What is transfer pricing? What is the purpose of transfer pricing?
Transfer pricing refers to the act of selling and buying between subsidiaries in a multinational company.
Transfer pricing is gaining importance in international trade.
How does transfer pricing work?
If you have a factory in Country A, and a factory in Country B, as well as a sale office in Country C, you can make use of transfer pricing to lower costs and taxation liability.
That means the factory in Country A can sell the raw material for production to the factory in Country B. the factory in Country B makes the products andsell them to the sale office in Country C.
This internal selling and billing within business entities in the same company is known as transfer pricing.
What is the purpose of transfer pricing?
Transfer pricing is used to reduce the chance of double taxation.
In the past, many companies use transfer pricing to get away with paying higher tax in the country with high taxation rate. That means they sell the material from Country A to Country B at a loss, so that they do not have to pay the higher taxation rate in Country A.
Since the taxation in Country B is lower, they declare a bigger profit margin Country B.
However, the arm’s length principle prevents the tax dodge in the event of transfer pricing.
The arm‘s length principle means that you have to set the same selling price regardless of selling to internal or external customers.
That effectively prevents the subsidiary in Country A from selling the goods at a loss to the factory in Country B.
The fact that the subsidiary in Country A will not sell things at a loss to external customers means it cannot sell at a loss to internal customer.
If you think you can get away with the illegal use of transfer pricing, you can look into the example of GlaxoSmithKline. The IRS caught GlaxoSmithKline for the wrong usage of transfer pricing. As a result, the company settled for $3.4 billion in 2006.
The right use of transfer pricing can reduce the risk of double taxation. If your business has an international presence, you need to understand the proper way of using transfer pricing.
You need to seek the expertise of international tax attorneys who specialize in transfer pricing to set up the system.
The problem with setting up a transfer pricing system is that there are many approaches to price setting. The common price setting methods are variable cost based method, resale cost approach, and cost plus method.
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