Transfer pricing is the method by which related companies determine the price for doing business with each other.
For example, a U.S. company may buy products from its overseas affiliate or pay its foreign office for customer support. The price charged for these transactions is called the transfer price.
Since the companies are related, they could choose almost any price they want. U.S. tax law prevents businesses from using unrealistic prices solely to reduce their taxes or shift profits to a lower-tax jurisdiction.
For example, suppose a U.S. parent company pays its Indian subsidiary an inflated price for buying components. Through the inflated price, the U.S. parent company pays more than the arm’s-length amount. This results in the parent company effectively transferring funds to India.
This means more profit is reported in India and less profit remains taxable in the United States. Tax authorities closely monitor such pricing to ensure it reflects what independent parties would have charged under similar conditions.
Next, let’s understand the meaning of transfer pricing under U.S. Tax Law.
The primary transfer pricing rule is found in Internal Revenue Code (IRC) Section 482.
This law allows the IRS to adjust the income or expenses of related companies if the prices they charged or paid do not fairly reflect the profits. In simple terms, the IRS expects related companies to deal with each other as though they were completely independent businesses.
One of the foundations of U.S. transfer pricing is the arm’s length principle. Next, let’s understand the meaning of the arm’s length principle.
The arm’s length principle means that the price charged between related companies should be similar to the price that two unrelated businesses would have agreed to under similar circumstances.
Suppose an independent company would have paid $100 for a product or service. The related companies should generally charge a similar amount unless there is a valid business reason for a difference.
Let’s understand the concept of the arm’s length principle through a simple example.
Example:
ABC Furniture Inc. is a U.S. company that owns a manufacturing subsidiary in Ireland. The Irish subsidiary makes office desks and sells them to the U.S. parent company. The U.S. company then sells the desks to customers in the United States.
The price the U.S. company pays its Irish subsidiary is called the transfer price.
Suppose an independent furniture manufacturer would normally sell the same desk for $250. Under the arm’s length principle, the U.S. company should also pay about $250 per desk to its Irish subsidiary.
Now assume the U.S. company pays $295 instead.
The customer in the United States still pays $300 for the desk. However, because the U.S. company pays more to buy the desk, it keeps less profit. At the same time, the Irish subsidiary earns more profit.
The table below compares the profits when the transfer price is $250 (the arm’s-length price) and $295 (the actual price charged).
Profit Comparison (Per Desk)
| Item | Arm’s-Length Price ($250) | Actual Transfer Price ($295) |
| Selling price to the customer | $300 | $300 |
| Transfer price paid to the Irish subsidiary | $250 | $295 |
| Profit earned by the U.S. company | $300 − $250 = $50 | $300 − $295 = $5 |
| Additional profit earned by the Irish subsidiary | $0 | $50 − $5 = $45 |
As we can see from the above table, if the U.S. company had paid the arm’s-length price of $250, it would have earned $50 of profit on each desk. Instead, because it paid $295, its profit falls to $5 per desk.
The remaining $45 of profit is earned by the Irish subsidiary. In other words, $45 of profit has been shifted from the United States to Ireland.
Now let’s see how this affects the taxes paid by the group.
Assume the following corporate tax rates:
U.S. corporate tax rate: 21%
Irish corporate tax rate: 12.5%
| Scenario | U.S. Taxable Profit | U.S. Tax (21%) | Irish Profit | Irish Tax (12.5%) | Total Tax |
| Arm’s-length price ($250) | $50 | $10.50 | $0 | $0 | $10.50 |
| Actual transfer price ($295) | $5 | $1.05 | $45 | $5.625 | $6.675 |
By charging $295 instead of $250, the group shifts $45 of profit from the United States to Ireland.
Because the United States taxes corporate profits at 21% and Ireland taxes them at 12.5%, the group pays less tax overall.
At the U.S. corporate tax rate of 21%, the U.S. tax decreases from $10.50 to $1.05 per desk.
As a result, the U.S. company reports less taxable income and pays $9.45 less U.S. tax on each desk sold. This reduction in U.S. taxable income is one of the main reasons the IRS closely reviews transfer prices between related companies.
If the IRS determines that $295 is not an arm’s-length price, it may adjust the transfer price back to $250. This increases the U.S. company’s taxable income by $45 per desk, and the company may have to pay additional U.S. tax, interest, and penalties.
Next, let’s look at why transfer pricing is so important and why foreign businesses should pay close attention to these rules in the United States.