What it is

In all but the simplest companies, it often happens that one unit of the firm provides a good or service to another unit, which uses it in a product it sells to the outside world.  In some cases, unit #1 has no customer other than unit #2; likewise, unite #2 may have no other source than the internal one, unit #1.

For management control purposes–figuring out whether the units are earning money or doing a good job in other ways, as well as for other reasons I’ll write about below, companies want to decide a notional price at which unit #1 “sells” its output to unit #1.  That selling price is called the transfer price. The process of figuring out what the price is is transfer pricing.

Three ways companies use transfer pricing–

Management control:

There are lots of ways of figuring out the transfer price, all with their plusses and minuses.

The process can be complicated.  Unit #1, for example, may have external customers as well as internal ones.  Unit #2 may have external sources of supply in addition to the internal one.  However, internal and external customers may have somewhat different requirements, so products available on the open market may not be strictly comparable to the internally produced ones.  So market price may be hard to use.  The competitive situation within an industry may also argue against selling to or buying from certain external parties.  In addition, cost-plus, another common method, may just institutionalize inefficiency.

The process can also be intensely office-political.  This stands to reason, since a dollar of notional profit that goes into the bonus pool of unit #1 is a dollar that stays out of the bonus pool of unit #2, and vice versa.  In well-managed companies, everyone is slightly unhappy and things work out for the best.  In poorly-run firms, internal pricing may reflect the delusions of the chairman or testifies to the infighting skills of the most “profitable” units–an creates horrible distortions that end in ruin.

Tax planning:

Except for the smallest and simplest companies, there’s no reason that different units in the firm have to be in the same tax jurisdiction.  In fact, there may be very good reasons to have them located in different states or different countries.

When I began investing in the Japanese stock market, I soon came across lists of the financial results of foreign brokers located in Tokyo.  Virtually every one was making huge losses.  As I asked around to try to figure out why this should be, I found out that many trading transactions were legally structured to occur in Hong Kong instead of Japan.  Why?  The total tax on profits for a transaction done in Tokyo would be over 50%.  In Hong Kong, the tax would be zero. So Tokyo had the costs of maintaining research, sales, a trading desk and investment banking–and the trades were farmed out to Hong Kong.

At one time, many computer manufacturing operations were set up in Ireland, which offered tax incentives, had a low income tax rate and was inside the EU.  Let’s say you make a PC in Ireland and ship it to the UK (a high tax-rate regime) for sale to a consumer electronics store.  Should you set the transfer price from manufacturing subsidiary to distribution subsidiary high or low?  Obviously, high–unless you had tax loss carryforwards in the UK that you wanted to use up.

You can see the effects of this sort of activity in the low tax rate reported by publicly traded companies with extensive foreign operations.

Twenty years or more ago, investors didn’t like low tax rates.  Theorizing that the phenomenon was only temporary, the custom in the UK was for analysts in their reports to explicitly correct or “normalize” the tax rate to whatever the (higher) norm was for a purely domestic company.  In the US, investors mostly made a mental adjustment and paid a correspondingly low p/e for the stocks of low tax-rate companies.

Today as far as I can see, no one makes this distinction.

There is one hitch to the low tax rate strategy.  For the US, and also typically elsewhere, if the profits held in a low tax-rate regime are repatriated to the home country, they are subject to tax at the full home-country corporate rate.  And unless repatriated, the funds can’t be used to pay dividends.

Foreign exchange controls:

Some countries, developing nations in particular, may regard their holdings of hard foreign currency as a scarce national resource.  So they restrict companies’ ability to convert local currency profits into foreign currency and send them out of the country.

The most straightforward of the ways creative companies try to get around such policies is through transfer pricing.  A foreign company with a subsidiary in a developing economy will typically act as the sole agent for purchases of foreign materials and equipment for its sub, as well as being the distributor of its finished goods abroad.  The parent can aggressively mark up the foreign currency price of the materials supplied to the domestic company.  And the local sub will sell finished goods at very low prices to the parent, so that the lion’s share of profits will be realized in hard currency and outside the developing nation.