Transfer pricing is a key part of U.S. tax law that affects both U.S. and foreign businesses. It applies when related companies buy or sell goods, provide services, license intellectual property, or enter into other cross-border transactions.
Whenever one related company provides goods or services to another, the receiving company should pay for them. The price charged by the selling company is called the transfer price. For example, if a U.S. parent company purchases products from its own foreign subsidiary, the subsidiary will issue an invoice to the U.S. parent. The amount shown on that invoice is the transfer price.
Under Internal Revenue Code (IRC) Section 482, the transfer price should be the same as the price that two independent, unrelated businesses would have agreed to under similar circumstances. This is known as the arm’s length standard. In other words, related companies should not charge each other more or less than what an independent business would charge for the same transaction.
The transfer price affects the taxes of both related companies. The company selling the goods or services generally records the receipts as income, while the company buying them records it as an expense. If one related company is in the United States and the other is in another country, the transfer price determines how much profit each company reports in its country. Since taxes are generally based on net profits, the transfer price can also affect how much tax is likely accrued in each country.
Because transfer prices determine where profits are reported and taxed, the IRS closely reviews these transactions. Understanding the U.S. transfer pricing rules helps businesses set appropriate prices, reduce the risk of transfer pricing adjustments, avoid double taxation, and minimize interest and penalties.
Next, let’s understand the meaning of transfer pricing under U.S. tax law.