What is transfer pricing explain with an example?

Transfer pricing is a technique used by multinational corporations to shift profits out of the countries where they operate and into tax havens. The technique involves a multinational selling itself goods and services at an artificially high price. By using its subsidiary in a tax haven to charge an inflated cost from its subsidiary in another country, eg buying boxes of pens from the tax haven-based subsidiary for $200 for a pen, the multinational corporation “moves” its profits out of the country where it genuinely does business and into a tax haven where it has to pay very little or no tax on profit.

Another example: let’s say it costs a multinational corporation $100 to produce a crate of bananas in Ecuador. It then sells that crate to an affiliate located in a tax haven for $100, leaving no profits in Ecuador. The tax haven affiliate immediately sells that crate on to an affiliate in Poland for $300, leaving $200 profit in the tax haven. That Polish affiliate sells the crate at the genuine market price of $300 to a supermarket, leaving no profits in Poland.

As a result, the multinational pays no tax in Ecuador and no tax in Poland, and the $200 in profits shifted to the tax haven do not get taxed.

In this way, multinational corporations avoid their responsibility to pay tax and fail to contribute to the societies in which they operate.

Transfer pricing is the price determined for the transactions between two or more related entities within a multi-company organization. This price is also known as the cost of transfer which shows the value of such transfer between the related entities in terms of goods or even transfer of employees or labor across different departments.

Table of contents

• Transfer Pricing Meaning
  • Explanation
  • How does it Work?
  • Transfer Pricing Examples
  • Determining Transfer Pricing
  • Why is it Important?
  • Purpose of Transfer Pricing
  • Functions and Risks
  • Objectives of Transfer Pricing
  • Benefits
  • Drawbacks
  • Conclusion
  • Recommended Articles

Explanation

Article 9 describes the rules for determining the arms-length transactionArms-length TransactionAn arm's length transaction is one in which two parties operate independently and the price agreed between them (also known as the transfer price) is free of any influence.read more prices for related party transactionsRelated Party TransactionsRelated party transaction is an arrangement between two related parties for the transfer of resources, services or obligations, irrespective of whether a price is charged or can affect the statement of profit or loss and the financial position of an entity.read more between associated enterprises in the OECD Model Tax Convention. Such an arm’s length price is fairly a market price for such a commodity or service. This price is widely accepted by tax authorities and users of financial statementsUsers Of Financial StatementsFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers.read more. It assists entities in determining their real income.

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Source: Transfer Pricing (wallstreetmojo.com)

How does it Work?

• The transfer price is more related to the market price of the product or service involved in such related party transactions. This will eliminate the entities purchasing or selling such products or services in the market as they can buy or sell them between the related parties at the market price itself; this is the reason it is more of an accounting conceptAccounting ConceptAccounting concepts are the principles, assumptions, and conditions that govern accounting's foundation. They ensure that the accounting is done in a way that the financial statements present a true and fair view.read more that accounts for the transaction between such related entities at a correct and fair price.
• This is determined based on a few widely accepted methods such as comparable uncontrolled price, cost-plus pricingCost-plus PricingCost Plus pricing is the strategy of determining the selling price of a product in the market by adding a markup or profit premium to the actual cost of the product. This additional margin represents the entrepreneur's profit.read more, resale price, Transactional Net margin, and transactional profit split methods.
• The above-listed methods are used based on the transaction, such as if there are comparable products or services in the market for which there is a market price determined, then such price could be used to determine Transfer Pricing. Similarly, if the product is resaleable and such resale price is determined along with profit on such sale, then the resale price method can be utilized. Related entities use other methods.

Transfer Pricing Examples

Let us take an example of two associated entities X and Y, where X is situated in a high tax country. On the other hand, y is located in a Low tax country which is a tax haven destination; in this case, X would shift most of the revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more generated to Y through means of some associated transfers to avoid taxation or reduce the incidence of tax for the company, with the use of these provisions, such type of tax avoidance transactions could be eliminated. Similarly, due to this, there will not be the eradication of revenue from one country to another by benefiting the country of source of generating such revenue.

Determining Transfer Pricing

Suppose the assembly division of an automobile company, ABC Company, offers to purchase 50,000 tires from the tire division of the same company for $100 per unit. The production costs per tire at a volume of 200,000 tires per year are as follows:

The tire division typically sells 200,000 tires every year to arm’s length customers at $140 per unit. In addition, the capacity of the tire division is 300,000 batteries/year. The assembly division typically buys the tires from the arm’s length suppliers at $125 per unit.

Now, the question is whether or not the tire division manager should accept the offer? If yes, how will the company benefit from this internal transfer?

The tire division has a surplus capacity of (300,000-200,000) = 100,000 tires per year. So the relevant costsRelevant CostsRelevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management's decision-making process. For example, businesses use relevant costs in management accounting to conclude whether a new decision is economical.read more to the tire division will be $82 / battery (total of $124 minus the fixed factory overheadFactory OverheadFactory Overhead, also called Factory Burden, is the total of all the indirect expenses related to the production of goods such as Quality Assurance Salaries, Factory Rent, & Factory Building Insurance etc. read more of $42).

