Transfer Pricing

Transfer price is the trade between two departments within the same company or the transaction between companies under one legal entity.  It is the goods that a subsidiary company sells to its parent or vice versa.

Taxation is the main reason that encourages the company to do the transfer pricing. The company try to minimize their income tax expense. They manage to increase the profit of the company which locate in low tax rate and decrease the profit of high tax rate country, and as a result. It will reduce the income tax expense in the consolidate financial statements and parent company will take full benefit.  However, the government has aware of this issue and they take many actions to regulate this issue.

Example

ABC is a manufacturer that produces shoes at a total cost of $5 per unit. It locates in a country that has a low-income tax rate of 10%. ABC supplies all the products to its parent company which located in the US with an income tax rate of 30%. The parent company purchases the product from ABC at $ 8 per unit and sells at $ 20 per unit.

Without transfer pricing, both companies have profit at tax as follows:

Description ABC Parent Total
Sale 8 20 28
Cost (5) (8) (13)
Profit before tax 3 12 15
Tax (0.3) (3.6) (3.9)
Profit after tax 2.7 8.4 11.1

After the management decides to do the transfer price, they increase the selling price of ABC from $8 to $15 per unit.

The profit of both companies will look like:

Description ABC Parent Total
Sale 15 20 35
Cost (5) (15) (20)
Profit before tax 10 5 15
Tax (1) (1.5) (2.5)
Profit after tax 9 3.5 12.5

We can see that the tax expense has decreased from $ 3.9 to $ 2.5 per unit as the result of transfer pricing.

Note: Please ignore the elimination entries, as this example just to show the difference of tax only, we do not want to confuse the reader.

Benefits of transfer pricing

Decrease the cost of duty We can minimize the duty cost by decreasing the value of goods when transfer across the border.
Decrease the income tax The company can increase its revenue in the low tax rate country by selling at a high price to another company located in the high tax rate.

Risk of transfer pricing

The conflict between company or division Each division/company has its own KPI which used to determine the management performance. If we allow one company to charge an unusually high price, it will hurt the profit of another division. So it will impact management performance as well. It will be very hard to come up with a proper price.
Complicate and time-consuming The process of transfer price sounds easy than it actually is. It requires time from top management to make the proper decision to set up the process.
Hard to control in an accounting system The price of goods sold between each company will vary from time to time. It hard to set a standard price, it will hard to consolidate group reports. The information in the accounting system is not reliable.