What is Transfer Pricing?
Transfer pricing is the amounts charged during intercompany transactions between related companies. It is the price paid for goods or services that are transferred from one unit of an organization to its other units in different states or countries.1
Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided and it is used to reduce the overall tax burden of the parent company.
Transfer Pricing Regulations apply only to transactions between connected taxable persons. Connected taxable persons generally include individuals and entities who share common control, management, or shareholders; or individuals and entities who participate directly or indirectly in the management, control, or capital of one another.
How does Transfer Pricing Work?
Transfer pricing enables businesses and subsidiaries to price transactions internally when they are owned or controlled by the same entity. The practice is applicable both inside and outside of countries.2
It is an accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries that operate under common control or ownership. The transfer pricing practice extends to cross-border transactions as well as domestic ones.
Multinational corporations (MNCs) are legally allowed to use the transfer pricing method to allocate earnings among their subsidiary and affiliate companies that are part of the parent organization. However, companies sometimes can also use (or misuse) this practice by altering their taxable income, thus reducing their overall taxes.
The transfer pricing mechanism is deployed by companies to shift their tax liabilities to low-cost tax jurisdictions. Companies charge a higher price to divisions in high-tax countries (reducing profit) while charging a lower price (increasing profits) for divisions in low-tax countries.
It is the price that one division in an organization charges another division in that same organization for the supply of goods and services. The expenses could be transportation, packaging, insurance, freight, or customs fees. It is used to set prices and define the terms and conditions of controlled transactions.
Transfer pricing applies to specific transactions to wit:
- acquisition of fixed assets
- royalty fee
- sales of finished goods
- machinery sales or purchases
- charges for corporate guarantees
- refunds of expenses incurred
- support services
- IT services and software development
- management fees and technical service fees
- receiving or paying a loan
- transactions that affect profits, income, losses, or assets of enterprises
Types of Transfer Pricing Models
There are quite a number of transfer pricing models but for the purpose of this article, we will explain the three main models of transfer pricing below.
Market-based transfer price
Market-based transfer prices provide a simulation of the market within a company by representing market conditions. A company sells the product at the same price as it does in the market. This method requires access to a standardized, existing market for the product or substitute. Companies can calculate a market-based transfer price by comparing the current prices of the product. In a competitive market, companies can obtain transfer prices from the marketplace if a comparable product is available.
Cost-based transfer price
Cost-based transfer prices are the most commonly used transfer prices. This applies when market prices are unknown or unestablished. A cost-based transfer pricing method is common for the sale of goods within a company to different divisions. There is only one subsidiary that pays the production costs of goods it purchases from another subsidiary. The purchasing enterprise benefits from this practice by maximizing its profitability. Several factors affect the price, including production costs, manager reviews, and international taxation.
Negotiated transfer price
In negotiated transfer pricing, firm representatives negotiate prices on their own, instead of relying on market prices. Sometimes, a transfer price between subsidiaries is required to be determined with no reference to market pricing. This situation occurs when there is no obvious market price because the market is small or has highly tailored items. In this situation, the price is determined by how each party negotiates. Negotiated transfer prices cannot always fulfill the primary functions of transfer prices, such as profit allocation and coordination.3
Benefits of Transfer Pricing
Transfer pricing allows for better pricing, higher efficiency, and simplicity of the accounting process. Simplifying processes and methodologies also reduces human costs, enhances profitability, and emphasizes business operations strategy. Some benefits of transfer pricing include:
- Reduction of taxes and tariffs: This refers to the reduction of duties by transferring goods at minimal transfer prices into high-tariff countries. To lower the transaction's duty base, companies can use a low transfer price when shipping goods to locations with high tariff rates.
- Competitiveness in the international market: Increasing the prices of goods reduces income taxes in high-tax nations and transfers profits to low-tax nations. Transfer pricing allows businesses to raise the prices of products they may sell in higher-taxed locations to balance profits.4
- Minimization of foreign exchange risk: In the case of the prohibition of dividend repatriation, the government can facilitate it by inflating the price of goods transferred.
Legal Consideration Surrounding Transfer Pricing in Nigeria
One of the legal issues surrounding transfer pricing in Nigeria is the ambiguity surrounding how transfer pricing between divisions should be accounted for and which division should take the brunt of the tax burden.
Also, the financial reporting of transfer pricing has strict guidelines and is closely monitored by tax authorities, thus, it requires extensive documentation. If the transfer value is done incorrectly, the financial statements may need to be restated, and fees or penalties could apply.5
Multinational Corporations (MNCs) are legally allowed to use the transfer pricing method to allocate earnings among their subsidiary and affiliate companies that are part of the parent organization. However, companies sometimes can also use (or misuse) this practice by altering their taxable income, thus reducing their overall taxes.6 It gives MNCs a tax loophole.
Conclusion Transfer pricing is a legal technique used by large businesses to move profits around from parent companies to subsidiaries and affiliates to ensure funds are evenly distributed. However, many multinational corporations use it as a tactic to lower their tax burdens and end up fighting the Internal Revenue Service (IRS) in court.
3. https://in.indeed.com/career-advice/career-development/what-is-transfer-pricing accessed on 04/09/2023
4. https://in.indeed.com/career-advice/career-development/what-is-transfer-pricing accessed on 04/09/2023
5. https://www.investopedia.com/terms/t/transfer-pricing.asp accessed on 04/09/2023
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