The "transfer price" is the amount charged by one segment of an organization for a product or service that it supplies to another segment of the same organization. The economic reason for charging transfer prices is
to be able to evaluate the performance of the group entities concerned. By charging prices for goods and services transferred within a group, managers of group entities are able to make the best possible decision as to whether to buy or sell goods and services inside or outside the group. About half of the major groups in the world transfer goods and services internally on the basis of a cost-oriented system. Some MNEs use only variable costs, other full costs, and still other use full costs plus a profit mark up (cost-plus method). Some use standard costs, other actual costs.
When there is a competitive open market for the products or services transferred internally, an alternative method is to use the market price as a transfer price. The market price may be derived from published price lists for similar products and services (external market price) or it may be the price charged by a group entity to its external customers (internal market price). Sometimes, the transfer may take place in an earlier stage of production instead of as marketable unit. In this case, by subtracting costs and a reasonable profit of the last internal stage from market price, tansfer price can be determined.
Apart from the cost-based methods and transfer prices based on open market prices, a third way is negotiation among group entities like independent parties. The transfer price resulting from such
negotiations is equally acceptable from a business economics point of view.
THE ARM'S LENGTH PRINCIPLE
Prices set for transactions between group entities should - for tax purposes - be derived from prices which would have been applied by unrelated parties in similar transactions under similar conditions in the open market.
This is the so-called "dealing at arm's length" principle, which is the international standard for transfer pricing matters.
PRACTICE AMONG MNEs
In 1992 the International Bureau of Fiscal Documentation sent a questionnaire on the use of transfer pricing methods to about 150 large MNEs in 20 countries.
Seventy answers from 12 countries provided useful information.
Main sectors of activity were: oil and chemicals, electronics, finance, forestry, metals, pharmaceuticals, retailing and textiles.
Per country the following pattern appears:
Belgium:
Germany:
large majority uses cost-plus/resale price,
goods and services: if CUP is available it is used, but nevertheless the majority applies cost-plus or
resale price;
intangibles: majority applies CUP.
CUP: Comparable Uncontrolled Price
Netherlands;
goods and services: almost all use cost plus or
resale price;
intangibles: great majority use cost-plus/resale
price, some CUP or mixed methods.
Switzerland:
large majority use cost-plus/resale price,
services: cost-plus;
intangibles: CUP.
goods and services: a clear majority applies costplus/resale
price;
intangibles: equally divided over CUP, cost-plus
and other methods.
The surevey reveals a clear dominance of the cost-plus and resale price methods in the case of goods and services. CUP is better represented with respect to intangibles. Some respondents indicated that internal CUPs were used: prices charged by group members to non-related clients.
Reference
http://archivo.cepal.org/pdfs/1995/S9500513.pdf
Updated 2 May 2016, 8 Dec 2011
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