Transfer pricing
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Understanding Transfer Pricing: Key Insights and Methods
Introduction to Transfer Pricing
Transfer pricing refers to the pricing arrangements for transactions between related business entities, such as divisions within a company or subsidiaries of a multinational enterprise (MNE). These transactions can include the transfer of intellectual property, tangible goods, services, and loans3. Transfer pricing is crucial for both compliance with tax regulations and strategic business management.
Importance of Transfer Pricing in Multinational Enterprises
Multinational enterprises face significant pressure to comply with transfer pricing regulations due to the potential for tax adjustments by foreign countries. This compliance is essential for managing tax risks and ensuring that inter-company transactions are conducted at arm's length, as per the OECD Guidelines8. Transfer pricing also plays a vital role in measuring the performance of responsibility centers and their managers within MNEs8.
Transfer Pricing Methods
Cost-Based Transfer Pricing
Cost-based transfer pricing methods involve setting transfer prices based on the costs incurred by the supplying division. These methods can include actual-cost transfer pricing, where prices are based on the actual production costs plus a markup, and standard-cost transfer pricing, where prices are predetermined by the central office or the supplying division2 6.
Research indicates that actual-cost methods with markups based on the joint contribution margin (contribution-margin transfer pricing) are more effective than purely additive markups (cost-plus transfer pricing)2. Additionally, centralized standard-cost transfer pricing is preferred when there is low cost uncertainty, while actual-cost methods are better when there is high cost uncertainty and sufficient cost information at the trading stage2.
Negotiated Transfer Pricing
Negotiated transfer pricing involves setting transfer prices through negotiation between divisions. This method can provide better investment incentives compared to cost-based methods, which may suffer from distortions in intra-company transfers4. However, negotiated transfer pricing can lead to "hold-up" problems, where divisional managers have insufficient incentives to invest due to the uncertainty of future negotiations4.
Full-Cost Transfer Pricing
Full-cost transfer pricing charges downstream units the full cost of production, including both variable and fixed costs. While this method can lead to a "death spiral" where production units face insufficient incentives to economize, it can also motivate managers to reduce costs and focus on products with the best sales prospects9. This method can serve as a credible commitment device to encourage cost management9.
Strategic Use of Transfer Pricing
Transfer pricing should not be limited to compliance and tax management. It can be a strategic tool for business management, helping to align corporate and personnel goals, motivate managers, and evaluate performance1 10. Future research should explore how transfer pricing can be used more meaningfully in strategic business decisions1.
Conclusion
Transfer pricing is a complex but essential aspect of business management, especially for multinational enterprises. By understanding and strategically applying various transfer pricing methods, companies can not only comply with tax regulations but also enhance their internal performance evaluation and investment incentives. Future research should continue to explore innovative ways to leverage transfer pricing as a strategic business tool.
Sources and full results
Most relevant research papers on this topic
What do we know about transfer pricing? Insights from bibliometric analysis
Transfer pricing research needs to move beyond compliance and tax management towards using it as a strategic tool in business.
Systematic Review
Highly CitedCost-based transfer pricing
Actual-cost methods dominate centralized standard-cost transfer pricing when cost uncertainty is low, while actual-cost methods dominate reported standard-cost transfer pricing when cost uncertainty is high and the buyer has insufficient cost information.
An introduction to transfer pricing
Transfer pricing is crucial for businesses, as it relates to inter-company pricing arrangements and is a key issue in global tax reform.
Negotiated versus Cost-Based Transfer Pricing
Negotiated transfer pricing often performs better than cost-based pricing, but cost-based pricing may be the superior alternative in certain situations.
Highly CitedTransfer Pricing – Choice
Transfer pricing within manufacturing companies can be categorized into cost, cost plus, market price, and dual pricing methods, with implications for both departments and the company as a whole.
A model of cost-based transfer pricing
A compensation system utilizing divisional managers' private information and cost-based transfer pricing can optimize profits in decentralized organizations.
Highly CitedTransfer Pricing Based on Actual Cost
Using an additive markup above the unit production cost improves the performance of actual cost-based transfer pricing, dominating alternative policies and increasing with product prices and decreasing with investment costs.
International transfer pricing in multinational enterprises
Multinational enterprises face increasing pressure to comply with transfer pricing tax regulations, requiring them to consider tax risk management in their transfer pricing decisions.
Full-Cost Transfer Pricing and Cost Management
Full-cost transfer pricing can lead to a death spiral in production units, but when production units are at risk, it can serve as a credible commitment device to motivate managers to reduce costs.
Transfer Pricing
Transfer pricing can create conflicts but can also motivate personnel and align corporate and personnel goals when practiced strategically.
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