Imagine a US company with subsidiaries in two other countries—one with an income tax rate of 40% and the other with a 25% rate. The parent company is thinking about a way of managing the subsidiaries’ tax liabilities so it pays the least possible taxes and makes the most possible profit. Transfer pricing is one way to accomplish this.
What is transfer pricing?
Transfer pricing is the practice of exchanging goods or services between related parties—typically businesses controlled by a parent company or holding company—and establishing a price for the transfer. Since such transfers are internal transactions, the related businesses need some accounting basis for their transfer price. For example, this might be a market price (if there is a public market for the product or service) or the production cost plus some amount of markup.
Multinational companies use transfer pricing to juggle the profits and tax burdens of their operations in countries with varying tax rates. Smart management of transfer pricing can allow a company to avoid paying unnecessary taxes and keep the maximum allowable profit. Tax authorities such as the Internal Revenue Service pay close attention to transfer pricing to check that companies aren’t dodging lawful tax obligations.
Advantages of transfer pricing
Companies may find some advantages in using transfer pricing, including:
A company can reduce its overall tax liability by managing the transfer pricing of its subsidiaries. For example, a subsidiary in a higher-tax jurisdiction is charged a higher transfer price for receiving goods and services, raising its costs and lowering profit (taxable income). A cross-border subsidiary in a lower-tax jurisdiction is charged a lower transfer price for the opposite effect—to reduce costs and boost taxable income.
Allocating profits among subsidiaries according to their tax rates can boost the parent company’s profit by maximizing the low-tax subsidiary’s profit while minimizing the high-tax subsidiary’s profit. The parent company benefits by having the increased profit from the low-tax subsidiary offset the reduced profit from the high-tax subsidiary.
Lower import duties
Companies shipping overseas can use low transfer prices to reduce the basis for import duties. For example, Country Z assesses a 20% duty on imported products, so Company A sets a transfer price of $40 for its product shipped to Subsidiary B in that country, instead of the commercial price of $80.
Disadvantages of transfer pricing
At the same time, transfer pricing can carry some disadvantages and risks. Among them:
Less tax revenue
The primary disadvantage is to the taxing countries. Countries may get less tax revenue, particularly those with higher tax rates.
More regulatory scrutiny
Tax authorities watch companies that use transfer pricing, and they may audit a company’s financial statements for a company’s pricing methods to check for proper documentation of transfers between related businesses.
Complications and costs
Any transfer pricing method involves complicated accounting and record-keeping. To be implemented properly, the practice takes time, money, and a qualified staff.
Tax authorities might have different views about a transfer transaction between subsidiaries in two countries, and each country could impose its own determination of tax liability. That could result in double taxation: a problem requiring time and effort to resolve.
A company that aggressively uses transfer pricing, provoking audits or other regulatory action, could suffer loss of reputation, potentially impacting its relationship with customers, suppliers, investors, and lenders.
How the OECD handles transfer pricing
The Organization for Economic Cooperation and Development (OECD) is an international body that provides guidelines for international tax laws and international trade. More than 35 industrialized free-market countries, including the US, participate in the organization and use OECD recommendations in setting their tax regulations. The OECD classifies businesses related to a parent company in three ways, and it relies on a few key principles to determine fair transfer prices.
OECD company classifications
Transfer pricing guidelines from the OECD are about transactions among a parent company and related businesses, which the OECD calls “entities under common control.” Those entities can be:
A company that is majority-owned, meaning more than 50% of its equity is owned by the parent. This typically means that the parent company controls the subsidiary’s board of directors, executives, and financial decisions. A parent company usually includes the financial data from subsidiaries in its own financial statements; these are known as consolidated statements. Despite this control, a subsidiary is legally a distinct entity in terms of taxation, regulation, and liability.
A company that is less than 50%-owned by another company and whose board, management, and finances—while not directly controlled by a parent—may be strongly influenced. The minority owner usually accounts for the affiliate’s profits under the equity method, meaning in proportion to its ownership. So for example, if Company A owns 40% of Company B’s shares, it reports 40% of Company B’s profit on its income statement.
A business that is fully integrated within the company and not a legally distinct entity.
OECD guidelines for transfer pricing
The OECD guidelines focus on the difference between what it calls “controlled transactions” and “uncontrolled transactions.” Controlled transactions are those between related business entities in which a parent has some control of the price. Uncontrolled transactions are between two independent, unrelated businesses—and they are generally based on market prices.
Arm's-length pricing is a key OECD principle related to these two types of transactions. 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 an outsider on the open market. The OECD calls this the comparable uncontrolled price (CUP) method of determining transfer prices.
Alternative pricing methods include using production cost plus a markup as the pricing basis, resale price minus a profit margin, and negotiated price between related businesses. Although the OECD stresses the arm’s-length principle and making transfer prices comparable to market prices, companies may argue that market data are lacking or insufficient and use other pricing methods. Cost-based or margin-based pricing typically offers companies the best tax advantages.
Example of transfer pricing
As an example of how transfer pricing works, let’s use a hypothetical company and subsidiaries. Ace Golf Inc., the parent company, has two subsidiaries:
1. Ace Golf Manufacturing Co., which makes clubs and irons
2. Ace Sales & Marketing Co., which sells clubs and irons
Ace Golf Manufacturing operates in a higher-tax country with a 40% tax rate, while Ace Sales & Marketing operates from a lower-tax country with a 30% rate. Ace Golf Manufacturing sells clubs and irons to Ace Sales & Marketing, which then sells to consumers at the market price.
- Cost of manufacturing: $60 per club or iron
- Transfer price: $75
- Market price: $150
Let’s assume the $75 transfer price is using the basis of the selling subsidiary’s cost per unit, plus a markup for some presumed profit margin.
The table below shows distribution of profit between the two subsidiaries, using the market price for clubs and irons in the center column and the transfer price in the right column.
|Profit using market price
|Profit with transfer price
|Ace Golf Manufacturing
|$150 – $50 = $100
|$75 – $50 = $25
|Ace Sales & Marketing
|$150 – $150 = 0
|$150 – $75 = $75
|Total, Ace Golf (parent)
The table below shows the hypothetical tax liability, based on the above table’s distribution of profit between the subsidiaries and their tax rates:
|Ace Golf Manufacturing, 40% tax rate
|$100 X 0.4 = $40
|$25 X 0.4 = $10
|Ace Sales & Marketing, 30% tax rate
|$0 @ 30% = $0
|$75 X 0.3 = $22.50
|Total tax, Ace Golf
|$40 + $0 = $40
|$10 + $22.50 = $32.50
This example shows how a company might use transfer pricing to allocate profit among subsidiaries according to their different tax rates, in order to reduce its tax liability and keep more profit.
Transfer pricing FAQ
Why is transfer pricing used?
Transfer pricing is used by companies to shift the profits and tax burdens among subsidiaries or other entities under their control, to reduce their overall tax liability, and to hold onto more profit.
What are the transfer pricing methods?
Various methods of determining a transfer price that meets regulatory guidelines include: comparable uncontrolled price, cost plus, resale minus, net margin, and profit split. In short, a transfer price that meets regulatory guidelines typically is based either on a market price or a seller’s cost plus some markup.
How do you calculate the minimum transfer price?
Minimum transfer price is typically based either on the going market price of a product or service, if there is a public market for it, or on the seller’s cost plus some markup.
Is transfer pricing a form of tax evasion?
Transfer pricing is permitted as long as companies follow the guidelines of the OECD and the transfer pricing regulations of the countries where they operate. A company might be tempted to push the limit on transfer pricing, but this may draw the attention of tax authorities, possibly leading to an audit of financial statements and even legal action.