Intercompany transfer pricing: methods, importance and taxation

Intercompany transfer pricing is a large area of attention for top management, chief financial officers, finance directors, auditors, and others within organizations with multiple business units or subsidiaries. In this accounting tutorial, we take a look at what transfer pricing is, why intercompany transfer pricing is important, different transfer pricing methods, and the tax implications of transfer pricing.

1. What is intercompany transfer pricing?

In the context of accounting and taxation, intercompany transfer pricing is a combination of policies and procedures used to determine the prices at which goods or services are exchanged between affiliates or divisions of an organization.

Typically, transfer pricing comes to mind when we talk about intercompany sales of tangible and intangible goods. However, transfer pricing can also apply to the sales of services.

The question of transfer pricing is applicable to companies that have multiple divisions and affiliates. For example, a company may have three divisions that are separate legal entities. These divisions may be selling and buying goods or services from each other. Transfer pricing will help determine the optimal price at which business units would exchange good and services internally or rather use outside market.

At a high level, intercompany transfer pricing helps answer the following two questions:

  1. Should the company as a whole (via its separate divisions) procure goods or services from external suppliers or source them internally? This is the buy-or-make decision.

  2. If it is more cost effective to source goods or services internally, how much of the savings (compared to buying externally) should the selling and buying division of the company get?

Letís look at these two questions more closely because it is important to understand their application in transfer pricing decisions. First, a company with several divisions can either buy a certain product from an external supplier or have one of its division produce it (and sell to other divisions if needed). In general, if a company can get the product from an external vendor for less compared to producing the product internally, it should do so. For example, if Company ABC can get a particular widget at a cost of $100 per unit while the lowest cost at which one of its divisions can produce it is $120 per unit, it is clear that the company should purchase the unit at $100 (and save $20 by doing so). On the other hand, if one of the divisions can produce the unit at a cost of $90, it is better to produce it internally and save $10 compared to an external vendor price. Second, if the company decides to produce the widget internally to save $10 and one division needs to buy this widget from another division, at what price should intercompany trade be conducted? The key here is how the $10 savings (compared to buying from an external vendor) should be split between the buying and selling divisions.

Now that we have reviewed the intercompany transfer pricing nature, letís consider why transfer pricing is important. Transfer pricing policy and procedures affect the following:

  • Goal congruence: management needs to ensure that the chosen intercompany transfer pricing method helps the organization to achieve its strategic goals (including manager motivation and relationships between divisions).

  • Autonomy: the intercompany transfer pricing methodology should allow sufficient autonomy of divisions within the company to buy and sell goods at terms beneficial to them and the company as a whole.

  • Resource allocation: transfer pricing should foster appropriate resource allocation and operating efficiency within the company.

  • Performance evaluation: transfer pricing methods applied by a company impact how much profit each division is going to make. Thus, it is important to consider division or manager performance evaluation criteria when establishing intercompany transfer pricing.

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