What is Transfer Pricing? Methods, Objectives, Advantages

What is Transfer Pricing?

Transfer pricing is a term used to describe aspects of intercompany pricing arrangements between related business entities and commonly applies to intercompany transfers tangible property, intangible property services and finance transfers.

Prices of goods transferred from a country’s operations to its units elsewhere as the companies increase the number of worldwide subsidiaries, joint ventures , company owned subsidiary systems and other marketing arrangements , is known as transfer pricing.

This is done to enhance the ultimate profit of the company as a whole.Intercompany transactions across borders are growing rapidly and becoming more complex.

Objectives of Transfer Pricing

1. Competitiveness in the international marketplace
   
   
2. Reduction of taxes and tariffs
   
   
3. Management of cash flows
   
   
4. Minimization of foreign exchange risks
   
   
5. Avoidance of conflicts with home and host governments over tax issues and repatriation of profits
   
   
6. The price that is assumed to have been charged by one part of the company for products and services it provides to another part of the company, In order to calculate each division’s product and loss separately.

Transfer Pricing Methods

1. Market-based transfer price
2. Cost-based transfer price

Market-based transfer price

In the presence of competitive and stable external markets for the transferred product, many firms use the external market price as the transfer price.

Cost-based transfer price

The transfer price is based on the production cost of the upstream division. A cost-based transfer price requires that the following criteria be specified :

• Actual cost or budgeted (standard) cost.
  
  
• Full cost or variable cost.
  
  
• The amount of mark-up, if any, to allow the upstream division to earn a profit on the transferred product.
  
  
• Negotiated transfer price: Senior management does not specify the transfer price. Rather, divisional managers negotiate a mutually-agreeable price.

Advantages of Transfer Pricing

• Lowering duty costs by shipping goods into high-tariff countries at minimal transfer prices so that duty base and duty are low.
  
  
• Reducing income taxes in high-tax countries by overpricing goods transferred to units in such countries; profits are eliminated and shifted to low-tax countries.
  
  
• Facilitating dividend repatriation when dividend repatriation is curtailed by government policy by inflating prices of goods transferred

Challenges of Transfer Pricing

• Performance Measurement: The clouding effect of manipulating intra corporate prices on a subsidiary’s apparent and actual profit performance ü Difficulty in maintaining relationships with subsidiaries that are negatively impacted by transfer pricing.
  
  
• Taxation: Tax and regulatory jurisdictions contribute to and compound transfer pricing problems. Pricing that is justified and reasonable in the home country may not be perceived as such in the host country.