It can achieve this by lowering the transfer prices of components going into the subsidiaries located in those tax jurisdictions having the lowest tax rates.Ī company should adopt those transfer prices that result in the highest total profit for the consolidated results of the entire entity. Ideally, the corporate parent wants to recognize the most taxable income in those tax jurisdictions where corporate income taxes are lowest. If a company has subsidiaries located in different tax jurisdictions, it can use transfer prices to adjust the reported profit level of each subsidiary. As a result, the upstream subsidiary may have too much unused capacity, and will have to cut back on its expenses in order to remain profitable.Ĭonversely, these issues are not important if corporate headquarters uses a central production planning system, and requires upstream subsidiaries to ship components to downstream subsidiaries, irrespective of the transfer price.Īn additional topic that impacts the overall level of corporate profitability is the total amount of income taxes paid.
If the manager of a downstream subsidiary is given the choice of buying either from an upstream subsidiary or an outside supplier, then an excessively high transfer price will cause the manager to buy exclusively from outside suppliers.
If the manager of a subsidiary is given the choice of selling either to a downstream subsidiary or to outside customers, then an excessively low transfer price will lead the manager to sell exclusively to outside customers, and to refuse orders originating from the downstream subsidiary. It forms part of the revenue of his subsidiary, and is therefore crucial to the financial performance on which he is judged. The manager of a subsidiary treats it in the same manner that he would the price of a product sold outside of the company. Transfer pricing impacts the purchasing behavior of the subsidiaries, and may have income tax implications for the company as a whole. Transfer pricing is the method used to sell a product from one subsidiary to another within a company. This approach is used when the subsidiaries of a parent company are measured as separate profit centers.