Transfer PricingExplained with Advantages & Disadvantages

Written By:
Lisa Borga

What is Transfer Pricing?

Transfer pricing refers to the prices charged for goods or services for divisions in a company or between affiliates, subsidiaries, or companies that are under common ownership or control.

This pricing can be helpful in achieving tax savings for large corporations but it can potentially cause problems with tax authorities.

Explaining Transfer Pricing 

Transfer pricing is used to determine the rules that will be used when setting prices for goods that will be exchanged between different companies or subsidiaries under common ownership or control.

This practice can be used within one country or internationally as well.

The transfer price, or as it is also called the transfer cost, is the price that the related parties involved in the transaction will charge.

This price will usually be based on the current market price for goods or services being exchanged.

Transfer pricing can be used for intangible property as well, including patents, royalties, and research.

The transfer pricing method can be used by multinational corporations that want to allocate their earnings throughout the affiliate companies and subsidiaries that make up their corporation.

Additionally, these companies sometimes use transfer pricing to change their taxable income in an effort to reduce the taxes they pay.

The companies do this by using transfer pricing to move some of their income from high tax countries to low tax countries.

How Transfer Pricing is Used To Lower Taxes

In order to better explain how transfer pricing can help a company lower its overall taxes, we will give an example.

Suppose a company manufactures light airplanes.

They have Division One that makes the airplanes and Division Two that makes the engines.

Division Two sells engines to the parent company.

But, it also sells to other companies that manufacture light airplanes.

Division Two sells the engines to the parent company for the current market price, which it charges to other light airplane manufacturers.

Division One pays the current market price to the company for the engines.

If Division Two were to charge less than the market price to Division One for the engine, its profits would be lower.

However, since Division One would be paying less and have a lower cost of goods sold, its profits would be higher.

This means that there would be no change in profits for the parent company because the decrease in profits for Division Two would equal the increase in profits for Division One.

But, if Division Two is located in a high tax country and Division One is located in a low tax country, it could be advantageous to have Division Two charge less than the market price to Division One.

This could be advantageous because if Division Two is less profitable, it will pay less taxes.

Then, the increase in profits that Division One will have as a result of paying less to Division Two for the engines will be taxed at a lower rate.

By charging lower prices to Division One, Division Two is helping the parent company to avoid taxes.

Transfer Pricing and the IRS

According to the IRS, transfer pricing needs to be the same in inter-company transactions as it would have been had the company dealt with a company or customer outside of their own company.

Because of this, there are specific guidelines that need to be followed when companies use transfer pricing.

Tax authorities often pay close attention to these transactions, so it is important for corporations to carefully follow the guidelines.

It is common for regulators to require documentation for these inter-company transactions.

Then, if the regulators find that the company did not follow the guidelines for transfer pricing, the company may have to restate its financial statements and possibly be assessed fees or penalties.

Transfer Pricing Example

One example of a case involving the tax authorities and a prominent company is the case between the IRS and Coca-Cola.

The IRS claimed in this case that Coca-Cola was undercharging its foreign affiliates, thus allowing them more profits than they would have made in an arm’s length transaction.

Coca-Cola was determining its transfer pricing based on a method that the IRS had agreed to in 1996.

However, the IRS stated that the company should have used the CPM method that would have provided a better analysis.

Coca-Cola objected to this, but the court stated that according to Treasury Regulation Section 1.482-1(c), the best method should be applied.

This could leave Coca-Cola having to pay an additional $3.3 billion in taxes.

Key Takeaways

• Corporations make use of transfer pricing in an effort to lower their tax burden.
• Sometimes companies with divisions in a country with high taxes will charge high prices, thus reducing their profits, and divisions in countries with low taxes will be charged lower prices to increase their profit.
• Market prices are used to help determine the transfer price for goods or services that will be charged to a subsidiary, holding company, or division.
• According to the IRS, the transfer pricing that companies use should be the same whether it applies to outside companies or inter-company transactions.
• When companies exchange goods or services between their divisions, transfer pricing accounting is used.