Problems with Transfer Pricing

If you think transfer pricing affects only big companies, think again. Size is immaterial. The only condition that triggers transfer pricing is the existence of multiple facilities in more than one taxing jurisdiction. For example, a company with 45 employees in five locations in two states would activate transfer pricing concerns if one of its offices provides data processing, payroll or other services to the others. Similar situations arise in manufacturing, when one division ships parts or unfinished products for final assembly at another location in a different jurisdiction.

A key element of transfer pricing is the presence of a buyer-seller relationship between units of a single company. Although owners and managers may not think of one location as selling services or parts to another unit, the various taxing authorities whether state or national may impose that view. Under such circumstances, a company has to determine the monetary value of the goods or services and treat that amount as sales revenue of the selling unit and as a cost of the buying unit. The two most common approaches to setting and revising transfer prices are to apply cost-plus and market-based procedures. While cost-plus prices have the appeal of simplicity and ease of calculation, be aware that cost-plus transfer prices can provide exactly the wrong incentive for the producing unit.

A critical issue is establishing a transfer price for marketing and administration services. Assuming Alpha charges Beta and Gamma a low price (in relation to what Alpha incurs to provide those services) for marketing and administration services, taxable income effectively would shift away from Alphas high-tax jurisdiction and to Betas and Gammas low-tax jurisdictions. Thus, if Alpha received a transfer price of $80,000 ($40,000 each from Beta and Gamma) for marketing and administration services that cost $100,000 to provide, Alphas income would be reduced by the $20,000 difference. Correspondingly, Betas and Gammas income would be $20,000 higher because they are paying only $80,000 as opposed to the full $100,000 that Alpha incurs to provide the services. To be sure, the company would have to justify that price.

Transfer pricing is not, in itself, illegal or necessarily abusive. What is illegal or abusive is transfer mispricing, also known as transfer pricing manipulation or abusive transfer pricing. (Transfer mispricing is a form of a more general phenomenon known as trade mispricing, which includes trade between unrelated or apparently unrelated parties. The conventional international approach to dealing with transfer mispricing is through the “arm’s length” principle: that a transfer price should be the same as if the two companies involved were indeed two unrelated parties negotiating in a normal market, and not part of the same corporate structure. Many companies strive to use the arm’s length principle faithfully. Many companies strive to move in exactly the opposite direction. In truth, however, the arm’s length principle is very hard to implement, even with the best intentions.

Another example, if an international enterprise has a tax rate in the residence country of the parent company of 30% and it has a subsidiary entity resident in another country with a tax rate of 20%, the parent has an incentive to shift profits to its subsidiary to reduce its tax rate on these amounts from 30% to 20%. If the parent company shifts $100 million of taxable profits to its subsidiary, it will make a tax saving of $10 million. This may be achieved by the parent being over-charged for the acquisition of property and services from its subsidiary. The aim in such cases is to usually reduce a multinational group’s worldwide taxation by shifting profits from associated entities in higher tax countries to associated entities in relatively lower tax countries through either under-charging or over-charging the associated entity for intra-group trade. 

Any transfer pricing system creates internal revenues and expenses recorded for the goods and services transferred between units. The company must eliminate them to calculate the overall entities income. If transfer prices exist between only two units of a company, the recordkeeping may be simple. It must create a structure to justify the many eliminations needed when transfer pricing is used at multiple levels of a company. As business gets more complex, the likelihood grows that your company will eventually have to deal with transfer pricing issues.

Sources:

William K. Carter, David M. Maloney and M. H. Van Vranken. (1998). The Problems of Transfer Pricing. Journal of Accountancy.

Sheppard, Lee. (2012). Transfer Pricing. Retrieved from www.taxjustice.net.