Transfer pricing: Definition and explanation

Transfer pricing: Definition and explanation

Transfer pricing is a principle and practice in taxation and managerial accounting, as well as a form of government regulation, that involves standardizing the prices of business transactions between related or similarly controlled parties or entities. These prices should be consistent with those between unrelated and independent entities. This article provides a concise overview, specifically a simplified definition of transfer pricing and transfer price, as well as a simplified explanation of its purpose and benefits.

What is transfer pricing? What is a transfer price?

Note that transfer pricing is based on the principle of arm’s length transaction. This principle argues that parties involved in a transaction should always act in their own self-interest. It also argues that there should be no collusion between the buyer and seller to promote not only mutual benefits but also an efficient market transaction.

To explain further, it is important to note that there are entities that conduct intercompany transactions. This is especially true for multi-entity companies or those conglomerates and multinational companies with several divisions, subsidiaries and/or affiliates. Transfer pricing is the setting of the prices of goods and services that are sold and bought internally within a multi-entity company.

Examples of multi-entity companies that practices transfer pricing include those that operate in the oil and gas industry. To be specific, multinational companies such as Royal Dutch Shell and Exxon Mobil Corporation own and operate different divisions, subsidiaries, and affiliates placed across the upstream, midstream, and downstream segments of the global oil and gas industry. Internal transactions are inevitable due to this extensive presence within a single industry.

Based on the definition of transfer pricing, a transfer price represents the price at which a division, subsidiary, or affiliate of a company sells goods or services to another division, subsidiary, or affiliate. Simply put, it is the prices involved in internal transactions.

What is the purpose of transfer pricing? What are the benefits?

Maintaining the internal and operational integrity of a large and complex organization involved in an intercompany transaction is one of the purposes of transfer pricing. Because it is based on the principle of arm’s length transaction, transfer pricing ensures that each division, subsidiary, and/or affiliate of a multi-entity company is treated as a separate and independent party that acts on its own interest.

Proper taxation is another purpose and benefit of transfer pricing. As a form of government regulation, setting and adjusting transfer prices discourages a multi-entity company involved in the internal cross-border transaction from distorting its financial reporting and taxable income. This is the reason why auditors and tax authorities require the observance of a strict documentation standard.

From the perspective of a multi-entity company, the organization of operations and proper itemization of financial reporting are another purpose and benefit. Transfer pricing enables a multi-entity company to determine and evaluate the value created from the internal transactional activities of its divisions, subsidies, and/or affiliates, thus allowing it further to organize its value chain. As a principle in managerial accounting, transfer pricing allows the easy identification of cash flow coming from intercompany transactions.

Another purpose and benefit of transfer pricing center on reducing duty costs that are associated with shipping goods or providing services to a country with higher tariffs and tax rates. For example, a multinational company might reduce its tax obligations, including cross-border tariffs, by booking profits from internally selling goods or services in a different country with a lower tax rate.