While transfer pricing is a confusing topic, this post will help to provide an overview and answer some frequently asked questions.
What is transfer pricing?
In short, it refers to how the prices of goods and services are determined when they cross national borders or state lines. It’s also used to determine the value of certain intangibles (such as royalties) utilized in international transactions.
Why does transfer pricing matter?
It can have a significant impact on company operations: for example, profits, liabilities, tax expenses, cost of goods sold and accounting standards can all be impacted by how transfer pricing is conducted. It can also have a significant impact on the relationship between the related parties: for instance, transfer pricing can cause unrealized losses and stranded fixed assets.
What is arm’s length pricing?
Many countries have established guidelines for determining what constitutes arm’s length transactions in order to prevent corporations from under- or over-reporting profits. These guidelines are called transfer pricing methodologies and there are two primary methodologies used – the transaction value methodology (TVM) and the comparable uncontrolled price (CUP) methodology.
What is the transaction value methodology (TVM)?
The TVM methodology determines prices by comparing the actual consideration to be paid for a good or service with what would be paid under an arm’s length transaction, i.e., if the transaction were performed between unrelated parties. Broadly speaking, it applies only to transactions between related parties and assumes transactions between related parties are not at market value. For example:
As described here in greater detail , the TVM requires a book of records for each related party to keep track of their foreign operations and such records should include all significant activities as well as services rendered as well as any contracts and agreements entered into (including currencies).
In most cases, the TVM assumes that all value is captured on either the seller’s or buyer’s books and not both (it is assumed that small pricing deviations are immaterial and do not affect market prices). Related parties are those that perform similar functions or have similar risks, but can also be groups of companies from a common parent. In some cases, Xpeer it is necessary to analyze intangibles as well.
When determining transfer prices for royalty agreements, a functional analysis is often used to determine the transfer price. In functional analysis, there is a “functional unit of value”, which includes all costs for manufacturing/producing an intangible asset and receives royalties from other units of value within the same company.