What is Transfer Pricing?

Dec 25 / Borys Ulanenko
Contents:
 
1. What Is Transfer Pricing?
 
Key Takeaway: Transfer pricing is the process of setting the price for goods or services when one part of a business sells them to another division ("subsidiary"), usually in another country.


Transfer pricing is a bit like a family business where members sell products or services to each other. Imagine a family that owns several bakeries across different countries. If one bakery in Italy sells flour to another in France, they need to decide on a price. This internal pricing is what we call transfer pricing.

In the corporate world, transfer pricing occurs when different divisions of a multinational company, often located in different countries, trade with each other. Think of a tech giant in the U.S. selling software to its subsidiary in Ireland. The price set for this software is crucial. It's like setting the right temperature in a greenhouse; it needs to be optimal for growth without upsetting the balance.

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2. Why Is Transfer Price Used?
 
Key Takeaway: transfer pricing is used for various reasons. 
1. To allocate taxable profits and losses among the members of a group of companies and to have these profits and losses taxed in the jurisdictions where they are generated. 
2. To create profit centres that can be used to set up and incentivize internal transfers of valuable property, services, and capital in the group. 
 
You may now ask, "who cares what price they use?". Taxation is the answer. 
 
We call Company A and Company B "related" because Company A is the parent company and Company B is the controlled affiliate. At the same time, these two companies are separate legal entities from the German and US legal and tax perspectives, i.e. they have their own legal and tax obligations. They also have separate financial reporting. 
 Let's now assume that it costs $100 for Company A to produce phones, and Company B sells them to the US customers for $150. It means that Company A and Company B (together) generate $50 profit in this business model. The transfer price (i.e. the price that Company A charges Company B for the phones) is effectively a mechanism that allows allocating profits to a particular jurisdiction. And tax authorities of both countries (for example, Internal Revenue Service in the US) want to ensure that companies pay proper profit tax. 
For example, let's assume the German corporate tax rate is 50%, and the US rate is 20%. If Company A sells phones to Company B for $110, it means that Company A's profit in the transaction is $110-$100 = $10, and it pays 50%*$10=$5 tax. At the same time, Company B's profit in the US is $150-$110 = $40, and it pays 20%*$40=$8 in the US corporate tax. So in total, they pay $5+$8=$13 tax worldwide. If they change the transfer price to $140, this would mean that they would pay $20 tax in Germany and $2 in the US, i.e. $22 tax globally. If, instead, the transfer price is just $100 (i.e. Company A sells phones without any profit), the tax would be only $10. 
Of course, tax authorities are well aware that multinational companies may use transfer pricing to shift profits to low-tax countries and make some tax cost savings. That is why transfer pricing is a highly regulated tax area, and tax authorities may do transfer pricing examinations to ensure that the financial statements of taxpayers are accurate from a TP perspective. The main principle here is that the prices in intercompany transactions should be set AS IF these companies were independent (also called arm's-length price, or market price). 
 
At the same time, transfer pricing is used by corporations to incentivize their management and have a proper set of KPIs so that every manager looks after the P&L of her subsidiary. So, for example, a manager of Company B who sells phones at $140 would have a higher P&L than her peer who sells them at $100. And this is the way that the company achieves "performance-based" rewards through transfer pricing. Hence, it is called "managerial transfer pricing". However, tax transfer pricing is usually much more important in the modern world, as companies may have separate KPI scorecards to assess the performance of their subsidiaries. 


When is transfer pricing relevant?


Transfer pricing is relevant in situations where a group of companies, owned by the same shareholders, or with one company being owned by the other, need to exchange funds for goods or services. It is a method used to determine the appropriate price for these transactions between related parties. While one might think to simply transfer the necessary funds to cover costs or continue operations, it is not as straightforward as it seems. Allocating the correct price becomes crucial as it can potentially generate taxable profits in specific regions. This concept is especially important in cross-border scenarios, where companies have been known to utilize transfer pricing to shift profits to jurisdictions with lower tax rates, thereby avoiding paying taxes. To prevent such manipulation, international taxation bodies have developed transfer pricing rules. Therefore, transfer pricing becomes relevant when there is a need to establish accurate pricing for transactions between related entities, particularly in cases involving multinational companies. 

