How Transfer Pricing Works: Everything You Need To Know


Transfer pricing is a pricing method used when two or more companies of the same multinational enterprise tradegoods, services, or assets. For example, a transfer price is a cost at which one division or subsidiary sells goods or services to the holding company that is located in another country. That price also determines how much profit the company reports and, consequently, the tax rate that it will pay.

Typically, the prices at which multinationals trade goods or services reflect the going market price. However, international groups sometimes manipulate these prices to avoid paying the necessary taxes in countries with higher tax rates.That is why tax authoritiesneed to ensure that the taxable income of these businesses is reported properly and not shifted out of the appropriate tax jurisdictions. Needless to say, setting artificial prices for these transactions can lead to serious tax compliance issues.

In this blog post, we will discuss how transfer pricing works and provide you with everything you need to know about it.

What is a transfer pricing policy?

A transfer pricing policy is used to define how a multinational business generates profit and in which countries it files its taxes. It also determines how its prices are set. Many countries have defined their own legislations on transfer pricing, whichare generally based on international guidelines by the UN and OECD.The international standard that these guidelines follow for setting the prices of cross-border transactions is called the “arm’s length principle”.

The arm’slength principle

In simple terms, the arm’s length principle dictates that the prices of transactions between related parties should be the same as the prices for comparable transactions between unrelated parties. The reason is that this would ensure a market-based allocation of income and profits, as opposed to an unfair allocation due to artificial margins on goods or services.

Objectives of a transfer pricing analysis

Transfer pricing is important – if not crucial – for businesses that operate in more than one country. Conducting a transfer pricing analysis allows these enterprises to:

  • Determine adequate prices for transactions between associated parties;
  • Ensure that the allocation of income between tax jurisdictions is reflective of all economic activity;
  • Reach an agreement between the taxpayer and the authorities in the respective countries; and
  • Avoid running into double taxation.

When determining adequate prices, multinationals need to ensure that the ratesat which they trade goods between related parties reflect the market rates and are based on actual costs. Naturally, those principles should be applied consistently across all related companies. That also requires that the prices are reviewed and updated regularly.

Transfer pricing can be a complex topic, but an important one to understand if you are conducting business with related companies. The key points above should help you understand what a transfer pricing policy is, what is the arm’s length principle on which the policy is typically based, and what are the main objectives of a transfer pricing analysis. If you have questions or need help with performing your own transfer pricinganalysis, you should definitely seek help from companies with the necessary experience to navigate the complex topic.