Transfer pricing happens whenever two companies that are within the same multinational group trade with each other and the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. In other words, when Commercial transactions between the different parts of the multinational groups may not be subject to the same market forces shaping relations between the two independent firms than one party transfers to another goods or services, for a price. That price is known as “transfer price”.
Suppose a company X purchases goods for Rs 100 and sells it to its subsidiary company Y in another country for Rs 200, who in turn sells in the open market for Rs 400. Had X sold it directly, it would have made a profit of 300 rupees. But by routing it through Y, it restricted it to 100 rupees, permitting Y to appropriate the balance. The transaction between X and Y is arranged and not governed by market forces. The profit of Rs 200 is, thereby, shifted to the country of Y. The goods are transferred on a price (transfer price) which is arbitrary or dictated (Rs 200), but not on the market price (Rs 400).
Transfer price policy is generally aimed at evaluating the financial performance of different business units (profit centers) of a conglomerate, and/or to shift earnings from a high tax jurisdiction to a low-tax one. Tax authorities usually frown upon transfer pricing aimed at tax avoidance and insist that each internal part of the firm deals with the other on ‘arm’s length’ (market price) basis also called transfer cost.
The effect of transfer pricing is that the parent company or a specific subsidiary tends to produce insufficient taxable income or
excessive loss on a transaction. For instance, profits accruing to the parent can be increased by setting high transfer prices to siphon profits from subsidiaries domiciled in high tax countries, and low transfer prices to move profits to subsidiaries located in a low-tax jurisdiction. It can be used as a profit allocation method to attribute a multinational corporation’s net profit (or loss) before tax to countries where it does business. Transfer pricing is the major tool for corporate tax avoidance also referred to as Base Erosion and Profit Shifting (BEPS).
Base Erosion and Profit Shifting (BEPS) is a technical term referring to the negative effect of multinational companies’ tax avoidance strategies on national tax bases. BEPS can be achieved through the use of transfer pricing, or, more correctly, “transfer mispricing”. BEPS is used in a project headed by the Organization for Economic Co-operation and Development (OECD) which produced detailed reports in September 2014 in response to seven actions agreed previously. BEPS is said to be an attempt by the world’s major economies to try to rewrite the rules on corporate taxation to address the widespread perception that the corporations don’t pay their fair share of taxes.
A company should adopt those transfer prices that result in the highest total profit for the consolidated results of the entire entity. Almost always, this means that the company should set the transfer price to be the market price of the component, subject to the issue just noted regarding the recognition of income taxes. By doing so, subsidiaries can earn more money for the company as a whole by having the option to sell to outside entities, as well as in-house. This gives subsidiaries an incentive to expand their production capacity to take on additional business.