• Explanation

Transfer pricingThe amount used to measure the cost of goods transferred between entities that are part of a related group of entities. is the amount charged by one group (eg, Company A) to another group (eg, Company B) for transactions between entities under common control. The objective of transfer pricing is to generate tax savings for the consolidated parent (ie, Company C) by allocating revenues to entities in low-tax countries (ie, Company A) while assigning costs to entities in high-tax countries (ie, Company B).

Companies must exercise caution in their transfer pricing strategies because these transactions are subject to strict guidelines. The IRS website requires that transfer pricing "yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances."

A transfer price of $200 maximizes after tax profits of $170 ($200 revenue less 15% tax of $30) for Company A and also for the parent Company C (the parent). In this scenario, Company B is only purchasing goods and therefore does not have revenue or profit from this transaction (Choices A and C).

(Choice B) A transfer price of $100 results in $85 after tax profits for Companies A and C ($100 revenue less 15% tax of $15).

Things to remember:
Transfer pricing assigns costs to exchanges of goods and services between entities under common control. The objective is to maximize profits by generating revenue in the country with the lower tax rate while incurring purchase cost in the country with the higher tax rate.

Lecture References :

• BEC 1.06 : Economic Concepts : Financial Risk Management