Transfer Pricing: Definition and How It Works

Many jurisdictions are under increased pressure to secure a larger portion of an entity’s profits for their tax bases as a result of rising government deficits. Due to this, there is a chance of tax assessments, penalties for improperly allocating income among two or more jurisdictions, and double taxation of the same income by those jurisdictions. As a result, almost all large MNCs should review their international transfer pricing strategies and potential risks on a regular basis.

The arms-length principle is the accepted international standard for determining the proper transfer price. According to this principle, transactions between two related parties should result in outcomes that are identical to those that would have been obtained from comparable transactions between independent businesses in the same situation. The US transfer pricing regulations (Code Section 482, and the Treasury regulations that follow), the Transfer Pricing Guidelines, and the UN Transfer Pricing Manual for Developing Countries all make reference to this principle. There are some countries (e. g. Brazil) that don’t adhere to the arm’s-length principle’s international application.

The extensive Section 482 regulations aim to cover a wide range of transactions in light of the arms-length principle. However, choosing the right arms-length outcome based on a specific set of facts and circumstances can be challenging in practice. The exchange of goods and services may include particular, company- or industry-specific elements that make comparisons to exchanges involving other companies difficult. The Section 482 regulations acknowledge that identical transactions are uncommon and instead try to determine the results at arms’ length using the “best method” rule.

Transfer Pricing

How does transfer pricing work?

Businesses and subsidiaries operating under the same ownership or control are able to price transactions internally thanks to transfer pricing. This practice can apply to domestic and cross-border transactions. Take Great Diamond Company, a company in the diamond sector, as an illustration:

Example: Great Diamond Company owns two subsidiaries: Diamond Extraction Inc. and Diamond Sales. All three companies are associated enterprises. Diamond Extraction Inc. extracts diamonds and creates jewelry that is distributed by Diamond Sales.

The price at which Diamond Sales sells jewelry on the market is determined by supply and demand, not the Great Diamond Company, which owns the two subsidiaries. However, the Diamond Sales and Diamond Extraction Inc. transactions are under the control of the Great Diamond Company.

Diamond Extraction Inc. Internal sales to Diamond Sales are regulated transactions, and the transfer price is the price that Great Diamond Company sets for these transactions.

What are transfer prices?

Management staff can determine a special price for this transaction when related companies conduct internal transactions. This is referred to as a transfer price, and it may affect the profits and taxes of a company.

Associated enterprises can fit into two categories:

3 types of transfer pricing models

Here are three main types of transfer pricing models:

1. Market-based transfer price

Market-based transfer pricing mimics the market conditions. It corresponds to the price at which the business would offer the product to customers. For businesses to use this strategy, there needs to be an existing market. You can examine comparable products on the market, such as those that rivals sell, to determine the market-based transfer price.

2. Cost-based transfer price

In situations where market prices are uncertain or unrecognized, the most widely used transfer price is cost-based. When transferring costs, only one subdivision is responsible for covering the costs of the goods it purchased from another subdivision. This practice maximizes the profit for the purchasing enterprise.

3. Negotiated transfer prices

Managers can refuse internal transactions if there is a negotiated transfer price, and subunits must bargain as if they were regular customers. Therefore, the primary functions of transfer prices—profit allocation and coordination—cannot always be satisfied by negotiated transfer prices.

How companies use transfer pricing

Transfer pricing is a tool that businesses can use to distribute profits among their subsidiaries. By transferring tax liabilities to entities located in low-tax jurisdictions, they may use this legal strategy to lower their taxable income and, as a result, lower their taxes. Keeping with the diamond industry, here is an illustration:

Example: The transfer price for diamond bracelets set by Great Diamond Company is lower than the going rate. This decision results in lower revenues for Diamond Extraction Inc. , which makes the bracelets, and Diamond Sales, which sells the bracelets, would have lower cost of goods.

This transfer price was determined by Great Diamond Company because Diamond Extraction Inc. is in a region with higher taxes, whereas Diamond Sales is in one with lower taxes. By increasing Diamond Sales profits and decreasing Diamond Extraction Inc. through the transfer price Great Diamond Company has shifted profits to the company in the lower tax area, resulting in a situation where the company will ultimately pay less taxes.

Benefits of transfer pricing

Transfer pricing can reduce income taxes in areas with higher taxes, which is another advantage for many businesses. This is so that companies can better balance their profits by raising the prices of goods they might sell in regions with higher taxes through the use of transfer pricing.

Example of transfer prices

The three businesses that were mentioned above as being related are used in this example:

Diamond Extraction Inc.’s manufacturing costs for a single diamond bracelet is $60. It is provided to the general public by Diamond Sales for a $500 market price. Great Diamond Company determines a transfer price between Diamond Extraction Inc. and Diamond Sales because Diamond Sales is a distributor in a nation with a less onerous tax system. and Diamond Sales lower than the market price. That way, it shifts the profit to Diamond Sales.

The transfer price is set at $100 by Great Diamond Company, and Diamond Extraction Inc. sells jewelry to Diamond Sales for a transfer price of $100 per bracelet. Here’s a layout of the profits:

Here’s a layout of the tax situation:

The local tax rate is 45% in Diamond Extraction Inc. s area, and 35% in the Diamond Sales area for local taxes. Great Diamond lowers its overall tax obligation by transferring the profit to the organization in a country with lower taxes.

In conclusion, by setting its transfer price below the market price and then allocating profits to the business in the lower tax area, Great Diamond, the head organization, pays fewer taxes overall.

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