Ultimate Guide of Transfer Pricing: Concepts, Purpose, and Types.

The Concept of Transfer Pricing:

Transfer pricing (TP) is the price of goods or services sold or bought between divisions in the same group or entity. For the divisions that operate in the same jurisdiction, transfer pricing is set for performance management and motivation of division from the group or entity level.

Sometimes it is set up to solve the conflict between divisions. However, TP is set to comply with law and tax purposes for the group with many divisions operating in multinational countries.

To summary, the purposes of transfer pricing are:

  • To keep goal congruence among divisions: Pricing police are normally set to ensure that the decision-making at the divisional level is retaining the benefit for both divisions and the group as a whole. It is risky when the decision-making delegates all the power to the divisional level since some divisions made at the division benefit the division but impairs group profit.
  • To allow managers to retain autonomy: In modern performance management, the decision-making is delegated to the local manager as they know the situation more than the group level. Transfer Pricing is part of modern performance management so that divisions can survive for themselves. Yet, not all of the power and decision are delegates.
  • To permit performance evaluation of division: Divisional performance management is very important as it is affected the performances, rewards, and motivation of starts and managements at the divisional level. This is one of the most important parts of TP.
  • Tax Management: For group companies with many divisions operating in different countries and corporate tax rates are different, transfer pricing that manages by the group is very important to make sure that the group pays too much tax or, in other words, how the group could save tax.
  • Managing profit for minor shareholders: Well, it might be a bit difficult at this point, but some of the major shareholders are managing the profit of the companies and have the chance to manage the benefit of the minor shareholder as well. Mostly through the pricing of goods or services transferred among the group.
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Types of Transfer Pricing:

The following are the five types of transfer pricing usually set by the group company and jointly set by the division.

  • Market Price Transfer Pricing: Marketing price is the transfer price policy that uses the available market price of the same or similar products or services in the market as the base price for charging. This type of pricing is fair for both transferring division and receiving division. Both divisions could compare the price they are paid and receive to the market price; however, by using Transfer Price, the Transferring Division might not spend on transportation fees if they are in the same country.
  • Adjusted Market Price Transfer Pricing: Adjusted Marketing Price is the type of TP policy that uses the available price in the market and makes adjustments for some types of expenses that are not incurred by the outsider. For example, transport fee.
  • Marginal Costs Transfer Pricing: This pricing is charged at the variable cost incurred at the transferring division. Such pricing might demotivate the transfer division as some cost incurred at their department is not considered. For example, fixed cost is not taken into account.
  • Full Cost Transfer Pricing: The price is charged based on the full cost incurred at the transferring division. This type of TP has many disadvantages. First, it might be motivating the transferring division not to control the cost of products or services because all of the costs incurred at the transferring division will be charged to the receiving division. From the group’s point of view, there is poor cost control and results wasted by the group. Another disadvantage is that the receiving division will be demotivated as they could control the cost.
  • Negotiate Transfer Pricing is the transfer price type in which a Group Company delegates the power to its division to have the right to negotiate the prices. This TP strategy is almost the same as adjusting the market as the prices are decided by both transferring and receiving divisions.
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Issues Need to Consider for International Transfer Pricing

Many of the group of companies now have many international divisions for market expansion and low-cost strategies. In such a situation, transfer pricing plays a significant role, and usually, there are many issues to consider.

The following are the five issues that need to consider when setting Transfer Pricing for International Division:

  • Exchange Rate Fluctuation: Some of the divisions operating in the county have low economic and highly fluctuating exchange rates. For example, if the transferring division is operating in a high fluctuation exchange rate; the receiving division will incur the loss of exchange rate. In such a case, the hedging currency might need to consider.
  • Taxation Rates: It is for obverse reasons operating in different countries, the group has to expose different tax rates, and the pricing has to set based on those tax rates to ensure that the group does not pay too much tax.
  • Import Duties: Some countries try to control and manage the transfer price by setting the price for imports or exports. It is also the main factor that we need to consider when considering the transfer pricing strategy.
  • Fund Repatriation: The concept of fund repatriation is that the government wants to control the fund outflow from its country by investors through transfer pricing by charging high prices for products or services.
  • Anti-dumping legislation: Such a concept that governments want to propose the local products by setting the market price for products exported from the country. For example, some of the group companies open the production division in the low labor cost country and the product charge from those countries is at the low price.
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Written by Sinra