What is Transfer Pricing: Example, Benefits & Principle

Introduction

We have all heard of multinational corporations (MNCs) that own several other companies. Take Coca-Cola, for example. The MNC owns Costa Coffee, Minute Maid, and has several subsidiaries by the same name across the globe. 

On first thought, intercompany transactions between two companies associated with Coca-Cola might not sound significant. However, such transactions are governed by a concept called transfer pricing. 

In this blog, we are going to discuss what transfer pricing is and the benefits and risks associated with it. 

What is Transfer Pricing?

Transfer pricing is the pricing of goods or services that are exchanged between related companies. The companies involved in such transactions are usually related to each other in some way. For example, it could be a parent company and its subsidiary or two subsidiaries of the same company.

The transfer pricing method is generally used by multinational companies (MNCs) and their subsidiaries or sister companies to allocate income and expenses. The benefits of transfer pricing are tax savings, profit allocation among subsidiaries, and enhanced financial efficiency. However, transfer pricing must comply with international regulations to avoid issues such as tax evasion.

Example of Transfer Pricing

To better understand what transfer pricing is and why it is used by MNCs, let’s consider the following example:

The two holdings of a MNC, ABC, are XX and YY, and both the subsidiaries are located in different countries. XX produces electronic items, and YY produces materials required to create those electronic products.

XX and YY get into a business relationship where YY is selling goods to XX so it can manufacture the electronic goods. Both of these companies will determine a transfer price for the services YY is offering to XX. The transfer price will need to be close to the actual market price at which YY sells their services to other customers; however, it can be lower or higher than the actual market price as well.

In case YY charges XX a lower price than the market price, YY’s cost of goods sold will be less, and XX will be able to procure goods at a lower price. YY’s revenue will be lower, but XX will have more cost savings due to this transaction. All in all, this won’t affect the ABC MNC as the overall profits (reduced revenue of YY and increased cost savings of XX) remain the same.

In the above scenario, if YY is in a higher tax country than XX, then the ABC company can get more tax benefits by making XX more profitable than YY.

What is the Arm’s Length Principle?

Tax regulations for international companies are overseen by the Organization for Economic Cooperation and Development (OECD). This means that OECD provides transfer pricing guidelines, which member countries utilize for tax regulations and for conducting audits for international organizations. Article 9 of the OECD Model Tax Convention has stipulated that the transfer prices between two subsidiaries controlled by the same parent company should be treated as those of two independent companies. Therefore, subsidiaries engaging in internal business activities must negotiate the transfer price at arm’s length.

The arm’s length principle helps MNCs avoid double taxation and subsequently enables governments of different countries to collect the right amount of taxes from MNCs.

In order to comply with the arm’s length principle, the terms and conditions of an intercompany transaction must be comparable with transactions between two independent companies.

Transfer pricing methodologies

There are different methods that businesses can use to apply the arm’s length principle and determine the right transfer price.

Here are the most commonly used methodologies:

1. Comparable Uncontrolled Price (CUP) Method: This method to determine the transfer price compares the price charged in a controlled transaction to that of the uncontrolled transaction. The circumstances for both the controlled and uncontrolled transactions should be similar in order to apply the CUP method. While this method is direct and reliable, the services being exchanged between companies in both controlled and uncontrolled transactions should be highly comparable.
2. Cost Plus Method: To determine the arm’s length price through this method, a markup is added to the costs of the supplier’s goods and services in a controlled transaction. The markup cost is calculated after taking into account the indirect and direct costs related to the production or supply of goods.
3. Resale Price Method (RPM): This method takes into account the price at which the company involved in an intercompany transaction sells their services to an independent company. This price is called the resale price. The gross margins of comparable controlled and uncontrolled transactions are compared to determine the right gross margin. The figure is then subtracted from the resale price to evaluate the arm’s length price.

Benefits of Transfer Pricing

Transfer pricing is a tricky topic to deal with. However, with the imposition of proper laws and regulations, it can be beneficial for businesses as well as the tax authorities.

