- It is a tool/instrument of tax planning avoidance.
- It is the mechanism for determining the cost/price while transferring a product or service from one department to another.
Transfer pricing is the method used to determine the price of a product transferred from one department to another within the same organisation. In the modern corporate business, multiple departments are assumed to be profit centres and have autonomy to function.
So, within the organisation, there is a transfer of the product from one department to another, and the price to be paid from one department to another for the transfer of the product is the transfer price.
There are two cases/situations under transfer pricing, such as:
- i) No External Market
- ii) Presence of External Market
#No External Market
In the case of no external market, the department can transfer the product within the organisation, but cannot sell it in the market.
Similarly, if the department or unit can supply the product to other departments of the same organisation as well as to the external market, then it is said that there is a presence of the external market.
To explain the transfer pricing, consider a firm with two departments.
- Production
- Sales Department
The production department transfers the product to the sales department and assumes that the objective of the firm is to maximise profit.
- Production MCp = 50/-
- Sales MCs = 10/-
- Total Marginal Cost (TMC) = 60/-
It is assumed that the firm has the information about the market demand and marginal revenue ot the final product. It has the information about the marginal cost of production and the sales department. Then, by vertical summation of the MC of the production and sales department, the firm determines the aggregate marginal cost.
i.e. MCf = MCp + MCs
- Where, MCf = Aggregate/total marginal cost of the firm
- MCp = Marginal cost of the production department
- MCs = Marginal cost of the sales department
Since the objective of the firm is to maximise profit, it produces units that satisfy the conditions of profit maximisation.
And they are:
- First Order Condition: MFc = MRf
- Second Order Condition: Slope of MCf>Slope of MRf
Here, Df and MRf are the demand and marginal revenue of the firm. MCp and MCs are the marginal costs of the production and sales department. By vertical summation of MCp and MCs, the aggregate marginal cost of the firm, MCf, is estimated.
Both conditions of profit maximisation are satisfied at E*, and so the firm produces OQ* quantity at P* price.
Since there is an external market, the production department produces OQ* quantity only, and the marginal cost of the production department for OQ* output is AQ*.
This means PT is the transfer price that the production department receives from the sales department. So, if there is no external market, then the transfer price is determined by the internal demand, based on the marginal cost of the department that transfers the product.
#Presence of External Market
To explain the transfer pricing in the presence of an external market, assume that the market is perfectly competitive and the objective of the production department is profit maximisation.
Because the production department is a profit centre.
- MRf>MRe = Supply more to own firm and less to the external market
- MRf<MRe = Supply more to the external market and less to the own firm
- MRf = MRe = equilibrium
Here, Df and MRf are the demand and marginal revenue of the firm.
- De and MRe are the demand and marginal revenue of the production department in the external market.
- MCp and MCs are the marginal costs of production and sales department, where MCf=MCp+MCs is the aggregate marginal cost of the firm.
- Since the production department is the profit centre and tries to maximise profit, both conditions of profit maximisation are satisfied at Ep, and so the production department produces the OQp quantity.
- The production department allocates this profit-maximising output between the external market and its own firm or sales department in such a way that marginal revenue from each equals the MC of the production department. i.e. MRf = MRe = MCp
- In the figure, the production department supplies OQf quantity to the own firm or sales department and QfQp quantity to the external market at the existing price in the external market Pe, such that MRf = MRe = MCp
This means the production department transfers the product to its own sales department or firm at the external market price, and so, if there is the presence of an external market, then the external market price itself is the transfer price.
Transfer pricing is a tool of tax avoidance or tax planning by the corporate firm.
Transfer pricing is used by most of the multinational companies, as well as large domestic corporations, to avoid taxes due to the differences in tax rates between countries and across sectors.
Under transfer pricing, a product is transferred from a department or a subsidiary company to another department or the parent company and vice versa.
In the MNCs, or the corporate house, avoids the tax by showing higher expenses and lower profit in the high tax countries or sector, and so higher profit in the country or sector where the tax rate is lower.
For example, there are many tax haven countries where the tax is very low or zero.
So, an organisation established a parent company in such countries and transferred the product, such as goods and services, to the countries where there is a market, but a high tax rate.
Then the MNCs show higher expenditure on the import of the product from the tax haven country, and they show lower profit or even a loss in the high tax country and higher profit in the tax haven country.
In this way, they can avoid the tax. The major techniques used by the MNCs to avoid tax through transfer pricing are:
- Over-invoicing to a high tax country: When the MNC imports the product from another subsidiary in a low tax country, they show higher payment for the imports, which results in higher expenditure and lower profit in the higher tax country and lower expenditure and profit in the low tax country.
- Under-invoicing in a low tax country: To show more profit in a low tax country, they under-invoice the imports from the subsidiary or parent company in the high tax country. This reduces profit in a high-tax country, which helps to avoid tax.
- Royalty, trade, make or patent manipulations: The company registers the intellectual property rights (IPR) in the low tax country, and all other subsidiaries carry their business in a high tax country. Then the subsidiaries from high-tax countries pay the high royalty or patent fee to the parent company in a low-tax country.
- Internal loan and excess interest payment: A subsidiary in a high-tax country borrows from the related company in a low-tax country at a high interest rate. This helps to increase expenditure or lower profit in a high-tax country, and allows it to avoid tax.
- Technology transfer and managerial support: The subsidiary company hires the technical experts and top-level management from the related company in the low-tax country. Then the subsidiary company in the high tax country pay excessively higher fees or service charges to the related company in the low tax country.
Control of tax avoidance due to transfer pricing
Transfer pricing is a tool for MNCs for tax avoidance internationally. So, to control such tax avoidance due to transfer pricing, the government can use various policy instruments such as:
- Submission of transfer pricing-related documents is mandatory.
- Promote digital payment for the transfer price, such as e-invoicing, real-time reporting, etc.
- Appropriate fines and penalties for mispricing through under- or over-invoicing.
- Strengthen the audit capacity of the revenue administration by developing a special transfer pricing unit.
- Limit the excessive interest deduction by fixing the interest reduction cap.
- Cap on royalty and management fee for the transfer of such services.
- Strengthen the bilateral and multilateral relationships with the trading countries in order to exchange the relevant information.
- The provision of using the market price of the same or a similar product in calculating the transfer price.
- Benchmarking with comparable companies to compare profit margin, royalty rates, interest rates, service charges, etc.
- Provision of public disclosure of key financial data for the large MNCs.
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