What You Need To Know About Operational Transfer Pricing

Operational transfer pricing is an important topic as tax authorities pay more attention to how companies manage their transactions with overseas subsidiaries. When a company operates in several countries, it must go beyond theoretical discussions of how profits are attributed based on functions, assets, and risks, and actively prepare for the day-to-day aspects of transfer pricing.

In this article, we'll explore the practice of operational transfer pricing, showing you why it’s important and what you need to know to use it successfully.

What is operational transfer pricing?

Here’s an operational transfer pricing definition in its simplest form: It is the practice of pricing individual intercompany transactions to accurately reflect transfer pricing policies.

For example, if a U.S. manufacturer sells 1,000 different SKUs to its Irish subsidiary, which, as a routine distributor, should earn a 4% operating margin under the company transfer pricing policy, the company must price each of the 1,000 SKUs in a way that ensures the Irish distributor will earn its 4% margin.

Operational transfer pricing is widely used in industries that sell tangible goods across borders. (Tweet this!) It increases in complexity as the number of countries involved increases, or when a company manufactures and sells a lot of different product types.

A well-executed operational transfer pricing strategy has many benefits:

It helps avoid unnecessary tax leakages or customs costs.

If the Irish distributor must pay customs duties on 500 of the 1,000 products, for example, the U.S. manufacturer will want to take this into account. Overpricing the products could result in overpaying duties. Conversely, if the company reduces the price later in the year, there's no guarantee they will get those customs duties back.

It reduces financial risk.

If a company misprices its intercompany transactions, it likely would face increased scrutiny from the tax authorities in the jurisdictions in which it does business. Done well, operational transfer pricing can help you properly manage your financial statements and global tax burdens.

Companies can always make adjustments to a year-end or quarterly statement to make sure their financial results are consistent with arm’s length transfer pricing. However, planning an operational transfer pricing strategy that is consistent and correct from the start reduces potential risks.

It provides foresight.

Companies can identify potential issues in advance and fix them before they develop into major problems. Waiting until year-end to sort out issues would only serve to complicate matters, so it makes sense to get all company financials in order ahead of time.

Operational Transfer Pricing Considerations

There are three areas you must understand to succeed at operational transfer pricing:

1. Intercompany transactions—You must understand the intercompany transactions at the lowest level of detail possible, potentially product category or SKU.
2. Financial records—Assess the information available in the company's financial systems, including full cost information for the products it manufactures. Get a good idea of the market sales prices and operating expenses.
3. Company policies—Consider the financial results that the transfer pricing policies are trying to achieve. Which entities are targeting specific returns? Which entities are the risk-takers?

When you bring these three aspects together, you can develop a holistic picture of what the company is doing now, and how you can improve your pricing model.

If a company’s financial operations are more complex, with multiple layers of international transactions, the more difficult and time-consuming it will be to maintain proper transfer pricing. It isn’t always possible to make something perfect. Ultimately, it may be best to plan your transfer pricing policy in a way that covers 90% of possible situations you may encounter, and then you can deal with the outliers separately. Very often, the perfect is the enemy of the good.

Valentiam offers a tailor-made solution for operational transfer pricing.

Companies can adopt a basic approach to transfer pricing by managing it in-house with spreadsheets or using some type of operational transfer pricing software. However, software doesn't always work well because transfer pricing is unique to each company, depending on your industry, your products, and which countries you operate in currently.

Transfer pricing is a complex matter that can be difficult for companies to navigate without guidance, particularly when you deal with several layers of international transactions. For example, if you manufacture goods in China, ship them to Germany for packaging, then sell them in the U.S. to end users, you have three layers to consider—and three tax jurisdictions for which you need to manage your transfer pricing.

Valentiam has the world’s leading transfer pricing advisors under one roof. We take the time to get an intimate understanding of your company, its financial systems, current transfer pricing policies, and product flows to design a transfer pricing strategy tailored specifically for you. We immerse ourselves in the details to understand where your company is now—and what your leaders have planned for the future. To find out how we could work with your tax team to optimize your transfer pricing policies, schedule a discovery call today.