Here are the major benefits of transfer pricing:

1. Tax benefits: Businesses can use transfer pricing to get tax benefits by reducing the profit margin for a company based in a high tax country.
2. Better resource allocation: Transfer pricing is also a good solution for spreading costs across different subsidiaries to ensure every company has enough resources to run their operations smoothly.
3. Tax compliance: If transfer pricing is set according to the prevalent tax laws, it can help businesses avoid double taxation and ensure that the tax authorities collect the right amount of tax from MNCs. Regulations such as the arm’s length principle ensure that MNCs are not conducting intercompany transactions in a fraudulent manner and enable tax authorities to deal legally with those who try to evade taxes.
4. Enhanced transparency: In order to stay compliant with tax laws, MNCs need to determine the right transfer pricing and have the correct documentation for the same. This helps with increased transparency and accurate financial reporting.

Risk Associated with Transfer Pricing

Despite being advantageous for MNCs, transfer pricing creates a complicated situation. Let’s understand the risks associated with transfer pricing in detail:

1. Setting up the transfer pricing is itself a time-consuming process. In addition to this, if there’s disagreement between the two parties regarding the transfer pricing, it can lengthen the process even further and cause distress among companies.
2. Transfer pricing is regulated by stringent tax laws, and therefore, companies need to have detailed documentation regarding the entire process. Moreover, companies are more likely to get audited if they engage in intercompany transactions. Any non-compliance in such a scenario can lead to the imposition of heavy penalties.
3. Maintaining intercompany transactions is a complex process because of the need to set up accurate transfer pricing. Additional resources are needed to conduct the entire process, as companies need to adhere to the arm’s length principle to stay tax compliant.

How HighRadius Can Help

HighRadius offers a cloud-based Record to Report Suite that helps accounting professionals streamline and automate the financial close process for businesses. We have helped accounting teams from around the globe with month-end closing, reconciliations, journal entry management, intercompany accounting, and financial reporting.

Our Financial Close Software is designed to create detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30%.The workspace is connected and allows users to assign and track tasks for each close task category for input, review, and approval with the stakeholders. It allows users to extract and ingest data automatically, and use formulas on the data to process and transform it.

Our Account Reconciliation Software provides an out-of-the-box formula set that can configure matching rules and match line-level transactions from multiple data sources and create templates to automate various transaction processing required for month-end close. Our solution has the ability to prepare and post journal entries, which will be automatically posted into the ERP, automating 70% of your account reconciliation process.

Our AI-powered Anomaly Management Software helps accounting professionals identify and rectify potential ‘Errors and Omissions’ throughout the financial period so that teams can avoid the month-end rush. The AI algorithm continuously learns through a feedback loop which, in turn, reduces false anomalies. We empower accounting teams to work more efficiently, accurately, and collaboratively, enabling them to add greater value to their organizations’ accounting processes.

FAQs

Q1. What are the different methods of transfer pricing?

There are a lot of methods that can help companies agree on the right transfer pricing and adhere to the arm’s length method. However, the most common methods include the comparable uncontrolled pricing method, resale price method, cost plus method, and transactional net margin method.

Q2. What are the advantages of transfer pricing?

Agreeing on the accurate transfer pricing has a lot of advantages. For example, transfer pricing can help MNCs increase their profits, allocate resources to their subsidiaries in a better way, be tax compliant, and increase transparency and accuracy when it comes to financial reporting.

Q3. What are the disadvantages of transfer pricing?

Transfer pricing is a complex process that requires businesses to allocate significant resources in order to conduct intercompany transactions in the right way. Furthermore, transfer pricing requires a lot of documentation to stay tax compliant and makes companies more prone to auditing.

Q4. What is transfer pricing in income tax?

Transfer pricing in income tax refers to the methodologies and regulations used to evaluate the fair value at which companies that are related to each other can conduct business. The purpose of transfer pricing is to ensure that related parties abide by the arm’s length principle to avoid any fraudulent practices.

Q5. How is transfer pricing used to avoid taxes?

Transfer pricing can be used in a wrongful manner by businesses to avoid paying the right amount of taxes. For example, if a company is in a low-tax country, the MNC will increase their cost savings and reduce the profit margins of the company in a high-tax country in order to pay low taxes.