Transfer pricing refers to the pricing of transactions between related entities within the same multinational corporation. This includes transactions between a parent company and its subsidiaries, or between different subsidiaries of the same group. These internal prices affect how profits and costs are allocated across different parts of the organization.
Transfer pricing works through a systematic process. First, related entities within a multinational group conduct business transactions with each other. Then, internal prices are set for these transactions, such as when a US parent company sells goods to its UK subsidiary for one hundred dollars. These transfer prices directly affect how profits are allocated between different entities and jurisdictions, which has significant tax implications since different countries have different tax rates.
The arm's length principle is the international standard for transfer pricing. It requires that transfer prices between related entities should be the same as prices that would be charged between unrelated parties in comparable circumstances. For example, if related parties set a transfer price of eighty dollars, but unrelated parties would charge one hundred dollars for the same transaction, then an adjustment is required to meet the arm's length standard.
There are several established methods for determining arm's length transfer prices. The Comparable Uncontrolled Price method compares prices with identical transactions between unrelated parties. The Resale Price Method starts with the resale price and subtracts an appropriate margin. The Cost Plus Method adds a markup to costs. The Profit Split Method allocates profits based on each party's contribution. Finally, the Transactional Net Margin Method compares net profit margins. Each method requires careful step-by-step analysis to ensure compliance.
Transfer pricing matters because it prevents multinational companies from artificially shifting profits to low-tax jurisdictions to avoid paying fair taxes. Without proper transfer pricing rules, companies could manipulate internal prices to move profits from high-tax countries to tax havens. Transfer pricing regulations ensure that profits are taxed where real economic activities occur, maintaining fair tax allocation across jurisdictions and supporting competitive markets. Compliance with these international standards is essential for multinational corporations operating globally.