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Transfer Pricing Definition

August 29, 2023
Bill Kimball

Where adopted, transfer pricing rules allow tax authorities to adjust prices for most cross-border intragroup transactions, including transfers of tangible or intangible property, services, and loans. These adjustments are generally calculated using one or more of the transfer pricing methods specified in the OECD guidelines and are subject to judicial review or other dispute resolution mechanisms. One solution to this and other problems is to use a cost-plus-investment method for establishing the transfer price while retaining mandated internal sourcing. Several chemical companies, an electronics company, and a heavy machinery company in my study used this approach at some point. This method transfers the intermediate good on a full-cost basis, but it also “transfers” the portion of the selling unit’s assets used for internal needs to the books of the buying unit.

Buying unit managers have to believe that selling unit managers are doing their best to forecast raw material costs accurately. A common complaint is that these estimates are purposefully conservative so that the selling unit can show positive variances. Transfer pricing adjustments have been a feature of many tax systems since the 1930s. The United States led the development of detailed, comprehensive transfer pricing guidelines with a White Paper in 1988 and proposals in 1990–1992, which ultimately became regulations in 1994.

  • Although owners and managers may not think of one location as selling services or parts to another unit, the various taxing authoritieswhether state or nationalmay impose that view.
  • Transfer pricing schemes are a means of generating information and control for implementing corporate, business unit, and product strategy.
  • THE TWO MOST COMMON approaches to setting and revising transfer prices are to apply cost-plus and market-based procedures.
  • Many such authorizations, including those of the United States, United Kingdom, Canada, and Germany, allow domestic as well as international adjustments.
  • Transfer pricing adjustments have been a feature of many tax systems since the 1930s.
  • Unlike in competitive organizations where the transfer price is a market price that determines whether sourcing will be internal or external, the transfer price in cooperative organizations is determined after the decision to source inside has already been made.
  • Accounting for goods or services from a third-party supplier is fairly straightforward, but what about transactions within the corporation?

In the absence of transfer price regulations, ABC Co. will identify where tax rates are lowest and seek to put more profit in that country. Thus, if U.S. tax rates are higher than Canadian tax rates, the company is likely to assign the lowest possible transfer price to the sale of pens to XYZ Co. The CEO has made special efforts to let managers know that he recognizes their individual contributions to the company. What’s more, his word carries weight because he receives much information and also has a deep understanding of all three businesses. Because the company is placing more emphasis on measuring unit profitability and return on investment, the CEO’s knowledge and judgment are especially reassuring to the unit managers. Cost-plus-investment transfer pricing also has its problems, many of which are related to allocating costs and investments.

Commensurate With Income Standard

As the head office gets more involved with interunit relationships, complaints of unfairness may rise. Nevertheless, top management may want to increase internal transfers because of excess capacity in the selling unit or to take advantage of proprietary technologies.

The Comparable Uncontrolled Price, or CUP, Method, is the most common method and preferred in most cases by the OECD. The CUP Method compares the price of goods or services in an intercompany transaction to the price changed between independent parties. It’s important that goods and services are assessed under comparable conditions to get an accurate price that tax authorities will accept. Accounting for goods or services from a third-party supplier is fairly straightforward, but what about transactions within the corporation? When either unit is having trouble meeting its profit objectives, changing the transfer price is one of the easiest fixes for the bottom line. The CEO has managed all three of these businesses at different points in his career and understands them very well. When managing these businesses he had shifted to a cost-plus-investment approach because he said he wanted to improve the profits and motivation of the buying units.

The rules generally require that market level, functions, risks, and terms of sale of unrelated party transactions or activities be reasonably comparable to such items with respect to the related party transactions or profitability being tested. Disputes about the transfer price of this product have raged off and on for nearly 20 years. The price of the intermediate good rose on the external market and the selling unit general manager set a new transfer price on the good internally. The result was a conflict that generated a series of memos and internal studies providing a great deal of information. In presentations to the president, the buying unit managers reported their performance using both cost- and market-based transfer prices.

While providing a useful framework for thinking about transfer pricing, the MAP must be supplemented by management judgment. For example, the MAP enables a manager to determine if conflict is useful, as it is in collaborative organizations, or not, as is more likely in competitive or cooperative organizations. But by itself the MAP does not enable a manager to determine if the conflict is a result of other factors having little to do with transfer pricing. A standard-cost system can also isolate the effects the buying unit has on the selling unit, such as when the former buys less than anticipated. When buying units are responsible for negative volume variances if other customers don’t turn up, a portion of the selling unit’s capacity has to be identified as dedicated to a particular buyer. Disputes can arise about whether a buying unit’s capacity was used to meet the demand of another customer. A transfer price is used to determine the cost to charge another division, subsidiary, or holding company for services rendered.

Alternative Approaches To Profit Allocation

However, both sets of rules generally prohibit applying hindsight in making allocations. Where services performed are of a nature performed by the enterprise as a key aspect of its business, OECD and U.S. rules provide that some level of profit is appropriate to the service performing component. Testing of prices in such cases generally follows one of the methods described above for goods.

