Transfer Pricing Example

Transfer pricing is when the price is determined when transactions occur between two or more related entities within a multi-company organization. It is also called the cost of transfer which reflects the value of these transfers between related organizations. It could be with regards to goods or even transfer of employees or labour across different departments.
Coming to the example, we can consider two associated entities X and Y. Here where X is situated in a high tax country and Y is located at located at the low tax county or a tax haven destination. Hence in this case X would shift most of its revenue generated to Y through to avoid transactions through means of some form of associated transfers. Hence the incidence of tax for the company reduces through the use of these provisions. Similarly due to this we can see that there will be no eradication of revenue from one country to another by benefitting the country of source of generating such revenue

Determination of Transfer Pricing

We can take the example of an automobile company who has multiple assembly divisions. If a company offers to purchase 50,000 tires from the tire division of the same company for rupees for 2000 per unit then the production cost per tire would be as follows:

 

Item Production Cost
Direct Material 500
Direct Labour 200
Variable Factory Overhead 120
Fixed Factory Overhead 420
Total 1240

The tire division typically sells 200,000 tires every year to arm’s length customers at 1400 rupees per unit. In addition, the capacity of the tire division is 300,000 batteries per year. The assembly division typically buys the tires from the arm’s length suppliers at 1250 rupees per unit.

Now, the main question is whether or not the tire division manager should accept the offer? If yes, how will the company benefit from this internal transfer?

The tire division has a surplus capacity of (300,000-200,000) = 100,000 tires per year. So the relevant costs to the tire division will be 820 / battery (total of 1240 minus the fixed factory overhead of 420 rupees).
And the increased margin to the tire division would be 50,000*(100 –82) = 0.9 Lakh
Due to the above benefits to the tire division, its manager must undoubtedly accept the offer.
The assembly division pays 1250 to external suppliers for a tire that could be purchased internally at an incremental cost of just 820. So, the overall cost saved by the company would be 50,000 * (1250–820) = 2.15 Lakh per year.

This is how the company will benefit from the internal transfer.

Now, what should be the price range in this case?

The transfer price should be kept between 820 and 1250. If it goes below 820, the tire division will be at a loss, while if it goes beyond 1250, the assembly division will be paying more than what it pays to the external suppliers.

The type of legal on which the practice of transfer pricing can be applied is explained below.

Only the entities which are legally related are the ones that can adopt this practice. In other words, if two companies are owned wholly or where the majority is owned by the parent corporation, then only those companies can be considered to be under the control of a single corporation. Since they are under the control of a single corporation it automatically means they are legally related entities. Hence transfer pricing can be applied to them and can be practiced by them.
However under certain jurisdictions we can see that entities are considered under common control if they share family members on their boards of directors even though they may not necessarily be related legally, as described in the above paragraph.

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