What Is Transfer Pricing All About?

What is transfer pricing all about?

When an item is sold or a service is provided, a price is charged by the seller and paid by the buyer. If goods are sold in the open market, it is fairly easy to fix on a price that buyers are prepared to pay. A lot of market forces determine the selling price like nature of the market, the extent of the competition etc. But for transactions that are more complex, prices are negotiated between buyers and sellers.

What if the parties to the transaction are connected? In such case the conditions of their commercial relations will not be determined only by market forces. The price will not necessarily correspond to what would have been charged if they had not been connected. And when both the seller and the purchaser are companies owned by the same person the price charged will not make their common owner any richer or poorer; it will merely serve to determine the extent to which the common owner's funds or profits resources are transferred from one company to the other.

So a transfer price is the price charged in a transaction between connected parties. When connected parties transact with each other, there is not always the need to charge prices that precisely replicate what would have happened had they been dealing at arm's length. As a result the level of their commercial profits may differ from what would have arisen if they had done the same transactions with unconnected parties.

The Issue of Transfer pricing

The transfer pricing issue mainly arises in cross border transactions between two connected parties. However, transfer pricing problems are not limited to company to company transactions; for example a transaction between an individual and an overseas company he controls can be manipulated through the transfer price.

Usually large multinational group try to structure the business in such a way that profits are earned in a territory that taxes them at 10%, rather than a territory that taxes them at 40%. Tax planning to help bring about such a result is now very sophisticated.

For e.g.

Take a case of a subsidiary located in country A that pays 20 percent tax on $100 worth of goods, which it repackages and exports to the parent company, located in country B, at a selling price of $200. The parent company sells the goods for $300. Both entities have a $100 profit. But the tax rate in country A is 20 percent, and the tax rate is 60 percent in country B, or $60 on a $100 profit. After taxes, the multinational company's overall profit is $120.

But if the subsidiary sells the goods for $280 and the parent sells them for $300, the multinational's profit increases because more of the pre-tax profits are shifted to the subsidiary in country A, where the tax rate is lower. The subsidiary now makes $180 profit, with 20 percent of that paid