Often a company will use several transfer pricing policies depending on the strategy of the groups, business units, and products involved. The Circular instructs field examiners to review taxpayer’s comparability and method analyses. The method of analyzing comparability and what factors are to be considered varies slightly by type of transfer pricing analysis method.

Transfer Pricing

To qualify, the documentation must reasonably support the prices used in computing tax. U.S. rules require that the IRS may not adjust prices found to be within the arm’s length range. Where prices charged are outside that range, prices may be adjusted by the IRS unilaterally to the midpoint of the range.

transfer prices should be set at

Due to the emphasis on systems for measuring quantitative results, business units have an incentive to win at the expense of others. Structural interdependence, however, acts as an incentive for each business unit to be concerned with the performance of the other as it affects total corporate results.

China Specific Tax Rules

The structures of collaborative organizations are more complicated and messier than the clean multidivisional form of the competitive organization or the clean functional form of the cooperative organization. The major difficulty with actual full cost transfers is that the price of the intermediate good fluctuates.

The oligopolistic nature of the market for the intermediate good and the extent of vertical integration in the industry also make it difficult to determine a fair market price and an appropriate volume discount, if any. Bonuses for managers and capital budgets for units take into account both independent and interdependent contributions in a necessarily difficult-to-define combination of cooperative and competitive criteria. Collaborative organizations are usually organized as matrix structures or as multidivisional structures that are substantially interdependent. Business units might share such resources as corporate manufacturing or sales units.

When internal sourcing is required, both units actively seek the involvement of top management to solve the transfer price conflict. Control comes from top management’s using each unit to keep the other on its toes. More generally, business units turning out intermediate products have two roles, as a profit center for external sales and as a cost center for internal transfers.

Accounting Today is a leading provider of online business news for the accounting community, offering breaking news, in-depth features, and a host of resources and services. The Internal Revenue Service released proposed regulations that can help taxpayers, employers and insurers navigate the complex tax rules surrounding COVID-19 testing and health insurance coverage. One drawback is this method doesn’t necessarily encourage the supply division to be efficient in manufacturing practices and, in fact, it can be less efficient when it comes to limiting things like material labor and overhead variances. Internal teams can get lazy, receiving cost over time but not really getting competitive pricing. They report to group general managers and so are one layer removed from the president. A few prominent cases continue to be a matter of contention between tax authorities and the companies involved. Division B pays Division A for the software, typically at the prevailing market price that Division A charges other carmakers.

The burden of proof that a transfer pricing adjustment by the IRS is incorrect is on the taxpayer unless the IRS adjustment is shown to be arbitrary and capricious. However, the courts have generally required that both taxpayers and the IRS to demonstrate their facts where agreement is not reached. A key requirement to limit adjustments related to costs of developing intangible assets is that there must be a written agreement in place among the members. Tax rules may impose additional contractual, documentation, accounting, and reporting requirements on participants of a CSA or CCA, which vary by country.

With a methodology in place, the corporation can determine a strategy to collect, analyze and report transfer pricing data. For example, whichever method a company selects, there must be a profit elimination step as part of the consolidation process to remove the effects of such sales from the consolidated financial statements. Of course, this includes all intercompany sales and costs of sales recorded by the transfer partner affiliates. Companies that are collaborative emphasize both the interdependence of vertical integration and the independent contributions of the business units as diversified businesses. As individual profit centers, the units compete; but as a result of high interdependence, they must cooperate.

Testing Of Prices

Chinese transfer pricing rules apply to transactions between a Chinese business and domestic and foreign related parties. A related party includes enterprises meeting one of eight different tests, including 25% equity ownership in common, overlapping boards or management, significant debt holdings, and other tests. Transactions subject to the guidelines include most sorts of dealings businesses may have with one another. OECD guidelines give priority to transactional methods, described as the “most direct way” to establish comparability. The Transactional Net Margin Method and Profit Split methods are used either as methods of last resort or where traditional transactional methods cannot be reliably applied. The value added by use of intangibles may be represented in prices of goods or services, or by payment of fees for use of the intangible property. Licensing of intangibles thus presents difficulties in identifying comparable items for testing.

A chemical company in my study illustrates how a standard full-cost transfer pricing policy can be effective even when it does not include take-or-pay provisions. The company’s transfer pricing approach had evolved out of a standard-cost system that had been implemented in the early 1960s. In the mid-1960s, as part of a reorganization to a matrix structure, a task force recommended a market-based system to allocate variances. Top management preferred the standard-cost approach and rejected the team’s proposal.


It also makes it possible to more clearly separate the profit-center and cost-center roles of the selling unit. Although nothing can eliminate it, standard full-cost transfers reduce the effect interdependence has on performance measures. The criteria for performance measurement, evaluation, and reward are also very different in cooperative organizations. Although managers use objective quantitative criteria—budgeted costs and revenue—these are largely based on comparisons with historical performances or budgets. Because of the problems, companies probably cannot use dual pricing for a long period of time for all products, although they may employ it for a few strategically important items. One electronics company, for example, set a dual pricing policy to enable a division selling batteries as a replacement part to price more competitively and regain lost market share.