Transfer pricing is used to allocate costs to different parts of the same business that are trading with each other across locations or countries. It's both ethical and legal and is an important part of proper accounting. However, it must be conducted according to strict guidelines — otherwise it could be a tactic for avoiding tax payments.
Transfer pricing is a way to allocate resources over different locations to accurately account for the production costs in a specific location to accurately calculate income and tax liability. For example, a company that manufactures its products in Mexico and ships plastic parts from China should charge those plastic parts to the operations in Mexico, not to a U.S. manufacturing facility. However, the plastic part price must be taken into full account when the finished goods are finally trucked into the United States.
Generally accepted accounting principles, or GAAP, have legal guidelines for assigning costs that are at "arm's length" or basically within the same company or an interrelated firm. Essentially, GAAP instructs companies to compare the internal pricing to a market-based price to provide a final value. This guideline is called the comparable uncontrolled price method and states that an accountant should examine similar sales that aren't influenced by the company to determine a final value.
Transfer pricing has become an ethical issue as well because there are gray areas on the value that's place on any imported resource. A highly ethical corporation estimates the goods at their full value and then deals with the consequences of a higher tax burden. Firms with looser ethical policies may choose to assign an imported product's value to a more favorable location. This is especially true when it's a highly specialized piece of equipment that's not sold frequently on the open market.
Multinational corporations in the U.S. have a history of stretching the gray area with transfer pricing and tax evasion. Due to the United States' 35 percent tax rate, corporations often feel that it's better to book their profits in other countries where the corporate tax is lower. For example, General Electric used aggressive transfer pricing tactics to reduce its tax liability to virtually nothing in 2010, even though the company reported billions in profits to shareholders. They also used loss carry forwards, which apply tax credits for income losses from previous years to the current year.