Taxpayers with affiliates located in lower tax jurisdictions may seek to reduce their income subject to US income tax by using transfer pricing arrangements that artificially shift income away from (or deductions to) the US, in favor of the lower tax jurisdiction.

To combat these abuses, the transfer pricing rules give the IRS the power to distribute, apportion or allocate items of income, gain or loss between such organizations as necessary to prevent evasion of taxes or clearly to reflect the income of any such businesses. Essentially, the IRS can adjust US income by tweaking items of income and expense to reflect an arm’s-length price.

Transfer Pricing Methods

Here are a number of ways to derive a transfer price:

• Market rate transfer price. The simplest and most elegant transfer price is to use the market price. By doing so, the upstream subsidiary can sell either internally or externally and earn the same profit with either option. It can also earn the highest possible profit, rather than being subject to the odd profit vagaries that can occur under mandated pricing schemes.
• Adjusted market rate transfer price. If it is not possible to use the market pricing technique just noted, then consider using the general concept, but incorporating some adjustments to the price. For example, you can reduce the market price to account for the presumed absence of bad debts, since corporate management will likely intervene and force a payment if there is a risk of non-payment.
• Negotiated transfer pricing. It may be necessary to negotiate a transfer price between subsidiaries, without using any market price as a baseline. This situation arises when there is no discernible market price because the market is very small or the goods are highly customized. This results in prices that are based on the relative negotiating skills of the parties.
• Contribution margin transfer pricing. If there is no market price at all from which to derive a transfer price, then an alternative is to create a price based on a component’s contribution margin.
• Cost-plus transfer pricing. If there is no market price at all on which to base a transfer price, you could consider using a system that creates a transfer price based on the cost of the components being transferred. The best way to do this is to add a margin onto the cost, where you compile the standard cost of a component, add a standard profit margin, and use the result as the transfer price.
• Cost-based transfer pricing. You can have each subsidiary transfer its products to other subsidiaries at cost, after which successive subsidiaries add their costs to the product. This means that the final subsidiary that sells the completed goods to a third party will recognize the entire profit associated with the product.