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.

The company transfer goods or service between each other at price that is different from the market. The transfer pricing will benefit one party and impact another party. However, both parties remain under the same parent or shareholder. The transfer price will maximize the parent company’s benefit.

Taxation is the main reason that encourages the company to do the transfer pricing. The company tries to minimize their income tax expense. They manage to increase the profit of the company which locates in a 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 the parent company will take full benefit.  However, the government has aware of this issue and they take many actions to regulate this issue. Many countries have strict policies for multinational corporations to follow when they sell and purchase goods across the country. It will prevent the company from transferring profit to the tax haven country.

Example of Transfer Pricing

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.

Purpose Transfer Pricing

Transfer prancing is a method that determines the reasonable price between buyer and seller when they are under the same legal entity.

  • Prevent tax evasion: most companies will use the selling price to transfer profit from a high tax country to a low tax country. Transfer pricing will help to determine the market price for both parties which prevents such an issue.
  • To prevent window dressing financial statement: besides tax expenses, the parent may want to improve one company’s profit for the purpose of selling. The transfer price will also be able to prevent part of this fraud.
  • Ensure true and fair financial statements: It is part of the information that will present on both balance sheet and income statement. If we are able to manage it properly, it will help to improve the quality of the financial statement.

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 a low tax rate country by selling at a high price to another company located in a 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 by 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.
Exchange rate fluctuates The transfer pricing will take a very long time as the transaction needs to go from one country to another. By the time it is completed, the exchange rate will be different. It can turn the situation from profit to loss.
Law and legislation The government in each country has strict laws to prevent the company from transferring the profit to low-tax countries. They will review all the purchases across the country to ensure the price is charged reasonably with the market.

Type of Transfer pricing

The company needs to use various methods to review the transfer pricing transaction to ensure transparency. Those methods include:

  • Market price method: The price of goods or services must be comparable with the market price. They will look at the market price of the same or similar product and make a comparison. The variance between the two prices must be within reasonableness and explainable. It will provide
  • Full cost: Both parties will agree on the price which depends on the cost of production and other associated costs such as transportation and so on. It will help to ensure that seller will not charge any huge markup to the buyer. And the buyer will get the best deal if compare to other suppliers.
  • Marginal Cost: this method only allows the seller to charge based on the variable cost only. They exclude the fixed cost as it is not relevant anymore. Variable cost is the only cost that matter to the seller.