As transfer pricing practitioners, we hear it so often we almost start to believe it: transfer pricing is “left pocket, right pocket,” its impact eliminated in consolidated financial statements. This assertion is not always intended dismissively, but is often used as a reason to delay, or “opt out" of, transfer pricing planning and compliance.
Fortunately for my ego and livelihood, there are several reasons this is not the case. Transfer pricing can affect both operating and net income at the consolidated level, and we’ll review a few of the most important below.
Effective Tax Rate Differentials
Transfer pricing’s most obvious and widely recognized effect on net income is in the Income Taxes Paid line. Say $100 in profit is split 50-50 via transfer pricing between Company A (income tax rate 20%) its related party Company B (income tax rate 30%). The total income tax on the transaction would be $25 ($10 at Company A and $15 at Company B). If the transfer pricing is adjusted such that profit is split 70-30 in favor of Company A, the total income tax on the transaction would be $23 ($14 at Company A and $9 at Company B). The change in transfer pricing policies produces a $2 increase in net income.
Customs, Tariffs, Withholding, and Value-Added Tax
As we have covered in previous posts, transfer pricing policies that affect the valuation of products, services, intangibles, or financial instruments can directly impact tariffs paid on said values. For example, adjusting a product's transfer price from the top of the arm's length range (say $100) to the bottom (say $80) may result in a $20 decrease to the base on which a tariff/customs duty is applied.
Optimizing transactional and operating models may also mitigate or even eliminate leakage from taxes such as withholding, due to favorable trade terms or treaties. These savings (or costs!) are not eliminated and feed into a company's consolidated bottom line.
Penalties and Interest
Last but not least, let's not forget that improper or deficient transfer policies and practices can lead to tax assessments, penalties, and interest. Failure to comply with transfer pricing rules in one justification can be costly for the company as a whole.
The Bottom Line
Think of transfer pricing not only as internal, eliminating transactions, but also as a driver of overall business profit and loss - and don't sleep on your compliance and documentation obligations!
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