Transfer pricing is a sort of black art in international law—picking the best arbitrary price for an international transaction in order to minimize the amount of tax paid for that transaction.

To illustrate how this works, let's take a hypothetical multinational business scenario:

  • Sekicho Heavy Industries K.K. (SHI) is a manufacturer in Tokyo which makes widgets. It costs SHI $100 to manufacture one widget.
  • Sekicho North America, Inc. (SNA) is a distributor in California which sells widgets made by SHI for $200 each. It is a wholly-owned subsidiary of SHI.
  • The marginal tax rate for SNA is 20 percent; the marginal tax rate for SHI is 25 percent. Assume, for the purposes of this hypo, that there are no duties or import/export taxes, and that transportation across the Pacific is free.

For businesses, income tax is charged based on profit. SNA and SHI are part of the same enterprise and ultimately controlled by the same people, but they are considered to be separate individuals, and so when the widgets go from Japan to the U.S., there's going to be a contract between the two companies. Like any sales contract, there has to be a price, too. The company is paying itself the amount of this price, so it might seem like a useless figure. But when you look at the final tax liability at different pricing levels, you realize it's not so useless after all:

Contract      SHI           SNA       Total
  price   profit  tax   profit  tax    tax
  $100      $0     $0    $100   $20    $20
  $125     $25     $6     $75   $15    $21
  $150     $50    $12     $50   $10    $22
  $175     $75    $19     $25    $5    $24
  $200    $100    $25      $0    $0    $25

So this situation dictates a low price for the transaction, so as to keep all of the profit in the U.S. where taxes are lower. By setting the price for the transshipped widgets at $100 rather than $200, the Sekicho empire saves $5 in taxes for each widget it sells.

If SHI's management really wanted to get creative, they could pick an oddball price.... say, 1 cent. Now SHI is taking a loss on the transaction, which will offset some of its other profits, while SNA is picking up the tax bill for the profits offset in Japan. Or, if Japanese tax rates were better than the U.S., SHI could price the widgets at $1,000 each and suck all of its profits back to Japan.

In the real world, governments like to maximize their tax intake, and so they make rules to keep businesses from dodging tax liability. But in this kind of case, what's best for the U.S. Internal Revenue Service is also what's worst for the Japanese Ministry of Finance. Both countries can't tax the maximum possible amount at the same time.

So most countries hold the view that multinational businesses should transfer items across borders at fair market value—a sort of arm's length price that would be likely between an independent buyer and seller. But every country has a different way of deciding what's fair and what isn't, and a lot of rules to help them reach their conclusion. So there are a variety of laws applicable to transfer pricing, which provide a variety of tax attorneys with a variety of billable hours for a variety of big clients. (Hey, somebody's got to win.)

Some of the methods used to calculate a fair price:

  • Comparable uncontrolled price method (CUP) - How an unrelated company prices a similar product for a similar transaction.
  • Resale price method (RPM) - How much markup another seller would add on a similar product.
  • Cost plus method (CPM or C+M) - How much markup another manufacturer would add for production of a similar product.
  • Profit split method (PSM) - Takes the total profit to the enterprise from all of the transactions put together, and apportions that profit among the various companies.
  • Transactional net margin method (TNMM) - Takes the total profit to the enterprise and apportions it among the various companies based on the costs at each company's stage of the chain.

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