Transfer pricing can be defined as the value which is attached to the goods or services transferred between related parties. In other words, transfer pricing is the price that is paid for goods or services transferred from one unit of an organization to its other units situated in different countries (with exceptions).
Transfer price, also known as transfer cost, is the price at which related parties transact with each other, such as during the trade of supplies or labor between departments. Transfer prices may be used in transactions between a company and its subsidiaries, or between divisions of the same company in different countries.
Transfer Price
Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. It is common for multi-entity corporations to be consolidated on a financial reporting basis; however, they may report each entity separately for tax purposes.
A transfer price arises for accounting purposes when related parties, such as divisions within a company or a company and its subsidiary, report their own profits. When these related parties are required to transact with each other, a transfer price is used to determine costs. Transfer prices generally do not differ much from the market price. If the price does differ, then one of the entities is at a disadvantage and would ultimately start buying from the market to get a better price.
For example, assume entity A and entity B are two unique segments of Company ABC. Entity A builds and sells wheels, and entity B assembles and sells bicycles. Entity A may also sell wheels to entity B through an intracompany transaction. If entity A offers entity B a rate lower than market value, entity B will have a lower cost of goods sold (COGS) and higher earnings than it otherwise would have. However, doing so would also hurt entity A’s sales revenue.
If, on the other hand, entity A offers entity B a rate higher than market value, then entity A would have higher sales revenue than it would have if it sold to an external customer. Entity B would have higher COGS and lower profits. In either situation, one entity benefits while the other is hurt by a transfer price that varies from market value.
Purposes of Transfer Pricing
- Generating separate profit for each of the divisions and enabling performance evaluation of each division separately.
- Transfer prices would affect not just the reported profits of every centre, but would also affect the allocation of a company’s resources (Cost incurred by one centre will be considered as the resources utilized by them).
Transactions Subject to Transfer Pricing
The following are some of the typical international transactions which are governed by the transfer pricing rules:
- Sale of finished goods
- Purchase of raw material
- Purchase of fixed assets
- Sale or purchase of machinery etc.
- Sale or purchase of intangibles
- Reimbursement of expenses paid/received
- IT enabled services
- Support services
- Software development services
- Technical Service fees
- Management fees
- Royalty fees
- Corporate Guarantee fees
- Loan received or paid
Importance of Transfer Pricing
For the purpose of management accounting and reporting, multinational companies (MNCs) have some amount of discretion while defining how to distribute the profits and expenses to the subsidiaries located in various countries.
Sometimes a subsidiary of a company might be divided into segments or might be accounted for as a standalone business. In these cases, transfer pricing helps in allocating revenue and expenses to such subsidiaries in the right manner.
The profitability of a subsidiary depends on the prices at which the inter-company transactions occur. These days the inter-company transactions are facing increased scrutiny by the governments. Here, when transfer pricing is applied, it could impact shareholders wealth as this influences company’s taxable income and its after-tax, free cash flow.
It is important that a business having cross-border intercompany transactions should understand the transfer pricing concept, particularly for the compliance requirements as per law and to eliminate the risks of non-compliance.
Transfer Pricing Methodologies
The Organisation for Economic Co-operation and Development (OECD) guidelines discuss the transfer pricing methods which could be used for examining the arms-length price of the controlled transactions.
Here, arms-length price refers to the price which is applied or proposed or charged when unrelated parties enter into similar transactions in an uncontrolled condition. The following are three of the most commonly used transfer pricing methodologies.
For the purpose of understanding, associated enterprises refer to an enterprise that directly or indirectly participates in the management or capital or control of another enterprise.
Comparable Uncontrolled Price (CUP) Method
Under the CUP method, a price that is charged in an uncontrolled transaction between the comparable firms is recognized and evaluated with a verified entity price for determining the Arm’s Length Price. Example:
A Ltd. purchases 10,000 MT metal from B Ltd. its subsidiary @INR 30,000 /MT. Also purchase from C Ltd. 2,500 MT @ INR 40,000/MT.
A Ltd. received a discount of INR 500 /MT as a quantity discount from B Ltd. B Ltd. allows credit of one month at 1.25% pm. The transaction with B Ltd. is at FOB (Free on board) whereas with C Ltd. is at CIF (Cost, Insurance, and Freight). The cost of freight and Insurance is INR 1,000.
Here, the terms of transactions are not the same and hence, it has affected the cost of the crude metal. Hence, adjustments are needed. Adjustments required for differences in;
1. Quantity discount: In case a similar discount is offered by C Ltd., the price that was charged by C Ltd. would have been lower by INR 500/MT.
2. Freight & Insurance (FOB Vs CIF): In case the purchase from C Ltd. was also on FOB, then the price charged by C Ltd. would have been lesser. Hence, the cost of freight & insurance must be reduced from the purchase price.
3. Credit period: In case similar credit was offered by C Ltd., then the price charged by them would have been more after factoring in such cost. Hence, 1.25% pm must be added to the purchase price.
Cost Plus Method
With the Cost Plus Method, you emphasize on costs of the supplier of goods or services in the controlled transaction. Once you’re aware of the costs, you need to add a markup. This markup must reflect the profit for the associated enterprise on basis of risks and functions performed. The result is the arm’s length price.
Generally, the markup in the cost plus method would be calculated after the direct and indirect cost related to production or supply is considered. But, the operating expenses of an enterprise (like overhead expenses) aren’t part of this markup.
Example: Associated Enterprise-A, a computer manufacturer in Thailand, manufactures under a contract for Associated Enterprise B. Associated Enterprise B would instruct Associated Enterprise-A about the quantity and quality of computers to be manufactured.
The Associated Enterprise-A would be guaranteed of its sales to Associated Enterprise B and would have little or no risk.
Let’s assume that the Cost of goods sold is INR 50,000. Also, assume that the arm’s length markup which Associated Enterprise-A should earn is 40%.
The resulting arm’s length price between Associated Enterprise-A and Associated Enterprise B is INR 70,000 (i.e. INR 50,000 x (1 + 0.40)).
Resale Price Method or Resale Minus Method
In this method, it takes the prices at which the associated enterprise sells its product to the third party. This price is referred to as the resale price.
The gross margin which is determined by comparing the gross margins in a comparable uncontrolled transaction is then reduced from this resale price. After this, costs which are associated with the purchase of such product such as the customs duty are deducted. What remains is considered as arm’s length price for a controlled transaction between the associated enterprises.
FAQs
Why Is Transfer Price Used?
Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. While it is common for multi-entity corporations to be consolidated on a financial reporting basis, they may report each entity separately for tax purposes. When these entities report their own profits a transfer price may be necessary for accounting purposes to determine the costs of the transactions.
What Are the Benefits of Transfer Pricing?
Transfer prices will usually be equal to or lower than market prices which will result in cost savings for the entity buying the product or service. It increases transparency in intra-entity transactions. Finally, the desired product is readily available so supply chain issues can be mitigated.