Transfer pricing refers to the accounting practice that allows pricing of the transactions taking place between the two business units that is under same ownership and control. It is also known as Transfer Cost. It applies to cross border transactions as well as domestic ones. The transaction can be of goods and services. It is also applied to intellectual property rights such as Patents, Royalties and Research.
It can be between the subsidiaries, affiliates or companies that are part of a lager enterprise. It is being exercised by the companies to reduce the overall tax burden. Multinational Corporations are legally allowed to use transfer pricing methods.
Companies charge a higher price to divisions/business units which is located in high tax countries and thus reducing the profit and hence the tax liability and They charge a lower price to divisions/business units which is located in low tax countries. The pricing differs from the market value and thus benefits one entity by lowering the profits of other entity.
It is a practice to determine the cost that will be charged to another division. However, It is sometimes used as a way to avoid Tax (Transfer mispricing). Companies misuse the transfer pricing practice by shifting their income to their subsidiaries or units and thus reducing the overall tax burden on the single/the parent company. It provides a means to transfer the tax liabilities from high tax-cost jurisdictions to low tax-cost ones.
According to The Internal Revenue Service, transfer pricing should be the same between inter-company (transactions between different business units of a company) transactions and the outside transactions.
Tax burden transferred from Parent Company to Subsidiaries or between Subsidiaries and Vice versa.
For Example: XYZ Ltd. is a parent company and has 2 different Entities- Entity C and Entity D. Entity A accumulates raw materials and Entity B assembles and processes it into finished goods i.e. Garments. Entity A sells raw materials to B at a lower price than the market price and thus B has lower cost of goods sold (COGS) and higher profits but that could be covered in future when A has shortage of funds or will be facing loss in revenue.