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Transfer Pricing; Methods, Advantages and Disadvantages
By Candice Manko,
When a company decides to add other facilities in another state or even more so, when they choose to trade internationally, then they must act in accordance with the complex process of transfer pricing. Transfer pricing is known as the rates or prices that are established when selling goods or services between company departments, divisions, or even between a parent company and a subsidiary. Just in case you aren't aware, a parent company is what's known as a company who takes control over another company (or several companies) by owning a significant amount of it's voting stock. Whereas a subsidiary would be a company of which is owned and controlled by another. When it is used correctly, one of the many advantages of transfer pricing is that it can assist the company in managing its profit and loss ratios more efficiently. However, one of the most common disadvantages the company must look out for is double taxation. There are various methods and options that a company can pick and choose from in order to try and work their way through their desired advantages and undesired disadvantages.
Companies have three general methods that they can choose from when establishing their transfer pricing and each of them have their own advantages and disadvantages as well. The first option would be market-based transfer pricing, which is an act of pricing based off of a competitive and stable external market that is concerned with a similar transferred product or service. Through this method, the transfer will occur when it is in the best interests of the shareholders. If the shareholders do not prefer the transfer, it will be refused by at least one of the divisional managers. However, one of the disadvantages is that the prices for some commodities can undergo unpredictable price changes and can fluctuate widely and quickly. A second option could be cost-based transfer pricing, through which the pricing is based on the production costs. This method would require the specified notation of any costs (actual or budgeted, full or variable, as well as the amount of added markups, if any). Adding a markup to costs would be the result of adding a set amount to the cost of goods or services, which would then be charged to the buyer. One possible disadvantage of this method is the chance that the buyer might be able to source the product that is needed at a lower cost elsewhere. Lastly, the third method would be negotiated transfer prices, which is when the divisional managers negotiate a mutually agreeable price. One of the advantages of this method is that it creates the concept of which division managers buy and sell from one another in a manner that stimulates arm's length transactions. However, it is not guaranteed that the outcome of these price negotiations will serve the best interests of the company or the shareholders. Therefore the transfer price doesn't necessarily depend on profit-maximizing production and sourcing decisions, instead it could mainly depend on whichever manager is the better poker player.
One general advantage that all companies involved in transfer pricing can look out for and try to manage on their own, would be to establish high transfer prices for their goods and services and transfer them to a unit that is located in a jurisdiction that has low tax rates. This will result in the company having more revenue that is subjected to a lower tax rate and less revenue that is subjected to a higher tax rate. However, when the goods and services are traded in the opposite direction, from a low-tax rate jurisdiction to a higher tax rate jurisdiction, it is better to set the transfer price to as low as possible. This is not an illegal or bad way of working the system; in fact, in a way it sort of helps the shareholders out by creating ways to avoid paying unnecessary taxes.
A key element when working with transfer pricing is to maintain a buyer-seller relationship between units of a single company. Even though owners may not think that one location selling parts or services to another unit falls under this category, the various taxing authorities may think otherwise. This leads to a common disadvantage that unfortunately many companies that are involved in transfer pricing within different taxation authorities or jurisdictions have to deal with, which is double taxation. Double taxation occurs when a company is forced to obey the taxation authorities of two jurisdictions due to overlapping or conflicting tax laws and regulations. When companies are dealing with companies in another state it might be a good idea for them to look into their tax laws and regulations first to be sure of what method to choose when they begin their transfer pricing. It's a difficult process already to handle a business within one state, let alone having to prepare multiple tax filings and understand and follow multiple taxation methods as well. Nonetheless, it is better for a company who is involved in transfer pricing to have a knowledgeable understanding of the different ways they can increase their chances of experiencing the advantages while decreasing their chances of experiencing disadvantages.