Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided. Transfer pricing allows for the establishment of prices for the goods and services exchanged between a subsidiary, an affiliate, or commonly controlled companies that are part of the same larger enterprise. Transfer pricing can lead to tax savings for corporations, though tax authorities may contest their claims.
Purpose of Transfer Pricing
The key objectives behind having transfer pricing are:
• 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 center, 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).
Why Organizations need to understand 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 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 inter company transactions should understand transfer pricing concept, particularly for the compliance requirements as per law and to eliminate the risks of non-compliance.
Aims & Objective Of Transfer Pricing:
1. Transfer pricing minimizes the tax burden or arranging direction of cash flow:
Transfer price, as aforesaid, refers to the value attached to transfer of goods, services, and technology between related entities such as parent and subsidiary corporations and also between the parties which are controlled by a common entity. Its essence being that the pricing is not set by an independent transferor and transferee in an arm's length transaction. Transaction between them is not governed by open market considerations.
2. Transfer pricing results in shifting profits:
Whatever the reason for fixing a transfer price which is not arm's length, the result is the shift of profit. The effect is that the profit appropriately attributable to one jurisdiction is shifted to another jurisdiction. The main object is to avoid tax as also to withdraw profits leaving very little for the local participation to share. Other object is avoidance of foreign exchange restrictions.
3. Shifting of Profits- Tax avoiding not the only object:
Transfer between the enterprises under the same control and management, of goods, commodities, merchandise, raw material, stock, or services is made at a price which is not dictated by the market but controlled by such considerations such as:
• To reduce profits artificially so that tax effect is reduced in a specific country;
• To facilitate decentralization of production so that efforts are directed to concentrate profits in the State of production where there is no or least competition;
• To remit profits more than the ceilings imposed for repatriation;
• To use it as an effective tool to exploit the fluctuation in foreign exchange to advantage.