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Guide to Intercompany Transfer Pricing

insightsoftware -
November 14, 2022

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In accounting, intercompany transfer pricing is the price charged for goods or services exchanged between companies within the same group of companies. The purpose of transfer pricing is to ensure that each company in a group contributes fairly to the overall profitability of the group.

In order to properly price transactions between related companies, an understanding of intercompany transfer pricing is necessary. The purpose of transfer pricing is to ensure that each company in a group earns a fair return on its investment, taking into account risk and the cost of capital.

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There are two methods commonly used to price intercompany transactions: the cost-plus method and the market price method. The cost-plus method simply adds a markup to the cost of the goods or services being sold. The market price method, on the other hand, uses prices that would be charged to an unrelated third party as a benchmark. We will touch on these two methods and two others later on.

The choice of transfer pricing method will depend on a number of factors, including the nature of the transaction, the degree of market power of the companies involved, and the availability of information. In general, the cost-plus method is more commonly used for transactions involving manufactured goods, while the market price method is more commonly used for transactions involving services.

When choosing a transfer pricing method, it is important to consider the potential impact on tax liabilities. In some cases, using a particular transfer pricing method may result in a higher tax bill for one or more of the companies involved. As such, it is important to seek advice from a qualified tax professional before implementing any intercompany transfer pricing arrangements.

Transfer prices are typically reviewed on a regular basis to ensure that they remain fair and accurate. If a company believes that its transfer prices are not fair, it may negotiate with the other companies involved to reach a new agreement.

Transfer Pricing Examples

A transfer pricing example would be where two companies within the same group transfer goods or services to each other at an agreed price. This price may be higher or lower than the market price, but it is set between the two companies in order to help them manage their overall tax bill.

Coca-Cola

Because the production and sales of Coca-Cola are conducted across global markets, the company has to legally defend its $3.3 billion transfer pricing of a royalty agreement. The company transferred IP value to affiliates between 2007 and 2009. The IRS and Coca-Cola continue to litigate the case it is still being heard in court.

Transfer pricing is a way for companies to shift profits from one country to another, typically to a lower-tax jurisdiction. It can also be used to help companies avoid tariffs. In some cases, transfer pricing can be used to exploit loopholes in tax laws.

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Medtronic

Medical device manufacturer and inventor of the pacemaker, Medtronic, used to be headquartered in Minneapolis. After moving their primary business to Ireland, Medtronic and the IRS have been litigating in court since 2021 to try and settle a dispute of $1.4 billion.

The IRS has accused Medtronic of transferring intellectual property to low-tax havens globally. The transfer involves the value of intangible assets between Medtronic and its Puerto Rican affiliate for the tax years 2005 and 2006.

A lower court had originally sided with Medtronic, but the IRS filed an appeal. Both sides are still awaiting a judgement from the Tax Court.

Intercompany transfer pricing is a complex area of tax law, and there are many different ways that companies can go about setting prices for transfers between related parties. As such, it is important for businesses to seek professional advice when setting prices for transfers, to ensure that they comply with the law and do not end up paying more tax than they need to.

Intercompany Transfer Pricing Best Practices

In recent years, multinational enterprises (MNEs) have been the subject of intense public and media scrutiny with respect to their use of transfer pricing. This has led to an increased focus by tax authorities on transfer pricing compliance and a greater level of scrutiny of MNEs’ transfer pricing practices.

In response to this increased scrutiny, many MNEs have adopted best practices with respect to their transfer pricing. These best practices generally fall into three categories: documentation, process and substance.

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Documentation

The first category, documentation, relates to the level of detail and analysis required in a transfer pricing study. In order to meet the increased level of scrutiny from tax authorities, MNEs should ensure that their transfer pricing documentation is comprehensive and includes a detailed analysis of the economic factors underlying the pricing of the transaction.

In addition, MNEs should consider adopting a “master file” approach to their documentation. This approach involves creating a central repository for all transfer pricing documentation which can be easily accessed by tax authorities. This approach has the advantage of simplifying the process of providing transfer pricing documentation to tax authorities and reducing the risk of providing incomplete or inaccurate information.

Process

The second category, process, relates to the procedures and processes used by MNEs to arrive at their transfer prices. In order to meet the increased level of scrutiny from tax authorities, MNEs should ensure that their transfer pricing processes are robust and defensible.

