Financial Planning & Analysis

Transfer Pricing Methods & Other Insights for Multi-Company Operations

As businesses grow and business leaders look for new opportunities and markets for their product, the idea of expanding into foreign geographies becomes attractive and strategically appropriate. However, favorable market conditions can lead executives to move forward before fully considering the business arrangements between the U.S. entity and the newly formed foreign entity. Let’s cover how transfer pricing methods and other techniques can make financial planning & analysis more effective for multi-company operations. 

Typically, the parent company will create a foreign corporation that will perform the distribution and sales function in the new locale. The new corporation will be staffed with local sales and operations personnel. Product will be shipped from a U.S. manufacturing facility, or a sub-contracted manufacturer, to the new foreign business unit. However, if both entities are inadequately compensated for the products and services provided or performed then various inconsistencies may arise relative to income tax and customs & duties liabilities.

When expanding internationally, transfer pricing methods, royalty arrangements, and service agreements need to be fully considered and defined such that income tax and customs & duties liabilities can be appropriately managed and reported for all domestic and foreign entities in a controlled group. Without appropriate consideration, problems that may arise include:

  • Improper transfer pricing on goods manufactured domestically by the parent company and sold to the foreign subsidiary;
  • Omission of royalty payments by the foreign entity to the parent company for trademark usage the use of or other intangible assets or where the domestic parent company manages the production of goods performed by a subcontract manufacturer; and
  • Lack of reimbursement to the parent company for support services provided to the foreign subsidiary for accounting, legal, IT or other necessary services.

Our Example Scenario

To illustrate the issues that arise, let’s assume a controlled group of companies is engaging in transactions between each other. The parent company is located in the United States and manufactures some of its products in its own U.S. factory.

Additionally, when it is economically viable, the domestic parent company also contracts with various foreign manufacturing subcontractors to produce product that carries a trademark or involves a patent. The domestic parent company then sells the goods it produces to their foreign corporation, or the parent directs the foreign subsidiary to purchase goods produced by the sub-contracted manufacturers.

Let’s also assume the parent company provides accounting, legal, IT, HR and other administrative services to the controlled foreign subsidiary.

Keeping Things at Arm’s Length

When products or services transfer from the parent company to the foreign subsidiary, the transactions must be conducted in an arm’s-length manner, with each entity appropriately receiving or appropriately paying the market price for value received or value provided. Without adequate consideration and documentation to support these intercompany transactions, the following irregularities may occur based on the example:

  • Income for both entities may be misstated, as the transfer pricing methods for goods by one entity to another may not adequately reflect an arm’s-length transaction, thus causing the exchange price to be too low or too high. If the transfer price is too low, higher profits will be reported and accumulate in the foreign entity. Conversely, if the price is too high, the domestic entity will recognize higher profit. If a tax audit of the under-reporting entity were to occur, the consolidated group could experience additional taxation due to a reassessment of the transfer price by the taxing authority resulting in higher income for that unit. The adjustment of taxable income and the related tax liability under this scenario may not be recoverable in the opposing tax jurisdiction as the ability to amend filings may expire and/or other penalties may apply.
  • Income for the parent company may be understated due to the lack of a royalty arrangement for the use of company trademarks or for supply arrangements from by a sub-contract manufacturer where the domestic parent company manages all aspects of product sourcing. This will result in higher than appropriate income to the foreign subsidiary and lower than appropriate income to the entity managing the subcontracted manufacturing activity.
  • Income for the parent company may be understated to the extent that there are unbilled services provided by the parent company to the foreign subsidiary. When one company in the controlled group provides administrative services, for example, to another entity within that group and there is no compensation for such services, this will result in higher than appropriate income to the foreign subsidiary and lower than appropriate income for the organization providing services.
  • Customs & duties assessments relative to product shipments may be understated. If incoming product is not reported at the appropriate value, customs & duties relative to the destination country will be understated. In the event of an audit by authorities, the value could be restated, and an assessment levied. Penalties and interest would also be assessed. The higher customs & duties fee may not be deductible by the foreign subsidiary due to the timing or other restrictions that may apply.
  • Cash may build up in the foreign subsidiary due to excess profits, relative low transfer pricing methods, lack of a royalty agreement, and lack of a service agreement. When excess profit accumulates in a foreign corporation, distributions of those profits back to the US parent may be subject to a withholding tax by the foreign government.

About Transfer Pricing Methods

To avoid these risks, the U.S. parent company should perform a transfer pricing study to evaluate the intercompany transactions between the U.S. parent company and the foreign entity and determine the appropriate price. Transfer pricing refers to rules and methods for pricing transactions between multinational firms under common control where such transactions for goods, services, or intangible property are made across international borders. Various governments have adopted transfer pricing rules, which are based on the arm’s-length principle. Most developed nations have adopted similar measures through bilateral treaties, domestic legislation, regulations, or administrative practice. Countries with transfer pricing legislation generally follow The Organization for Economic Co-operation and Development (OECD) guidelines in most respects, although important exceptions may apply.

When intercompany transactions have been identified, the following pricing methods and considerations would then be reviewed to determine pricing for such transactions involving the exchange of goods and services between the related entities.

