Transfer pricing is a complicated issue, but worth understanding on at least a basic level if you work at all with multinational corporations.
The price at which one unit of a firm sells goods or services to another unit of the same firm.
The price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately.
Transfer pricing is the setting of prices in transactions that are not at 'arm's length'--for example, when one company sells goods to another company, but both companies have common ownership.
There are several ways to determine the transfer price, including cost methods, market price methods, negotiation or even simply using an arbitrary figure.
A goal of transfer pricing may be to maximize after-tax revenue by setting transfer prices that reduce the total tax paid.
For example a multinational company say in India produces shoes for $100.
They sell the shoes to another part of the corporation in Japan for $300, which is the transfer price.
They are then retailed for $700 in Japan.
Gross profit to the corporation is $600 ($700 - $100): $200 of the profit ($300 - $100) is earned in India, and $400 ($700 - $300) is earned in Japan.
Assuming tax rates are 20% in India, and 50% in Japan, the taxes paid by the corporation are $40 ($200 * 20%) in India and $200 ($400 * 50%) in Japan for a total tax liability of $240.
The profit after-tax is $360 ($600 - $240).
If the multinational corporation changes the transfer price from India to Japan from $300 to $600, the gross profit remains the same at $600.
But, profit in India is now $500 ($600 - $100) and in Japan $100 ($700 -$600).
Taxes paid in India are $100 ($500 * 20%), and in Japan are $50 ($100 * 50%) for a total tax liability of $150.
The after-tax profit has now increased to $450 ($600 - $150), although production costs have not changed.
Given this scenario, a country with laws governing transfer pricing may require the company to adjust prices in order to ensure a fair division of their taxable profits and prevent them from reducing taxable profits by artificial price management.
TP is often a contentious political issue in corporations and especially amongst senior level executives.
This is because the level at which transfer prices are set may negatively influence their division profits and as a result cause lower bonuses to accrue to the managers.
A second dimension of TP is to attempt to allocate profits and losses for each division in such a way that the corporate strategy of the overall corporation is supported in the optimal way.
Thirdly, Transfer Pricing can be manipulated for taxation reasons: by charging low transfer prices from a unit based in a high-tax country that is selling to a unit in a low-tax country, a firm can record a low profit in the first country and a high profit in the second.
In my opinion, what the transfer pricing issue is all about.
Revenue agencies want to assure that companies based in their country are not engaged in complicated transactions by which expenses are shifted to high-tax countries, while income is shifted to lower tax countries.
Companies that do so have minimized taxable income, while maximizing deductions on an aggregated basis.
What this means is that some companies may have failed to charge an arm's length price for transactions with a related entity in another country.
Companies -- at least those in the Europe.
-- typically have one of the final four international accounting firms do a transfer pricing study every few years.
This helps those companies document the amounts charged between these related entities.
If companies charge prices that are not at arm's length, then they will nevertheless be taxed as if the transactions had been at arm's length.
The price at which one unit of a firm sells goods or services to another unit of the same firm.
The price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately.
Transfer pricing is the setting of prices in transactions that are not at 'arm's length'--for example, when one company sells goods to another company, but both companies have common ownership.
There are several ways to determine the transfer price, including cost methods, market price methods, negotiation or even simply using an arbitrary figure.
A goal of transfer pricing may be to maximize after-tax revenue by setting transfer prices that reduce the total tax paid.
For example a multinational company say in India produces shoes for $100.
They sell the shoes to another part of the corporation in Japan for $300, which is the transfer price.
They are then retailed for $700 in Japan.
Gross profit to the corporation is $600 ($700 - $100): $200 of the profit ($300 - $100) is earned in India, and $400 ($700 - $300) is earned in Japan.
Assuming tax rates are 20% in India, and 50% in Japan, the taxes paid by the corporation are $40 ($200 * 20%) in India and $200 ($400 * 50%) in Japan for a total tax liability of $240.
The profit after-tax is $360 ($600 - $240).
If the multinational corporation changes the transfer price from India to Japan from $300 to $600, the gross profit remains the same at $600.
But, profit in India is now $500 ($600 - $100) and in Japan $100 ($700 -$600).
Taxes paid in India are $100 ($500 * 20%), and in Japan are $50 ($100 * 50%) for a total tax liability of $150.
The after-tax profit has now increased to $450 ($600 - $150), although production costs have not changed.
Given this scenario, a country with laws governing transfer pricing may require the company to adjust prices in order to ensure a fair division of their taxable profits and prevent them from reducing taxable profits by artificial price management.
TP is often a contentious political issue in corporations and especially amongst senior level executives.
This is because the level at which transfer prices are set may negatively influence their division profits and as a result cause lower bonuses to accrue to the managers.
A second dimension of TP is to attempt to allocate profits and losses for each division in such a way that the corporate strategy of the overall corporation is supported in the optimal way.
Thirdly, Transfer Pricing can be manipulated for taxation reasons: by charging low transfer prices from a unit based in a high-tax country that is selling to a unit in a low-tax country, a firm can record a low profit in the first country and a high profit in the second.
In my opinion, what the transfer pricing issue is all about.
Revenue agencies want to assure that companies based in their country are not engaged in complicated transactions by which expenses are shifted to high-tax countries, while income is shifted to lower tax countries.
Companies that do so have minimized taxable income, while maximizing deductions on an aggregated basis.
What this means is that some companies may have failed to charge an arm's length price for transactions with a related entity in another country.
Companies -- at least those in the Europe.
-- typically have one of the final four international accounting firms do a transfer pricing study every few years.
This helps those companies document the amounts charged between these related entities.
If companies charge prices that are not at arm's length, then they will nevertheless be taxed as if the transactions had been at arm's length.
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