What Is a Transfer Price?
Transfer price is the price at which divisions of a company transact with each other, such as the trade of supplies or labor between departments. Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. A transfer price can also be known as a transfer cost.
Understanding Transfer Price
A transfer price arises for accounting purposes when different divisions of a multi-entity company are in charge of their own profits. When divisions are required to transact with each other, a transfer price is used to determine costs. Transfer prices generally do not differ much from the market price. If the price does differ, then one of the entities is at a disadvantage and would ultimately start buying from the market to get a better price.
Regulations on transfer pricing ensure the fairness and accuracy of transfer pricing among related entities. Regulations enforce an arm’s length transaction rule that states that companies must establish pricing based on similar transactions done between unrelated parties.
Transfer Pricing Documentation
Transfer pricing is closely monitored within a company’s financial reporting and requires strict documentation that is included in financial reporting documents for auditors and regulators. This documentation is closely scrutinized. If inappropriately documented, it can lead to added expenses for the company in the form of added taxation or restatement fees. These prices are closely checked for accuracy to ensure that profits are booked appropriately within arm's length pricing methods and associated taxes are paid accordingly.
Transfer prices are most often used when companies sell goods to divisions in other international jurisdictions. This type of transfer pricing is common, and a large part of intentional commerce is actually done within companies as opposed to between unrelated companies.
Transfer Pricing Taxes
Transfer pricing can also refer to regulations that governments and tax authorities use for regulating intercompany transfers. Intercompany transfers done internationally have tax advantages, which has led regulatory authorities to frown upon using transfer pricing for tax avoidance. When transfer pricing occurs, companies can book profits of goods and services in a different country that may have a lower tax rate. In some cases, the transfer of goods and services from one country to another within an interrelated company transaction can allow a company to avoid tariffs on goods and services exchanged internationally. The international tax laws are regulated by the Organisation for Economic Cooperation and Development (OECD), and auditing firms within each international location audit financial statements accordingly.
Example of Transfer Pricing
To better understand the concept of transfer pricing, consider a U.S.-based technology company that offers a unique and patented cloud computing service and to clients across the globe. It has an overseas office in the low-tax Cayman Islands. A client in the Bahamas accesses the company’s cloud service from his office in the Bahamas and is being served by Cayman Islands-based cloud servers. Should this activity, and its associated economic value, be accounted for in Bahamas (client location), or in Cayman Islands (serving location), or in the U.S. (company headquarters)?
Much of the actual value in 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).