 
3. How does transfer pricing work? And how to determine the transfer price?
 
Key Takeaway: Transfer pricing is not a random number. It has to be transparent, supported by facts, applied in accordance with the law and regulations. There are multiple ways to establish the transfer price and different methods are best-suited for different industries and scenarios.
 
There is a set of rules around how transfer pricing should be established. These rules can vary from country to country, but in general:
 
  • The transfer price is established by comparing a good or service with another good or service. 
  • The terms of sale are similar to those negotiated between unrelated parties.
 
Sounds simple, right? But what is "comparability" and how to establish it? How to do the comparability analysis? The critical point here is that multinational corporation does not just pick the price out of thin air. There are different methods and approaches to arrive at it. OECD, the international organization, published 600+ pages of guidelines on how the transfer prices should be determined for tax purposes, and taxpayers must follow the rules (if they don't want to be challenged by tax authorities and face transfer pricing issues). The document is called the "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations". Most of the countries in the world follow the OECD standard with some minor deviations. 
 
Regulations on transfer pricing have a lot of nuances, which is why there is even a separate profession of transfer pricing expert. Let's have a look at the options on how the prices could be established in our Company A/Company B mobile phone example:
1. If Company A sells phones to unrelated parties (uncontrolled taxpayer) in uncontrolled transactions, we could use this information to establish prices in transactions with Company B. Similarly, if Company B buys similar goods from third party suppliers (independent enterprises), these prices could also be used ("comparable uncontrolled price method").
2. We could check the profitability of Company A as a manufacturing entity. Does Company A earn fair mark-up on its manufacturing costs? If yes, this could indicate that the phone price is also reasonable ("cost plus method"). 
3. Similarly, we could test the profitability of Company B in selling mobile phones. We could compare the resale profit margin to the profitability of electronics distributors ("resale price method").
 
We just listed three options, but there are more of them. The process of determining the transfer price involves the application of the transfer pricing method. Also, every scenario has nuances and features which may make it the best or the worst, depending on the facts and circumstances of a particular case. This makes transfer pricing practices complex and drives the number of transfer pricing disputes around the world.  
 
4. What is Transfer Pricing as a Profession?
 
Key Takeaway: The two main processes that TP specialists perform are transfer pricing price setting and transfer pricing documentation. Transfer pricing professionals analyze supply and demand, how the market prices things, how much capital is invested in the transaction, what are functions, assets and risks, and more to establish an appropriate transfer price for any given transaction.
 
Transfer pricing specialists deal with two tasks - first, they need to determine the transfer price to be charged in the intercompany transaction. Second, they need to prepare a set of documents to prove to tax authorities that the price is at an appropriate level. 
 
Many companies have in-house transfer pricing specialist (or even a transfer pricing team) to set prices and prepare TP documentation; some companies prefer outsourcing - they hire professional advisors to do TP. These professionals may need to establish the correct transfer prices for any number of services and/or products, including materials, labour, equipment, real estate, software, licensing agreements and more. This can be challenging because many factors vary from one transaction to another. 
 
Transfer pricing professionals analyze supply and demand, how the market prices things, how much capital is invested in the transaction and more to establish an appropriate transfer price for any given transaction. They also need to check and balance the books to ensure that the transfer prices are recorded accurately, as this can significantly impact how much income a company will owe in taxes. Therefore, transfer pricing professionals need to be highly skilled and knowledgeable to do their job. They also need to verify the accuracy of their work, which can be a challenge because there is no set formula for determining the correct transfer price.
 
In any case, the transfer pricing function is essential for every company with significant overseas operations because not doing transfer pricing properly can result in high tax bills, penalties, and even prosecution. It can also allow competitors to capture market share. 

