essay on tranfer pricing

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Essay on transfer pricing.

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Transfer pricing is, in effect, the ways in which a company adjusts and sets the prices it charges between various companies. This sample essay from Ultius explores ways in which transfer pricing can affect the development of tax opportunities for companies, as well as discussing the downsides to the use of transfer pricing in the modern marketplace. Transfer pricing can be:

Analyzed to determine how a company allocates its resources
Defined as the practice of setting, analyzing, documenting, and adjusting the prices charged between companies for products, services, or property use

The following analysis will:

Determine the ways in which transfer pricing affects organizations
Analyze the way in which transfer pricing can provide tax planning opportunities for organizations
Explore the way transfer pricing can affect the personnel who work in an organization
Explain how the practices of transfer pricing are beneficial as certain ethical issues arise

Understanding transfer pricing

Transfer prices can provide tax planning opportunities for organizations. According to Stayon, in order to be able to obtain tax planning opportunities, organizations must work closely with the IRS in order to determine which method of transfer prices they must utilize in order to obtain the best tax planning opportunity. Company executives must prove their leadership ability and put careful foresight into the decisions that go into setting transfer prices.

“Current law allows considerable flexibility in setting the transfer price. Within the limits allowed, the price can be set to maximize taxable income for the entity with the lower marginal tax rate and to minimize taxable income for the entity with the higher marginal tax rate” (Stryon, 2007).

The appropriate method for setting transfer prices can be beneficial or damaging for an organization’s tax planning needs.

Methods and guidelines for transfer pricing

The United States treasury sets methods and guidelines for setting prices. If these guidelines are followed, tax deductions are provided to the organizations.

“If the taxpayer plans and properly documents the process used in setting the transfer price and the adjustments made to improve comparability, the taxpayer can effectively plan transfer prices to reduce taxes for the controlled group as a whole” (Stron, 2007).

By ensuring that their arrangements with other transactions are comparable, the organizations can qualify for the tax deductions provided by the IRS. They can also plan future tax planning initiatives. For example, Samsung's electronics division could benefit from transfer pricing by adjusting costs between its battery and microchip vendors. Setting these prices could reduce tax burdens for that year or future filings.

Negative consequences

Transfer pricing can also have important consequences for the personnel in an organization. The model of transfer pricing which an organization chooses to use can have consequences for the morale, compensation, and productivity of a company’s personnel. If transfer pricing is done in a manner which is effective and beneficial for the company, the profits of the company can be increased. However, if transfer pricing is done ineffectively it can have negative ramifications for the company.

“In these cases, inaccurate transfer prices may impede rather than stimulate the efficient allocation of resources. For example, if a transfer price is established at an arbitrary low level, divisions that purchase the transfer good may appear to be more profitable and thereby command a disproportionately large allocation of scarce resources” (Abdel-Khalik, 1974).

When the results of transfer pricing lead to success this leads to increased morale within the company which can lead to increased productivity, as happy workers equal efficient workers. With increased productivity and increased profits for the company can lead to increased compensation for the personnel of the company. If a company has additional money they may be more willing to increase the pay they give their personnel, which in turn motivates employees to perform better and increases profits. This demonstrates why it is crucial to engage in effective transfer pricing policies for organizations and also the management that drives these practices.

Downsides to transfer pricing

Transfer pricing is not all beneficial as the practice can lead to unethical conduct in business. The pursuit of profits from the methods of transfer pricing. As demonstrated earlier companies can use transfer pricing to create tax planning opportunities for themselves. However, the practice can also lead to abuse of the tax laws.

“There is evidence that multinational corporations take advantage of the detailed, subjective regulations which govern Internal Revenue Code Section 482, with regard to intercompany transfer pricing” (Hansen 1992).

By adjusting prices solely for the benefit of obtaining tax deductions the company could be seen as violating not just ethical business practice codes but also IRS regulations.

