What is transfer pricing?
According to the OECD definition of transfer pricing, a “transfer price is a price […] which is used to value transactions between affiliated enterprises integrated under the same management at artificially high or low levels in order to effect an unspecified income payment or capital transfer between those enterprises.”
Transfer prices are transaction prices between companies from the same group but in different countries. This is an import-export operation but in the same group. The object of this transaction could be goods and services.
Example: In the same group, a filial A established in France is selling the computer to Filial B in China, the selling price of this computer is the transfer price.
Multinational corporations use mostly transfer pricing as a method of allocating profit among their various subsidiaries within the organization. Deciding the location of your profit brings you tax advantages. Indeed, there are different tax regimes in each country, and it allows you to lower your company’s expenditure on interrelated transactions by avoiding tariffs on goods and services exchanged internationally.
Let’s take an example with two scenarios.
Scenario 1: X charges Y for the supply of one computer at market price (RMB 10,000 as this ensures a profit of RMB 7,000). The Malaysian tax rate is 25 percent. The production costs are RMB 3,000. This is an uncontrolled transaction.
Scenario 2: X charges Y for the supply of one computer at a non-market price of RMB 4,000. The Hong Kong tax rate is 16.5 percent. This a controlled transaction (transfer pricing).
As shown above, in the second scenario, profits are increased considerably without even optimizing. That is the main point of using transfer prices. Also, the key issues here are the prices and the rates. That is why international institutions are trying to legislate on this problem.
The main benefits of using transfer pricing are clear: reducing costs into countries with high tariff rates at minimal transfer prices and vice versa. But there are some risks. First, there could be a disagreement between the different divisions of the organization. Also, transfer pricing engages costs (time and money). Finally, buyers and sellers perform different functions which result in different types of risks that are hard to identify.
This is a big problem for countries because business taxes are a big part of their revenues. Thus, to solve this issue, the OECD implemented the Arm’s length principle.