If your manufacturing company operates through two or more entities and is expanding into multiple states or even overseas, you need to become familiar with transfer pricing. While the term is typically associated with large, multinational corporations, manufacturers of various sizes may encounter transfer pricing issues.

Defining transfer pricing

Transfer pricing refers to pricing arrangements for transfers of goods or services between related companies in different jurisdictions. Examples of related companies include a parent and its subsidiary, or brother-sister companies with common ownership. Transfer pricing arrangements also include cross-border, related-party transactions involving intellectual property, such as patent or trademark licenses.

These arrangements may invite scrutiny because they're easily manipulated to reduce a company's tax liability by shifting income to jurisdictions with lower tax rates. For example, let's say that Parentcorp, a manufacturing company in a high-tax jurisdiction, has a wholly owned subsidiary, Subcorp, in a low-tax jurisdiction.

Subcorp manufactures component parts and sells them to Parentcorp, which, in turn, assembles them into finished products. Subcorp sells the components to Parentcorp at inflated prices, increasing Subcorp's taxable income and reducing Parentcorp's taxable income. In this example, the transfer pricing arrangement essentially shifts income to Subcorp's low-tax jurisdiction, reducing the enterprise's overall tax liability.

Understanding IRS regs

Transfer pricing regulations are complex. Generally, the IRS aims to prevent manipulation by requiring transactions between related companies to be roughly comparable to arm's-length transactions between unrelated companies.

Specifically, Internal Revenue Code Section 482 allows the IRS to distribute, apportion or allocate gross income, deductions, credits or allowances between or among related parties to prevent evasion of taxes or to clearly reflect the income of any parties. State tax rules vary and may mirror IRS rules.

Depending on the jurisdictions involved and the circumstances, there are a few methods for setting appropriate transfer prices. Two common methods are:

  • Comparable profits. This analyzes the profitability of comparable transactions involving similar companies.
  • Cost-plus. This applies a market-based markup to the "suppliers'" costs to arrive at a suitable profit.


In addition, many jurisdictions require companies to present documentation to support their transfer prices. Even if it's not required, maintaining documentation to back up an enterprise's transfer pricing is a best practice.

The penalties for noncompliance with transfer pricing regulations can be substantial. For example, in the United States, they can be up to 40% of the amount by which federal taxes are underpaid.

Protecting your manufacturing company

If transfer pricing becomes an issue for your manufacturing company, an audit by the IRS or other tax authorities can result in substantial assessments of back taxes, interest and penalties. So, it's a good idea to take steps to protect your company.

The first step is to conduct a risk assessment. Next, ensure you have appropriate transfer pricing policies and procedures in place based on your company's risk profile, corporate structure and activities. These policies and procedures should incorporate appropriate methods for determining arm's-length prices.

Finally, document your methodology to help support your position in case your transfer pricing arrangements are challenged. Even if not required, this documentation can smooth the audit process and help avoid or reduce penalties by establishing a good faith effort to comply with transfer pricing regulations.

Avoiding compliance issues

If your manufacturing company does business with related companies in other states or countries, stay on top of transfer pricing. Establishing reasonable transfer policies and practices will help your business avoid potential compliance problems. It also may reveal opportunities to reduce your enterprise's tax bills by adjusting transfer prices within acceptable limits.