What Is Transfer Pricing and How Is It Determined?
Transfer pricing is a complex accounting and taxation practice. Since its tax implications could be huge, it's important to understand transfer pricing.
In an order dated Oct. 26, the US tax court denied Coca-Cola’s plea for reconsideration of its 2020 transfer pricing decision that increased the company’s tax liability by nearly $9 billion. The case involved the pricing of cross-border intercompany royalties. Transfer pricing could have a large impact on a company’s tax liability. As a result, it's important to understand what transfer pricing is and how it's determined.
Transfer pricing is an accounting and taxation practice that sets the price that will be charged internally from another division, subsidiary, or holding company for goods and services. It can also be applied to intellectual property like research, patents, and royalties, according to Investopedia.
Transfer pricing is done so that each of the divisions or independent businesses in an organization can generate a separate profit. The profitability of a division or a subsidiary depends on the prices at which the inter-company transactions occur. It also enables performance evaluation. Transfer pricing allows companies to avoid paying taxes unnecessarily for the best financial outcome.
How's the transfer price determined?
A transfer price is usually the market price of a good or service. Multinational companies are legally allowed to allocate their earnings between their various subsidiaries and divisions through transfer pricing.
The OECD (Organization for Economic Co-operation and Development) is responsible for regulating transfer pricing for multinational organizations. It specifies that these controlled transactions must follow the arm’s length principle. According to the principle, a company must charge a similar price for a controlled transaction as an uncontrolled transaction made by a third party. It implies charging a fair market price.
The OECD has also outlined five primary transfer pricing methods:
- Comparable uncontrolled price method
- Resale price method
- Cost plus method
- Comparable profits method
- Profit split method
What does the IRS say about transfer pricing?
Since transfer pricing can alter tax calculations significantly, it's important to understand what the IRS says about the transfer pricing rules. According to the IRS, transfer pricing should be the same between intercompany transactions as the company would charge for any other transaction done outside the company. The financial reporting of transfer pricing has strict guidelines and is closely watched by tax authorities.
There are several examples of high-profile cases where the litigation is ongoing between the IRS and big companies regarding the treatment of transfer pricing. The dispute between Meta (formerly Facebook) and the IRS has been ongoing. The IRS alleges that Meta undervalued intangible assets that were allocated to its Irish subsidiary. According to the company’s estimates, a loss in the case could result in an overall tax liability of around $9 billion, plus interest and penalties.
Meanwhile, Coca-Cola and Medtronic are also fighting cases against the IRS regarding transfer pricing.
What skills are required for transfer pricing jobs?
Transfer pricing is quite complex and involve many technicalities. You have to navigate international regulations and numerous calculation methods. A great deal of technical expertise and first-hand experience is required for transfer pricing jobs. Moreover, due to the growing international trade and significance of transfer pricing, the demand for transfer pricing jobs is on the rise.