Multinational companies (MNCs) and conglomerates share the common practice of transfer pricing as it helps them establish prices in internal products and services trade. In this blog, we intensively discuss what is transfer pricing, its bounds and how it works for businesses.
What is Transfer Pricing?
Determining the cost of transactions between company divisions is a process widely known as transfer pricing (TP). Parent companies are also legally permitted to do this to properly allocate earnings among their affiliate firms.
Transfer pricing basics
According to an article, TP transactions include, but are not limited to, the following:
- Sale of finished goods;
- Purchase of raw material;
- Purchase of fixed assets;
- Sale or purchase of machinery etc.
- Sale or purchase of Intangibles.
- Reimbursement of expenses paid/received;
- IT Enabled services;
- Support services;
- Software Development services;
- Technical Service fees;
- Management fees;
- Royalty fee;
- Corporate Guarantee fees;
- Loan received or paid.
TP is imposed on both tangible and intangible assets, such as patents, intellectual properties, research and the like when the transfer happens between holding companies of the same parent company, regardless if they cross borders or are domestic.
------> External Clients
Above, you can see that the mother company from the US holds both affiliate companies in China, where they do the mass production, and in Singapore, where the products are disseminated from.
The umbrella organization participates directly in the capital of both secondary firms, but has no control over the Chinese and Singaporean internal transactions. Consequently, when the Singapore affiliate sells the product to external clients, the parent company has no control as well over its selling price.
Thus, determining the exact cost of transactions between the China and Singapore entities is what we call the transfer price.
TP is practiced between subsidiaries, affiliates or commonly controlled companies operating under a large enterprise to pave the way for large savings when it comes to taxes, albeit tax governing bodies say that it proliferates a questionable principle.
Benefits of Transfer Pricing
Reducing duty costs
Duty is referred to as a levied tax on items purchased abroad. Through TP, the duty base is lowered by imposing low transfer prices on products exported to high tariff countries.
Lowering income taxes
Both corporate and income taxes in high tax states are reduced by overpricing their products in countries with low tax threshold, thus generating higher profit margins.
TP and the Internal Revenue Service (IRS)
As mentioned, there have been existing qualms about the practice of TP, and whether some big names in the industry use it to reduce their tax burdens illegally. This is where the IRS comes in.
IRS states that TP should yield the same results between company affiliate transactions, should it happen that outside clients perform the same transaction with the same surrounding circumstance.
IRS and other tax authorities have come up with a strict set of rules to make sure companies aren’t practicing TP to evade settling their dues. They require extensive transfer pricing documentation and are watched under the close eye of auditors and regulators. If they spot any miscalculation in the transfer price, financial statements should be revamped, and in some cases, penalties and fees may be applied.
With a working knowledge of what is transfer pricing, MNCs and large corporations can cut costs and increase business revenues if followed in compliance with the government regulations.
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