What Is Transfer Pricing and Why Does It Matter for Business?
If your business has international operations or transactions with related parties, transfer pricing rules affect how you allocate income across borders.
Transfer Pricing Basics
What Is Transfer Pricing?
Transfer pricing refers to the prices charged in transactions between related parties (e.g., parent companies and subsidiaries in different countries).
Why It Matters
Multinational companies can manipulate transfer prices to shift profits to low-tax jurisdictions:
- Charge high prices to subsidiaries in high-tax countries (reduces profits there)
- Charge low prices to subsidiaries in low-tax countries (increases profits there)
The IRS and tax authorities worldwide require transfer prices to follow the arm's length standard: Transactions between related parties must be priced as they would be between unrelated parties.
Common Transfer Pricing Methods
- Comparable Uncontrolled Price (CUP): Compare to similar transactions between unrelated parties
- Cost Plus: Mark up the seller's costs
- Resale Price Method: Work backward from the resale price
- Profit Split: Divide combined profit based on contribution
- Comparable Profits Method (CPM): Compare return on assets to unrelated companies
Section 482 Penalties
The IRS can impose significant penalties for improper transfer pricing:
- 20% penalty for substantial valuation misstatements
- 40% for gross valuation misstatements
Documentation Requirements
Large businesses must maintain contemporaneous documentation supporting their transfer pricing.
Business with international operations? Transfer pricing compliance is critical and heavily scrutinized.