If your business operates across multiple entities (either domestically or internationally), you may have faced questions about how to set prices for transactions between related companies. This practice, known as transfer pricing, is often associated with large multinational corporations, but it can just as easily affect small and mid-sized businesses.
The challenge is that transfer pricing is anything but simple. Regulations are detailed, enforcement is strict, and the implications for tax compliance and financial reporting can be significant. Business leaders often find themselves uncertain about whether their approach will withstand scrutiny from tax authorities.
The good news is that by understanding how transfer pricing works, why it matters, and how to manage it effectively, your business can stay compliant while reducing unnecessary tax exposure.
What is Transfer Pricing?
At its core, transfer pricing refers to the rules and methods used to set prices for transactions between related entities within the same organization. These transactions may include the sale of goods, provision of services, use of intellectual property, or even loans between business units.
For example, if a U.S. company sells products to its subsidiary in another country, transfer pricing rules determine the price at which those products are sold. Governments enforce these rules to ensure that profits are not artificially shifted to low-tax jurisdictions.
In other words, transfer pricing ensures that intercompany transactions are conducted at “arm’s length,” meaning the same price that would apply if the transaction occurred between two unrelated parties.
Why Transfer Pricing Matters in Tax
Transfer pricing plays a central role in how profits are distributed across jurisdictions and, ultimately, how much tax a business pays. Tax authorities around the world closely monitor transfer pricing practices to prevent businesses from minimizing taxes by moving income to low-tax environments.
Failure to properly document or justify transfer pricing arrangements can lead to:
- Tax adjustments and penalties: Authorities may adjust reported income, resulting in higher tax liabilities
- Double taxation: Two countries may attempt to tax the same income, creating costly disputes
- Reputation risks: Transfer pricing audits can draw unwanted scrutiny from regulators and stakeholders
For businesses, this means transfer pricing should be treated as a critical tax compliance issue that can directly affect profitability. It also influences which intercompany expenses, such as management fees, royalties, or service charges, are considered legitimate tax deductions, making proper documentation essential.
Common Transfer Pricing Methods
To comply with regulations, businesses must select and document an appropriate method for determining transfer prices. The most recognized methods, outlined by the IRS and the OECD (Organization for Economic Cooperation and Development), include:
Comparable Uncontrolled Price (CUP) Method
Compares the price of a controlled transaction with that of a similar transaction between independent parties.
Resale Price Method
Starts with the price at which a product is resold to an independent party, then subtracts an appropriate margin.
Cost Plus Method
Adds a reasonable markup to the costs incurred by the supplier of goods or services in a controlled transaction.
Transactional Net Margin Method (TNMM)
Examines the net profit margin relative to sales, costs, or assets, compared to similar businesses.
Profit Split Method
Allocates combined profits among related parties based on their relative contributions.
Choosing the right method depends on the nature of the transaction, available data, and industry standards.
Key Considerations for Businesses
Businesses navigating transfer pricing must balance compliance, efficiency, and risk management. Key considerations include:
- Documentation Requirements: Tax authorities expect detailed records explaining how transfer pricing was determined
- Consistency Across Entities: Pricing policies should be applied uniformly to avoid red flags during audits
- Industry Benchmarks: Comparing margins and prices to industry norms strengthens compliance
- Cross-Border Complexity: Different countries enforce transfer pricing rules differently, increasing the need for careful planning
- Future-Proofing: As tax laws evolve, proactive transfer pricing strategies help minimize future disputes
Keeping these factors in mind can help businesses avoid common pitfalls and stay ahead of regulatory challenges.
Real-World Implications
Consider a U.S.-based manufacturer that sells products to its Canadian subsidiary. If the transfer price is set too low, most of the profits remain in Canada, potentially reducing the company’s U.S. tax liability. However, the IRS may view this as an attempt to shift income and could adjust the U.S. company’s income upward, resulting in additional taxes, interest, and penalties.
On the other hand, if transfer pricing is properly documented and based on an accepted method, the business can defend its position during an audit and avoid costly disputes.
Transfer pricing can also influence mergers and acquisitions. For example, buyers often review transfer pricing policies during due diligence to identify hidden tax risks. Well-documented practices can provide reassurance and help preserve business value in a transaction.
Ultimately, transfer pricing also impacts financial decision-making. By ensuring compliance and predictability in tax outcomes, businesses can focus on growth rather than disputes with regulators.
How DHJJ Can Help with Transfer Pricing
At DHJJ, we know transfer pricing can feel overwhelming, especially for businesses growing across borders. Our team of tax professionals and business advisors helps clients:
- Evaluate transfer pricing risks and opportunities specific to their industry and structure
- Develop and document transfer pricing policies that satisfy IRS and international requirements
- Benchmark intercompany transactions against industry standards
- Resolve disputes with tax authorities through strategic planning and support
- Stay ahead of evolving tax regulations with proactive strategies tailored to long-term goals
Our mission is to simplify the complex and help you make well-informed financial decisions. With DHJJ by your side, transfer pricing becomes less of a burden and more of an opportunity to structure your business efficiently and compliantly.
Final Thoughts
Transfer pricing is far more than a technical tax issue. It’s a strategic financial consideration for businesses with intercompany transactions. Without clear documentation and a defensible method, businesses can face costly adjustments, penalties, or even double taxation. But with the right approach, transfer pricing becomes less of a compliance burden and more of a strategic tool for managing your business effectively.
At DHJJ, we partner with businesses to simplify the process, reduce compliance risk, and provide peace of mind. If you’re uncertain about whether your transfer pricing practices can withstand scrutiny, now is the right time to take a closer look. Contact DHJJ today to start the conversation.
