Question

How can you reduce your tax bill using transfer pricing?

Answer 1

Transfer Pricing

It is an accounting practice that represents the price that one division in a company charges another division for goods and services provided. It 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 enterprises. Transfer pricing can lead to tax savings for corporation, through tax authorities may contest their claims. Companies have used inter-company transfer pricing to reduce the tax burden of the parent company.

How can a company reduce its tax bill using transfer pricing

  Multinational companies are legally allowed to use the transfer pricing methods for allocating earnings among their various subsidiary and affiliate companies that are part of the parent company. However companies at times can also  use or misuse this practice by altering their taxable income, thus reducing their overall taxes. The transfer pricing mechanism is a way that companies can shift tax liabilities to low-cost tax jurisdictions.

To better understand how transfer pricing works in a company, Let's consider a scenario,

Let's say that an automobile manufacturer has two divisions- Division A, which manufactures software while Division B manufactures cars. Division A sells the software to other carmakers as well as its parent company. Divison B pays Division A for the software typically at the prevailing market price that Division A charges other carmakers. Let's say that Division A charge a lower price to Division B instead of using the market price. As a result, Divison A's sales or revenues are lower because of the lower pricing. On the otherhand Division B's cost of goods sold are lower, increasing the division's profit. In short Divison A's revenues are lower by the same amount as Division B's cost of savings- so there is no financial imoact on the overall corporation.

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 Divsion A less profitable and Division B more profitable. By making Division A charge lower prices and pass those savings onto Division B boosting it's profits through a lower COGS Division B will be taxed at a lower rate. In other words , Division A's dec ision to not to charge market pricing to Division B allows the overall company to evade taxes.

In short, by charging above or below the market price, companies can use transfer pricing to transfer profits and consts to other divisions internally to reduce their tax burden. Tax authorities have strict rules regarding transfer pricing to attempt to prevent companies from using it to avoid taxes.