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An Overview of Transfer Pricing
Large organizations that have multiple divisions, branch offices or subsidiary companies need to have a clear understanding of the transfer pricing basics. When goods or services are sold within the organization from one division to another, from one profit center to another, or between the parent company and a subsidiary, it is known as transfer pricing.
The critical part about this method of intra-organization transfer of goods and services is to adhere to the taxation rules and regulations pertaining to such transfers. If the rules are followed correctly, transfer pricing can be an effective tool in the hands of the management to achieve best output from each division or profit center, and to evaluate their corporate performance more objectively.
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Physical Transfer of Goods
Transfer pricing must be computed carefully when goods are physically transported from one place to another. In addition to the basic cost of the goods or the pre-decided price of goods, the price should also include the cost of packaging, shipping, handling, custom charges and insurance.
There may be a situation where a bulk purchase of goods is made by the parent company at a competitive price, and then the goods are distributed to various branches or profit centers within the organization. In such case, the profit center can calculate whether it is cost-effective to receive goods from the head-office after paying for the additional costs, or it may be more beneficially to source the goods locally.
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Accounting and Records Maintenance
Organizations that understand transfer pricing basics are usually keen to employ this methodology because it simplifies the accounting process for the organization as a whole. When the goods are transferred from one division to another under this method, it minimizes the need for entries in the accounts receivable and payable records.
In most situations, such transfers can be accomplished by filling up a form that accompanies the physical transfer. It cuts down the need for additional documentation such as price lists, commercial invoices, bills of lading, certificates of origin and other formal accounting records that may be usually necessary when a purchase is made from an external source.
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Tax Implications of Transfer Pricing
The business organization needs to evaluate the tax issues related to transfer pricing carefully, particularly when the transfers are made to international subsidiaries. This involves taxation rules of the country where the transfer is made, along with the rules of the country where the parent company is located.
Difficulties may arise if the parent company inflates or deflates the prices of goods while transferring from the parent company to a subsidiary in another country. If the price is inflated, it may result in higher taxation for the parent company, and lower taxation for the foreign subsidiary, and vice versa. Therefore, the process should be conducted with fair pricing or “arm’s length pricing" as regulated by the IRS in the United States.
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Arm’s Length Pricing Principle
The taxation laws pertaining to transfer pricing in the United States stipulate that a business organization should maintain the arm’s length pricing principle when using this methodology for accounting purposes. This principle essentially implies that an organization must apply only such pricing to all its divisions and subsidiaries as it would apply to an unrelated party.
Alternatively, the IRS also offers the provision for business organizations to enter into an Advance Price Agreement (APA) with the IRS. Under this program, the transfer price is mutually agreed upon between the company and the IRS in advance. This eliminates the chances of tax disputes later on, and business can be conducted in a cooperative manner rather than an adversarial manner on the issue of taxation.