Transfer Pricing: What It Is and How It Works, With Examples

Transfer pricing defines the price at which a multinational company (MNE) exchanges goods, services or intellectual property between two internal entities in different countries. In short, this practice allows companies to exchange internally while respecting price standards. In fact, each country has different tax regulations that affect declared income. For example, setting a price too high or too low could shift profits from a higher-tax country to a more favorable one. That’s why you should rely on the accounting and legal experts at Ascot International to get priority advice on how to set transfer pricing. 

What Is Transfer Pricing?

Transfer pricing is the cost at which companies internally exchange goods, services or intellectual property between entities located in different countries. Internal transactions are widespread among multinational corporations (MNEs) and also for operational purposes. For example—an American company that produces components in a branch in Mexico then sells them to another branch in France, which assembles and markets them. 

The importance of understanding what is transfer pricing is evident when we think about the complexity of these transactions and their influence on tax base erosion. The cost affects how profits are declared and taxed in jurisdictions—so this price must be consistent with the principle of fair competition (arm’s length principle).

Importance of Transfer Pricing in International Business

Understanding what is transfer pricing in international business is very helpful in comprehending how multinational companies trade their assets among various controlled entities. Buying or selling goods and services between firms in different countries has tax implications, such as where revenues are shifted and how they are taxed. 

To avoid misconduct—such as shifting revenues from a country with unfavorable taxation to one with better taxation—there are various oversight authorities worldwide such as the Internal Revenue Service (IRS) in the US.

So, multinational companies rely on the arm’s length principle to establish fair and aligned transfer pricing in international business. To conduct proper practices, use Ascot’s business consultant service. 

The Arm’s Length Principle

The arm’s length principle states that transactions between two controlled parties-subsidiaries of the same firm—must take place in the same manner and with the same economic data as between two unrelated parties. Let’s figure out what this definition means. 

The principle prevents misconduct aimed at shifting profits to jurisdictions with advantageous taxation. This is why it guarantees the fairness of, for example, the purchase and transfer of assets by a company and its subsidiary abroad (as in an international joint venture). The principle also underlies the OECD guidelines and is used by the IRS in the United States. 

Common Transfer Pricing Methods

Tax authorities and the OECD recognize five main approaches to determine arm’s length pricing for related-party transactions. Each procedure applies depending on the nature of the transaction and data availability. 

• Comparable Uncontrolled Price (CUP) Method: Compares the fee charged in a controlled transaction to the fee charged in an uncontrolled one. 
• Resale Price Method: Starts with the price at which a product is resold to a third party and subtracts an appropriate gross margin.
• Cost Plus Method: Adds an appropriate markup to production costs of goods or services transferred between entities.
• Transactional Net Margin Method (TNMM): Analyzes the net profit relative to an appropriate base (e.g., costs or revenue).
• Profit Split Method: Allocates profits based on each entity’s contribution to the transaction.

Each corps must justify its choice of approach through documentation aligned with the arm’s length standard. 

Real-World Examples of Transfer Pricing

There are several examples of transfer pricing used in buying and selling transactions. Here are three that explain the concept. 

1. Software company and Intellectual Property transfer. Suppose a US firm develops software and transfers it to its Singapore subsidiary. It must identify a market price for the IP transfer based on methods such as the Profit Split Method or TNMM. 
2. Manufacturing company and component sales. Entering the manufacturing sector, let us analyze a Mexican corporation that manufactures components and resells them to a distribution subsidiary in Germany. In this case the Cost Plush Method can be applied.

Documentary evidence and an explanation of why this criterion was chosen for target pricing should be shown for each approach.

Transfer Pricing Documentation and Compliance

Tax authorities have set requirements and necessary documentation for domestic purchases and deals. These requirements are part of the OECD’s Action Plan against Base Erosion and Profit Shifting (BEPS), aimed at improving transaction transparency and preventing tax avoidance practices. But what documentation is required to be compliant?

• Master File: A document that lists all the details (structure, activities, etc.) of the parent organization;
• Local File: A detailed analysis of local subsidiaries;
• Country-by-Country Reporting (CbCR): From the name, a country-by-country report with information on profits reported and taxes paid. 

Failure to comply or submit this documentation will result in financial penalties for companies or, in some cases, double taxation. 

Transfer Pricing Risks and Controversies

Obviously, transfer pricing also has risks that need to be dealt with while doing business. Indeed, the relevant authorities are increasingly restrictive, and in the event of an unjustifiable transfer of profits to more favorable jurisdictions they may require additional documentation or impose tax adjustments. 

On the other hand, another common problem is double taxation. This occurs in those countries which do not have precise criteria agreements and, therefore, do not recognize the pricing plan. 

There is to be considered that any abuse can cause very significant reputational damage to the company. It is therefore of paramount importance to follow strict criteria and not use these transactions for purposes not permitted by law.

In recent years then, tax audits have sharply increased thus necessitating a proactive approach and compliance with the required documentation. 

FAQs

What is transfer pricing?

Is the price at which goods, services, property, or intellectual property are exchanged between companies controlled by a multinational corporation based in different countries.

Why is transfer pricing important?

Because it determines how company profits are taxed. In fact, transferring profits to a more favorable jurisdiction can have a significant tax impact. 

What is the arm’s length principle?

It is a principle that states that the transfer of business between two related companies (because the same multinational corporations controls them) should occur between independent companies.

Do all countries follow the same transfer pricing rules?

No. Most countries follow the OECD guidelines but the requirements and documentation needed may vary from country to country.

What happens if a company violates transfer pricing rules?

If a company violates transfer pricing regulations, it may initially undergo extensive audits, which can turn into financial penalties or tax adjustments in the case of violations or misconduct. 

References

Eden, L. (1998). Taxing multinationals: Transfer pricing and corporate income taxation in North America. University of Toronto Press.
https://www.amazon.com/Taxing-Multinationals-Transfer-Corporate-Taxation/dp/0802007767

Lohse, T., Riedel, N., & Spengel, C. (2012). The increasing importance of transfer pricing regulations – A worldwide overview. Oxford University Centre for Business Taxation.
https://oxfordtax.sbs.ox.ac.uk/the-increasing-importance-of-transfer-pricing-regulations-a-worldwide-overview

Organisation for Economic Co-operation and Development. (2022). OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022. OECD Publishing.
https://www.oecd.org/en/publications/2022/01/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2022_57104b3a.html