How does transfer pricing work?
Transfer pricing within a firm is a complex issue under any circumstances. Transferring goods between unrelated firms is simple because the market sets the price. If one company thinks they are being unfairly charged, they can go find another supplier, assuming there is a viable substitute.
However, there is no price-setter on a transaction that occurs between related firms, and some companies try to use transfer pricing as a mechanism to move margin, and cash, to a low-tax country. For this reason, tax authorities maintain a watchful eye on transfer pricing within related firms, which is one of several reasons it is advisable to work with an international tax attorney when determining transfer prices for complex goods. Tax authorities wish to confirm that transfer prices are “arm’s length” transactions reflecting realistic and supportable valuations for intra-company transfers, otherwise they will make the company pay transfer pricing taxation.
Imagine a situation where a firm has related entities in four countries: Research in Switzerland, where there is significant intellectual property related to the production of a product; the United States is the headquarters for the company and also has marketing, management and engineering departments; the Chinese entity manufactures several parts and assembles the finished product; and an entity in the UK provides distribution:
· Intellectual property
· Final assembly
Each entity provides a key value-added activity to the final product. As the product moves through the value chain to final distribution into the hands of customers, the transfer price at each stage is should reflect the quantified value-added of each entity as they contribute to the production of this product.
However, it is not uncommon to have disputes within a group on how much they are contributing, and their quantified share is reflected in their own financial statements in the form of a per unit contribution margin. Additionally, as things change, like the design of the product, the cost of raw materials and parts, the cost of labor, advertising and marketing costs, etcetera, the contribution margins change, too.
So carefully studying the contribution of each entity to come up with a transfer price at each stage that everyone can agree on is a requirement of transfer pricing. Moreover, keeping up with changes in the process and costs of each division as they contribute to the production of the product is essential.
What makes transfer pricing complex and difficult is that it is a negotiation between entities that have their own agendas and who know their performance reviews are based, to some degree, on aggregated contribution margins of multiple parts for many products.
The risk of transfer pricing taxation.
For this and other reasons, working with an international tax attorney to determine and negotiate global transfer pricing and tax liability is very important. THEVOZ Attorneys will analyze transfer pricing for every step of the value chain that will be acceptable to the internal entities and the tax authorities, to avoid fines and penalties and maintain profitability for the firm.