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Transfer pricing: what is it and how to use it

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Last editedOct 20203 min read

In a global economy, it’s more important than ever for businesses to be aware of cross-border tax issues. Multinational organizations must stay on top of the latest international guidelines, with correct financial records and documentation. Transfer pricing is one aspect of international business that can impact compliance. But what is transfer pricing? Find out everything you need to know, starting with our transfer pricing definition.

Transfer pricing definition

A transfer price refers simply to the price charged for a service between two related parties within an intercompany transaction. It provides a means for valuing cross-border intercompany transactions, such as those involving two subsidiaries from the same multinational corporation.

Certain policies related to transfer pricing have been put in place to ensure consistency and compliance with international tax regulations. One fundamental example is the “arm’s length principle.” This means that even though the two companies are commonly controlled by a larger multinational enterprise, they must be treated as unrelated, independent entities.

The need for transfer pricing regulations arises to ensure that certain goods and services are valued impartially from a tax perspective. The types of transactions impacted by transfer pricing policies include:

Finance transactions (intercompany loans, guarantees, accounts receivable)
Services (sales support, management)
Tangible property (manufacturing, supply distribution, physical goods)
Intangible property (licenses, royalties, cost-sharing)

Why is the “arm’s length principle” important?

By using the arm’s length principle, multinational entities can ensure that they’re meeting all relevant tax requirements across borders. Without a consistent policy for these types of transactions, companies run the risk of tax evasion by sourcing their profits to jurisdictions with lower taxes.

Transfer pricing rules prevent profits from being stored in tax havens, allowing global tax authorities to adjust the value of related party transactions. These types of adjustments could lead to additional penalties, interest, or even double taxation.

For example, in the Internal Revenue Code (IRC), Section 6662e states that transfer pricing penalties could range from 20% to 40% of the underpayment of tax related to transfer pricing misstatements.

However, if the taxpayer provides documentation with a transfer pricing analysis, these penalties can be avoided. Proper transfer pricing methods help support this documentation, preventing the tax authority from making the types of costly adjustments mentioned above.

What is a transfer pricing analysis?

There are three fundamental components of a transfer pricing analysis.

Functional analysis – This process pulls together the facts needed for the transfer pricing evaluation. Relevant data could include written contracts, income statements, and invoices between parties, looking at the types of transactions occurring across borders. It should also pull together these functions and their risks.
Comparable relationships and transactions – This part of transfer pricing analysis looks at business strategies, economic circumstances, and functions performed by each of the related parties.
Application of the best transfer pricing method – Finally, the analysis evaluates the transfer pricing methods to choose the most relevant one.

What are the different transfer pricing methods?

There are many ways to apply transfer pricing principles. Here are a few of the most common.

Comparable uncontrolled price (CUP)

The CUP method compares the price of goods or services within an intercompany transaction to the fees that would be charged between independent parties. It makes use of the fair market price.

Cost-plus-percent method

Another option is to use the cost-plus-percent method, which compares the cost of sales to gross profit. The entity supplying the goods or services determines the transaction cost, adding a mark-up for profit. The mark-up should reflect what a third party would earn for this same transaction.

Transaction net margin method (TNMM)

This method compares the net profit margin within the intercompany transaction to the net profit margin that would be earned in a comparable third-party transaction.

Profit split method

Like the TNM, this uses profit rather than comparable market price as a mode of comparison. In this case, the transfer prices are pulled from an assessment of how profit would be split between independent businesses.

Transfer pricing: the bottom line

Transfer pricing potentially offers tax advantages to multinational companies by allowing higher profits to be transferred to jurisdictions with lower tax rates. This is why controls have been put in place to keep transfer prices consistent, independent, and fair across borders. It’s vital for any international corporation to be aware of the latest regulations set forth by the Organization for Economic Cooperation and Development (OECD) to avoid penalties.

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