MNEs should consider adopting a “bottom-up” approach to transfer pricing. This approach involves starting with an analysis of the underlying economic factors driving the pricing of the transaction and then working up to a transfer price that is consistent with those economic factors. This approach has the advantage of providing a more comprehensive and accurate analysis of the transaction and reducing the risk of transfer pricing manipulation.

Substance

The third category, substance, relates to the substantive content of the transfer pricing arrangement. In order to meet the increased level of scrutiny from tax authorities, MNEs should ensure that their transfer pricing arrangements have a sound economic basis and are consistent with the underlying economic factors driving the pricing of the transaction.

MNEs should also consider adopting an “arm’s length” approach to transfer pricing. This approach involves setting prices that would be charged by unrelated parties in comparable circumstances. This approach has the advantage of providing a more objective and unbiased transfer price.

Conclusion

The increased level of scrutiny from tax authorities has led many MNEs to adopt best practices with respect to their transfer pricing. These best practices generally fall into three categories: documentation, process and substance. By adopting these best practices, MNEs can improve their transfer pricing compliance and reduce the risk of transfer pricing manipulation.

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Methods of Transfer Pricing

The concept of transfer pricing refers to the prices charged for the sale of goods and services between related entities within an enterprise. The pricing of these transactions is generally determined by taking into account the costs, profits and risks associated with the underlying transactions.

There are four main types of transfer pricing methods:
1. Cost-plus pricing: This method involves setting prices based on the direct costs incurred plus a reasonable profit margin.
2. Market-based pricing: This approach involves setting prices based on prevailing market prices for similar products or services.
3. Negotiated pricing: This method involves setting prices through direct negotiation between the parties involved in the transaction.
4. Transfer pricing using financial indices: This approach uses financial indices to determine prices, such as the price-to-earnings ratio or the cost of equity.

Cost Based Transfer Pricing

Cost based transfer pricing is a pricing method used to price transactions between related parties in which the price is set based on the cost incurred by the supplier. This pricing method is commonly used in industries where the production process is complex and the products are heterogeneous. Cost based transfer pricing is advantageous because it encourages the efficient use of resources and leads to lower prices for the final product.

Full Cost Transfer Pricing

Full cost transfer pricing is a method used to calculate the cost of transferring goods or services between divisions within a company. This method assigns a value to the resources used in the production process, including materials, labor, and overhead costs. The full cost of each unit produced is then allocated to the division that consumes the unit.

This method is used to ensure that each division within a company pays the true cost of the resources it consumes. This pricing method can help prevent one division from unfairly subsidizing another division within the company. It can also provide management with valuable information about the cost of producing goods and services.

Marginal Cost Transfer Pricing

In economics, marginal cost is the change in the opportunity cost of a good or service as the quantity produced changes. Opportunity cost is the value of the best alternative use of a good or resource. In other words, it is what is given up in order to produce something.

For example, if a firm uses one hour of labor to produce a widget, the opportunity cost is the value of what could have been produced instead in that hour. If the firm could have produced two widgets, then the opportunity cost of the labor is two widgets.

Transfer pricing is the price at which a good or service is transferred from one unit of a company to another. For example, if a company has a factory and a sales department, the factory may transfer goods to the sales department at a certain price. The price charged for the goods is known as the transfer price.

The marginal cost of a good or service is the opportunity cost of producing one additional unit of the good or service. In the example above, if the marginal cost of a widget is two widgets, then the transfer price of the widget from the factory to the sales department should be two widgets.

This is because the opportunity cost of producing the widget is two widgets. If the transfer price is less than the marginal cost, then the company is losing money on the widget. If the transfer price is greater than the marginal cost, then the company is making a profit on the widget.

Marginal cost transfer pricing is the price at which a good or service is transferred from one unit of a company to another, taking into account the opportunity cost of producing the good or service.

Negotiated Transfer Pricing

Negotiated transfer pricing is a pricing arrangement between two related parties in which the price is not set in advance, but is negotiated between the parties at the time of the transaction. This type of pricing can be used when the parties have different interests or objectives, and when there is no market price for the good or service being exchanged.

Operational Transfer Pricing

Operational transfer pricing is the process of allocating the cost of goods and services between business units within the same company. This process is used to determine the price at which goods and services are exchanged between different parts of the company. The price is typically based on the market value of the good or service, but can also be based on other factors such as production costs.

Operational transfer pricing can be a complex process, and there are a number of different methods that can be used to calculate the price. The most common methods are the market value method and the production cost method.

The market value method is the most straightforward way to calculate the price of a good or service. This method simply uses the market value of the good or service as the price. This method can be used when the market value is known, and when there is no need to allocate costs between different parts of the company.

