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What is transfer pricing?

The value given to the commodities or services moved between related parties is known as transfer pricing. In other words, transfer pricing is the cost of transferring goods or services from one unit of an organization to its other units, which are located in various nations (with exceptions). 

What are the purposes of transfer pricing?

1. Producing distinct profits for each division and enabling independent performance review for each division

2. Transfer prices would impact not only the reported profitability of each centre but also how a corporation allocates its resources (Cost incurred by one centre will be considered as the resources utilised by them).

Importance of Transfer Pricing

Multinational corporations (MNCs) have certain freedom in deciding how to allocate profits and expenses to the subsidiaries in different countries for the purposes of management accounting and reporting.

A subsidiary of a company may occasionally be broken up into segments or reported as a separate entity. In these situations, transfer pricing aids in properly allocating revenue and expenses to such subsidiaries.

The pricing at which intercompany transactions take place affect a subsidiary's profitability. Governments are paying more attention to inter-company transactions these days. Here, the application of transfer pricing may have an effect on shareholders' wealth since it affects the company's taxable income and its free cash flow after taxes.

A corporation that works in cross-border intercompany transactions should be aware of the transfer pricing concept in order to comply with legal obligations and reduce risk of non-compliance.

Transfer Pricing Methodologies

The following are the three most used transfer pricing methodologies:

Comparable Uncontrolled Price (CUP) Method

The Arm's Length Price is calculated using the CUP technique, which recognises and compares a price charged in an uncontrolled transaction between comparable firms to a verified entity price.

This approach is regarded as the most trustworthy and direct technique to apply the arms-length principle and to calculate the costs of related party transactions. High caution must be used when determining if the controlled and uncontrolled transactions are comparable. Because of this, this method of determining transfer price isn't used unless goods or services satisfy the strict criteria of high comparability.

Resale Price Method or Resale Minus Method

The prices that the affiliated business sells its goods to the third party are used in this manner. The term "resale pricing" is used to describe this cost.

Then, the gross margin that is calculated by comparing the gross margins in a comparable uncontrolled transaction is subtracted from this resale price. Then, expenditures related to the acquisition of the commodity, such as customs duty, are subtracted. The balance is regarded as the arm's length price for a managed transaction between the affiliated businesses.

Cost Plus Method

The Cost Plus Method places a strong emphasis on the supplier's costs in the controlled transaction. After learning the expenses, you must add a markup. This markup must account for the connected enterprise's profit based on the risks and tasks completed. The arm's length price is the outcome.

In the cost plus technique, the markup is typically determined after all direct and indirect costs associated with manufacturing or supply have been taken into account. However, this markup does not include an organization's running expenses, such as overhead costs.

Problems associated with Transfer Pricing

1. There could be differences in opinions among organizational divisional managers with respect to how to transfer price needs to be set.

2. Additional time, costs and manpower would be required for executing the transfer prices and designing the accounting system to match the requirements of transfer pricing rules.

3. Arm’s length prices might cause dysfunctional behaviour among the managers of organizational units.

4. For some of the divisions or departments, for instance, a service department, arm’s length prices don’t work equally well as such departments don’t offer measurable benefits.

5. The transfer pricing issue in a multinational setup is very complicated.

References

1. https://taxguru.in/income-tax/transfer-pricing-tax-avoidance.html

Co-Author:Aashna Chopra