how transfer pricing works
transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries that operate under common control or ownership the transfer pricing practice extends to cross border transactions as well as domestic ones a transfer price is used to determine the cost to charge another division subsidiary or holding company for services rendered typically transfer prices are reflective of the going market price for that good or service transfer pricing can also be applied to intellectual property such as research patents and royalties multinational corporations mncs are legally allowed to use the transfer pricing method to allocate earnings among their subsidiary and affiliate companies that are part of the parent organization however companies sometimes can also use or misuse this practice by altering their taxable income thus reducing their overall taxes the transfer pricing mechanism is a way that companies can shift tax liabilities to low cost tax jurisdictions transfer pricing and taxesto better understand how transfer pricing impacts a company s tax bill let s consider the following scenario let s say that an automobile manufacturer has two divisions division a which manufactures software and division b which manufactures cars division a sells the software to other carmakers as well as its parent company division b pays division a for the software typically at the prevailing market price that division a charges other carmakers let s say that division a decides to charge a lower price to division b instead of using the market price as a result division a s sales or revenues are lower because of the lower pricing on the other hand division b s costs of goods sold cogs are lower increasing the division s profits in short division a s revenues are lower by the same amount as division b s cost savings so there s no financial impact on the overall corporation however let s say that division a is in a higher tax country than division b the overall company can save on taxes by making division a less profitable and division b more profitable by making division a charge lower prices and pass those savings on to division b boosting its profits through a lower cogs division b will be taxed at a lower rate in other words division a s decision not to charge market pricing to division b allows the overall company to evade taxes in short by charging above or below the market price companies can use transfer pricing to transfer profits and costs to other divisions internally to reduce their tax burden transfer pricing and the irsthe irs states that transfer pricing should be the same between intercompany transactions that would have otherwise occurred had the company done the transaction with a party or customer outside the company according to the irs website transfer pricing is defined as follows as a result the financial reporting of transfer pricing has strict guidelines and is closely watched by tax authorities auditors and regulators often require extensive documentation if the transfer value is done incorrectly or inappropriately the financial statements may need to be restated and fees or penalties could be applied however there is much debate and ambiguity surrounding how transfer pricing between divisions should be accounted for and which division should take the brunt of the tax burden tax authorities have strict rules regarding transfer pricing to discourage companies from using it to avoid taxes 