What is transfer pricing?
Transfer pricing refers to the pricing of all transactions including goods, services, financing and licensing between related parties.
Global regulations
Tax authorities worldwide have implemented transfer pricing regulations to ensure that transactions between related entities are priced as if they were between independent entities, known as the 'arm's length.'
Arm’s length pricing means simply that the price of a controlled transaction should be the same as the price of an uncontrolled transaction—that is, a subsidiary’s transfer price for selling to its parent or another subsidiary should be the price it would charge to a third-party under comparable facts and circumstances
Example of transfer pricing
As an example of how transfer pricing works, let’s use a hypothetical company and subsidiaries:
1. ABC Golf Manufacturing Co., based in the United States, is the parent company and makes clubs and irons and owns all intellectual property related to the business.
2. ABC Golf Distribution Co., based in Canada, purchases clubs and irons from ABC Golf Manufacturing Co. for sale into Canada.- Cost of manufacturing: $80 per club or iron
- Transfer price: $95
- Market price: $100
Let’s assume a $95 transfer price is used as the basis of ABC Golf Distribution Co.’s cost per unit with a market price per unit of $100.
The table below shows distribution of profit between the two subsidiaries.
| ABC Golf Manufacturing Co. | ABC Golf Distribution Co. | |
|---|---|---|
| Revenue | $95 | $100 |
| Cost of goods sold | $80 | $95 |
| Gross profit | $15 | $5 |
Why is transfer pricing important?
Regulatory landscape
Tax authorities generally audit a company’s transfer pricing to ensure they are conducted at arm’s length. Where the transfer pricing is not at an arms-length, tax authorities assess transfer pricing adjustments and related tax penalties and interest. Transfer pricing penalties vary significantly across different countries, and they are subject to change as tax laws evolve.
Compliance requirements
Most countries have adopted some form of transfer pricing documentation requirements, which requires taxpayers to contemporaneously document transactions with related parties.
The documentation includes background information on the company, its related parties, and industry in which the company operates; details of the related party transaction(s) including functions, assets, and risks employed by the related parties involved in the transaction; and the economic analysis detailing transfer pricing method selected and related support for the transaction(s).
Preparing such contemporaneous documentation may avoid transfer pricing penalties as discussed above, but is subject to local country rules. In other countries, failure to produce transfer pricing documentation may result in penalties.
Reputational risk
A company that does not have appropriate transfer pricing policies may provoke audits or other regulatory action and could suffer loss of reputation, potentially impacting its relationship with customers, suppliers, investors, and lenders.
Strategic planning
Transfer pricing can be used strategically to support business efficiencies, such as cash management as well as intellectual property and legal entity rationalization.
OECD Transfer Pricing Guidelines
The OECD Transfer Pricing Guidelines provide guidance on the application of the arm’s length principle.
A full list of transfer pricing methods with a short description of each method is provided below:
- CUP Method: Compares the price charged in a controlled transaction to that of a comparable uncontrolled transaction. Adjustments may be needed for differences in circumstances.
- Resale Price Method: Used when a product purchased from a related party is resold to an independent party. The resale price minus an appropriate gross margin equals the arm's length price.
- Cost Plus Method: Adds an appropriate mark-up to the cost incurred by the supplier in a controlled transaction based on comparable uncontrolled transactions.
- Transactional Net Margin Method (TNMM): Examines the net profit margin relative to a base (e.g., cost, sales, assets) from a controlled transaction. These margins are based on comparable companies performing similar functions with similar risks and assets.
- Profit Split Method: Suitable for highly integrated activities or transactions and splits the combined profit between related parties based on the value of functions performed, considering assets used and risks assumed.
In addition to the transfer pricing methods above, alternative methods may be used as the most appropriate method depending on the transaction type (e.g., a transfer of intellectual property) based on the options realistically available.
While most countries follow a similar logic as the OECD Transfer Pricing Guidelines, it is important to reconcile any differences and take into consideration the local country transfer pricing regulations depending on the jurisdictions in which you operate. Take the stress out of sales tax with Shopify Tax
Transfer pricing FAQ
Where do I learn about local transfer pricing compliance requirements in the countries I operate in?
Several public accounting firms or law firms typically publish global transfer pricing guides that detail the transfer pricing documentation requirements expected by local tax authorities, including the governing transfer pricing regulations, content that should be included in the report, the penalty regime in that country, deadlines, and other relevant information taxpayers should consider.
How do companies manage transfer pricing risks?
Companies manage transfer pricing risks by implementing robust transfer pricing policies, maintaining thorough documentation, and may obtain advance pricing agreements (APAs) from tax authorities to pre-approve their transfer pricing methods for very large cross-border transactions.
Who should I contact to assist with my transfer pricing?
Most countries have reputable accounting, consulting, or law firms that can assist with your transfer pricing matters. It is advisable to contact several firms to negotiate the best pricing for an advisor’s services.
How does transfer pricing affect financial reporting?
Transfer pricing can affect a company’s consolidated financial statements, particularly the allocation of income, expenses, and taxes among different subsidiaries, which in turn affects the overall profitability and tax liabilities.
Disclaimer: This blog provides general information and is not intended as legal or tax advice. We encourage you to consult with professional advisors to address your specific circumstances.