Transfer pricing can also lead to unethical business practices in that a company might unfairly set prices that are profitable for themselves while unprofitable for other companies. These practices may occur more often with wealthier companies engaging in services with poorer companies. (Watson, 1975). Transfer pricing can lead to a small business failing while a major corporation like Walmart continues to make a profit. Unethical practices can create a negative connotation for the practice of transfer pricing and lead to the creation of additional laws and regulations which may lead to the practice of transfer pricing being abolished.

Summarizing transfer pricing

As other business practices, the practice of transfer pricing needs to be conducted in an ethical manner. Transfer pricing practices need to take into account the benefit of not only the upper management within a company but also the personnel within the company and the other businesses with which the organization does business with. The methods of transfer pricing need to be analyzed thoughtfully as the right transfer pricing method can benefit a company or do harm to a company. The study of transfer pricing is important in analyzing the various ways in which organizations interact and do business with each other.

Abdel-Khalik, A. R., Lusk, E. J. (1974). Transfer pricing-a synthesis. The Accounting Review, 49(1), 8-23.

Garrison, Noreen Noreen, Eric. (2010). Managerial Accounting for Managers. McGraw Hill Education.

Hansen, D. R., Crosser, R. L., Laufer, D. (1992). Moral ethics v. tax ethics: The case of transfer pricing among multinational corporations. Journal of Business Ethics, 11(9), 679-686.

Stryon, Joey. (2007). Transfer Planning and Tax Planning. The CPA Journal. Retrieved from: [http://www.nysscpa.org/cpajournal/2007/1107/essentials/p40.htm]

Watson, D. J., Baumler, J. V. (1975). Transfer pricing: a behavioral context. Accounting Review, 466-474.

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Ultius, Inc. "Essay on Transfer Pricing." Ultius | Custom Writing and Editing Services. Ultius Blog, 25 Aug. 2013. https://www.ultius.com/ultius-blog/entry/essay-on-transfer-pricing.html

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What Is Transfer Price?

Understanding transfer price, transfer price example, international transfer pricing, how transfer pricing impacts taxation, the bottom line.

Corporate Finance

Transfer Price: What It Is, How It's Used, and Examples

Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

Transfer price, also known as transfer cost, is the price at which related parties transact with one another, such as during the trade of supplies or labor between departments. Transfer prices are often used in transactions between a company and its subsidiaries or between different divisions of the same company operating in different countries.

Beyond corporate settings, transfer pricing is also applied in other complex organizations like universities, where it helps differentiate cost, revenue, and profit centers.

Key Takeaways

Transfer prices that differ from market value will benefit one entity, but reduce the profits of the other entity.
Multinational companies can manipulate transfer prices to shift profits to low tax-rate regions.
To remedy this, regulations enforce an arm's length transaction rule that requires pricing based on similar transactions between unrelated parties.
Transfer pricing carries significant compliance risk for multinational corporations, impacting both tax planning and financial reporting.

Investopedia / Ellen Lindner

Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. It's 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 associated parties are required to transact with each other, a transfer price is used to determine costs.

Transfer prices generally don't 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.

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 .

Conversely, if Entity A sells at a rate above market value, it boosts its own sales revenue, while Entity B incurs higher COGS and reduced profits. In either situation, a transfer price that varies from market value benefits one entity while harming the other.

Regulations on transfer pricing ensure the fairness and accuracy of transfer pricing by enforcing an arm’s length transaction rule. This rule requires companies to price transactions between related entities similarly to those between unrelated parties. Transfer pricing is closely monitored within a company’s financial reporting.

Transfer pricing requires strict documentation that's included in the footnotes to the financial statements for review by auditors, regulators, and investors. This documentation is closely scrutinized. If inappropriately documented, it can burden the company with added taxation or restatement fees. These prices are closely checked for accuracy to ensure that profits are booked appropriately within arm's length pricing methods and associated taxes are paid accordingly.

Transfer prices are used when divisions sell goods in intracompany transactions to divisions in other international jurisdictions. A large part of international commerce is actually done within companies rather than between unrelated companies.

