Transfer Pricing

Transfer pricing is the price charged for goods or services that are exchanged among different organizational units of the same company. Transfer prices are used to allocate profit to company divisions. The price charged by the selling division becomes a cost to the buying division. Thus, a higher transfer price will result in more profit to the seller and less profit to the buyer. Transfer pricing might allow multinational corporations (MNCs) to reduce income tax worldwide, thereby increasing profit.

Companies set transfer prices so that divisions in low-tax countries report large profits, while those in high-tax countries report low profits. For example, assume a U.S.-based MNC has a division in France selling goods to a division in Ireland. Ireland then sells the goods to buyers outside the MNC. The tax rate in France is 35 percent, but the tax rate in Ireland is only 12 percent. The corporate goal is to set a low transfer price so that the France division reports close to zero taxable profit, thus paying little or no tax. As a result, Ireland division reports more profit and pays more tax. Nonetheless, the corporate entity generates savings on the difference in tax rates (35 percent minus 12 percent) for each dollar of profit shifted from the France division to the Ireland division.

Regulations and Standards

As world trade increases, more countries are implementing regulations to ensure they receive a fair share of taxable corporate profits. The universally acceptable approach for setting transfer prices is the “arms-length standard.” This is a price that would have been reached by two independent parties trading in a free market. However, problems arise in applying this concept across country borders. Regulations and legal interpretations differ from country to country. A price acceptable to authorities on one side of a transaction [Page 1612]may not be considered acceptable to those on the other side. Failure to comply with transfer pricing laws can result in significant penalties and fines. Even worse, a country may disallow a transfer price, thus forcing a change in a division's taxable profit. If the division on the other side of the transaction is not allowed to revise its price in unison, the same corporate profit can be taxed twice.

Transfer pricing regulations were established by the Internal Revenue Service (IRS) in the United States and the Organisation for Economic Co-operation and Development (OECD) for Europe. Most of the world has adopted some form of OECD regulations. The two sets of rules are essentially the same: both agree that transfer prices can be calculated by a number of acceptable alternative methods. All methods look at some element of comparability in the marketplace to determine an arm's-length transfer price. For example, one of these methods is called comparable uncontrollable price. It estimates transfer price by looking at prices charged by independent sellers of similar products. Another method, called cost plus, derives transfer price by using gross profit earned by independent sellers of similar products. It is up to the corporate entity to choose a method. The main criterion is that the method used should result in the most reliable means to estimate a price that would have been charged in a free-standing market.

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