Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax jurisdiction for goods, services, and intangibles. Transfer pricing attempts to assign one of the two parties, also known as the test party, with arm's length returns determined by a group of third-party comparable companies. While third-party comparables can be found that resemble the tested party, and therefore transfer pricing can be accurately estimated, adjustments must be made to make both parties more similar.
For working capital adjustments, if there are any differences between the test party's accounts receivable, inventory, accounts payable, or other current assets and liabilities and the comparable group of third-party companies, adjustments must be made. These working capital adjustments make the two parties more comparable so that the arm's length standard can be assessed and the applicable transfer pricing can be determined.
The Arm's Length Standard and Transfer Pricing
Under the arm's length standard, transfer prices are considered to be correct if they are within a range of prices that would be realized by independent parties dealing goods, services, or intangibles at arm's length. However, it is difficult to apply an arm's length standard for transfer pricing because no two parties or transactions are the same. Goods, terms of sales, market conditions, and company profiles are always unique to the situation.
Adjustments must be made to use the arm's length standard to find appropriate prices. In the United States, adjustments must be made for all differences between related party items that could affect the situation being examined.
For example, some companies include employment obligations such as vacation pay or sick days in their current liabilities. If the test party includes these obligations, but the comparable group does not, the liabilities must be removed from the test party's working capital calculations to make transfer pricing more comparable.