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Transfer Pricing

A well-planned and economically supportable transfer pricing policy can have a large impact on a company’s profitability. Learn about the current issues and potential solutions for transfer pricing in our digital world.

As international trade increases, many startups, especially in tech industries, are expanding overseas operations. As these startups expand globally, one of the challenges they face is transfer pricing. According to the 2019 Global Pricing Survey by Ernst & Young, 64% of respondents rank transfer pricing of goods as their most critical tax controversy, and it has been ranked at the top for many years.1 This article’s purpose is to introduce and address the issue of transfer pricing, identify how it affects not only large multinationals, but startups as well, and consider how companies can proactively address the inherent risks and opportunities within transfer pricing.

Transfer Pricing Effect on Business

A transfer price is the price charged for intercompany transactions between related parties. For example, a transfer price arises when transferring goods, services, loans, or intellectual property (such as the license of technology or marketing intangibles) between two related entities that may be subject to different tax rates and/or tax jurisdictions. Transfer pricing may also be between departments within a company, with each department being subject to different incentives. Although intercompany transactions between related parties are eliminated for financial accounting purposes, the related parties are legally separate and tax authorities treat these intercompany transactions differently.2 Therefore, these internal transactions are not eliminated for tax purposes and will have an impact on the consolidated company’s taxable income and tax liabilities, especially when the company operates in different countries that have different tax rules and rates. Tax authorities want to protect against tax-base erosion in their local jurisdiction, so they expect transfer prices to be arm’s length (i.e., consistent with what independent companies would charge for the same product, service, or right).


Regardless of company size, transfer pricing can create risk of double taxation if one tax authority does not agree that the pricing is consistent with the arm’s-length standard. However, transfer pricing can also be an opportunity for companies with the appropriate supporting analysis to justify the increase or decrease of taxable income in one jurisdiction or another. In the following example, we will see how appropriate transfer pricing can help Pepper Co. (Pepper), a U.S. corporation, lower their overall tax liability.

Pepper Co. and Salt Co. Cash flow figure with license and royalty payments

If Pepper’s proprietary technology is used in another jurisdiction which happens to have a lower tax rate than the U.S. (e.g., Ireland), Pepper would set up a corporate subsidiary (Salt) that would be a tax resident in Ireland and sign an intercompany license agreement allowing Salt to use Pepper’s technology in return for a 10% royalty fee on Salt’s annual gross revenues.

Assume that Salt’s gross revenues are $10 million, cost of sales are $4 million, other operating expenses are $3 million, and their royalty expense to Pepper is $1 million (10% of $10 million), leaving them with $2 million in taxable income. At an assumed tax rate of 12.5% in Ireland3 (which is much lower than the U.S. corporate rate of 21%), Salt would owe $250,000 in Irish taxes, which is $170,000 less than Pepper would have paid on the same amount of taxable income in the U.S.

In this scenario, the royalty rate is the transfer price, with Ireland being the location where Pepper would prefer to recognize more of its taxable income, all else being equal, given the difference between the corporate tax rates. If Pepper could economically support a lower royalty rate (transfer price), they would decrease the amount of overall tax liability. For example, a 5% royalty rate would mean that Salt’s royalty expense would decrease by $500,000 annually, effectively moving $500,000 in taxable income from the U.S. to Ireland, saving the company $42,500 in annual taxes by having $500,000 of taxable income subject to Ireland’s 12.5% tax rate instead of the U.S. rate of 21%. The table below shows these relationships:

Salt Co.
10% Royalty (in thousands) 5% Royalty (in thousands)
Gross Revenue Gross Revenue
Cost of Sales Cost of Sales
Operating Expenses Operating Expenses
Royalty Paid Royalty Paid
Pre-Tax Income Pre-Tax Income
Ireland Tax (12.5%) Ireland Tax (12.5%)
Pepper Co.
10% Royalty (in thousands) 5% Royalty (in thousands)
Operating Income4 Operating Income
Royalty Received Royalty Received
Pre-Tax Income Pre-Tax Income
U.S. Tax (21%)5 U.S. Tax (21%)
Overall Tax Liability
10% Royalty (in thousands) 5% Royalty (in thousands)

As shown in the example above, a well-planned and economically supportable transfer pricing policy can lower a company’s overall tax liability, which is beneficial for a startup because it will increase the company’s cash flow and potential valuation. Proactively designing a transfer pricing policy and being able to strategically support having more income in certain jurisdictions by aligning business functions with the policy is a strategy that many successful companies have employed, sometimes saving them millions of dollars a year.6 Tax authorities are aware of these considerations and have created rules that try to eliminate base erosion and profit shifting, oftentimes as the result of aggressive and unsustainable transfer prices. In our example above, if Pepper used a 5% royalty fee, but the U.S. tax authorities claimed that a 10% royalty fee was arm’s length, they could tax Pepper as if they earned the 10% royalty fee, causing the company to be double taxed for the additional 5%.

