Understanding Transfer Pricing and Its Implications for Businesses on Global Commerce

With exponential advances in technology, transportation and communication over the past few decades, many multinational companies (MNCs) have had the ability to place their enterprises, and conduct their activities, anywhere in the world. When an MNC engages in the practice of cross-border intercompany transactions, there are a variety of direct and indirect implications, including the effects of those transactions on tax rates, shareholder wealth, governmental tax revenue, corporate after-tax cash flow and more.

For an MNC itself, the implications can seem fairly straightforward. For example, when viewed solely from the standpoint of management accounting and reporting, expenses and returns to subsidiaries in different countries can be apportioned through several widely accepted approaches. That said, national governments focus exclusively on statutory returns to an MNC’s local entity. In the wake of the recent global recession, governments everywhere seek to maintain or boost their tax bases. Therefore, intercompany transactions – and their tax implications to the governments in which subsidiaries reside – remain solidly in the crosshairs of government officials across the globe.

Circle back to MNCs for a moment and consider how significantly transfer pricing can impact shareholder wealth, owing to its influence on how taxable income gets distributed among countries with different tax rates.

Transfer pricing is one of the top audit issues for the IRS and other revenue-strapped tax authorities, and global businesses could risk incurring steep penalties of 20-40 percent on transfer pricing adjustments if they are not in compliance. It is now more important than ever for global companies to fully grasp the concept of transfer pricing and use it to maximum advantage.

Transfer Pricing Basics

Consider Switch Corp, which manufactures electric switches for consumer and industrial products. One day, Switch Corp is purchased by Umbrella Corp—and Umbrella Corp also owns Ballast Corp, which manufactures lighting ballasts.

Soon, Ballast Corp seeks to purchase switches from Switch Corp. These companies now share a parent company – Umbrella Corp – so to support these sale prices, they must use a transfer price.

Simply put, a transfer price is defined as the price at which different parts of a given company transact with one another in an arm’s-length manner. Like our three companies above, transfer prices are often used by multi-entity firms in cases where the firm’s individual units are treated separately. Also, contrary to popular belief, transfer pricing isn’t limited to international transactions—it also applies to domestic companies that do business with related parties across state lines.

Generally speaking, transfer prices stay fairly in line with market prices (i.e., arm’s-length manner). Why is that? If a different price were to be set, one of the firm’s units would always come up short in the transaction. This, in turn, could affect the unit’s performance and therefore the overall financial health of the multi-entity company.

This concept of transfer price and market price being generally aligned is referred to as the arm’s length principle (ALP). In other words, the transfer price should be within reach of the current market price.

That’s the theory. If only it were that simple in practice. Things start to get complex when you consider that the transfer price affects the income of the two entities involved—and therefore, it also impacts the tax base of the countries in which the entities are located.

Owing to this, transfer pricing must account for jurisdiction, allocation and valuation issues. We’ll briefly cover each issue below.

Jurisdictional issues

As the global economy becomes more and more connected, it is difficult to determine which country has the right to tax the transaction. In select cases, companies have utilized this complexity and ambiguity to avoid tax liabilities.

Allocation issues

The multinational entities (MNEs) still share common resources and overheads; therefore, allocation of resources among MNCs is essential. Yet countries in which MNCs reside are concerned about efficient allocation for tax reasons, and consequently, this issue can materially affect transfer pricing.

Basic Methods Used to Calculate a Transfer Price

There are several methods that companies use to set transfer prices. The most commonly used methods are described below.

Market rate transfer price (or comparable uncontrolled price)

Market rate is generally the most straightforward method of calculating a transfer price. Put simply, it means the transfer price is the same as the current market price for the goods or services in question.

With market rate transfer price, the upstream unit can sell its goods or services either by conducting its sale internally or externally. Under both methods, the profit for the unit remains the same.

Adjusted market rate transfer price

The adjusting market rate method is often used to derive a transfer price when the market rate method is unavailable. This method accounts for an adjustment to current market price to some stated degree.

For example, a company may choose to use a reduced price to eliminate the risk of late payments. In most cases, this stills falls within the arm’s length principle.

Negotiated transfer pricing

With negotiated transfer pricing, specific corporate units negotiate a price regardless of the market baseline price. In fact, it can be quite different than the prevailing market price.

Companies often opt for this method in situations where the market price is difficult to calculate; the market for the goods or service is limited; or the item in question is highly customized.

Contribution margin transfer price

Companies tend to use the contribution margin transfer price method in cases where no set market price for the goods or services being sold exists. Under this method, companies calculate a market price “alternative” based on the unit’s contribution margin.

Cost-plus transfer price methodology

Cost-plus transfer price methodology is another method that’s used when no valid market price exists. This method is often used in cases where the item in question is a manufactured good.

When calculating the cost-plus transfer price, companies tend to add a margin on the cost of the good by adding the standard cost onto a standard profit margin.

Cost-based transfer pricing

Some companies choose to sell their goods or services to other units by simply using the production cost as the price point. If that product or service is then sold to a third party, that unit can add its own costs to the final price.

Under the cost-based transfer pricing method, the company that makes the final sale receives the entire profit of the goods or service. This method is often used as a tax avoidance strategy.

For questions about international tax issues, please contact Michael Milazzo, Partner, Tax & Business Services