Question

Define transfer pricing. Describe at least two methods of defending transfer prices if they are challenged by tax authorities. How are transfer prices used in managing multinational tax exposures?

Answer 1

TRANSFER PRICE

Definition

According to the IRS website, transfer pricing is defined as follows:

The regulations under section 482 generally provide that prices charged by one affiliate to another, in an inter-company transaction involving the transfer of goods, services, or intangibles, yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.

Companies in high-tax countries often establish affiliates in low-tax countries to run some of their operations in order to minimize tax exposure. Transfer pricing is the practice by which a fair price is established for transferring of goods and services between the affiliates and the holding company. Although transfer pricing is computed based on market rates, companies have used inter-company transfer pricing to reduce the tax burden of a company.

Methods of Defending Transfer Pricing
1. Proper Documentation - The rules of many countries require taxpayers to document that prices charged are within the prices permitted under the transfer pricing rules. Documentation may be required to be in place prior to filing a tax return in order to avoid these penalties.

2. Sign-off from Chartered Accountant - Acquiring a sign-off on transfer price computation prior to filing a return, and also getting the documentation certified by an auditor (chartered accountant) or regulators will support your case against tax authorities.

Transfer Price for managing tax

To better understand how transfer pricing impacts a company's tax exposure, below is a short scenario as example.

1. Let's say that an automotive manufacturer has two divisions: Division A, which manufacturers software while Division B manufactures cars.
2. Division A sells the software to other car-makers as well as its parent company. Division B pays Division A for the software typically at the prevailing market price that Division A charges other car-makers.
3. Let's say that Division A decides to charge a lower price to Division B instead of using the market price. As a result, Division A's sales or revenues are lower because of the lower pricing.
4. On the other hand, Division B's costs of goods sold (COGS) are lower, increasing the division's profits.
5. In short Division A's revenues are lower by the same amount as Division B's cost savings—so there's no financial impact on the overall corporation.
6. However, let's say that Division A is in a higher tax country than Division B. The overall company can save on taxes by making Division A less profitable and Division B more profitable.
7. By making Division A charge lower prices and pass those savings onto Division B, boosting its profits through a lower COGS, Division B will be taxed at a lower rate. In other words, Division A's decision not to charge market pricing to Division B allows the overall company to evade taxes.
8. In short, by charging above or below the market price, companies can use transfer pricing to transfer profits and costs to other divisions internally to reduce their tax burden.