Transfer price, also known as transfer cost, is the price at which related parties transact with each other. This often occurs during the trade of supplies or labor between departments within a company or among subsidiaries of the same organization in different countries.
Key Takeaways
- Transfer prices differing from market value can be advantageous for one entity while lowering the profits of the other entity.
- Multinational companies can manipulate transfer prices to shift profits to low-tax regions.
- Regulations enforce an arm’s length transaction rule, requiring pricing to be based on transactions conducted among unrelated parties.
Understanding Transfer Price
Transfer prices are pertinent when individual entities of a larger, multi-entity firm are treated and measured as separately run divisions. Although multi-entity corporations are consolidated for financial reporting, they might report each entity individually for tax purposes.
A transfer price arises during intracompany transactions for accounting purposes. This usually happens when divisions within a company, or a company and its subsidiary, report their own profits. Transfer prices are generally aligned with market prices. If they deviate, one entity faces a disadvantage and may opt to buy from the market instead.
Assume entity A and entity B are segments of Company XYZ. Entity A builds and sells wheels, and entity B assembles and sells bicycles. If entity A sells wheels to entity B at a price lower than market value, entity B will enjoy lower [Cost of Goods Sold (COGS)] and higher [earnings]. However, this would reduce entity A’s sales [revenue]. On the other hand, if entity A offers a higher-than-market value, entity A benefits with higher sales revenue, leading to higher COGS and lower profits for entity B.
Regulations ensure fairness and accuracy in transfer pricing. The arm’s length transaction principle mandates companies to establish pricing based on transactions among unrelated parties and is rigorously monitored within financial reporting. Transfer pricing also requires precise documentation in the footnotes of financial statements for review by auditors, regulators, and investors.
Transfer pricing becomes crucial when divisions participate in international jurisdictions’ intracompany transactions. While international commerce involves significant intercompany transfers, these transfers can lead regulatory authorities to scrutinize transfer pricing for tax avoidance purposes.
Transfer Pricing Example
To comprehend the taxation impact of transfer pricing, consider entity A in a high-tax country and entity B in a low-tax country within Company XYZ. By setting a low transfer price for selling wheels from entity A to entity B, Company XYZ can shift profits to the low-tax entity B, hence reducing overall taxes.— Although, such strategies often lead to conflicts between businesses and tax authorities whose aim is to maximize respective region’s tax revenue.
Why Is Transfer Price Used?
Transfer prices are essential when individual entities of larger firms are treated as separate entities. Although multi-entity corporations consolidate for financial reporting, reporting separately for tax purposes makes transfer pricing pivotal.
What Are the Benefits of Transfer Pricing?
- Cost savings: Transfer prices, often equal to or lower than market prices, result in reduced costs for the buying entity.
- Transparency: They enhance clarity in intra-entity transactions.
- Availability: Products and services are readily available, reducing supply chain issues.
What Are the Disadvantages of Transfer Pricing?
- Revenue Impact: The selling entity might earn less revenue due to lower transfer prices than market rates.
- Complexity: Determining appropriate transfer prices can be complicated, as opposed to the straightforward market price mechanism.
- Intra-entity Issues: Disputes can arise within the organization if perceived transfer prices unfairly benefit one party over another.
Related Terms: market value, cost of goods sold, earnings, revenue, financial statements.
References
- Internal Revenue Service. “Allocation of Income and Deductions Under IRC 482”.
- Organisation for Economic Cooperation and Development. “Transfer Pricing Country Profiles”.
