Intercompany transfer pricing: methods, importance and taxation

2. Intercompany transfer pricing methods

There are many ways to skin a cat when we talk about intercompany pricing methods. As we noted earlier, the two important questions affecting the transfer pricing choice are (a) whether a company as a whole can produce goods (or services) internally at a cost lower than buying externally and (b) how to establish intercompany prices so that they appropriately allocate any savings from producing internally between the selling and buying divisions. Let’s take a look at the intercompany transfer pricing methods:

Transfer pricing methods

  1. Market-based transfer pricing. Under this method, the intercompany prices are established by reference to the market (e.g., at what price external vendors sell products or services under question).

  2. Cost-based transfer pricing. This method uses internal cost data to establish transfer pricing. There are multiple ways of determining relevant costs when using this method (e.g., variable cost only, variable and fixed cost, variable cost + margin).

  3. Negotiated transfer pricing. This method is applied when there is no clear external market-based pricing and cost-based transfer pricing is not possible. The selling and buying divisions of a company negotiate the transfer prices.

3. Transfer pricing in multination corporations

We have not yet touched on another big aspect of intercompany transfer pricing. Among multinational organizations, transfer pricing can be used to shift revenues and costs and reduce tax liabilities. Organizations may have affiliates (divisions) in different countries which have varying tax systems and tax rates. When these divisions buy and sell goods or services across country boarders, they can effectively shift net income between countries where their divisions operate (i.e., agree on higher or lower transfer prices). Some tax jurisdictions may have higher tax rates so it is natural for multinational corporations to establish transfer pricing so that more net income ends up in jurisdictions with the lower tax rates. This is where tax authorities come in and claim their part of tax revenue. For example, the IRS (Internal Revenue Service) in the United States can audit a corporation headquartered in the U.S. with a division in another country and question why the firm shifted more net income (using intercompany transfer pricing) to the division located in a country with a lower (than U.S.) tax rate.

A common way to reduce the number of questions from the IRS when multinational corporations operate in different tax jurisdictions and countries is to enter in an advance pricing agreement (APD). Advance pricing agreements are binding contracts between the IRS and the organization that provides details of how a transfer price is to be determined. The APD protects the company from penalties and tax adjustments if the methodology agreed upon in the APD is followed. These agreements are usually good for a number of years.

Intercompany transfer pricing and advance planning agreements are rather complicated and resource consuming. Usually, a multi-departmental group (Finance, Tax, Accounting, IT, Legal, Operations, etc.) is established to work on advance planning agreements and on transfer pricing studies. Due to the risks involved and potential costs (and savings), external expertise is also utilized for this purpose. There are a lot of accounting and consulting firms that provide these specialized services. For example, the large accounting firms have entire departments devoted to providing services related to intercompany transfer pricing and advance planning agreements.

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