Transfer pricing refers to the methods and practices used to determine the price of goods, services, or intellectual property transactions between affiliated entities or divisions within a single company operating across different countries or tax jurisdictions. These transactions are commonly referred to as intercompany transactions. For instance, if a subsidiary of a multinational corporation manufactures products in one country and sells them to another subsidiary operating in a different country, the price at which these goods are sold is the transfer price.
The purpose of transfer pricing is primarily to allocate income among the different tax jurisdictions where a company conducts its business, ensuring compliance with tax regulations and avoiding issues such as double taxation or tax evasion. Transfer pricing also aids businesses in internal budgeting, cost control, and performance evaluation of different business units. However, because transfer pricing directly impacts the allocation of taxable income across countries, it is a subject of intense scrutiny by tax authorities worldwide.
Proper transfer pricing policies should align with the "arm's length principle," which means the prices set in intercompany transactions should be comparable to prices charged between independent parties under similar circumstances. Violations of these guidelines often result in adjustments, penalties, or audits by tax authorities, highlighting the importance of accurate and compliant documentation. Techniques such as comparable uncontrolled price, resale price method, and cost-plus method are commonly employed to determine fair transfer prices.
An example of transfer pricing in use is when the headquarters of a company provides marketing support to its international subsidiaries and charges them for these services. The price charged must reflect the market value of similar services provided by an independent third party. Thus, effective transfer pricing not only ensures compliance with laws but also promotes fairness and transparency in business operations.