When transfer pricing occurs, companies can manipulate their profits from goods and services to book higher profits in another country with a lower tax rate. In some cases, transferring goods and services from one country to another within an intracompany transaction can also allow a company to avoid tariffs on goods and services exchanged internationally.

However, tax authorities worldwide are increasingly cracking down on transfer pricing practices by imposing stricter regulations and closer scrutiny to prevent profit shifting and ensure compliance with international tax laws. The Organisation for Economic Cooperation and Development (OECD) regulates international tax laws, and auditing firms within each international location audit the financial statements accordingly.

Let's take the example above with Entity A and Entity B. Assume Entity A is in a high-tax country while Entity B is in a low-tax country. It would benefit the organization as a whole if more of Company ABC's profits appeared in Entity B's division, where the company would pay lower taxes.

In that case, Company ABC may attempt to have Entity A offer a transfer price lower than market value to Entity B when selling them the wheels needed to build the bicycles. As explained above, Entity B would then have a lower cost of goods sold (COGS) and higher earnings, and Entity A would have reduced sales revenue and lower total earnings.

Companies will attempt to shift a major part of such economic activity to low-cost destinations to save on taxes. This practice continues to be a major point of discord between multinational companies and tax authorities like the Internal Revenue Service (IRS) . For example, the IRS has implemented strict documentation requirements for transfer pricing to ensure compliance and reduce tax avoidance; taxpayers must provide pricing documentation to avoid penalties.

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's 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 are usually equal to or lower than market prices, which results in cost savings for the entity buying the product or service. This increases transparency in intra-entity transactions. Finally, the desired product is readily available, so supply chain issues can be mitigated.

What Are the Disadvantages of Transfer Pricing?

Since transfer prices are usually equal to, or lower than, market prices, the entity selling the product is liable to get less revenue. There's also the fact that it's a complicated process. Market prices are based on supply-demand relationships, whereas transfer prices may be subject to other organizational forces. Additionally, intra-entity animosity might arise, especially if the transfer price is appreciably higher or lower than the market price, as one of the parties will feel cheated.

Transfer pricing helps companies manage transactions between their divisions or subsidiaries, especially when operating in different countries. If an organization shifts profits to low-tax-rate regions using transfer pricing, it can create tax savings, but it also carries risks of tax manipulation and penalties.

Regulations like the arm's length transaction rule aim to ensure fairness in these transactions. Ultimately, transfer pricing can be useful when handled correctly. But, if not properly managed, it can create compliance issues and conflicts with tax authorities. To avoid penalties, companies must keep accurate records and documentation.

West Texas A&M University. " Transfer Pricing: How to Apply the Economics of Differential Pricing To Higher Education ."

Journal of Accountancy. " Transfer Pricing and its Effect on Financial Reporting ."

Internal Revenue Service. " 4.11.5 Allocation of Income and Deductions Under IRC 482 ."

IMF eLibrary. " Treatment of Intercompany Transfer Pricing for Tax Purposes ."

Organisation for Economic Cooperation and Development. " Transfer Pricing Country Profiles ."

Internal Revenue Service. " Transfer Pricing Documentation Best Practices Frequently Asked Questions (FAQs) ."

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TRANSFER PRICING: CONCEPTS, EVOLUTION, METHODS, EXISTING GUIDELINES AND ITS EFFECTS IN DEVELOPING COUNTRIES

Transfer pricing is high on the agenda because globalization has lifted the level of cross-border trade between related entities to new heights. It is estimated that, worldwide, about 2/3 of all business transactions take place within a group. In the absence of Transfer Pricing legislation, both tax administrations and MNEs have only limited guidance they can refer to when determining transfer pricing in related-party transactions. However, we find that developing countries encounter particular problems when dealing with transfer pricing. Local tax administrations are often inexperienced with regard to transfer pricing and lack basic understanding in the field. The paper indicates that, despite strong affinity to the OECD standards, the scope of existing transfer pricing legislation or draft transfer pricing legislation is in part significantly broader as regards the definition of related parties than is outlined in the OECD Guidelines. From a transfer pricing policy perspective