Transfer pricing is an intriguing phenomenon that many people want to know about. The word has been a big mystery and many business owners seem oblivious to this thing and want a proper clarification for it. Thankfully, we’ve got you covered in this article.
What is Transfer Pricing?
Transfer pricing is the process of pricing the goods or services that are transferred within a multinational corporation across its various departments. this involves determining the cost and profits of the services and goods to record the viable amount on the books of accounts.
For say, a small business only needs to deal with outside customers. Still, when it comes to a big company or multinational company, the goods and services are transferred or sold between various divisions as per the requirement. This is where transfer pricing comes into play as it allows the companies to record the cost of the goods sold and make sure that each department is compensated well for their goods or services.
Transfer pricing can be a complex subject at times to understand citing its taxation usability and applications along with a host of other regulatory rules to be followed. It comes with a lot of advantages and a few caveats too. Let’s check out both of these to get a clearer picture of transfer pricing.
Advantages of Transfer Pricing
1. Cost-saving tool for departments
In the transfer pricing process, the cost of the goods or services is often lower than the market price since such goods or services are being transferred within the departments of the company. This allows the departments of the companies to gain a big cost advantage in the books of account. For say, an OEM manufacturer in the business of mobile phones and batteries has two different units, one manufacturing mobile phones and the other manufacturing batteries operating in different tax jurisdictions. The battery department can sell its batteries to the mobile unit at a lower price than that of the market price for other consumers. This allows the company to have lower production costs and generate higher profits on the end product.
2. Transparency in dealing with departments
Transfer pricing practice allows for the various departments of the organization to have transparent and clear communication during dealings for products and goods. For say, in the lack of transfer pricing, the department can charge arbitrary amounts to other units or departments of the company. This will result in the increased cost of production for the final product and lessen the profit margin. This also erodes the relations and the transparency between the departments degrading the relations further and capsizing the business growth.
3. Future-proofing yourself from uncertain vendors and suppliers
Indulging in a production or a manufacturing business often requires mitigating various cost centers and getting the highest quality of product manufactured at the lowest possible cost for the company. When the outside vendors or suppliers know the needs of the brand, they may try to rinse them off with high prices for goods. This is where having a transfer pricing policy can help mitigate and future-proof yourself from such a scenario and keep the production cost low.
4. Tax saving
Transfer pricing helps in the reduction of taxes and can help mitigate various tax usage. Utilizing the transfer pricing works in this way, a company may overprice its products in a higher tax jurisdiction and then supply the same to a department where a lower tax jurisdiction. This helps in balancing the profits and allows the business the lessen the tax burden to some extent. Furthermore, transfer pricing is also done to lessen the duty costs in the case of international trade for multinational companies. With transfer pricing, the price of the product can be lessened, and as such lower duty taxes are levied.
Disadvantages of Transfer Pricing
1. Complication Procedure
Transfer pricing is a complicated process and requires multiple steps and considerations to be made to determine the right price for the supply of goods and services. Since no market considerations or factors are coming into play since the transfer of goods and services is between the departments of the company, setting the appropriate prices can be difficult in the absence of qualified personnel.
2. Inter-departmental animosity
Though transfer pricing helps the company to keep the costs to a minimal level when it comes to production or manufacturing, this can also hinder the chances for the sales of such OEM products directly from the department to the outside market. Since the departments may feel that they are sacrificing their profit levels by not being able to sell to the market directly, this may in the long term cause a rift in the functioning of the company.
3. Forceful buying
Transfer pricing practice means buying raw materials or semi-finished products from another department of your company. This at times can mean that even if the departments manufacture substandard or inferior quality products, the company still has to buy them rather than buying from the substitute supplier from the market.
4. Legal Compliance
Use of transfer pricing policy requires various legal mandates and compliance to be followed. The absence of such legal practice will mean breaking of the laws and can push the company into penalty and other forms of punishment. This has been seen time and again where sudden changes in the government policies have resulted in the disruption in the transfer pricing mechanism of the company.
Final Words
The transfer pricing practice has been utilized by various multinational and large corporations indulging in the manufacturing or production of goods. The laws related to transfer pricing have been penned down and companies need to abide by them for their use. Transfer pricing does allow lots of advantages for the company but also has a few caveats that need to be addressed. We hope this aforementioned breakdown of the advantages and disadvantages of transfer pricing will help you understand it better.
