If you are in a business that deals with imports and exports or has to deal with two or more legal entities of the same firm or organization operating in two different countries or regions, you may have heard the term Transfer Pricing.
What exactly is transfer pricing and what purposes does it serve? In today’s post, we will attempt exploring the concept of Transfer pricing and its objectives.
What is Transfer Pricing?
Transfer pricing refers to the value of the goods transferred between the two parties related to one another. The amount thus attached can be related to both goods and services alike. The concept of transfer pricing comes in place when goods are transferred from one unit to another, especially when the two units are located in different countries.
The transfer of the goods and services should happen between the two units of a multinational or multi-state firm. Larger organizations are divided into multiple divisions, and this is done to ensure effective managerial control over the happenings in the entity as a whole. The transfer price is the price one unit of the organization charges to the other unit for the goods or services rendered.
This transfer takes place between the two units of the same organization and thus constitutes an internal transfer and not a sale. It can be one of the important factors for evaluating the flow of goods and services among the different divisions of a company.
This can help you take up the performance measurement of different divisions and units. It becomes essential when there are a considerable number of internal transfers and thus needs to be addressed carefully.
The pricing needs to be set with a good amount of consideration concerning the final market price. If the transfer price is set high, you will end up with a favored selling center, while if it is set too low, the buying center will be favored.
What are the Objectives of Transfer Pricing?
Now that we have understood what exactly constitutes a transfer pricing mechanism and why it is an important factor let us evaluate the objectives that the concept wants to achieve. Here are a few objectives you would find interesting enough –
The transfer pricing should pay close attention to the profitability of both the divisions of the organizations. Since both, the divisions belong to the same firm. Thus the items, goods, and services can be configured at any arbitrary price.
But, if you want to the profit margins of both the divisions to stay unaffected, it would be a great idea to keep the prices as close to the market prices as possible.
The transfer price will also have a bearing on taxation. A proper transfer pricing will help you offset the tax liability of one division with an equivalent one on the other. One of the major objectives of the transfer pricing is to maximize the overall tax profits of your organization. The transactions are not governed by open market considerations. This helps you improve upon the taxation options.
3) Goal Congruence
The transfer pricing should be configured in such a manner that the divisional earnings of each of the divisions are quite consistent with the goals of the parent company. The focus should be such that the profit margins of the subdivisions increase while it will not affect the total profitability of the parent organization.
Transfer pricing needs to be configured in a way where the company profits as a whole also improve.
4) Performance evaluation of individual units
Some of the areas that transfer pricing can assist the performance appraisal, and performance management includes appraising the managerial performance of the divisions, evaluation of the contributions of the individual entities for the overall profits of the company, and assessment of the worth of each division as an individual unit.
5) Taking a good look at international trade
Another prime objective that transfer pricing aims to achieve is to measure the international trade scenario. The pricing should be in tune with the import and export standards and should be accurately measured.
Too low a price can distort the international trade figures to a greater extent. The transfer pricing prices should be such that they will not distort the international trade figures.
6) Shifting of profits
Profit shifting is aimed at reducing the tax liabilities in a particular country can be reduced. This can be achieved by reducing profits artificially. It is also aimed at decentralization of the production so that the profits are concentrated enough in the region where the production of the goods is undertaken.
Some other objectives of transfer pricing
While the transfer pricing needs to take care of the major objectives as outlined in the above discussion, it also has a few other essential objectives to fulfill. A few of the other objectives laid out in a simple to understand language include-
- Reduce the customs duty payments since the transfer is between the two division of the same parent organization. This will help reduce the pricing so that your products will stay in tune with the market prices.
- Transfer pricing assists you in circumventing the restrictions on the import quota restrictions. This helps you import the items without any restrictions.
- Letting you transfer the funds to locations to aid in corporate funding standards.
The major aim of the concept of transfer pricing is to allocate the profits between the parent organization and its subsidiaries. But, if the two units or divisions are located in two different countries, there will be different taxation patterns, and this will make the proper calculation and fixing of the transfer price a complex situation.
In any case, the major objective of opting for a proper transfer price is to avoid or reduce the taxation and thus to increase the profit. The international objectives of transfer pricing will involve lesser foreign exchange risks, better competitive advantage, and enhanced governmental relations.
The Concluding Thoughts
The concepts associated with transfer pricing are a little difficult and complex to understand-, especially for beginners. Arriving at the right transfer price will have a lot of bearing on taxations, import-export guidelines and a lot of the other international transaction rules. We assume we have been able to bring about a little information while understanding it fully will need you to go through a more wider study.