Transfer pricing is the price that is paid for goods or services transferred from one unit of an organization to its other units situated in different countries. It comes into play when various departments in a company operate as separate entities and is also referred as cost of transfer.
The transfer price is based on market prices in charging another division, subsidiary, or holding company for services rendered.
OBJECTIVES OF TRANSFER PRICING
Transfer pricing is aimed at following objectives –
- To maximize the total profit of the subsidiaries.
- To facilitate parent company’s control over its subsidiaries
- To ensure true and fair reporting of financial statements.
- Avoidance of double taxation and avoiding tax evasion by entities.
HOW TRANSFER PRICING WORKS ?
A company needs a transfer price when dealing with the divisions, its subsidiary, or an affiliate. When these entities transact with each other, they use transfer prices to determine their costs. The transfer price is more related to the market price of the product or service involved in such related party transactions. This will eliminate the entities purchasing or selling such products or services in the market as they can buy or sell them between the related parties at the market price itself.
ARM’S LENGTH PRINCIPLE FOR TRANSFER PRICING
The Arms’s Length Principle is an ideal way of determining the transfer pricing. It states that the price charged in a controlled transaction between two related parties should be the same as that in a transaction between two unrelated parties on the open market. This principle ensures that governments get their due taxes and the company is not a victim of double taxation.
Companies in related-party transactions should ensure the compliance with the Arm’s Length Principle to prevent arbitral adjustments of their taxable income by the FIRS.
RISKS INVOLVED IN TRANSFER PRICING
- Departments or subsidiaries may sometimes disagree over the rules governing transfer pricing.
- There is a risk of mispricing a self-generated commodity or service that is not related to any other resource in the market due to limitations present in domestic pricing rules.
- Use of transfer pricing method for intangible products is very complicated.
Thus, in a nutshell, Transfer pricing refers to the internal pricing system used between related parties which plays an important role in avoiding improper pricing of related party transactions between associate enterprises, resulting in the elimination of tax evasion through such methods assisting the government and tax authorities.