written by | May 9, 2022

What Is Transfer Pricing? Explained With Examples

So, what do you mean by transfer pricing? Transfer pricing is the internal price system used by related parties. It decides the tax rate that must be paid and the reported amount of profit. Transfer pricing is crucial for taxpayers and the tax authorities of both countries. 

They are accountable for managing the flow of cross-border transactions within a multinational corporation (MNCs). We should determine the transfer cost for group companies at an arm's length rate, and that is the amount that a third party would be able to pay.

The OECD has developed guidelines for how to determine the transfer price. The majority of tax jurisdictions worldwide adhere to and integrate into their tax laws.

Did you know? 

Businesses charge higher prices to divisions operating in high-tax nations (reducing profits) but charge less (increasing profit) for divisions operating in low-tax countries.

The Arm's Length Principle 

All countries have vast variations regarding tax rates. These variations incentivise multinational corporations to transfer profits from countries with high tax rates to countries with fewer tax burdens. Profit shifting is easily accomplished through internal transactions. It may include:

  • Manufacturing divisions that give the final product to a distribution branch
  • The holding company that provides financial or consulting services to its affiliates.
  • An associated company is providing services to an additional.

The MNCs can set prices and manage their terms of transactions. Hence, they influence the amount of profit earned and the consequent amount of tax payable. To avoid this, tax authorities developed the principle of arm's length, which stipulates that transactions controlled by the tax authorities are conducted at market prices. The arm's length principle could be defined as "entities connected by control, management or capital through their controlled transactions.

It should be able to agree on the identical terms and conditions by other entities that are not related for similar uncontrolled transactions". If this is the case, it is possible to conclude that the conditions and terms of the specific transaction are at arm's length'. 

Transfer Pricing Methods

Traditional methods of analysing transactions highlight each transaction specifically compared to the overall shape of profit for connected entities in the ALP. OECD Guidelines submit the following methods as a method for transactions.

  • Comparable Uncontrolled Price (CUP) method 
  • Resale Price Method (RPM)
  • Cost-Plus Method (CP method ) 

Transfer pricing applies during a contract with two or more enterprise associate parties. It is a way of acting like they are not connected, meaning that there isn't any question of a conflict of interest. It is easy to explain this as a deal between two independent parties. OECD implemented the guidelines for the transfer pricing of multinational corporations and tax authorities in 1995. The guidelines of OECD are widely appreciable. We should decide on transfer pricing under the principle of the arm's length within the pricing of transfers. Therefore, the price determined is the arm's length pricing (ALP). According to ALP, the two types of methods for pricing transfers are:

  1. Traditional transaction method
  2. Methods to earn profit from transactions or non-transacting methods.

Also Read: How to Write a Business Plan - A Step-By-Step Guide

Comparable Uncontrolled Price (CUP) Method 

This method is where the price in an uncontrolled transaction with comparable entities is acknowledged and compared with the confirmed price of the entity to determine the arm's length principle. The CUP method in transfer pricing is the most reliable proof of ALP. The following can trigger an arm's length cost:

  • Taxpayers or other members from the affiliate group sell the product with comparable sizes and in similar terms to ALP on similar markets for promotion (internal similar).
  • An ALP company sells the same product in the same quantities and under similar conditions to other arm's length parties on comparable markets (an external similar).
  • The taxpayer purchases the same quantities in similar amounts and at the same terms from the associate parties on the markets comparable to them (internal similar).
  • An ALP party purchases the products in similar quantities and with similar terms from an arm's-length associate in markets similar to the one they are competing with (external similar).

Resale Price Method (RPM)

The RPM method is akin to CPM. This technique helps when the vendor provides similarly low value to the goods that associate companies own. In this case, the arm's length price is calculated by subtracting the gross profit mark-up by the sale price charged to the free entity.

The resale price approach begins with the resale price for arm's-length entities (of the goods purchased from a non-arm's length company ) which is reduced by a comparable gross margin. A similar gross margin is established through reference to:

  • The price margin for resales earned by an arm's length company in similar transactions that are not controlled (external similar).
  • The profit on resales by a member or group of members in comparable uncontrolled transactions (internal similar) or

Cost Plus Method (CPM)

The cost-plus method contrasts gross profits with the sales cost. Firstly, you determine the costs the supplier incurred in the translation. To get the perfect transfer price, you need to add an appropriate mark-up to this cost.

The more similarity in the risks, aspects and properties, the more likely the cost-plus method will estimate the arm's length outcome. 

Profit Split Method (PSM)

This method is a good way to satisfy the principle of arm's length. It compares the earnings earned by the parties involved in similar unregulated transactions. PSM is the most suitable method to use on the services from associated enterprises (AE) within a specific transaction. Firstly, the combined net profit of all associated enterprises engaged in international or specified domestic transactions is computed. Then, the contribution proportional to every associated enterprise is assessed by performing a Functions, Assets and Risks (FAR) analysis. This net profit is divided between the associated enterprises according to their contributions. 

The guidance note on transfer pricing suggests a different approach in which a base return will be first distributed to AEs considering market forces. The remaining profits will then be divided among associated enterprises as described above. This method is useful when an associated enterprise uses exclusive intangibles.

What is Transfer Pricing Audit?

With different requirements in various taxes, determining the appropriate price for transfer is often a tedious job. Tax authorities from both regional and local tax authorities conduct comprehensive price checks of financial records to ensure that the business follows the regulations. Audits on transfer pricing are vital, and tax authorities determine who they will audit and who they do not. There should be no risks if a business can prove its transfer pricing policies with solid and substantiated documents.

Also Read: Master Tips to Start an Online Advertising Agency in India

Transfer Pricing is a Risk

  1. Many extra costs are incurred in the form of manpower and time needed to execute transfer prices and maintain an accounting system to facilitate the process. Pricing for transfers can be a time-consuming method.
  2. There may be disagreements among the departments of an organisation about the policies on transfer pricing and price.
  3. Buyers and sellers pay various duties. Therefore, they are both subject to different risks. For example, the seller might not assure the item. However, the customer payment paid will affect this difference.
  4. It is difficult to determine the cost of intangible products.

The Benefits of Transfer Pricing

  1. Taxes on corporate income in countries with high tax rates by charging more for goods shipped to countries with lower tax rates can help companies get better profit margins.
  2. Transfer pricing assists in reducing the cost of sending goods into countries with high tariffs using low transfer prices to ensure that the duty base of these transactions lessens.

Conclusion

If you're a small or medium-sized company or a massive operation, transfer pricing could cause tax problems for international companies. This is why it's crucial to examine your strategy for transfer pricing to reduce the risks of credit and market while ensuring that you comply with global compliance rules.
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FAQs

Q: What does cost-based transfer pricing mean?

Ans:

Cost-based transfer pricing (CBT) is used to set prices for selling products to separate divisions within the company. Various factors affect the price, such as production costs, taxations, managers' reviews, etc.

Q: What is the importance of transfer pricing?

Ans:

Transfer pricing is the cost of goods and services exchanged between companies with common control. For instance, if a subsidiary company sells products or services for its sister company or parent company, the price paid is known as the transfer price.

Q: What is transfer pricing?

Ans:

Transfer pricing is a method that establishes the price for transactions in services or goods between companies or related businesses. Transfer pricing can increase efficiency and price improvements and simplify the accounting process.

Q: What are the various types of transfer pricing?

Ans:

We can classify transfer prices in three ways: cost-based transfer prices, market-based transfer prices and negotiated transfer prices.

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