What is Transfer Pricing?
Transfer pricing is the price charged when goods, services, or intangibles move between divisions or subsidiaries of the same multinational company. Tax authorities require these internal prices to follow the arm's-length principle, matching what unrelated parties would charge.
Transfer pricing is the price set for transactions between related entities within a company, determined via cost-plus, market-based, or negotiated pricing methods.
- •Based on internal production cost
- •Add an agreed markup %
- •Simple, works when no external market exists
- •Can distort performance evaluation
- •Based on external comparable price
- •Reflects true market value
- •Preferred by tax authorities
- •Requires an active external market
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Step-by-step worked examples
A division's production cost is $40/unit. With a 25% markup, what is the transfer price?
TP = Cost × (1 + Markup%) TP = 40 × 1.25 = $50 per unit
An external market price for a similar component is $80. Using market-based transfer pricing, what price should the selling division charge?
Market-based method uses external comparable price Transfer price = $80 per unit
Two divisions negotiate a transfer price between the cost floor ($30) and market ceiling ($70). They agree on $55. Is this valid?
Negotiated pricing allows any price between cost floor and market ceiling $30 ≤ $55 ≤ $70 → valid negotiated transfer price
Flashcards
Quick quiz
Q1.A subsidiary's unit cost is $50 with a 20% markup. What is the cost-plus transfer price?
Q2.Which transfer pricing method uses the price charged to external customers?
Q3.Why do multinational companies use transfer pricing?
Q4.What is a key risk of transfer pricing across countries?
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Common mistakes
Transfer pricing only matters for tax purposes. — Correct: It also affects performance evaluation, resource allocation, and divisional autonomy.
Any transfer price a company sets is acceptable. — Correct: Tax authorities require an 'arm's length' price comparable to unrelated-party transactions.
Cost-plus pricing ignores the markup. — Correct: Cost-plus pricing = cost + an agreed markup, not cost alone.
Transfer pricing is only used domestically. — Correct: It's most critical in cross-border intercompany transactions due to differing tax rates.
FAQ
What is transfer pricing?
Transfer pricing is the price charged for goods, services, or intangibles transferred between related entities (subsidiaries) within the same company.
What is the transfer pricing formula?
A common formula is cost-plus: TP = Cost × (1 + Markup%). Other methods include market-based and negotiated pricing.
What are examples of transfer pricing?
A manufacturing subsidiary selling components to a sister sales subsidiary at an internally set price is a classic transfer pricing example.
How is transfer pricing calculated?
It's calculated via cost-plus (cost + markup), market price (comparable external price), or negotiation between divisions, following the arm's-length principle.