Managerial Decisions

Outside the impact on taxes, transfer pricing also affects a company’s managerial accounting, especially when it occurs between departments and each department must account for its own profit. In a downstream sale, where an upper division sells a good or service to a lower division, a higher transfer price will increase the income of the upper division while forcing the lower division to bear the higher cost and suffer lower profit. This will affect the profitability of the upper and lower divisions in opposite ways and could result in bias in performance evaluation of the divisions. A misaligned transfer pricing policy may also lead to incorrect business planning and internal disputes. This misalignment can occur for transactions between domestic entities or between departments within one entity; transfer prices differing from the market value will be advantageous for one entity or department, while increasing the costs of the other, potentially masking actual results.

Tax Penalties

Tax authorities around the world have started to concentrate more effort on regulating transfer pricing over the past few years. The G207 secured political commitment in 2013 to counter Base Erosion and Profit Shifting (BEPS) issues, and they tasked the Organization for Economic Co-operation and Development (OECD) with developing a series of recommendations for stronger international cooperation on corporate tax.8 The World Bank has also cooperated with tax authorities from different countries outside the OECD member countries to provide international guidance for transfer pricing policies. In the U.S., the IRS has the authority to adjust taxable income of related parties to reflect the true earning of each party and impose penalties on underpayments, as shown in the Internal Revenue Code sections 482 and 6662. Violation of transfer pricing compliance regulations may expose a company to serious scrutiny and penalties under audit. The current penalty for transfer pricing misconduct is 20% of the tax-adjustment amount and can be up to 40% of the tax-adjustment in some cases if no transfer pricing documentation exists contemporaneous with the filing of the corporate income tax return.9

Choosing the Appropriate Transfer Price

Both the OECD and the IRS emphasize that to properly reflect the true income of the company, the price of all internal transactions must be determined using the arm’s-length standard.10 This standard specifies that the income realized in the transactions between related parties must be consistent with the income that would be realized from a transaction with unrelated parties under similar conditions. This means that the transfer price should be close or equal to the price charged to an unrelated third party on a similar transaction. A transaction performed by an unrelated party at arm’s length is called an “uncontrolled” transaction. In contrast, a controlled transaction occurs between two or more “associated enterprises,” i.e., related parties. According to the OECD, enterprises are related if:

  1. An enterprise participates directly or indirectly in the management, control or capital of another enterprise or,
  2. The same persons participate directly or indirectly in the management, control or capital of two enterprises.11

Transfer Pricing Methods

Along with the arm’s-length standard, the IRS also requires companies to follow the “best method rule” when documenting their transfer pricing. The “best method rule” specifies that the method used to support a company’s transfer prices must “provide the most reliable measure of an arm’s length result.”12 The OECD and the IRS give examples of common methods that could be used to document transfer pricing:

  1. Comparable uncontrolled price (CUP) method

           CUP method evaluates the transfer price by referring to the price of a similar transaction between unrelated parties. The CUP method is the most reliable and direct way to apply the arm’s-length standard.

         2. Cost plus method

           The cost-plus method is often used by manufacturing companies to support their transfer pricing. Using this method, the transfer price is calculated by taking the cost of goods or services and adding a markup that reflects the profits and risks associated with the transaction. The markup can be determined by using the markup applied on a comparable transaction between the company and unrelated parties.

         3. Resale price method

           To apply this method, the company first identifies the resale price of a similar transaction with an unrelated party. Then, the transfer price is calculated by reducing the resale price by a gross margin, which could be decided using the gross margin from a similar transaction between unrelated parties.

         4. Profit split method

           Sometimes both associated enterprises are involved in the production and consumption of goods or services in a controlled transaction; therefore, it can be difficult to determine how to split the costs and allocate income. When a company uses the profit split method, it begins by identifying the total operating profit realized from the transaction. Then, this profit is split between related parties using the division of profit that simulates the results if two independent parties were to engage in the same arm’s-length transaction.

         5. Comparable Profits Method (CPM)

           This method evaluates whether the amount charged in a controlled transaction is arm’s length based on profitability measures that would be realized by unrelated parties in a comparable transaction. The CPM is known as the transactional net margin method (TNMM) in countries outside the U.S. This method is commonly used because it utilizes publicly accessible external financial data showing the result of comparable transactions, making it easier to implement.

Transfer Pricing Issues and Solutions

One of the main challenges in designing and documenting a transfer pricing policy is choosing an appropriate method, because the process often involves a certain level of management judgment, which may be scrutinized by tax authorities. According to the IRS and OECD, there are two factors that a company needs to consider when choosing the appropriate transfer pricing method:

  • Transfer pricing is all about benchmarking your internal transaction to a similar market transaction. Comparability measures the similarity of the controlled and uncontrolled transactions. In the process of determining comparability between transactions, the company needs to account for several criteria such as the similarity of operations, cost structure of goods or services, contractual terms, and risks.
  • A company must determine the level of reliability of the data and assumptions that were used in setting the transfer price. When considering the reliability of data and assumptions, the company needs to consider the completeness, accuracy, and potential deficiency of the data.

