What is transfer pricing?
A commonly used transfer pricing definition is “the price charged by one member of multinational organization to another member of the same organization for the provision of goods or services or the use of a property, including intangible property.”
In other words, transfer pricing relates to the price applied to intercompany transactions. These transactions can include the sales of products, the provision of a service, the lending of money and the use of (intangible) assets.
From a business perspective, transfer pricing is important for assessing the performance of business units of multinational companies and the managers of those business units.
Transfer pricing from a tax perspective is relevant for the allocation of profits between the various legal entities and branches of multinational companies. Local governments have an interest to tax a ‘fair share’ of the profits of multinational companies, i.e. the part of the profit that is realized in their jurisdiction. Hence, they have an interest in a proper allocation of profits to the various subsidiaries of a multinational companies.
The leading principle in transfer pricing is the arm’s length principle: the principle that requires associated enterprises to charge the same prices, royalties and other fees in relation to a controlled transaction that would be charged by independent parties in an uncontrolled transaction in otherwise comparable circumstances.
In other words, the prices and conditions applied between related companies should be equal to the prices and conditions charged between independent companies. It is important to remember that transfer pricing does not only relate to pricing: other conditions of intercompany transactions, such as delivery, warranty and payment terms, should be arm’s length as well.