If you are interested in knowing more about transfer pricing profession, check out blog post below:

 
5. How to Study Transfer Pricing?
 
Key Takeaway: The material needed for studying transfer pricing is available online for free, but it can be more efficient and convenient to take training courses.
 
Transfer pricing is full of various rules, guidelines, and transfer pricing regulations regulations that corporations must follow to comply with different countries' laws. This can make transfer pricing a somewhat tricky topic to study. Many accountants and auditors are not familiar with it, and some even consider it illegal. However, it is possible to learn about transfer pricing and become a skilled professional who can apply the skills needed to do this job. It's also an exciting area that can be pretty rewarding.
 
As a starting point, you may want to take a short onboarding transfer pricing fundamentals course - for example, this Udemy course will introduce you to the main TP concepts in just two hours. If you are interested in more in-depth training, consider study materials and detailed transfer pricing courses. 
 
If you are familiar with international tax and finance, you may learn transfer pricing from source documents, such as the OECD Guidelines. Check this post for a list of relevant resources.   
 
I hope this article helped you understand what transfer pricing is and how it works. So now you can immediately understand what transfer pricing means when you come across transfer pricing in various financial and regulatory documents.
 
6. When should a company start thinking about transfer pricing?
 

You should start thinking about transfer pricing as soon as your company begins conducting transactions involving the transfer of money between different companies. It is important to address this matter promptly, even if you have already been engaging in such transactions without awareness of transfer pricing. It is recommended to consult with an accountant at the earliest opportunity.

Furthermore, it's essential to understand that considering transfer pricing is not a one-time task. It should be periodically reviewed to ensure that the proper prices are established. Make sure to maintain all documentation related to transfer pricing and the ongoing reviews. Having this documentation on hand can be helpful for future reviews or when presenting your business to potential investors, as it demonstrates your commitment to corporate responsibilities and risk mitigation.

An annual review is ideally conducted, or more frequently if there are changes in the nature of the transactions, costs, the wider economic environment, or tax regulations that may warrant it.

By changes in costs, we are referring to significant, incremental changes, rather than normal expected fluctuations which can be accounted for in the pricing calculation.

 
7. Other questions
 


What is the Comparable Uncontrolled Price (CUP) Method?


The Comparable Uncontrolled Price (CUP) Method involves comparing the price of a good or service in a controlled transaction with the price of a comparable good or service in an uncontrolled transaction between unrelated parties. The transfer price is then set at a level that aligns with what would be charged in an arm's length transaction. This method is based on the principle of market comparability.


How is transfer pricing reported and what documentation is needed?


Transfer pricing transactions must be reported, and it is mandatory to have supporting documentation. To report transfer pricing accurately, an accountant or transfer pricing advisor can provide a document template that complies with the reporting requirements. This documentation includes details of the transfer pricing method used, supporting data, and any relevant financial information.

What are the potential complexities and hybrid models in transfer pricing?

Transfer pricing can become complex due to various factors. Hybrid models, which combine or modify different transfer pricing methods, can add to the complexity. Additionally, the unique characteristics of certain industries or scenarios may require a tailored approach, making transfer pricing calculations more intricate.

Why is it important to involve an accountant or transfer pricing advisor in transfer pricing calculations?

Involving an accountant or transfer pricing advisor in transfer pricing calculations is crucial for several reasons. Firstly, they have expertise in this area and can provide guidance on the appropriate method to use. Secondly, they are familiar with the reporting requirements and can assist in preparing the necessary documentation for end-of-year filings. Lastly, an accountant or transfer pricing advisor can help with the annual review of transfer pricing to ensure compliance.

What are the five basic methods used to calculate transfer pricing?

There are five basic methods for calculating transfer pricing, all based on the 'arm's length' principle. These methods are the Comparable Uncontrolled Price (CUP) Method, Cost-Plus-Percent Method, Resale Price Method, Transaction Net Margin Method (TNMM), and Profit-Split Method. Each method has its own suitability depending on the industry or process involved.



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