Transfer pricing is the price that related companies charge each other for the transfer of goods and services. Say a holding company is made up of two entities: one company manufactures motherboards, while the other produces complete desktop computers. Naturally, the desktop maker would, whenever possible, purchase its motherboards from the sister company. The price that this sister company charges the computer maker for motherboards is the transfer price and is a critical figure for several reasons.
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Companies pay close attention to the precise level of transfer pricing because it will impact the profitability of both corporations. Keep in mind that both businesses are owned by the same holding company or individuals, and the motherboards can be sold from one company to the other at any arbitrary price. The higher the sale price of motherboards, the more profitable the motherboard maker will seem, while the computer manufacturer's profits will decline. If both businesses are interested in assessing their true profitability, the transfer price should be as close to a fair market price for the good changing hands as possible .
Since taxes paid by corporations are directly proportional to their profits, the transfer price will also impact the tax liability of the two businesses involved in the transaction. If both companies are subject to the same tax rate, the net impact on the holding company's total tax bill for the two firms will be same regardless of the transfer price. This is because the more profitable you make one company appear on paper, the less profitable the other will be. Tax savings in one company will offset the added tax liability in the other business.
Sometimes the two companies involved in transfer pricing are subject to different tax rates. One business may be located in a state or country where taxation as a percentage of profit is lower, for example. In such cases, the tax authority must keep a close eye on transfer pricing, because the holding company can reduce its total tax liability by maximizing the profitability of the corporation subject to lower tax rates and minimizing that of the other. If the motherboard maker is paying higher taxes, it can charge the computer maker $1 for a motherboard that should cost 20 times as much. The tax code contains provisions to prevent such abuse.
Measuring International Trade
Another key objective in setting transfer prices is to accurately measure the imports and exports for the nations where these entities are located. If the motherboard maker appears to charge $1 for a device that costs $15 to manufacture and sends these motherboards to another nation, the international trade figures will be distorted. The nation where the motherboard maker is located will appear to sell less-valuable goods to other countries. Similarly, the country where the computer maker is located will appear to be purchasing only a small quantity of materials from abroad and sell the resulting finished good at extremely elevated prices, which is not really the case.