Since the question of appropriate transfer pricing is a complex balance between economics and tax regulations, it often requires significant judgment and documentation to appropriately support the company’s position. According to EY’s 2019 transfer pricing survey, only a third of companies maintain contemporaneous documentation, with only 11% indicating high satisfaction with their current global transfer pricing documentation process.13 Inadequate documentation can result in a lack of support for transfer pricing policies.

Political Scrutiny

Another challenge in transfer pricing is an increase in political, and even media, scrutiny. Currently, a common transfer pricing strategy used by companies is to locate the ownership of intellectual property in tax-favorable jurisdictions and then use licensing to sell the product and earn revenue globally. This strategy is facing more intense scrutiny as tax authorities around the world release new rules to diminish a company’s ability to move income into low-tax jurisdictions and effectively erode the tax base in the country where the company is headquartered. The 2017 Tax Cuts and Jobs Act (TCJA) in the U.S. created the GILTI (global intangible low tax income) tax to discourage companies from using intellectual property to shift profits out of the U.S. GILTI taxes earnings that exceed 10% of a company’s foreign assets at a rate between 10.5% and 13.125% annually. In the same year, the UK released a Diverted Profits Tax (DPT), which taxes 25% of profits that the tax authority considers to be artificially diverted out of the UK. Similar legislation has been drafted in China and Australia and is being considered by other countries.14

The G20 and OECD are currently working on solving tax challenges arising from digitalization, which is commonly referred to as BEPS 2.0. The recent and rapid growth of digital transformation in the globalized economy has led to discussion about reallocation of taxing rights. This reallocation plans to address the question of business presence in a country when a company may have many digital customers or consumers but limited or no actual physical presence. BEPS 2.0 looks to ensure a minimum level of tax is paid by multinational enterprises and determine what portion of profits could or should be taxed in jurisdictions where the users are located.15

Potential Solutions

One of the best solutions to transfer pricing challenges is proactively designing an appropriate transfer pricing policy and preparing adequate documentation using one of the five methods described above, rather than seeking a justifiable method after the transfer price was determined. Companies should collect written statements from management regarding business strategy and what drives value across the organization. Contracts, accounting data, and invoices related to controlled transactions should also be maintained and updated regularly. Additionally, companies should have global policies in place regarding the setting and documentation of transfer pricing to increase consistency and transparency among their entities, as well as to be prepared if tax authorities ever audit their transfer pricing.

Transfer pricing is an area that often faces great scrutiny by tax authorities. One way companies can proactively deal with this issue is through using an advance pricing arrangement (APA) or mutual agreement procedure (MAP). An APA is an agreement between the company and the tax authority that allows the company to identify supportable transfer pricing policies that will be applied in the future. While only 37% of companies are currently using an APA, 57% of respondents to EY’s survey say they are either very satisfied or satisfied with their APA. A MAP is an agreement between tax authorities that can help resolve potential disputes regarding double taxation. Both APAs and MAPs are great tools that provide business solutions for transfer pricing ahead of time and allow the company to have more control in transfer pricing planning. Although these methods bring certainty, they are often expensive to implement, and thus may not be the right solution for startups with limited resources.


A well-planned transfer pricing strategy can have a huge impact on a company’s profitability, risk profile, and potential valuation. Transfer pricing is a complex area that requires management judgment and often faces intense scrutiny from tax authorities. Your company should be aware of the main transfer pricing issues and work proactively with external advisors, internal employees, and tax authorities to create a transfer pricing policy that is economically supportable. Choosing an appropriate method for transfer pricing and providing the necessary documentation are critical for justifying your pricing policy to tax authorities.

  1. EY Transfer Pricing and International Tax Survey 2019
  2. Journal of Accountancy October 2013
  3. EY’s 2019 Worldwide Corporate Tax Guide (pg. 745)
  4. For simplicity, operating income here represents the net of revenues, cost of sales, and other operating costs before considering the royalty received from Salt.
  5. U.S. Corporate Tax Rate as of 2020 is 21%; for simplicity, we disregarded the U.S. tax credit for foreign taxes paid.
  6. For example, see how Uber designs their transfer pricing policy to save on taxes here: Fortune Magazine: How Uber Plays the Tax Shell Game
  7. The G20 is an international forum of central bank governors and governments from the world’s largest economies, including 19 individual countries and the European Union.
  8. OECD/G20 Inclusive Framework on BEPS: Progress Report
  9. 26 U.S. Code § 6662 – Imposition of accuracy-related penalty on underpayments
  10. 26 U.S. Code § 482 – Allocation of income and deductions among taxpayers
  11. OECD: Model Tax Convention on Income and on Capital and Transfer Pricing Asia: What is a Controlled Transaction?
  12. Treas. Reg. §1.482-1(c) –Best Method Rule
  13. EY Transfer Pricing and International Tax Survey 2019 pg. 5
  14. PwC “From startups to stalwarts: Transfer pricing in the technology sector”
  15. OECD “Tax Challenges Arising from Digitalization”