Transfer pricing is the price a company pays to buy products and services from itself, which can cause concern for tax agencies. Companies use transfer pricing to track profit and loss, but if the price is too high or low, it can raise questions. Tax authorities are interested in transfer pricing for international transactions to ensure fair prices.
A transfer price is the price a company pays to buy products and services from itself, either by trading between departments or between subsidiaries. An automaker with a subsidiary that handles production of electrical systems, for example, would pay a transfer price for each electrical system it purchases from the subsidiary. Because these prices are determined internally, they are not subject to the same market forces that dictate prices on the open market. This is a cause for concern in some regions, especially when it comes to tax agencies that are worried about not collecting their fair share.
Companies use transfer pricing to clearly track the profit and loss of different departments and subsidiaries. If goods and services were transferred without cost, it would be difficult to determine their value at different stages of the manufacturing process. This, in turn, would make it difficult to establish an open market price for the finished product, and determine how much profit the company is actually making.
Sometimes the transfer price is set as the open market value for the product or service in question. If there is a known market for the product or service, it can be very easy to determine a fair price. Other companies may discount their transfer prices. However, paying too little for products and services deprives the department or subsidiary that sells them. Shareholders may question significant price disparities and may wonder why a subsidiary does not sell to outside companies that pay more.
Conversely, if the transfer price is too high, it raises questions about why the company does not obtain the product or service more cheaply elsewhere. While individual departments also need to make a profit, if they benefit at the expense of the parent company, it suggests they need to reorganize to change their pricing structure and operations. One problem that can arise occurs when companies agree to buy products and services from a subsidiary in a specific country, while competitors in other nations offer the same things at much lower prices.
Tax authorities are interested in transfer pricing mainly when it comes to international transactions. If a company pays a low transfer price for products made abroad, the government of that nation collects less tax, while the profits are concentrated in the company’s home nation, and the tax authorities collect more tax. Laws have been passed to address this issue and ensure that prices are fair and honest.
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