Transfer Pricing: What It Is and How It Affects Investors

SmartAsset Team

Sun, Mar 9, 2025, 12:08 PM 5 min read

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Transfer pricing refers to the pricing of goods, services and intellectual property transferred between related entities within a multinational corporation. Companies use transfer pricing to allocate costs and revenues across different jurisdictions, which can impact taxable income and financial reporting. While the practice is legal, tax authorities scrutinize the details of how it is done in order to prevent improper profit shifting and tax avoidance. A financial advisor can also help investors analyze a company's transfer pricing strategies to better assess potential regulatory risks and their impact on earnings.

Transfer pricing is the method multinational corporations use to set prices for transactions between their subsidiaries, affiliates or divisions operating in different tax jurisdictions. These transactions can involve goods, services, intellectual property or financial arrangements. Since the parties to the transactions are under the control of a single entity, companies can choose how they allocate costs and revenues across their global operations within the boundaries of tax rules.

The primary purpose of transfer pricing is to reflect the economic value of transactions while optimizing tax liabilities and regulatory compliance. A common approach employs the arm's length principle. This method requires that prices between related entities resemble those that unrelated parties would agree to in an open market. This principle is a cornerstone of international tax regulations and is enforced by tax authorities to prevent artificial profit shifting.

Let's consider a multinational corporation, which has a U.S.-based parent company and a subsidiary in Ireland. The U.S. parent develops proprietary software and licenses it to its Irish subsidiary, which sells the software to customers in Europe.

To determine the licensing fee, the multinational must follow transfer pricing regulations to align the fee with what an unrelated company would charge under similar conditions. If the U.S. parent charges the Irish subsidiary $50 per license, but an independent company would charge $100 per license, tax authorities might argue that the multinational is charging its subsidiary less than it should so it can shift profits to Ireland, where corporate tax rates are lower.

If the U.S. tax authority determines the fair market price should have been $100, it could adjust multinational's taxable income, requiring additional taxes and penalties. On the other hand, if the company correctly applies the arm's length principle, it can justify the transfer price, reducing the risk of regulatory scrutiny.