What is Transfer pricing?
Pricing of goods transferred from operations or sales units in one country to the units of company elsewhere is called Transfer pricing. This is intra firm trading of goods and services.
Transfer pricing is a common practice in MNCs. MNCs have many subsidiaries which trade among themselves or with the parent firm. This is evident from the fact that about one-third of US exports goes to US subsidiaries and business affiliates overseas.
The World Investment Report (UN 1995) states that intra-firm trading of goods and services amounts to about one-third of total world trade. Broadly speaking, any price charged should be acceptable, as sales are among subsidiaries. If the selling price is low, the buying unit makes profit. If the price is high, the selling subsidiary gains.
Finally, the same amount of profits is reported in the parent company irrespective of the changes in price. Anyway, the transfer price should be correctly determined as it is bound to affect the profit level of subsidiaries.
Objectives of transfer
Transfer pricing is aimed at the following:
1. To maximize the total profit of the subsidiaries.
2. To facilitate parent company’s control over its subsidiaries.
3. To provide adequate basis, both to product divisions and international divisions for receiving credit for their own profitability.
Methods of determining transfer price
There are four methods of determining transfer pricing namely,
- Direct manufacturing cost
- Direct manufacturing cost plus a predetermined markup to cover additional expenses
- Market based transfer price; and
- Arm’s length price.
1. Direct manufacturing cost
This methods involves transfer of goods at direct manufacturing cost incurred by the production division. When a buying subsidiary acquires products at very low price, it has no incentive to minimize expenses. Moreover, the selling unit cannot show profit for inter-firm transfer at manufacturing cost. In this sense, direct manufacturing cost method does not encourage the selling unit as well as the buying unit.
2. Manufacturing cost plus a predetermined mark up
This method is an improvement over direct manufacturing cost method. Under this method, merchandise is transferred at a price which covers both the manufacturing cost and a predetermined markup to cover additional expenses. The chief merit of this method is that profit is produced and added at every stage.
The drawback of this method is that it does not take into account market conditions. Ultimately, when it comes to the market, the price generated may be too high.
3. Market based transfer price
Market based transfer price overcomes the limitations of manufacturing cost plus markup. The price is determined purely on the basis of market conditions. Though the market based transfer price considers market conditions sometimes, it may not cover up production costs.
4. Arm’s length price
An arm’s length price is the amount or price that would be charged or would have been charged for the same product or service if independent transactions were carried out with unrelated parties under similar conditions. This requirement applies to
- both goods and services (e.g. performance of marketing, managerial, technical or other services for an unaffiliated party, and;
- possession, use, occupancy, loan, and assignment of tangible and intangible property.
The arm’s length price is one which is acceptable to unaffiliated traders or external buyers. Under this method, goods are sold at a price which unaffiliated traders would agree on a particular transaction. Problems are experienced in determining arm’s length price when the product has no external buyers and is sold at different prices in different markets.
Commonly used transfer price method
Of various methods of transfer pricing, cost plus and market-based pricing are most common with more developed countries and less developed countries. The use of market-based pricing is due to legal considerations such as compliance with tax and customs regulations, anti-dumping and antitrust legislation and financial reporting rules of most countries.
Economic restrictions in host countries like exchange controls, price controls, restrictions on imports and political and social conditions seem to have less influence over market-based transfer pricing.
In practice, the parent company endeavors to maximize its income in low tax countries and minimize profit in high tax markets. Based on this, use of arm’s length price minimizes the income of a buying subsidiary in a high tax country.
If the buying subsidiary is in a low tax country, it should maximize its profit. This can be achieved by buying at “direct manufacturing cost“. In this context, the buying unit buys products at low price. Though its profit is very high, it is subject to low tax rates in the market.