Transfer pricing, which allocates profits and losses among different parts of a multinational entity for tax and related purposes, can have a significant financial effect on your supply chain because the companies in a commonly controlled supply chain must comply with transfer pricing rules and regulations in determining what companies should recognize what amounts of income, deductions, credits, and allowances among the various tax jurisdictions.

Transfer pricing regulations, which are governed under section 482 of the tax code that authorizes the IRS to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent evasion of taxes in the US, and which must follow OECD Transfer Pricing Guidelines, can be quite complex, but as this recent article in Industry Week on what manufacturers need to know about transfer pricing, most regulations are based on one underlying principle: the arm’s length principle.

The arm’s length principle is the condition or the fact that the parties to a transaction are independent and on an equal footing. Transactions based on the arm’s length principle are arm’s length transactions and used in contract law to arrange equitable agreements that will stand up to legal scrutiny, even though the parties may have shared interests or are too closely related to be seen as completely independent. The principle requires that the amount charged by one party to another (related) party must be the same as it would be if the parties were not related. An arm’s length price is the same price that an independent company would pay for a good or service.

This sounds pretty easy until you get into international transactions when trying to split profits and you have to figure out who bears the product liability, the risk of currency fluctuations, and so on. At this point, most multinationals will use a transfer pricing study that performs a detailed analysis of the functions performed, assets employed, and risks borne by each party in the transaction. This will provide a justification of the cost breakdown that will stand up to regulatory and legal scrutiny.

For more information on transfer pricing, see the Transfer Pricing Network in the US, the Cole & Partners Transfer Pricing Site in Canada, or the Transfer Pricing Forum in the EU. Understanding the profit breakdowns will help you understand the cost savings that Procurement directly and indirectly generates for the supply chain.