DEFINITION of Transfer Pricing

Transfer pricing is an accounting practice that refers to the setting of prices of goods and services (including those linked with intellectual property like researchpatents and royalties) that are exchanged among the subsidiary, affiliate or commonly controlled companies or legal entities that are part of the same larger enterprise. It allows for tax savings for the companies, though tax authorities may contest their claims.

BREAKING DOWN Transfer Pricing

In a nutshell, 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, including cross-border transactions. If a subsidiary or affiliate company sells goods or services to the holding company, the price charged for such services is called a transfer price, and the business practice is called transfer pricing. Multinational companies (MNC) are legally allowed to use transfer pricing method for allocating earnings among their various subsidiary and affiliate companies that are part of the larger, global parent organization. However, companies at times can also use (or misuse) this practice by altering their taxable income and saving taxes, as transfer pricing mechanism allows room to shift tax liabilities to low-cost tax jurisdictions.

An example: A U.S.-based technology company offers a unique and patented cloud computing service and has clients across the globe. It also has an overseas office in low-tax jurisdictions like the Cayman Islands. A Jamaica-based client of this company is accessing the company’s cloud service from his office in Jamaica and is being served by Cayman Islands-based cloud servers. Should this activity, and its associated economic value, be accounted for in Jamaica (client location), or in Cayman Islands (serving location), or in the U.S. (company headquarters)? A majority of the value in such a global activity lies in the intellectual property (IP) that makes the service possible. Since a lot of ambiguity continues to exist around where and how much to account for such IP value, companies attempt to shift a major part of such economic activity to low-cost destinations to save on taxes. This practice continues to be a major point of discord between the various multinational companies and the tax authorities like the Internal Revenue Service (IRS).

Technology companies operating in a borderless virtual world are not alone in following such practices. It spans across other sectors, like pharmaceuticals and FMCG. For instance, U.S.-headquartered medical device makers and drug companies often shift their intangibles, like patent and research costs and intercompany licenses, to their affiliates or subsidiary companies like those based in Ireland, another low-tax haven. A global FMCG giant may also benefit big by transferring royalty-linked IP value to other destinations, as they serve global customers.

Few prominent cases that continue to be a matter of contention between the tax authorities and the companies are more than a decade old. Owing to the production, marketing and sale of the 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 under which it transferred IP value to subsidiaries in Africa, Europe and South America between 2007 and 2009. The IRS disagreed and filed a pretrial memorandum against the company in February 2018, according to Duff and Phelps.

In another high-stake 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 cough up to $5 billion in addition to interest and penalties. Alphabet Inc.’s (GOOGL) Google, too, is said to have used this practice in Singapore and Australia, to effectively reduce its taxes. In addition, the Dublin, Ireland-based medical device maker Medtronic, which has its operational headquarters in the U.S., also has an ongoing case linked to a transfer of $2.2 billion worth of intercompany licenses to a Puerto Rican manufacturing affiliate for the tax years 2005 and 2006.