The price charged when an article is passed from one part or department of a company to another. There are difficulties when the transfer is across national frontiers, as in the case of transnational companies, since the company may avoid taxes in a high-tax country by under-pricing exports from it and over-pricing imports to it, thus shifting profits to countries with lower tax rates.
Transfer pricing refers to the pricing of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary, with the choice of the transfer price affecting the division of the total profit among the parts of the company. This has led to the rise of transfer pricing regulations as governments seek to stem the flow of taxation revenue overseas, making the issue one of great importance for multinational corporations.
Economic theory
The discussion below explains an economic theory, but in practice a great many factors influence the transfer prices that are used by multinationals, including performance measurement, capabilities of accounting systems, import quotas, customs duties, VAT, taxes on profits, and (in many cases) simple lack of attention to the pricing.
From marginal price determination theory, we know that generally the optimum level of output is that where marginal costs equals marginal revenue.
Transfer Pricing with No External Market
It can be shown algebraically that the intersection of the firms marginal cost curve and marginal revenue curve (point A) must occur at the same quantity as the intersection of the production divisions marginal cost curve with the net marginal revenue from production (point C). Because the external market is competitive, the firm is a price taker and must accept the transfer price determined by market forces (their marginal revenue from transfer and demand for transfer products becomes the transfer price).
Transfer Pricing with a Competitive External Market
If the firm is able to sell its transfer goods in an imperfect market, then it need not be a price taker.
Transfer Pricing with an Imperfect External Market
Practical application
Role of administrative regulations and guidelines
Although there is sound economic theory behind the selection of a transfer pricing method, the fact remains that it can be advantageous to arbitrarily select prices such that, in terms of bookkeeping, most of the profit is made in a country with low taxes, thus shifting the profits to reduce overall taxes paid by a multinational group. However, most countries enforce tax laws based on the arm's length principle as defined in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, limiting how transfer prices can be set and ensuring that that country gets to tax its "fair" share. In the United States, the pricing of transactions between related parties that are reported for tax purposes are governed by Section 482 of the Internal Revenue Code and the regulations thereunder.
From the corporation's position, running afoul of such regulations can prove to be a costly mistake, as illustrated by GlaxoSmithKline's announcement on September 11, 2006 that they had settled a long-running transfer pricing dispute with the US tax authorities, agreeing to pay over $5 billion in taxes related to an assessed income adjustment due to improper transfer pricing.
Calculation of the arm's length price
Although there are discrepancies in the specifics of each country's laws concerning the calculation of the arm's length price, the fact that they are primarily based in the OECD Guidelines means that, although such a strategy carries a greater taxation risk than solutions tailored to each country, global transfer pricing policies can be effectively used to determine an appropriate range representing the arm's length price for transactions carried out across a global enterprise.
It is important to note, however, that different countries may accept different methods of calculating the transfer price (i.e.
Traditional methods
Comparable Uncontrolled Price method
The Comparable Uncontrolled Price (CUP) method compares the price at which a controlled transaction is conducted to the price at which a comparable uncontrolled transaction is conducted. This makes it the easiest to conceptually grasp, as the arm's length price is, quite simply, determined by the sale price between two unrelated corporations. An internal comparable transaction, then, would be either the trade of widgets between Company A and Company C, or the trade of widgets between Company B and Company A(sub), with the term "internal" referring to the fact that one of the parties involved in the tested transaction is also involved in the comparable uncontrolled transaction.
Cost Plus method
The Cost Plus (CP) method, generally used for the trade of finished goods, is determined by adding an appropriate markup to the costs incurred by the selling party in manufacturing/purchasing the goods or services provided, with the appropriate markup being based on the profits of other companies comparable to the tested party. For example, the arm's length price for a transaction involving the sale of finished clothing to a related distributor would be determined by adding an appropriate markup to the cost of materials, labour, manufacturing, and so on.
Resale Price method
The Resale Price (RP), while similar to the CP method, is found by working backwards from transactions taking place at the next stage in the supply chain, and is determined by subtracting an appropriate gross markup from the sale price to an unrelated third party, with the appropriate gross margin being determined by examining the conditions under which it the goods or services are sold and comparing said transaction to other, third-party transactions. In our clothing example, then, the arm's length price would be determined by subtracting an appropriate gross margin from the price at which the distributor sold the products received from the manufacturer to third-party retailers--department stores, boutiques, etcetera. it is exceedingly difficult to determine the costs involved in developing technological know-how, and so the arm's length price for the payment of royalties from one company to another is best determined by working backwards from the profits gained based on the usage of the know-how--in other words, the RP method).
Non-traditional methods
There are any number of non-traditional methods available for determining the arm's length price, with the most common being the Profit Split (PS) method and the Transactional Net Margin method (TNMM).
The PS method (and its derivatives, including the Comparative and Residual Profit Split methods) is applied when the businesses involved in the examined transaction are too integrated to allow for separate evaluation, and so the ultimate profit derived from the endeavor is split based on the level of contribution--itself often determined by some measurable factor such as employee compensation, payment of administration expenses, etc.--of each of the participants in the project.
TNMM, meanwhile, is a method that requires a thorough examination of the company in question in order to determine the net profit margin relative to an appropriate base of costs to be realized through the examined transaction. Although not one of the traditional three methods, TNMM is gaining recognition as a relatively accurate, easy method of calculating the arm's length price.
APA
An Advance Pricing Agreement/Arrangement (the specific terminology varies by country), or APA, is an agreement between the taxpayer and the competent taxation authorities that a future transaction will be conducted at the agreed-upon price, which is recognized as the arm's length price for the period designated. Although simpler to implement than a bilateral/multilateral APA, a unilateral APA will not be recognized by a foreign tax authority, meaning that a U.S. company securing a unilateral APA for trade with its British subsidiary would still run the risk of being assessed should the foreign tax authorities not agree with the method of calculating the arm's length price, resulting in double taxation.
External Links
OECD transfer pricing resourcesIRS transfer pricing documentation
Ernst & Young's Transfer Pricing Global Reference Guide U.S. transfer pricing laws, regulations and news portal site
User Comments Add a comment…