Introduction to Transfer Pricing: Part 1

Kay Biscopink, CPA

What is “Transfer Pricing?”
The operating units of multinational corporations usually engage in a variety of inter-company transactions. A key issue of international taxation is the problem of “transfer pricing.” The term refers to the pricing of goods and services transferred between related persons not dealing at arm’s length. Prices charged after bargaining between unrelated persons are called “arm’s length” prices.

When unrelated parties deal at arm’s length, the prices at which they transact reflect both prevailing competitive conditions and the specific course of bargaining between them. Among related persons transfer prices answer to no economic pressure. They may reflect a largely unconstrained decision by the parties to adjust accounts among themselves. Transfer prices affect the distribution but not the absolute amount of gain or loss among related persons. If entities within a related group face different tax environments, or different rates of taxation, transfer pricing may bear decisively on tax consequences. Departure from arm’s length prices between affiliates organized in different countries may shift taxable income to low-tax environment and deductible expense to a high-tax one.

From the earliest days, the U.S. tax laws have had provisions designed to strengthen the Treasury’s hand in dealing with artificially priced transactions between related parties. The provisions are embodied in the present Code Section 482. This code section empowers the IRS to reallocate income and expense in transactions between related persons so as to reflect income clearly. Section 482 is aimed at the unilateral advantage related taxpayers could otherwise obtain through unchecked transfer prices. Its goal, broadly stated, is to recast transactions among affiliates.