Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided. Transfer pricing 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 enterprise. Transfer pricing can lead to tax savings for corporations—although tax authorities may contest their claims.

How Transfer Pricing Works

Transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries that operate under common control or ownership. The transfer pricing practice extends to cross-border transactions as well as domestic ones.

A transfer price is used to determine the cost to charge another division, subsidiary, or holding company for services rendered. Typically, transfer prices are priced based on the going market price for that good or service. Transfer pricing can also be applied to intellectual property such as researchpatents, and royalties.

Multinational companies (MNC) are legally allowed to use the transfer pricing method for allocating earnings among their various subsidiary and affiliate companies that are part of the parent organization. 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.

Key Takeaways

  • Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods or services provided.
  • A transfer price is based on market prices in charging another division, subsidiary, or holding company for services rendered.
  • However, companies have used inter-company transfer pricing to reduce the tax burden of the parent company.
  • Companies charge a higher price to divisions in high-tax countries (reducing profit) while charging a lower price (increasing profits) for divisions in low-tax countries.

Transfer Pricing and Taxes

To better understand how transfer pricing impacts a company's tax bill, let's consider the following scenario. Let's say that an automobile manufacturer has two divisions: Division A, which manufacturers software while Division B manufactures cars.

Division A sells the software to other carmakers 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 carmakers.

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. On the other hand, Division B's costs of goods sold (COGS) are lower—increasing the division's profits. 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.

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. 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.

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. Tax authorities have strict rules regarding transfer pricing to attempt to prevent companies from using it to avoid taxes.

Transfer Pricing and The IRS

The IRS states that transfer pricing should be the same between intercompany transactions that would have otherwise occurred, had the company done the transaction with a party or customer outside the company. 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 intercompany 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."

As a result, the financial reporting of transfer pricing has strict guidelines and is closely watched by tax authorities. Extensive documentation is often required by auditors and regulators. If the transfer value is done incorrectly or inappropriately, the financial statements may need to be restated, and fees or penalties could be applied.

However, there is much debate and ambiguity surrounding how transfer pricing between divisions should be accounted for and which division should take the brunt of the tax burden.

Real World Examples of Transfer Pricing and Taxes

A few prominent cases continue to be a matter of contention between tax authorities and the companies involved.

Coca-Cola

Owing to the production, marketing, and sale of Coca-Cola Co.’s (KO) concentrates in various overseas markets, the company continues to defend its $3.3 billion transfer pricing of a royalty agreement. The company transferred IP value to subsidiaries in Africa, Europe, and South America between 2007 and 2009. The IRS and Coca Cola continue to battle through litigation and the case has yet to be resolved.

Facebook Inc.

In another high-stakes case, the IRS alleges that Facebook Inc. (FB) transferred $6.5 billion of intangible assets to Ireland in 2010—thereby, cutting its tax bill significantly. If the IRS wins the case, Facebook may be required to pay up to $5 billion in addition to interest and penalties. The trial, which was set for August 2019 at the U.S. Tax Court, has been delayed allowing Facebook to possibly work out a settlement with the IRS.

Medtronic

As of 2019, Ireland-based medical device maker Medtronic and the IRS are due in court in 2020 to settle a dispute worth $1.4 billion. Medtronic is accused of transferring intellectual property to low-tax havens globally. The transfer involves the value of intangible assets between Medtronic and its Puerto Rican manufacturing affiliate for the tax years 2005 and 2006. The court had originally sided with Medtronic, but the IRS has filed an appeal.

The IRS Commissioner is quoted in the Appeal from the U.S. Tax Court as stating that the Medtronic case is:

“The classic case of a U.S. multinational taxpayer (Medtronic) shifting income from its highly profitable U.S. operations and intangibles to an offshore subsidiary operating in a tax haven (Medtronic [Puerto Rico]), by charging an artificially low rate for the intangibles.”