Transfer pricing involves the assignment of costs to transactions for goods and services between related parties. Transfer pricing is typically used for purposes of financial reporting and reporting income to taxing authorities.
Transfer pricing is used to assign a cost to either tangible goods, intangibles or service transactions within an organization or related parties. For example, a business that manufactures clothing may have one business entity that produces the fabric. Since the business entity that produces the fabric does not formally sell it to the organization that cuts and assembles the fabric, transfer pricing is used to assign a sales price.
While transfer pricing is used to create financial statements and report income for tax purposes, it receives the most scrutiny from taxing authorities. Often, when products are produced in different countries or tax jurisdictions, organizations may utilize transfer pricing to assign the greatest profit to tax jurisdictions with the lowest tax rates.
To prevent businesses from assigning all profit to the lowest tax rate jurisdictions, most countries have stringent transfer pricing review processes. Most countries follow guidelines put forth by the Organisation for Economic Co-operation and Development (OECD). These guidelines allow a wide variety of methods to be used for setting transfer prices.