What is transfer pricing? Basic concepts and why it matters

“Our headquarters supplies products to an overseas subsidiary. How should we set the price so that it doesn’t cause tax problems?”

If your company has overseas subsidiaries or affiliates, you have probably asked yourself this question. The area of tax law behind it is transfer pricing. Many finance and tax professionals still find it unfamiliar: what exactly is transfer pricing, and why should our company care?
 

What is transfer pricing?

Transfer pricing refers to the prices charged in transactions between related parties. A typical case is a parent company and its overseas subsidiary, which belong to the same group through ownership or control, trading goods or services with each other. These are often called intercompany transactions.

For example, a Korean parent company may supply raw materials to its Vietnamese manufacturing subsidiary or provide management consulting services to its U.S. subsidiary in return for a fee. Why do these prices matter for tax purposes? Here is a simple transfer pricing example.

Suppose a parent company supplies a product that costs 100 to its overseas subsidiary at a price of 100, and the subsidiary sells it to consumers at 150. Assuming no other costs, the parent earns no profit and the subsidiary earns 50. If the parent instead charges 120, the parent earns 20, and the subsidiary earns 30.

As this shows, the intercompany price determines how profit is allocated among group companies and countries, and because tax rates differ by country, it can also affect the group’s overall tax burden. That said, transfer pricing itself is not the problem. What matters is whether the price and the resulting profit allocation are appropriate, given the functions each company performs, the risks it bears, and the terms of the transaction.

The standard for judging this is the arm’s length principle. It tests intercompany transactions against the prices and terms that independent third parties would have agreed under similar conditions. Korea has adopted this principle in its Law for the Coordination of International Tax Affairs, and the OECD Transfer Pricing Guidelines serve as the common international standard.
 

Managing transfer pricing: What should you prepare?

If a tax audit finds that intercompany prices do not meet the arm’s length standard, additional transfer pricing tax may be assessed. If the counterparty country does not accept the adjustment, the same income may even be taxed twice. Responding to an audit also takes considerable time and cost.

To reduce these risks, it helps to prepare three things in advance:

1. Supporting evidence for arm’s length prices: written intercompany agreements (Transfer pricing agreements), records of actual transactions and services, and benchmarking against comparable transactions or companies.
2. Transfer pricing documentation: a report summarizing the transactions, each company’s role, and the basis for the pricing, checked against contracts, actual transactions, and financial data.
3. A consistent group-level pricing policy: headquarters and overseas entities should set and explain prices on the same basis, and day-to-day operations should be reviewed regularly to confirm they follow the policy (Operational transfer pricing).

Companies that meet certain thresholds are legally required to file transfer pricing reports in Korea, so check in advance whether this applies to you and keep the necessary records up to date. Without preparation, you may have to reconstruct past transactions in a hurry during an audit.
 

Conclusion

Transfer pricing may sound technical at first, but the core idea is simple: even between related companies, prices should be set as if dealing with an independent third party. Forvis Mazars provides transfer pricing services, from policy design and arm’s length analysis to documentation and audit support. If you would like to check whether your intercompany prices are appropriate, please feel free to contact us.