What Is Transfer Pricing? (With Definition And Example)

By Indeed Editorial Team

Published 3 July 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Transfer prices are the amounts charged during intercompany transactions between related companies. It is the price paid for goods or services that are transferred from one unit of an organisation to its other units in different states or countries. Knowledge of transfer pricing and its various models can help you understand how companies use this technique to improve their accounting process and save taxes. In this article, we discuss what transfer pricing is, learn how it works, find out the types of transfer pricing models and review an example.

What Is Transfer Pricing?

Finding the answer to "What is transfer pricing?" can help you understand how businesses use this strategy to save taxes. This strategy is important if you are a business owner or work in a finance department. Transfer pricing is an accounting practice which refers to the price that one division in an organisation charges another for the supply of goods and services. The expenses could be transportation, packaging, insurance, freight or customs fees. Companies use transfer pricing to set prices and define the terms and conditions of controlled transactions.

A corporation can save money on taxes by taking advantage of differences in tax laws between countries or states by using transfer pricing. Corporations usually raise transfer prices in countries or states with a lower tax regime. To ensure compliance with government regulations, tax authorities closely monitor these strategies. Transfer pricing applies to specific transactions:

  • Acquisition of fixed assets

  • Royalty fee

  • Sales of finished goods

  • Machinery sales or purchases

  • Charges for corporate guarantees

  • Refunds of expenses incurred

  • Support services

  • IT services and software development

  • Management fees and technical service fees

  • Receiving or paying a loan

  • Transactions that affect profits, income, losses or assets of enterprises

Related: What Is Cost Of Production? (With Factors That Affect It)

Types Of Transfer Pricing Models

Here are some transfer pricing models:

Market-based transfer price

Market-based transfer prices provide a simulation of the market within a company by representing market conditions. A company sells the product at the same price as it does in the market. This method requires access to a standardised, existing market for the product or substitute. Companies can calculate a market-based transfer price by comparing the current prices of the product. In a competitive market, companies can obtain transfer prices from the marketplace if a comparable product is available.

Cost-based transfer price

Cost-based transfer prices are the most commonly used transfer prices. This applies when market prices are unknown or unestablished. A cost-based transfer pricing method is common for the sale of goods within a company to different divisions. There is only one subsidiary that pays the production costs of goods it purchases from another subsidiary. The purchasing enterprise benefits from this practice by maximising its profitability. Several factors affect the price, including production costs, manager reviews and international taxation.

Related: What Does A Production Planner Do? (Definition And Skills)

Negotiated transfer price

In negotiated transfer pricing, firm representatives negotiate prices on their own, instead of relying on market prices. Sometimes, a transfer price between subsidiaries is required to be determined with no reference to market pricing. This situation occurs when there is no obvious market price because the market is small or has highly tailored items. In this situation, the price is determined by how each party negotiates. Negotiated transfer prices cannot always fulfil the primary functions of transfer prices, such as profit allocation and coordination.

Types Of Transfer Pricing Methods

Below are some transfer pricing methods:

  • Comparable uncontrolled price method: Companies use this transaction method to compare the conditions and price of products or services in a controlled transaction with those in an uncontrolled transaction between unrelated parties.

  • Resale price method (RPM): This technique factors in the selling price of products or services, also known as resale price. A reselling price is a price that allows companies to sell an item to an independent business again.

  • Cost-plus method (CPLM): This method compares a company's gross profits with its overall costs of sales. By calculating the costs incurred by the supplier in an affiliated transaction, companies figure the overall cost of the transaction.

Related: Top Business Analyst Tools For Improving Efficiency

Benefits Of Transfer Pricing

Transfer pricing allows for better pricing, higher efficiency and simplicity of the accounting process. By simplifying processes and methodologies, it also reduces human costs, enhances profitability and emphasises business operations strategy. Some benefits of transfer pricing include:

  • Reduction of taxes and tariffs: This refers to the reduction of duties by transferring goods at minimal transfer prices into high-tariff countries. To lower the transaction's duty base, companies can use a low transfer price when shipping goods to locations with high tariff rates.

  • Competitiveness in the international market: Increasing the prices of goods reduces income taxes in high-tax nations and transfers profits to low-tax nations. Transfer pricing allows businesses to raise the prices of products they may sell in higher-taxed locations to balance profits.

  • Minimisation of foreign exchange risk: In the case of prohibition of dividend repatriation, the government can facilitate it by inflating the price of goods transferred.

Related: Business Strategy Components And Examples

How Does Transfer Pricing Work?

Transfer pricing enables businesses and subsidiaries to price transactions internally when they are owned or controlled by the same entity. The practice is applicable both inside and outside of countries. Consider the example:

Global Computers owns two subsidiaries namely Global Manufacturer Inc. and Global Distributors. All three companies are associated enterprises. Global Manufacturer Inc. manufactures computers and sells them to Global Distributors. Despite owning both subsidiaries, Global Computers does not control the prices at which Global Distributors sells computers, since supply and demand determine this price. Global Computers can control the transactions between Global Distributors and Global Manufacturer Inc. The internal sales of Global Manufacturer Inc. to Global Distributors are controlled transactions and they refer to the price set by Global Computers for these transactions as the transfer price.

Global Computers sets a transfer price for computers below the market price. This decision reduces the revenues for Global Manufacturer Inc. which produces the computers and the cost of goods for Global Distributors, which sells the computer. The reason for setting this transfer price is that Global Manufacturer Inc. is in a higher tax area, while Global Distributors is in a lower tax area. Due to the use of the transfer price, Global Distributors makes more profit while Global Manufacturer Inc loses revenue. By shifting profits to the enterprise in the lower tax area, Global Computers would pay fewer taxes.

Example Of Transfer Pricing

Refer to the example above for the names of the three companies:

  • Global Computers, the head company

  • Global Manufacturer Inc., the manufacturer

  • Global Distributors, the distributor

Profit = transfer price - manufacturing cost

For instance, the manufacturing costs for one computer at Global Manufacturer Inc. are ₹20,000. Global Distributor sells it to the public at a market price of ₹60,000. Because Global Distributors is located in a state with a lower tax regime. Global Computers sets a sub-market transfer price between Global Distributor and Global Manufacturer Inc. This transfers the profit to Global Distributors.

Global Computers sets the transfer price at ₹30,000, so Global Manufacturer Inc. sells computers at the transfer price of ₹30,000 per computer to Global Distributors. Here is a layout of the profits:

  • Profits of Global Manufacturer Inc.: ₹10,000 per computer (₹30,000 transfer price - ₹20,000 manufacturing cost = ₹10,000 profit)

  • Profits of Global Distributors: ₹30,000 per computer (₹60,000 market price - ₹30,000 transfer price = ₹30,000 profit)

The local tax rate in the area of Global Manufacturer Inc. is 35%, while the local tax rate in the area of Global Distributors is 25%. Global Computers reduces its tax liability by transferring profits to an entity taxed at a lower rate.

  • Global Manufacturer Inc. tax: ₹10,000 x 35% = ₹3500 per computer

  • Global Distributors tax: ₹30,000 x 25% = ₹7500 per computer

  • Global Computers total tax: ₹3500 + ₹7500 = ₹11000

Without transfer price, the total tax would be:

  • Manufacturing cost: ₹20,000

  • Sale cost: ₹60,000

  • Total profit: ₹60000 - ₹20000 = ₹40000

  • Global Computers tax: ₹40,000 x 35% = ₹14000

By setting its transfer price below the market price and then shifting profits to the lower tax region, Global Computers, the head organisation, pays fewer taxes overall.

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