The production cost method is a more complex way to calculate the price of a good or service. This method allocates the cost of the good or service between the different parts of the company based on the production costs. This method can be used when the market value is not known, or when it is necessary to allocate costs between different parts of the company.

Operational transfer pricing is a complex process, and there are a number of different methods that can be used to calculate the price. The most common methods are the market value method and the production cost method.

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Global Transfer Pricing

Global transfer pricing is the process of allocating the cost of goods and services between related parties in different countries. This process is used to determine the price at which one subsidiary company sells goods or services to another subsidiary company in a different country. The price is determined by taking into account the cost of production, shipping, and any other relevant factors.

International Transfer Pricing

In simple terms, international transfer pricing is the price charged for goods and services between related companies in different countries. The price charged is typically used as a means of shifting profits from one country to another, in order to minimize the overall tax burden.

Transfer pricing is a complex area, and there are many rules and regulations that govern how it should be done. In general, prices should be set in a way that is arm’s length, meaning that they should be similar to what would be charged between two unrelated companies. However, there are many factors that can come into play when determining the appropriate price, and it is not always easy to ensure that prices are fair and reasonable.

As global trade increases, and more companies expand their operations into different countries, transfer pricing has become a hot-button issue. Many governments are concerned about companies using transfer pricing to shift profits out of their countries, and they are taking steps to crack down on these practices.

If you are involved in international transfer pricing, it is important to stay up-to-date on the latest rules and regulations. Failure to comply with the rules can result in hefty penalties, and it can damage your company’s reputation.

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OECD Transfer Pricing

The OECD transfer pricing rules are a set of international guidelines that member countries use to determine the prices that related parties charge each other for goods and services. The rules are designed to ensure that related parties do not shift profits from one country to another by artificially setting prices.

The OECD transfer pricing rules are used by more than 100 countries, including all OECD member countries. The rules are constantly being updated to reflect changes in the global economy and the development of new technologies.

The OECD transfer pricing rules are divided into three main sections:

  • The Arm’s Length Principle
  • Methods for determining arm’s length prices
  • Documentation and disclosure requirements

The Arm’s Length Principle is the cornerstone of the OECD transfer pricing rules. It states that related parties must charge each other prices that would be charged by independent parties. This principle is based on the idea that unrelated parties engage in transactions with the goal of maximizing their own profits.

There are four methods that can be used to determine arm’s length prices:

  • The Comparable Uncontrolled Price Method
  • The Resale Price Method
  • The Cost Plus Method
  • The Profit Split Method

The Comparable Uncontrolled Price Method is the most commonly used method. It involves finding prices charged by unrelated parties for similar products or services.

The Resale Price Method is used when related parties are engaged in a resale transaction. This method involves determining the arm’s length price by adding a markup to the price charged by the supplier.

The Cost Plus Method is used when related parties are engaged in a production or service transaction. This method involves determining the arm’s length price by adding a markup to the cost of the production or service.

The Profit Split Method is used when related parties are engaged in a transaction where they share the risks and rewards of the venture. This method involves splitting the profits of the venture in an arm’s length manner.

Documentation and disclosure requirements are an important part of the OECD transfer pricing rules. Related parties must keep detailed records of their transactions and disclose their transfer pricing arrangements to the tax authorities.

The OECD transfer pricing rules are an important part of the global tax system. They ensure that related parties do not shift profits from one country to another by artificially setting prices.

Transfer Pricing Software

As the tax and operational transfer pricing processes go online, they can have a huge impact on an international organization’s ability to appropriately forecast and report its tax liability. With the new rollout of the OECD’s action plan on Base Erosion and Profit Shifting (BEPS), there are some distinct changes coming. Today’s investments in multinational tax reporting and transfer pricing software will pay dividends as finance teams work to meet the challenge of shifting to the new operational process.

Besides the transition to software, we’re also seeing greater volatility in global events, uncertainty in global trade policies, and corporate challenges. The pandemic also demanded greater flexibility, as a wave of stimulus programs and special tax provisions required tax professionals to change tactics in delivering maximum benefits to their clients.

New tax and transfer pricing software helps corporate accounting teams accomplish more with fewer resources. A commitment to modern tax and intercompany transfer pricing software will be as critical to operations as running a robust ERP system. The reputational risks associated with regulatory audits and last-ditch efforts to complete tax returns are too great, and the upside for competent management of the pertinent data is now simply too important to ignore.

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