Transfer Pricing

The American Marketing Association defines transfer pricing as “the pricing of goods and services that are sold to controlled entities of the same organization, for example, movements of goods and services within a multinational or global corporation.” Transfer pricing is an intra firm transaction that affects costs and profitability at the subsidiary level and overall after-tax profitability for the firm at the corporate level. How the firm accounts for its various intrafirm transactions is therefore of interest to host governments, who would understandably want to investigate any suspicions of tax evasion through transfer pricing practices.

Host governments are naturally concerned to ensure that multinationals are not using creative accounting to avoid paying taxes. As a result, host governments may impose restrictions and enact laws that curtail such practices if the intent is to avoid taxation. While different governments may have different laws prescribing how transfer pricing is to be accounted for, in general the principle of “arm's-length” transaction is the approach least likely to violate legal requirements. By arm's-length transaction, it is meant that a “fair” price is charged between subsidiaries as though these subsidiaries were unrelated. We should note, however, that such fair prices are often allowed to contain additional charges for technology transfer, R&D, other overhead expense allocations, and the like. The upshot is that even arm's length is not necessarily clear-cut or [Page 2100]straightforward. For instance, the IRS's Treasury Regulations Section 1.482, which is one of their publications pertaining to transfer pricing (among other things), runs to 103 pages.

If multinational or global corporations were few in number and minimal in economic impact, the issue of transfer pricing would be of only passing interest to most. However, multinational companies (MNCs) are becoming more and more pervasive, and mergers and acquisitions serve to make them even more powerful and omnipresent than ever before. Consequently, what these companies do to avoid taxes is of major import to most national treasuries and by extension to the economies of those societies. Corporations have always tried to minimize their tax obligations, and few would question any entity's (individual or otherwise) attempt to legitimately reduce its tax burdens. However, transfer pricing as an instrument to reduce or eliminate a multinational's taxes sometimes resembles “creative accounting” and corporate malfeasance. Especially in situations where an MNC is operating in a developing country and uses transfer pricing as a means to minimize its taxes payable to that country, such practices may be criticized as a blatant attempt to exploit a developing country's resources.

Global or multinational companies can manipulate transfer pricing to their advantage in at least two common ways—by adjusting the prices being charged intracompany, and by deciding what and how much of intrafirm goods and services will be bought. In an MNC, a lot of purchasing and selling take place within the boundaries of the firm itself. For example, say the Singapore subsidiary of XYZ Oil Company sells its lubricants to the Australian subsidiary for resale in Australia. The price that Singapore charges is the cost that Australia pays. Yet in the final analysis the funds stay within the firm. If not for taxation, the price being charged by Singapore (the transfer price) does not have an impact on the overall profitability of XYZ Corporation worldwide.

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