What is “Transfer Pricing”?

This website is intended to be a useful and interesting place not just for transfer pricing professionals, but also for non-specialists whose work or inclination makes them want to know more about transfer pricing. But if you’re new to the site you may be wondering: what does the term “transfer pricing” really mean in the first place? Let me provide a short explanation.

12651902_sSomewhere in the neighborhood of $30 trillion in goods and services are sold from one country to another each year. For context, the total value of all economic production is roughly $75 trillion annually… which means that more than one-third of all economic activity involves international trade.  The term “global economy” is certainly overused, but it’s overused for a reason: the phrase is an appropriate description of the world we live in.

Of that $30 trillion in cross-border sales of goods and services that happen every year, a huge chunk – probably one-third to one-half – are what are known as “intra-group” transactions, i.e. transactions between entities that are members of the same corporate group.  Think Toyota Japan shipping cars to Toyota USA for sale in the American market, or Novartis in Switzerland transferring pharmaceuticals to its UK branch for subsequent sale to consumers there.

These intra-group transactions are a bit peculiar: they are not “market” transactions such as we typically see between unrelated buyers and sellers, since the buyer and seller are part of the same organization.  As a result, the price applied to the transaction does not necessarily have to be a market price.  So instead we have a specific name for the prices that multinationals choose to apply to their intra-group transactions:  “transfer prices”.

And this is where taxes enter the picture. Since multinationals could theoretically set their transfer prices at whatever level would be most convenient to them, they might choose to pick a transfer price that reduces their tax bill.  After all, by altering the transfer price a multinational can effectively shift income between the “buying” and “selling” entities within its group, so transfer prices give it some control over how much income it reports in each jurisdiction.

But of course, multinationals aren’t the only ones to have figured this out, so transfer prices are of keen interest to governments and tax authorities. As a result, most countries have incorporated into their tax codes specific regulations that govern the transfer prices that multinationals are allowed to apply to their intra-group transactions.

Nearly every country has chosen to adopt what is known as the “arm’s length standard”: transfer prices must be the same as the market price that would have prevailed if the transaction had been conducted at arm’s length, that is, between unrelated buyers and sellers.  And this makes a lot of sense; if we are worried about multinationals choosing arbitrary transfer prices simply based on tax convenience, anchoring the allowable transfer prices to some sort of underlying economic reality seems both reasonable and efficient.

Of course, as always, the devil is in the details. It’s one thing to say that multinationals should simply set their transfer prices to be consistent with market prices, but it’s quite another to actually be able to figure out what the market price would have been. After all, many of the transactions that take place between different branches of a multinational have no direct market equivalent. If a pharmaceutical company with headquarters in country A develops a new drug in at its research facilities in country B, manufactures it in country C, and markets and sells it in country D, what is the correct arm’s length price for the transfer of the drug from country C to country D? And how should the entities in countries A and B be included in the transaction? In some cases the answers are fairly straightforward, but more often they are not.

In order to sort all this out, most multinationals devote significant resources each year trying to make sure that the transfer prices they’re applying to their intra-group transactions are consistent with the tax regulations in all of the jurisdictions in which they operate.  Do some of them still manage to identify and apply transfer prices that give them a good tax answer? Certainly. But the arm’s length standard is the fundamental rule that they must abide by, and as a result the underlying economics of each multinational firm becomes the key to understanding and recording its transactions and income.

So yes, transfer pricing is a rather arcane topic. But since the regulations and economic logic of transfer pricing directly affect trillions of dollars in economic transactions each year, determining whether, where, and at what price they occur, it’s actually an arcane topic with massive implications for the global economy.

One comment

  1. Mark Soutar says:

    You should do media presentations on why there are tax inversions showing the link to transfer pricing.

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