Transfer pricing refers to methods that determine the price for trading goods and services between related enterprises or companies. This practice helps improve pricing, promotes efficiency, and benefits the accounting process. Many corporations leverage the idea of transfer pricing. But why? Why is transfer pricing so important to companies?
Transfer pricing is important as it helps businesses reduce duty costs and income tax in locations that have higher taxes. This practice also helps businesses avoid high tariffs.
Understanding the concept of transfer pricing is one thing; having a good knowledge of its benefits is another. With transfer pricing, you can reduce some expenses for your business, thus saving more. In this post, I have outlined the importance of transfer pricing. Perhaps, they might convince you to consider it for your company.
Why Transfer Pricing Is Important?
After reading this post, you’ll understand the concept of transfer pricing, how it works, examples, how companies leverage it to cut expenses, and how it can benefit your company. First, let’s start with what transfer pricing is.
Transfer pricing is an accounting practice that portrays the price that one section in a company charges another section for goods and services provided. Transfer pricing allows the establishment of prices for the goods and services exchanged between subsidiaries, affiliates, or commonly controlled companies associated with the same larger company. Transfer pricing can result in tax savings for corporations, though tax authorities may challenge their claims.
How Does Transfer Pricing Work?
Transfer pricing allows businesses and subsidiaries operating under the same ownership or management to price transactions internally. This practice doesn’t only apply to domestic transactions but transborder transactions as well. For instance, consider a corporation in the Gold industry called Apex Gold enterprise.
Apex Gold Enterprise owns two subsidiaries: Apex Gold Extraction Inc. and Apex Gold sales. All three companies are associated enterprises. Apex Gold Extraction Inc. extracts gold and manufactures jewelry that sells to Apex Gold sales for distribution.
Apex Gold Company, which owns the two subsidiaries, doesn’t control the price at which Gold Sales sells jewelry on the market as supply and demand establish this price. But, Apex Gold Company can control the transactions between Apex Gold Sales and Apex God Extraction Inc.
Apex Gold Extraction Inc.’s internal sales to Apex Gold Sales are controlled transactions, and the price that Apex Gold Company sets for these transactions is the transfer price.
How Companies Leverage Transfer Pricing?
Companies can use transfer pricing to issue earnings among their subsidiaries. They may use this legal practice to cut down their taxable income and, as a result, lessen their taxes by transferring tax liabilities to entities based in low-tax areas. Continuing with our Apex Gold Industry examples, here is a case point:
Apex Gold Company sets a transfer price for a diamond necklace below the market price. This move leads to lower revenue for Apex Gold Extraction Inc., which produces the necklaces, and a lower cost of goods for Apex Gold Sales, which sells the necklaces.
Apex Gold Company’s reason for setting this transfer price is because Apex Gold Extraction Inc. is located in a higher tax area, while Apex Gold Sales is in a lower tax area. By using the transfer price to increase Diamond Sales’ profits and reduce Apex Gold Extraction Inc.’s profits, Apex Gold Company has created a situation where the organization will pay lower taxes generally by transferring profits to the enterprise in the lower tax region.
Benefits of Transfer Pricing:
Transfer pricing allows businesses to reduce duty costs and other expenses. When companies need to ship goods to places with high traffic rates, they can use a low transfer price to reduce the transaction’s duty base.
Many companies can also benefit from using transfer pricing as it can reduce income taxes in locations that often have higher taxes. This is because transfer pricing allows businesses to increase the prices of products that they might sell in places with higher taxes, which can benefit a company’s efforts to balance its profits.
Tax authorities establish rules for transfer pricing and its financial reporting, keeping an eye on the practice to stop corporations from using the transfer pricing principle to invade taxes. Per the IRS, transfer pricing should match the pricing the company would have applied if the transaction had taken place outside the company with an external customer.
The Organization for Economic Cooperation and Development (OECD) also controls transfer pricing in its international tax laws.
Types of Transfer Pricing Models:
- Marketing-based transfer prices
Market-based transfer pricing imitates the market conditions. It’s the same price at which the company would sell the product to the market. Companies need to have an existing market to use this method. To determine the market-based transfer price, you can check out similar products on the market, like those that competitors sell.
- Cost-based transfer price
Cost-based transfer price is the most commonly used transfer price and is an alternative when market prices are not known or unestablished. In cost-based transfer pricing, only one subdivision pays the cost of the products it purchases from another subdivision. This practice increases the profit for the buying enterprise.
- Negotiated transfer prices
A negotiated transfer price means managers can ignore internal transactions and that subunits need to negotiate like typical customers. Therefore, negotiated transfer prices can’t always fulfill transfer prices’ primary functions, which are profit allocation and coordination.