The term “Transfer Pricing” means something different to different people. An excellent example of transfer pricing is when a subsidiary sells goods or provides services to its holding company or sister business.
A single parent corporation has ultimate authority over all of the entities under its common ownership. Transfer pricing is a strategy used by multinational businesses to distribute profits (earnings before interest and taxes) across their different subsidiaries.
From a taxation standpoint, transfer pricing methods are extremely beneficial for a business. However, regulators typically frown upon the manipulation of transfer prices in order to save money. Tax regime differences in various nations can be used by boosting the transfer prices of products and services produced in countries with lower tax rates, while still being legal.
Accounting and taxes practices known as transfer pricing allow firms and subsidiaries operating under common management or ownership to price transactions between themselves. Transfer pricing applies to both domestic and international transactions.
To estimate the cost of charging a different division, subsidiary, or holding company for the services delivered, a transfer price is utilized. When it comes to transfer pricing, they usually represent the current market value of the product or service in question. Intellectual property, such as research, patents, and royalties, can also use transfer pricing.
Legally, multinational corporations (MNCs) can allocate profits among its subsidiaries and affiliates that are a part of the parent company using the transfer pricing technique. Even yet, businesses may utilize (or abuse) this strategy to lower their overall tax burdens by changing their taxable revenue. Companies can move their tax responsibilities to countries with lower tax rates by using the transfer pricing mechanism.
Accounting and taxes practices known as transfer pricing allow firms and subsidiaries operating under common management or ownership to price transactions between themselves. Transfer pricing applies to both domestic and international transactions.
Let’s take a look at the following example to see how transfer pricing affects a company’s tax burden. An automotive factory, for example, may be divided into two divisions: one for software and the other for automobiles.
Besides its own parent business, Division A also sells the software it develops to other automakers. Division B pays Division A for the software, usually at the market price that Division A charges other automobile manufacturers.
Division A decides to charge Division B a cheaper price instead of utilizing the market pricing, as an example. The reduced pricing has the effect of decreasing Division A’s sales or income. As a result, Division B’s earnings are higher since its COGS (cost of goods sold) is lower. Therefore, the revenues of Division A are reduced by the same amount as the cost reductions of Division B, and the total corporation is unaffected.
However, assume Division A is located in a nation with a greater tax rate than Division B. Increasing the profitability of Division B while decreasing the profitability of Division A will save the firm money in the long run in taxes. Division B will pay less tax if Division A lowers prices and then transfers those savings to Division B, increasing Division B’s profits through a lower COGS. To put it another way, Division A’s choice to not charge Division B market price results in the firm as a whole evading taxes.
To sum it up, corporations can utilize transfer pricing to shift revenues and costs to other divisions within the company in order to lower their tax bill by charging above or below the market price. To prevent corporations from evading taxes, tax authorities have enacted stringent laws around transfer pricing.
What are the advantages of using transfer pricing?
Shipping products into nations with high tariff rates while utilizing cheap transfer fees helps reduce duty expenses by lowering the duty base on such transactions.
Overpricing products that are exported to countries with lower tax rates help firms increase their profit margins by lowering income and corporate taxes in high-tax nations.
Transparency in pricing comes with risks.
There might be conflicts over overpricing and transfer rules within an organization’s divisions.
In order to implement transfer pricing and maintain a competent accounting system to support them, a great deal of time and labor are necessary. As a result, it’s a labor-intensive and time-consuming process.
Prices for non-transferable intangibles such as services given become more difficult to determine.
Vendors and purchasers have distinct roles to play and take on different kinds of risks as a result. For example, the vendor may decline to offer a product warranty. However, the buyer would be required to pay a premium because of the discrepancy in prices.