Selection of Pricing Method(s) to Apply to Transactions

  • The Comparable Uncontrolled Price (CUP) Method is a transactional method that determines the arm’s-length price using comparable transactions between unrelated or 3rd parties. Most countries consider the CUP method to be the most direct method. The method allows for price adjustments due to volume or terms, but otherwise relies on comparable transactions between unrelated parties or it may use comparable transactions between the parent or controlled party and unrelated parties.
  • Cost-Plus Method is where goods or services provided to unrelated parties are consistently priced at actual cost plus a fixed markup.
  • Resale Price Method (RPM) is where goods are regularly offered by a seller or purchased by a retailer to/from unrelated parties at a standard list price less a fixed discount. (Gross margin method is similar to resale price method and recognized in a few tax jurisdictions.)
  • Profit-Based Methods are used when pricing does not rely on actual transactions. Use of these methods may be necessary due to the lack of reliable data for transactional methods. In some cases, non-transactional methods may be more reliable than transactional methods because market and economic adjustments to transactions may not be reliable. These methods may include:
    • Comparable Profits Method (CPM): Profit levels of similarly situated companies in similar industries may be compared to an appropriate tested party.
    • Transactional Net Margin Method (TNMM): While called a transactional method, the testing is based on profitability of similar businesses.
    • Profit Split Method: Total enterprise profits are split in a formulary manner based on econometric analyses.

Most systems allow use of multiple methods to determine the transfer price for goods, but these different methods must be supported by reliable data. Most governments have granted authorization to their tax authorities to adjust prices charged between related parties. Many such authorizations, including those of the United States, allow domestic as well as international adjustments. Some authorizations apply only internationally.

The rules of nearly all countries permit related parties to set prices in any manner but permit the tax authorities to adjust those prices (for purposes of computing tax liability) where the prices charged are outside an arm’s length range. Most governments permit adjustments by the tax authority even where there is no intent to avoid or evade tax. The rules generally require that market level, functions, risks, and terms of sale of unrelated party transactions or activities be reasonably comparable to such items with respect to the related party transactions or profitability being tested.

Intangible Property Considerations

Valuable intangible property tends to be unique, and there may be no comparable items. The value added by use of intangibles may be represented in prices of goods or services, or by payment of fees (royalties) for use of the intangible property. Licensing of intangibles thus presents difficulties in identifying comparable items for testing. However, where the same property is licensed to independent parties, such license may provide comparable transactional prices. The profit split method specifically attempts to take value of intangibles into account.

Service Considerations

When enterprises engage related parties (e.g., the parent or sister company) to provide services they need, two issues exist with respect to charges between related parties for services. First, whether services were actually performed which warrant payment, and second, the price charged for such services. Transfer pricing rules recognize that it may be inappropriate for a component of an enterprise performing such services for another entity to earn a profit on such services. However, where services performed are a key aspect of its business, OECD and U.S. rules provide that some level of profit is appropriate to the service performing component. The cost-plus method, in particular, may be favored by tax authorities and taxpayers due to ease of application.


In order to execute the transfer pricing policy, the results of the study should be documented in a report to support the pricing for the intercompany transactions. After the completion of the report, a license and service agreement should be drafted and executed as appropriate. Together the transfer pricing study, the license agreement, and the service agreement should fully outline the terms of service and compensation for the intercompany transactions that occur between the related parties.

With a well-documented study and supporting agreements in place for cross border transactions, the risk of non-compliance with regulatory authorities, additional tax assessments and unnecessary withholding taxes would be greatly reduced in domestic and foreign geographies while remaining as tax efficient as possible.

About Commissioning a Transfer Pricing Study

A transfer pricing study should be performed by a subject matter expert, typically a certified tax professional or CPA, in tandem with senior financial management to ensure a complete and accurate study. Most national accounting firms possess the expertise required. However, many regional firms like ours also possess the ability to perform the engagement.

When picking a partner, keep in mind the expert should have experience designing and implementing transfer pricing models and specifically understand economic pricing methods, key pricing considerations for multinational companies, global transfer pricing regulations, and financial reporting and FIN 48 considerations.

When conducting a transfer pricing study, all the transactions occurring between the related entities should be reviewed—as well as the legal structure, the organizational structure (including organizational charts), job descriptions, product flow, and selling activities—to determine what activities are performed by the parent company and what activities are performed by the subsidiary. This portion of the study may involve face-to-face interviews with functional area leaders. The purpose of this review is to identify which products and services are provided by the parent to the foreign subsidiary and, therefore, should be included in study for the determination of pricing.

If you’re looking for help with transfer pricing, or if you’re thinking about bringing in financial consultants, then contact us! We’d be happy to help you define your needs and offer advice on next steps. We also offer related insights into creating an financial forecasting process in our ebook:

financial forecasting process guide

About the Author

Susan is a CPA with 20+ years of diverse finance and accounting experience in various industries including manufacturing, technology, apparel and real estate.  She is an Ernst and Young alumnus who has held leadership roles at Fortune 500, middle market and entrepreneurial companies as Controller, VP of Finance and CFO. These companies have included Power-One, Clipper Windpower, Allied Signal, and Special Devices among others. Susan has provided financial leadership and project management to accounting organizations, including turnaround and restructuring projects, creating international tax structures, implementing IFRS, managing internal and external financial reporting, system implementation and leading finance and accounting efforts for divesture, acquisition and process re-engineering. Susan holds a BS in Accountancy from San Diego State University.

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