What Manufacturers Need to Know About Transfer Pricing

What is Transfer Pricing?
Transfer pricing refers to the allocation of profits and losses among parts of a multinational entity for tax and other purposes. Transfer prices are the prices that the related members of a multinational entity charge one another for goods and services.

How a company sets its transfer pricing can have a major effect on the supply chain because the companies in a commonly controlled chain (i.e., a company and its related parties) must comply with transfer pricing rules and regulations in determining which companies should recognize what amounts of income, deductions, credits and allowances among the various tax jurisdictions in which the commonly controlled supply chain operates.

Transfer pricing regulations can be quite complex, and vary considerably in details across tax jurisdictions. But (nearly) all transfer pricing rules are based on one underlying principle: the arm's length standard.

The arm's-length standard requires that the amount charged by one related party to another for a given product or service must be the same as it would be if the parties were not related. An arm's-length price is the price that independent companies would pay for the same good or service purchased under the same or comparable circumstances.

Let's consider a simple example. A manufacturer in Country X, its controlled distributor in Country Y, and a controlled (or perhaps uncontrolled) retailer in Country Y. Assume that the Country X manufacturer can make the product for $200 and that the Country Y retailer can sell the product to consumers for $1,000. How much of the $800 profit should be recognized by each entity in the chain? These controlled companies could theoretically manipulate their intercompany prices, such that all (or none!) of that $800 profit was reported in Country X. Transfer pricing rules, however, require that the companies achieve arm's-length results. Thus, their intercompany prices must be "arm's length."

Determining that a transfer price is arm's length is often no easy task. Even for simple transactions like the example above, many factors must be taken into account when analyzing a transfer price. For example, is the transaction denominated in the currency of county X or country Y? Which party bears the risk of currency fluctuations? Which party is responsible for product liability? The number of factors to consider can be formidable, and each of these factors can have a material impact on transfer prices.

The arm's length nature of transfer prices are frequently supported by a transfer pricing study. Multinational corporations use these studies to help them set transfer prices that are arm's length, or to support their transfer pricing in front of a taxing authority. A typical transfer pricing study involves performing a detailed analysis of the functions performed, assets employed and the risks borne by each participant in the controlled transaction; selection of an appropriate transfer pricing method; and an economic analysis to set or support the arm's length price.

Why is Transfer Pricing Important?
"What's the big deal?" you may ask, "Doesn't transfer pricing get eliminated in consolidation?" That's true, but local tax authorities care about local legal entity income -- and transfer pricing is a key determinant of that income for members of a related group. Governments around the world have become increasingly concerned that multinationals strategically use transfer pricing to minimize their tax burdens in inappropriate ways, and have come to see transfer pricing as a potentially significant source of lost taxes. This sentiment has also been reflected in the popular media. Consequently, tax authorities around the world have become increasingly vigilant in enforcing transfer pricing regulations. This vigilance involves stricter penalties, new documentation requirements, increased information exchange, and heightened audit and inspection activity.

Transfer pricing audits have become more aggressive, making it all the more important to carefully and accurately document every aspect of companies' transfer pricing strategies to clearly reflect arm's-length results. And the impact of not getting your transfer pricing right has never been greater.

Improper transfer pricing can lead to all sorts of unpleasantness, including:

Transfer pricing adjustments to taxable income, possibly with interest and penalties
Double taxation
Burdensome administrative requirements
Legal and advisory fees
Financial statement disclosures and even restatement

These possible consequences are not to be taken lightly but, lest we incite panic, it's not all bad news. Proper documentation of transfer prices can provide a strong defense against adjustments in the event of inquiry by a tax authority. Transfer pricing documentation can also provide protection from tax penalties in the event an adjustment is imposed. Better yet, properly designed and executed transfer pricing can help multinational companies to align their tax and operational structures, and help meet operational goals.

For example, transfer pricing can be used to:

Examine transactions for restructuring or re-characterization to facilitate usage of excess foreign tax credits
Realign functions and risks with consideration for jurisdictions with net operating losses
Create, initiate, or adjust transactions to repatriate excess cash
Relocate functions, assets and risks to create a more tax-efficient supply chain.

Active management of the transfer pricing system is the best way to minimize transfer pricing risk, and ensure positive transfer pricing outcomes.

David Bowe is international transfer pricing principal and Jack O'Meara is international transfer pricing director at Grant Thornton.