1. What is Transfer Pricing? 

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"). We need to apply transfer pricing to establish what price should be charged by one company to another company within the same group of companies ("intercompany transfer").
 

Large companies (such as multinational corporations) often have subsidiaries, branches, and subsidiaries of subsidiaries. These entities perform certain operations that are too complicated for a large company to manage itself. The pricing of transfer of something valuable (tangible/intangible assets, intra-group services, capital, etc.) between these subsidiaries is known as transfer pricing. These transfers are also called "cross-border transactions". 
 

Multinational enterprises have utilized transfer pricing for years, but in most countries, it was not formally recognized as a practice until the 1980s. However, national governments are now more aware of its existence and use and issue laws to bring the practice into compliance with their own tax laws. 
 

 
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. 

 
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. 

 
There is a set of rules around how transfer pricing should be established. These rules can vary from country to country, but in general:
 

 
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:

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.  

 
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. 

 
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.