What is Transfer Pricing and Why is it Important?

Imagine a US company with subsidiaries in two other countries—one with an income tax rate of 40% and the other with a 25% rate. The parent company is thinking about a way of managing the subsidiaries’ tax liabilities so it pays the least possible taxes and makes the most possible profit. Transfer pricing is one way to accomplish this.

What is transfer pricing?

Transfer pricing refers to the pricing of all transactions including goods, services, financing and licensing between related parties.

Global Regulations

Tax authorities worldwide have implemented transfer pricing regulations to ensure that transactions between related entities are priced as if they were between independent entities, known as the ‘arm’s length.’

Arm’s length pricing means simply that the price of a controlled transaction should be the same as the price of an uncontrolled transaction—that is, a subsidiary’s transfer price for selling to its parent or another subsidiary should be the price it would charge to a third-party under comparable facts and circumstances

Example of Transfer Pricing

As an example of how transfer pricing works, let’s use a hypothetical company and subsidiaries:

1. ABC Golf Manufacturing Co., based in the United States, is the parent company and makes clubs and irons and owns all intellectual property related to the business.

2. ABC Golf Distribution Co., based in Canada, purchases clubs and irons from ABC Golf Manufacturing Co. for sale into Canada.

• Cost of manufacturing: $80 per club or iron
• Transfer price: $95

• Market price: $100

Let’s assume a $95 transfer price is used as the basis of ABC Golf Distribution Co.’s cost per unit with a market price per unit of $100.

The table below shows distribution of profit between the two subsidiaries.

ABC Golf Manufacturing Co. ABC Golf Distribution Co. Revenue $95 $100 Cost of goods sold $80 $95 Gross profit $15 $5

Why is transfer pricing important?

Regulatory landscape

Tax authorities generally audit a company’s transfer pricing to ensure they are conducted at arm’s length. Where the transfer pricing is not at an arms-length, tax authorities assess transfer pricing adjustments and related tax penalties and interest. Transfer pricing penalties vary significantly across different countries, and they are subject to change as tax laws evolve. 

Compliance requirements

Most countries have adopted some form of transfer pricing documentation requirements, which requires taxpayers to contemporaneously document transactions with related parties. The documentation includes background information on the company, its related parties, and industry in which the company operates; details of the related party transaction(s) including functions, assets, and risks employed by the related parties involved in the transaction; and the economic analysis detailing transfer pricing method selected and related support for the transaction(s). Preparing such contemporaneous documentation may avoid transfer pricing penalties as discussed above, but is subject to local country rules. In other countries, failure to produce transfer pricing documentation may result in penalties.

Reputational risk

A company that does not have appropriate transfer pricing policies may provoke audits or other regulatory action and  could suffer loss of reputation, potentially impacting its relationship with customers, suppliers, investors, and lenders.

Strategic planning

Transfer pricing can be used strategically to support business efficiencies, such as cash management as well as intellectual property and legal entity rationalization.

How the OECD handles transfer pricing

The Organization for Economic Cooperation and Development (OECD) is an international body that provides guidelines for international tax laws and international trade. More than 35 industrialized free-market countries, including the US, participate in the organization and use OECD recommendations in setting their tax regulations. The OECD classifies businesses related to a parent company in three ways, and it relies on a few key principles to determine fair transfer prices.

OECD company classifications

Transfer pricing guidelines from the OECD are about transactions among a parent company and related businesses, which the OECD calls “entities under common control.” Those entities can be:

Subsidiary

A company that is majority-owned, meaning more than 50% of its equity is owned by the parent. This typically means that the parent company controls the subsidiary’s board of directors, executives, and financial decisions. A parent company usually includes the financial data from subsidiaries in its own financial statements; these are known as consolidated statements. Despite this control, a subsidiary is legally a distinct entity in terms of taxation, regulation, and liability.

Affiliate

A company that is less than 50%-owned by another company and whose board, management, and finances—while not directly controlled by a parent—may be strongly influenced. The minority owner usually accounts for the affiliate’s profits under the equity method, meaning in proportion to its ownership. So for example, if Company A owns 40% of Company B’s shares, it reports 40% of Company B’s profit on its income statement.

Division

A business that is fully integrated within the company and not a legally distinct entity.

OECD Transfer Pricing Guidelines

The OECD Transfer Pricing Guidelines provide guidance on the application of the arm’s length principle. 

A full list of transfer pricing methods with a short description of each method is provided below:   

• CUP Method – Compares the price charged in a controlled transaction to that of a comparable uncontrolled transaction. Adjustments may be needed for differences in circumstances.

• Resale Price Method – Used when a product purchased from a related party is resold to an independent party. The resale price minus an appropriate gross margin equals the arm’s length price.

• Cost Plus Method – Adds an appropriate mark-up to the cost incurred by the supplier in a controlled transaction based on comparable uncontrolled transactions.

• Transactional Net Margin Method (TNMM) – Examines the net profit margin relative to a base (e.g., cost, sales, assets) from a controlled transaction. These margins are based on comparable companies performing similar functions with similar risks and assets. 

• Profit Split Method – Suitable for highly integrated activities or transactions and splits the combined profit between related parties based on the value of functions performed, considering assets used and risks assumed.

In addition to the transfer pricing methods above, alternative methods may be used as the most appropriate method depending on the transaction type (e.g., a transfer of intellectual property) based on the options realistically available. 

While most countries follow a similar logic as the OECD Transfer Pricing Guidelines, it is important to reconcile any differences and take into consideration the local country transfer pricing regulations depending on the jurisdictions in which you operate. Take the stress out of sales tax with Shopify Tax