Edited by Seema Yadav
Transfer price is an artificial price used when goods or services are transferred from one department to another department within the same company. Accountants record the transfer price as a revenue of the producing segment and as a cost, or expense, of the receiving segment. Usually, no cash actually changes hands between the departments. Instead, the transfer price is an internal accounting transaction.
Purposes of Transfer Pricing
- Generating separate profit for each of the divisions and enabling performance evaluation of each division separately.
- Transfer prices would affect not just the reported profits of every centre, but would also affect the allocation of a company’s resources (Cost incurred by one centre will be considered as the resources utilized by them).
Why Organizations need to understand Transfer Pricing
For the purpose of management accounting and reporting, multinational companies (MNCs) have some amount of discretion while defining how to distribute the profits and expenses to the subsidiaries located in various countries. Sometimes a subsidiary of a company might be divided into segments or might be accounted for as a standalone business. In these cases, transfer pricing helps in allocating revenue and expenses to such subsidiaries in the right manner.
The profitability of a subsidiary depends on prices at which the inter-company transactions occur. These days the inter-company transactions are facing increased scrutiny by the governments. Here, when transfer pricing is applied, it could impact shareholders wealth as this influences company’s taxable income and its after-tax, free cash flow.
It is important that a business having cross-border intercompany transactions should understand transfer pricing concept, particularly for the compliance requirements as per law and to eliminate the risks of non-compliance.
Risks associated with transfer pricing are as follows
- There can be a disagreement among the organizational division managers as what the policies should be regarding the transfer policies.
- There are a lot of additional costs that are linked with the required time and manpower which is required to execute transfer pricing and help in designing the accounting system.
- It gets difficult to estimate the right amount of pricing policy for intangibles such as services, as transfer pricing does not work well as these departments do not provide measurable benefits.
- The issue of transfer pricing may give rise to dysfunctional behaviour among managers of organizational units. Another matter of concern is the process of transfer pricing is highly complicated and time-consuming in large multi-nationals.
- Buyer and seller perform different functions from each other that undertakes different types of risks. For instance, the seller may or may not provide the warranty for the product. But the price a buyer would pay would be affected by the difference. The risks that impact prices are as follows
– Financial & currency risk
– Collection risk
– Market and entrepreneurial risk
– Product obsolescence risk
– Credit risk
Comparable uncontrolled price (CUP) method
The CUP method is grouped by the OECD as a traditional transaction method (as opposed to a transactional profit method). It compares the price of goods or services and conditions of a controlled transaction (between related entities) with those of an uncontrolled transaction (between unrelated entities). To do so, the CUP method requires comparable data from commercial databases.
Resale price method
Another traditional transaction method for determining transfer pricing is the resale price method. This method starts by looking at the resale price of a product that has been bought from an associated enterprise and then sold onto an independent party. The price of the transaction where the item is resold to the independent enterprise is called the resale price.
Cost Plus method
The cost-plus method is a traditional transaction method that analyses a controlled transaction between an associated supplier and purchaser. It is often used when semi-finished goods are transacted between associated parties or when related entities have long-term arrangements for ‘buy and supply’. The supplier’s costs are added to a mark-up for the product or service so that the supplier makes an appropriate profit that takes into account the functions they performed and the current conditions of the market. The combined price is the arm’s length price for the transaction.
Transactional net margin method (TNMM)
The TNMM is one of two transactional profit methods outlined by the OECD for determining transfer pricing. These types of methods assess the profits from particular controlled transactions. The TNMM involves assessing net profit against an “appropriate base”, such as sales or assets, that results from a controlled transaction. The OECD states that, in order to be accurate, the taxpayer should use the same net profit indicator that they would apply in comparable uncontrolled transactions. A tax payer can use comparable data to find the net margin that would have been earned by independent enterprises in comparable transactions. The taxpayer also needs to carry out a functional analysis of the transactions to assess their comparability.
Transactional profit split method
The second transactional profit method outlined by the OECD is the transactional profit split method. It focuses on highlighting how profits (and indeed losses) would have been divided within independent enterprises in comparable transactions. By doing so, it removes any influence from “special conditions made or imposed in a controlled transaction”. It starts by determining the profits from the controlled transactions that are to be split. The profits are then split between the associated enterprises according to how they would have been divided between independent enterprises in a comparable uncontrolled transaction. This method results in an appropriate arm’s length price of controlled transactions.
There are two main approaches that can be taken for splitting profits.
- Contribution analysis: The combined profits are divided based on the relative value of the functions performed by each of the related entities within the controlled transaction (considering assets used and risks assumed).
- Residual analysis: The combined profits are divided into two stages. First, each entity is allocated arm’s length compensation for its functions and contribution to the controlled transaction. Second, any remaining profit or loss after the first stage is divided based on analysis of the facts and circumstances of the transaction.