Question

Why would a corporate entity markup inventory when selling on an intercompany basis?

Answer 1

1) An inter company transaction is one between a parent company and its subsidiaries or other related entities.

2) It’s easy for a parent to purchase inventory that is subsequently transferred to related entities. This transfer of inventory is often done without any paperwork recorded in the parent company, which has an effect of overstating inventory on the parent company and understating inventory of the related entity. This issue may become more complex if the parent company sells inventory to the related entity. For example, does the parent company sell the inventory at cost or a markup?

3) Suppose the company is an MNC (Multinational Corporation) with operations in many diverse nations. It is likely that income taxation will be different in some respect in each of the countries in which the MNC does business. The critical difference, however, is the top marginal income tax rate in any given country.

4) The shrewd tax strategy is to “load up” cost of sales and other expense debits in the countries with the highest income tax rates through artful transfer pricing, thus lowering the MNC’s global effective tax rate and thus maximising after-tax net income.

5) Of course, the tax enforcement authorities in every country are wise to this, which leads inevitably to transfer pricing rules and limits based on the economic concept of arm’s length pricing. The main idea is to compel MNCs to price inter company transactions in accordance with some hypothetical arm’s length price, “as if” the transaction was between unrelated third parties. But there is still plenty of room for tax planning opportunities and aggressive (but still legal) tax avoidance strategies.

6) By the way, this is one of the most litigious, arcane and controversial areas in all of international corporate taxation. Every advanced economy on the planet has devoted considerable effort to regulate what the MNCs can do in the area of base erosion and profit shifting.

7) If this topic piques your career interests, you can do well to make transfer pricing a specialisation, especially if your background interests are taxation, economics, law, accounting or international finance.