Transfer pricing matters because it determines where a multinational business reports its profits and how much tax it pays in each country. Since related companies can decide the prices they charge each other, tax authorities want to ensure those prices are fair and are not used to shift profits to countries with lower tax rates.
In the United States, the IRS carefully reviews transactions between related companies. Under IRC Section 482, the IRS can adjust a company’s income or deductions if it believes the transfer prices do not reflect what independent businesses would have agreed to under similar circumstances.
For example, a U.S. company may buy products from its related manufacturing company in another country. The amount the U.S. company pays for those products is recorded as a business expense. Since business expenses reduce taxable income in the U.S., the transfer price directly affects how much U.S. tax the company pays.
If the U.S. company pays more than an independent business would normally pay for the same products, it claims a higher business expense. This reduces the U.S. company’s taxable income in the United States.
At the same time, the higher payment becomes additional income for the related company overseas. As a result, more profit is reported outside the United States instead of in the United States.
If the IRS determines that the transfer price is higher than the arm’s-length price, it may adjust the transfer price under IRC Section 482. This increases the U.S. company’s taxable income and may result in additional U.S. tax, interest, and penalties.
On the other hand, if the U.S. company pays less than the arm’s-length price, its business expenses are lower than they should be. As a result, it reports higher taxable income and pays more U.S. tax than necessary. In most cases, the company cannot later ask the IRS to reduce its taxable income or claim a refund simply because the transfer price was too low.
Further, generally, a transfer-pricing adjustment can result in the same income being taxed in both the United States and another country. In that situation, the U.S. company may be able to seek relief from double taxation through the IRS, typically via the competent-authority process under an applicable tax treaty.
However, in certain situations, a business may be able to ask the IRS and the foreign tax authority to correct the transfer price if it causes the same income to be taxed twice.
Getting transfer pricing wrong can have serious consequences for companies, including the following:
Transfer pricing also affects whether certain cross-border payments, such as management fees, royalties, service charges, or interest, can be deducted for U.S. tax purposes. Businesses should therefore establish reasonable transfer prices and maintain proper documentation to support them.
In short, transfer pricing is not just a tax compliance requirement. It helps businesses allocate profits fairly, comply with U.S. and international tax laws, reduce audit risk, and avoid costly tax disputes.
You may be wondering whether transfer pricing rules apply to your business.
Next, let’s look at which businesses are subject to U.S. transfer pricing rules and the types of cross-border transactions that typically fall within their scope.