Transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control. This is significant because setting prices for goods, services, and intellectual property affects where a multinational company's profits are made and where they are taxed. 
Components of Transfer Pricing
- Goods and Services: Transfer prices are used when one part of a company supplies goods or services to another part of the same company.
- Intellectual Property: Transfer pricing rules also apply to transactions involving intellectual property, like patents or trademarks, between related entities.
- Loans and Financial Services: Loans and financial services between parts of the same company also fall under transfer pricing rules.
- Allocation of Expenses: The allocation of central overhead costs to different parts of a multinational business can be part of a transfer pricing policy.
Purpose and Role of Transfer Pricing
Transfer pricing allocates a multinational corporation's net profit or loss before tax to countries where it does business. Transfer pricing can affect a company's overall tax efficiency, so it needs to be consistent with the business and operational structure.
Importance of Transfer Pricing
Transfer pricing is important because it determines, in large part, the allocation of income and thus tax obligations among different countries. Inappropriate transfer pricing, such as under- or overpricing, can distort taxable income, potentially leading to issues with tax authorities. Therefore, most countries have tax laws that require that transactions between related entities be priced as if they were between independent entities (the "arm's length principle").
Pros and Cons
The advantages of transfer pricing include optimizing global tax rates, better tracking the performance of different divisions, and ensuring regulatory compliance in all jurisdictions.
However, the downsides include the potential for tax disputes if the transfer pricing methods are not accepted by tax authorities, the difficulty in finding comparable transactions to determine arm's length prices, and the complexity of implementing and maintaining a transfer pricing policy.
For example, consider a multinational company with operations in Country A, which has a high corporate tax rate, and Country B, which has a lower tax rate. Suppose the company's factory in Country A produces a component that it transfers to its assembly plant in Country B.
Suppose the company sets a high transfer price for the component. In that case, more profit will be allocated to Country B (with its lower tax rate) and less profit to Country A (with its higher tax rate), potentially lowering the company's overall tax obligation. However, tax authorities in Country A might challenge this transfer pricing policy, requiring documentation supporting the transfer price's arm's length nature.
That's why multinational companies must have sound transfer pricing policies, aligned with current regulations and backed by robust documentation, to avoid potential tax adjustments and penalties.
- Defining Transfer Pricing Investopedia