Transfer Price

Key takeaways
* A transfer price is the price charged for goods, services, or labor exchanged between related parties (divisions, subsidiaries, or affiliates).
* Prices that deviate from market value shift profits between entities and can create tax advantages or disadvantages.
* The arm’s‑length principle—pricing transactions as if between unrelated parties—is the standard regulatory requirement to prevent profit shifting.
* Transfer pricing requires careful documentation and poses significant compliance and audit risk for multinationals.

What is a transfer price?

A transfer price (or transfer cost) is the internal price assigned when one part of a company sells goods or services to another part of the same company. It’s used when separate legal or accounting entities within a consolidated organization record their own revenues, costs, and profits.

Why companies use transfer pricing

• To allocate costs and revenues among divisions or subsidiaries for performance measurement and internal decision‑making.
• To manage supply availability and internal sourcing.
• In multinational contexts, to influence where profits are reported for tax optimization (legitimate planning or abusive profit shifting).

Example

Company ABC has two divisions:
* Entity A: manufactures wheels.
* Entity B: assembles and sells bicycles.

If Entity A sells wheels to Entity B at below‑market transfer prices:
* Entity B’s cost of goods sold (COGS) falls and its reported profits rise.
* Entity A’s revenue and reported profits fall.

If the transfer price is above market, the reverse happens. Any transfer price that departs from market value benefits one internal entity and harms another, which is why arm’s‑length rules exist.

International transfer pricing

Multinationals often perform a large share of trade within the corporate group. When divisions in different countries transact, transfer prices determine where profits are recognized. Companies can shift reported profits to subsidiaries in low‑tax jurisdictions or reduce tariffs by routing transactions internally. To counter abuse, international guidance (notably from the OECD) and national tax authorities scrutinize cross‑border transfer pricing.

Taxation and compliance implications

Tax authorities require transfer pricing to reflect arm’s‑length outcomes—prices that would be charged between independent parties in comparable transactions. Noncompliance or weak documentation can trigger:
* Adjustments to taxable income,
* Penalties,
* Audits and potential double taxation,
* Financial statement restatements.

Many jurisdictions (for example, the IRS) impose strict documentation and reporting requirements. Robust contemporaneous documentation is essential to support pricing methods and allocation decisions.

Documentation and reporting

Best practices include:
* Selecting appropriate arm’s‑length transfer pricing methods (comparable uncontrolled price, resale price, cost plus, transactional net margin, etc.).
* Preparing detailed transfer pricing studies and contemporaneous documentation.
* Including disclosures in financial statement footnotes and maintaining records for audits.
* Periodically revalidating comparables and methods as business conditions change.

Benefits and disadvantages

Benefits
* Clear internal pricing for performance measurement and budgeting.
* Easier internal supply management and reduced external sourcing disruptions.
* Potential tax optimization when compliant with laws and guidelines.

Disadvantages
* Risk of disputes with tax authorities and costly audits or penalties if pricing isn’t defensible.
* Complexity in selecting and applying appropriate methods.
* Possible internal conflicts between buying and selling units if prices are perceived as unfair.

Bottom line

Transfer pricing is a fundamental internal-pricing practice for multi‑entity firms that affects profitability, tax liabilities, and financial reporting. When set and documented according to the arm’s‑length principle and local rules, transfer pricing supports legitimate business management and tax compliance. Poorly designed or inadequately documented transfer pricing, however, can lead to audits, adjustments, penalties, and reputational risk.