What it means
Almost any group with more than one legal entity uses transfer prices, even if nobody in the business calls them that. A manufacturing subsidiary selling to a sales subsidiary, or a head office charging management fees to operating companies, are both transfer pricing arrangements.
The commercial importance is performance measurement. If the internal price is set too low, the making division looks unprofitable and the selling division looks brilliant, and bonuses, investment decisions and even factory closures can follow from an accounting choice rather than from economic reality.
The tax importance is larger still. Because tax rates differ between countries, a group could in principle shift profit to a low tax jurisdiction by charging an artificially high internal price, so the arm's length principle requires the price to match what independent parties would have agreed.
Common methods include the comparable uncontrolled price method, which looks at what the same item sells for externally, cost plus, which adds a defined mark-up to the supplying unit's costs, and resale price, which works backwards from the eventual selling price. Groups must document why the chosen method is appropriate and keep the supporting evidence for inspection.
The nuance that catches growing businesses out is that these rules apply well below multinational scale. A company with a small overseas development office recharging its costs to the parent still needs a defensible policy, and getting it wrong invites double taxation and penalties in two countries at once.
In practice
Real-world examples.
Example
A pump manufacturer sets an internal price of $230.00 per unit between its factory and its overseas distributor, based on a benchmarking study of independent contract manufacturers. The documentation is filed annually so the policy can be defended if queried.
Example
A software group holds its intellectual property in one entity and charges the operating companies a royalty of 6% of external revenue. The rate is supported by comparable third party licensing agreements found in a database search.
Example
A fashion brand runs a sourcing office abroad that inspects factories and manages suppliers. Because the office earns no external revenue, the group recharges its costs plus a 5% service mark-up, which is a common approach for routine support functions.
Think of it
“Transfer pricing is what one part of a company charges another-internal prices between divisions.
Formula
Calculation
Cost Plus Transfer Price = Total Cost per Unit x (1 + Mark-up Percentage)
A group manufactures industrial pumps in one country and sells them through a distribution subsidiary in another. The manufacturing division's fully absorbed cost is $200.00 per unit, and a benchmarking study shows that independent contract manufacturers in the sector earn a mark-up of about 15%.
Transfer price = $200.00 x 1.15 = $230.00 per unit
On 50,000 units, the manufacturing division records revenue of 50,000 x $230.00 = $11,500,000 and a profit of 50,000 x $30.00 = $1,500,000.
Suppose the group instead set the internal price at $210.00. Manufacturing profit would fall to 50,000 x $10.00 = $500,000, so $1,000,000 of profit would move to the distribution country. If the 15% mark-up is the correct arm's length benchmark, that is exactly the shift a tax authority would challenge and adjust.Case study
Seen in the real world.
Calderhame Pumps is a fictional group used here as an illustrative example. It manufactured in one country at a fully absorbed cost of $200.00 per unit and sold through a distribution subsidiary in a lower tax jurisdiction, using an internal price of $210.00 per unit on 50,000 units a year.
A tax audit challenged the policy. The auditors produced evidence that independent contract manufacturers doing comparable work earned mark-ups around 15%, implying a transfer price of $230.00 and manufacturing profit of $1,500,000 rather than $500,000. The adjustment moved $1,000,000 of profit back into the higher tax country, with interest and a penalty on top.
In this illustrative case the more expensive lesson was internal. Because the making division had looked barely profitable for three years, the group had already shelved a machinery investment there, a decision driven entirely by an internal price rather than by the economics of the business.
Watch out
Common mistakes.
- Assuming transfer pricing only matters for large multinationals, when the rules apply to any group with related entities in more than one tax jurisdiction.
- Setting internal prices at cost with no mark-up, which usually fails the arm's length test and makes the supplying unit look permanently unprofitable.
- Choosing a method once and never revisiting it, even though costs, comparable market rates and the group's structure all change over time.
Questions
People also ask.
Does transfer pricing change group profit?
No, the internal sale and purchase cancel out on consolidation; it changes only how profit is split between entities and countries.
What is the arm's length principle?
It is the requirement that related parties transact at the price independent parties would have agreed for the same transaction in similar circumstances.
What documentation is needed?
Most jurisdictions expect a description of the transactions, the method chosen, the benchmarking evidence supporting it, and a functional analysis of what each entity actually does.
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