And the increased margin to the tire division would be 50,000*$(100 –82) = $0.9 million.

Due to the above benefits to the tire division, its manager must undoubtedly accept the offer.

The assembly division pays $125 to external suppliers for a tire that could be purchased internally at an incremental costIncremental CostIncremental costs are the additional costs associated with the production of one additional unit, and it only considers costs that are likely to change as a result of a specific decision, such as replacing machinery or equipment or adding a new product, and so on.read more of just $82. So, the overall cost saved by the company would be 50,000 * $(125–82) = $2.15 million per year.

This is how the company will benefit from the internal transfer.

Now, what should be the price range in this case?

The transfer price should be kept between $82 and $125. If it goes below $82, the tire division will be at a loss, while if it goes beyond $125, the assembly division will be paying more than what it pays to the external suppliers.

Now, on which legal entities should the practice of transfer pricing be applied?

The entities which can adopt this practice must be legally related entities. In other words, if two companies are owned wholly or with the majority by the parent corporation, then those companies can be considered to be under the control of a single corporation. And since they are under the control of a single corporation, they are also legally related entities, and hence, transfer pricing can be applied to them and can be practiced by them.

Under certain jurisdictions, entities are considered under common control if they share family members on their boards of directorsBoards Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals. read more even though they may not be related legally, as described in the above paragraph.

Why is it Important?

• The critical importance of Transfer Pricing provisions is that there will be an equal and fair distribution of resources between associated entities leading to nondiscriminatory trade transactions.
• This provides opportunities for associated enterprises to transact businessTransact BusinessA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements.read more between them as the transactions are valued at market price; this will enhance the scope of business and have a positive impact on the group company as a whole due to internal profits generated by these associated entities,
• Also, it is useful for the tax authorities to determine the actual value of such transactions and estimate the profits derived from such transactions taking place between associate entities. Without transfer pricing provision, there would be a reduction or avoidance of tax by misleading authorities and transferring or reporting profits based on the limitation presented in tax provisionsTax ProvisionsProvision for Income Tax is the estimated income tax for current year and is the amount that the entity might have to deposit to settle their tax liabilities. It is adjusted for the expenses allowed to be deducted according the relevant tax laws.read more.
• It is used not only by multi-company organizations but also by entities that satisfy the conditions of associated enterprises.

Purpose of Transfer Pricing

• Determination of a fair and equitable price of a transaction that takes place between two related enterprises involving the purchase and sale of goods and services;
• Other purposes include accounting for a transactionAccounting For A TransactionAccounting Transactions are business activities which have a direct monetary effect on the finances of a Company. For example, Apple representing nearly $200 billion in cash & cash equivalents in its balance sheet is an accounting transaction. read more as per its market price, avoiding any collusion among associated enterprises, and providing a base for estimating income generated from such transactions. Also, this concept is useful for true and fair reporting of transactions between associated enterprises in the financial statements of such entities.

Functions and Risks

• This concept functions basically on the principles of price determination that is available in the market for such commodities or services involved in the transaction.
• Due to such a function, there are few risks involved, such as the valuation of those transactions that involve the use of intellectual property, services that are highly valued, and transactions that are not of financial nature. The exchange of goods and services with unrelated goods and services between associated enterprises, etc.
• Also, there is a risk of mispricing a self-generated commodity or service that is not related to any other resource in the market due to limitations present in domestic pricing rules.

Objectives of Transfer Pricing

• True and fair reporting of financial statements
• Better estimation of profits generated by entities from associated transfers
• Avoidance of double taxationDouble TaxationDouble Taxation is a situation wherein a tax is levied twice on the same source of income. It usually occurs when the same income is taxed both at corporate as well as at the individual level.read more and avoiding tax evasion by entities
• Promoting competitiveness among the associated enterprises.

Benefits

• Assists the entities to transact at market prices eliminating inconsistency in pricing a transaction.
• It helps the tax authorities to determine taxes and helps reduce tax evasionTax EvasionTax Evasion is an illegal act in which the taxpayers deliberately misreport their financial affairs to reduce or evade the actual tax liability. This includes using multiple financial ledgers, hiding or representing lesser income, gains, or profits than actually earned, overstating deductions, & failing to file returns. read more.
• Fair presentation of financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more

Drawbacks

• This would require additional administrative costsAdministrative CostsAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more and a time-consuming process.
• There are few limitations in determining arm’s-length prices as two products cannot be compared due to the homogenous nature of such commodities or services.

Conclusion

The introduction of this concept has eliminated improper pricing of related party transactions between associate enterprises, making way for the elimination of tax evasion through such methods assisting the government and tax authorities. However, as this concept is relatively new, various changes need to be made to provisions over time based on its nature of the use to make it a globally accepted principle.

Recommended Articles

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