When you have facilities in more than one tax jurisdiction.
It's hard enough for a company to do business when it's situated in only one state, but consider the complexities when it adds facilities in another state--or, even worse, when it goes international. In addition to having to prepare multiple tax filings, a business with far-flung facilities suddenly must contend with another complication: transfer pricing--in which local tax authorities view a company division in one political venue as a customer and/or a supplier of a related division in another political venue. The upshot is that the cost of any goods or services the two units exchange must be determined when the company calculates each unit's tax liability.
This article examines the process--including its tax, accounting and corporate profit implications.
If you think transfer pricing affects only big companies, think again. Size is immaterial. The only condition that triggers transfer pricing is the existence of multiple facilities in more than one taxing jurisdiction. For example, a company with 45 employees in five locations in two states would activate transfer pricing concerns if one of its offices provides data processing, payroll or other services to the others. Similar situations arise in manufacturing, when one division ships parts or unfinished products for final assembly at another location in a different jurisdiction.
A key element is a buyer-seller relationship between units of a single company. Although owners and managers may not think of one location as "selling" services or parts to another unit, the various taxing authorities--whether state or national--may impose that view. Under such circumstances, a company has to determine the monetary value of the goods or services and treat that amount as sales revenue of the "selling" unit and as a cost of the "buying" unit. Companies establish transfer prices in a variety of ways. Two of the most popular are by estimating competitive market prices and by adding a markup to costs.
To illustrate, look at Example, Inc., a producer of telephones and related equipment at its Alpha division, which is situated in an urban U.S. community with high taxes on property and income. Competitive pressures combined with those high taxes prompted Alpha to look for lower tax jurisdictions for expansion. An opportunity arose when a supplier offered to sell its entire operation. The supplier has two facilities: one, Beta, is in a state with no income tax; and the other, Gamma, is in Canada, near the U.S. border.
Beta produces a variety of molded plastic parts, including the hard-plastic exteriors or "shells" of telephones, using raw plastic purchased in bulk. Excluding shells, much of Beta's output is shipped to Gamma, where it is combined with purchased parts to create telephone subassemblies. As a result of the planned acquisition, Example will produce shells at Beta for sale to unaffiliated or "outside" entities and also will produce shells for its own use in final assembly at Alpha and for subassemblies at Gamma; some of these subassemblies will be shipped from Gamma to Alpha for final assembly. In addition, Alpha will provide marketing and administrative services for all three locations.
A danger that Example will want to avoid is being "whipsawed" between the taxing authorities of two jurisdictions--that is, having its sales revenue from a single source taxed in two jurisdictions because of overlapping or conflicting tax rules. Further, because Alpha is in a high-tax state, any transfer pricing system that shifts taxable income away from Alpha will probably be challenged almost automatically by the state in which Alpha is situated.
In most states, companies compute taxable income using the federal income tax rules as the starting point; however, in determining the portion of their net income subject to tax by each state, companies typically use allocation and apportionment formulas--which, unfortunately, vary from state to state. …