Many multinational companies manufacture products in one country and sell them to their subsidiaries in other countries. The subsidiary may use those goods to manufacture finished products or simply resell them to customers.
For example, suppose ABC Manufacturing Inc. is a U.S. subsidiary of a Singapore parent company.
The Singapore parent manufactures components and sells them to ABC Manufacturing. ABC Manufacturing uses these components to make finished products and sells them to U.S. customers for $100 per unit.
The price ABC Manufacturing pays its Singapore parent for the component is called the transfer price.
Suppose an independent supplier would charge $40 per component under similar circumstances. Under the arm’s-length principle, the Singapore parent would generally be expected to charge a similar price.
Now suppose the Singapore parent charges ABC Manufacturing $70 per component instead.
The U.S. company is paying $30 more than the assumed arm’s-length price.
That extra $30 is an additional expense for the U.S. company. As a result, the U.S. company’s profit decreases by $30, while the Singapore parent earns an additional $30.
In simple terms, $30 of profit has shifted from the U.S. to Singapore.
Profit Comparison
Arm’s-Length Price: $40 | Actual Transfer Price: $70 | |
Selling price to U.S. customer | $100 | $100 |
Amount paid to Singapore parent | $40 | $70 |
Profit remaining in U.S. | $60 | $30 |
Additional profit earned by Singapore parent | $0 | $30 |
Tax Amount (21% rate) | $12.60 ($60×21%) | $6.30 ($30×21%) |
The calculation is simple:
At the $40 arm’s-length transfer price: $100 − $40 = $60 U.S. profit
At the $70 actual transfer price: $100 − $70 = $30 U.S. profit
So, if the US paid $70, the U.S. subsidiary has $30 less profit, while the Singapore parent has $30 more profit.
Now let’s see how this affects taxes in both countries.
Tax Impact
For this simplified example, assume:
If the Transfer Price is $40.
The U.S. subsidiary earns $60 of profit.
U.S. tax: $60 × 21% = $12.60
The Singapore parent does not receive the additional $30 in this example.
So, the combined tax shown in this simplified example is $12.60 per unit.
If the Transfer Price Is $70
The U.S. subsidiary earns only $30 of profit.
U.S. tax: $30 × 21% = $6.30
The Singapore parent receives the additional $30 of profit.
Singapore tax on that additional profit:
$30 × 17% = $5.10
Therefore:
$6.30 U.S. tax + $5.10 Singapore tax = $11.40 combined tax
Simple Tax Comparison of Combined Tax
Transfer Price | Line Number | ||
Transfer Price | $40 | $70 | A |
Cost paid by customers | $100 | $100 | B |
U.S. profit | $60 | $30 | C = B-A |
U.S. tax rate | 21% | 21% | D |
U.S. tax | $12.60 | $6.30 | E = C x D |
Singapore profits due to making less payment | $0 | $30 | F |
Singapore tax rate | 17% | 17% | G |
Singapore tax | $0 | $5.10 | H = G x F |
Combined tax | $12.60 | $11.40 | I = E +H |
The difference is:
$12.60 − $11.40 = $1.20
Therefore, under these simplified assumptions, the higher transfer price results in $1.20 less combined tax per unit.
The U.S. tax decreases by $6.30 (see line number E in the above table), while the Singapore tax on the additional $30 of profit is only $5.10 (see line number E in the above table).
This illustrates why transfer pricing can be important when related companies operate in countries with different tax rates.
If the IRS determines that the price does not reflect an arm’s-length price, it may adjust the transaction under IRC Section 482. The company could also face interest and potentially penalties, depending on the circumstances.