TRANSFER PRICING

Transfer pricing is the value placed on goods and services exchanged between affiliates or divisions within a company. The transactions are not truly at arm's length, and therefore do not represent a market price for the goods or services provided. Because the organization may want to properly measure efficiency, productivity, or profitability at the division level, transfer prices must be established when one part of a company does business with another.

The need to track exchanges can occur for a variety of reasons. For example, a company might want to keep track of how its legal department's resources are consumed by various user groups. By charging other departments for use of legal department services, the company can rationally allocate the cost to the area utilizing those services (and responsible for the expense). An obvious side effect of such a policy is that users may think twice about using the legal department, thereby limiting unnecessary demands. On the other hand, management may want to be sure that various decisions—hiring, firing, ad copy, contract terms, etc.—are approved by the legal staff before being completed, which may not happen if user groups restrict use because of the charges incurred.

Beyond the question of staff department charge-backs are the issues of: interdepartment or intercompany transfers of product or services that ultimately will be sold to third parties, and the allocation of costs between subsidiaries. A common example is where one division manufactures a product and another sells it. Although the parent company's goal may be to report true profitability at each level, the management teams responsible at the plant and at the sales office will have opposing agendas, with the former arguing for relatively high transfer prices and the latter lobbying for lower transfer prices.

The best rule to follow is to let market prices be the guide; the factory would "sell" to the sales division at a price they could receive if selling to a third-party distributor. That way the manufacturing results are judged based on profits from market price transactions combined with manufacturing efficiency and know-how, while the sales division is tracked on how well they are able to manage the interplay of market forces on demand and pricing. This criterion is known as the "Basic Arm's Length Standard (BALS)" and is the preferred standard by which transfer prices are set.

Another important issue concerning transfer pricing arises with respect to income tax jurisdiction. Companies with international or interstate operations will often have separate subsidiaries in each jurisdiction, sometimes for legal and/or political reasons. The affiliates will likely be subject to differential tax rates in the various jurisdictions in which they do business. In these cases, the transfer price issue becomes the concern of an interested third party—the tax authorities. Here the motivation would be to shift profits from a high tax-rate location to a lower one; this can be easily accomplished by manipulating the transfer prices. Obviously the Internal Revenue Service is aware of this practice, and will challenge inappropriate transfer prices in the course of audits. Section 482 of the Internal Revenue Code was written to set tax rules and guidelines for acceptable transfer pricing and cost allocations between affiliates.

Transfer pricing within multinational corporations (MNCs) can be fairly complex, requiring different strategies for different transactions and markets. Foreign tax systems, exchange controls, and competition all need to be taken into account. Where two countries, such as the United States and Canada, might have similar substantive laws but differing compliance and reporting rules, companies might use advance pricing agreements (APAs) to ensure compliance. An APA defines an acceptable transfer price calculation method before being implemented, thus avoiding problems with a transfer price audit.