Transfer Pricing

Regards products transferred within an organization. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary. Since the prices are set within an organization (i.e. controlled), the typical market mechanisms that establish prices for such transactions between third parties may not apply. The choice of the transfer price will affect the allocation of the total profit among the parts of the company.

This is a major concern for fiscal authorities who worry that multi-national entities may set transfer prices on cross-border transactions to reduce taxable profits in their jurisdiction. This has led to the rise of transfer pricing regulations and enforcement, making transfer pricing a major tax compliance issue for multi-national companies.

A great many factors influence the transfer prices that are used by multinationals, including performance measurement, capabilities of accounting systems, import quotas, customs duties, VAT, taxes on profits.

Foreign Company  ----------->  Subsidiary  -------------> local customers

         <----------transfer------->                <----------sale---------->

         <----------internal-------->                <-------local profit----->

             pay taxes on import                      pay taxes on sales & profits

But, goal is to maximize:

         <------------------total ---profit------------------------------->

So, Multinional companies have the incentive to manipulate the "transfer" price.

• If, the loal country has;  high local taxes, or high inflation, high currency risk, or difficult rules for expatriating profits....then the company will.... claim the transfer price as HIGH  (making less profits in the country)
• But, if there is:  high import duties, or a reason that the firm would want to appear to be highly valuable to the local country....then the company will.....claim LOW  (making more profits in the country)

Note:  China has capital repatriation rules that keep money invested in China in China.  Or, so they hope.   For MNC's that have local subsidiaries, you can see how easily that foreign companies can use Tranfer pricing to keep profits out of China (and bring them home).   As interest rates go up in China, and foreign speculators wish to speculate on the chinese currency appreciating, this is one good way to also get money into / out of the country....making it difficult for China to really control the flow of money (as they would wish).  See our discussion on Mundell trilemma to see if you think this is sustainable. 

Links

for more:  http://en.wikipedia.org/wiki/Transfer_pricing