for goods transferred from one economic unit to another, assuming that the two units involved are situated in different countries, but belong to the same multinational firm.

Aims & Objective of Transfer Pricing

  1. Transfer pricing minimizes the tax burden or arranging direction of cash flow:

Transfer price, as aforesaid, refers to the value attached to transfer of goods, services, and technology between related entities such as parent and subsidiary corporations and also between the parties which are controlled by a common entity. Its essence being that the pricing is not set by an independent transferor and transferee in an arm’s length transaction. Transaction between them is not governed by open market considerations.

  1. Transfer pricing results in shifting profits

Whatever the reason for fixing a transfer price which is not arm’s length, the result is the shift of profit. The effect is that the profit appropriately attributable to one jurisdiction is shifted to another jurisdiction. The main object is to avoid tax as also to withdraw profits leaving very little for the local participation to share. Other object is avoidance of foreign exchange restrictions.

  1. Shifting of Profits: Tax avoiding not the only object

Transfer between the enterprises under the same control and management, of goods, commodities, merchandise, raw material, stock, or services is made at a price which is not dictated by the market but controlled by such considerations such as:

  • To reduce profits artificially so that tax effect is reduced in a specific country;
  • To facilitate decentralization of production so that efforts are directed to concentrate profits in the State of production where there is no or least competition;
  • To remit profits more than the ceilings imposed for repatriation;
  • To use it as an effective tool to exploit the fluctuation in foreign exchange to advantage.

Purposes of Transfer Pricing

The key objectives behind having transfer pricing are:

  • Generating separate profit for each of the divisions and enabling performance evaluation of each division separately.
  • Transfer prices would affect not just the reported profits of every center, but would also affect the allocation of a company’s resources (Cost incurred by one centre will be considered as the resources utilized by them).

Why Organizations need to understand Transfer Pricing?

For the purpose of management accounting and reporting, multinational companies (MNCs) have some amount of discretion while defining how to distribute the profits and expenses to the subsidiaries located in various countries. Sometimes a subsidiary of a company might be divided into segments or might be accounted for as a standalone business. In these cases, transfer pricing helps in allocating revenue and expenses to such subsidiaries in the right manner.

The profitability of a subsidiary depends on prices at which the inter-company transactions occur. These days the inter-company transactions are facing increased scrutiny by the governments. Here, when transfer pricing is applied, it could impact shareholders wealth as this influences company’s taxable income and its after-tax, free cash flow.

It is important that a business having cross-border intercompany transactions should understand transfer pricing concept, particularly for the compliance requirements as per law and to eliminate the risks of non-compliance.

Transfer Pricing Methodologies

The OECD (The Organization for Economic Co-operation and Development) Guidelines discusses the transfer pricing methods which could be used for examining the arms-length price of the controlled transactions. Here, arms-length price refers to the price which is applied or proposed or charged when unrelated parties enter into similar transactions in an uncontrolled condition.

The following are three of the most commonly used transfer pricing methodologies:

For the purpose of understanding, associated enterprises refer to an enterprise which directly or indirectly participates in the management or capital or control of another enterprise.

Problems associated with Transfer Pricing

There are quite a few problems associated with the transfer prices.  Some of these issues include:

  • There could be differences in opinions among organizational divisional managers with respect to how transfer price needs to be set.
  • Additional time, costs and manpower would be required for executing the transfer prices and designing the accounting system to match the requirements of transfer pricing rules.
  • Arm’s length prices might cause dysfunctional behavior among the managers of organizational units.
  • For some of the divisions or departments, for instance, a service department, arm’s length prices don’t work equally well as such departments don’t offer measurable benefits.
  • The transfer pricing issue in a multinational setup is very complicated.

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