TRANSFER PRICING

By – sobic agarwal

defination

The price at which divisions of a company transact with each other. Transactions may include the trade of

supplies or labor between departments. Transfer prices are used when individual entities of a larger multi-entity

firm are treated and measured as separately run entities.

Different Types of Transfer Pricing Methods

(i) Market-based transfer prices(ii) Full-cost based transfer prices(iii) Negotiated transfer prices

Market-based Transfer Price

•Market conditions which are appropriate for adoption are generally appropriate in a perfect market, where there is homogeneous product with only one price for both sellers and buyers and no buying or selling costs.

•The adoption of market-based transfer price in a perfectly competitive market meet the criteria of a good transfer price, that is it will promote goal congruent decisions, preserve divisional autonomy and provide an equitable basis for performance evaluation.

Full-cost based Transfer Price

•Market conditions which are appropriate for adoption in an imperfect market, it may be unwise to always set transfer price exactly at the variable costs of production, as such prices do not provide for the replacement of fixed assets.

•The Supply Division (SD) will want to base the transfer price on total absorption cost to ensure that it will provide a contribution to cover the fixed overheads.

Negotiated Transfer Price

• In this situation, it is more appropriate to adopt negotiated transfer prices. If both managers had been provided with all the information and were educated to use information correctly, it is likely that a negotiated solution would have emerged which would have been acceptable to both the divisions and the group.

• • When there is unused capacity, the transfer price range for negotiations generally lied between the minimum price at which SD is willing to sell (its marginal cost) and the maximum price BD is willing to pay (the external supplier price net off any external purchase related costs).

Importance of Transfer Pricing

Transfer Pricing refers to the allocation of profits between entities that are considered to be related based on the relevant local legislations. This allocation of profits must follow the application of the arm´s length principle which is the basis of every transfer pricing analysis. In essence, prices for services, sales of tangible or intangible assets between related parties must be set as if the referred transactions were undertaken by independent entities.

During recent years, transfer pricing has gained increasing attention from tax authorities as well as

tax payers around the world. Different countries are introducing legislation with detailed requirements for tax payers to justify and document the application of the arm´s length principle to their intercompany transactions. Globalization has also had an impact on the importance of transfer pricing, as a large part of world trade takes place within multinational groups