Transfer pricing, in terms of taxation and accounting, involves rules for setting a price tag on transactions that occur between enterprises which are under common ownership. These provisions were introduced in the Indian IT Act in the year 2001 which were in line with the Organization for Economic Cooperation and Development (OECD).
Importance of transfer pricing
To understand it in a better way, when a secondary company is selling goods or services to a bigger, parent company, the price of the goods paid by the parent company to the secondary company is referred to as transfer price. The two companies involved are generally in different countries but belong to the same firm.
Transfer pricing is important for the simple reason that the rules provide companies with an option of setting conditions around their international transactions. Planning lets the tax-paying population allocate income optimally within a group. On the other hand, if the rules are not followed, the companies may need to face double taxation, interest on tax underpayment, and other penalties. It can result in tax disputes and litigations.
Risks in transfer pricing
The risks associated with transfer pricing are:
- Conflicts and dissent: There can be a difference of opinion among the various organisational managers regarding transfer policies.
- Extra costs: There are numeral costs associated with the time and manpower to implement transfer pricing and designing an accurate accounting system.
- Transfer pricing does not sit well with services: The optimal pricing policy for services is hard to achieve since the profit cannot be measured as in the case of goods.
- Complex: The process of transfer pricing is quite complex and cumbersome, especially when there are huge organisations involved.
- Different functions, multiple risks: The buyers and sellers are associated with varying functions and along with it come various risks. As an example, a seller might or might not offer a warranty on particular goods. But for the buyer paying the price, this has effects like currency risk, credit risk, collection risk, market risk, etc.
Advantages offered by transfer pricing
The benefits that must not be ignored:
- Minimizing the tax burden: Since transfer pricing is the price attached to goods and services, it is not set by any independent transferor. Transactions are not controlled by the open market.
- Reduction in duty costs: The duty costs are decreased by transferring goods to high tariff nations at low transfer prices.
- Higher profit for low tax countries: Overpriced commodities in high tax nations are transferred to nations having a low tax rate, thus resulting in better profit margin.
Transfer pricing helps regulate the taxation aspects around the price paid by one entity to another (usually across different nations and controlled by the same parent organisation). These points should make it easier to assess how to approach transfer pricing the in right way in your organisation.