Transfer pricing refers to the pricing of transactions between companies under common ownership, such as a parent company selling goods or services to its subsidiary. These are known as “controlled transactions,” and tax authorities across jurisdictions monitor them closely.

Because transfer prices affect where profits are reported and, ultimately, where taxes are paid. To ensure fairness, authorities require these intercompany transactions to follow the arm’s length principle, meaning they should be priced as if the parties were unrelated and negotiating on open market terms.

In simple terms, even though companies are part of the same group, they must transact as if they were strangers. There are no “family discounts” allowed. If a parent sells cupcakes to a subsidiary, the pricing must mirror what it would charge an unrelated third party.

Transfer pricing gets even more complex when cross-border trade is involved. Tariffs - government-imposed duties on imported goods - add another layer of cost and compliance.

Here’s the challenge:

• Customs authorities want to see a reasonable import price for tariff calculation
• Tax authorities want to ensure that profits aren’t being artificially shifted between jurisdictions.

These objectives can sometimes clash. A higher declared import price might appease tax authorities but lead to higher tariffs. A lower price may save on duties but trigger tax authority concerns. Multinationals must navigate this delicate balance carefully.

A U.S. distributor buys products from an overseas affiliate and earns a 4% operating margin as a limited-risk entity. When tariffs are introduced, import costs surge. If the distributor absorbs these costs, that slim margin could vanish, possibly resulting in a loss.

Should the distributor bear the full burden, or should the overseas manufacturer - also part of the group - share in the cost? These are fundamental questions that call for a reassessment of risk allocation and pricing strategy.

Consider a contract manufacturing setup in Indonesia earning a 7% markup. With new tariffs making imports more expensive in the U.S., that margin might no longer be justifiable. The company must either lower that markup or accept squeezed profits elsewhere in the supply chain.

In both cases, tariffs are reshaping the financial dynamics, and companies must adjust their transfer pricing models accordingly.

When facing shifting tariffs, companies typically consider three options:

• Exit the market: Rarely desirable, especially in large or strategic markets where significant investments have already been made
• Wait and see: Often the riskiest option. Prolonged inaction can lead to losses in parts of the group, attracting unwanted scrutiny from tax authorities who expect that independent businesses wouldn’t operate at a loss without justification
• Plan and adapt: The most effective approach.

A strategic response begins with a simple but critical question: Who should bear the cost of tariffs?

If a company wishes to maintain its existing structure, it might consider adjusting its benchmarking analysis. For example, if the entire market is experiencing lower margins post-tariff, the group may be justified in updating its transfer pricing expectations.

Alternatively, the group could reallocate risk. For instance, transforming a limited-risk distributor into a full-risk entity gives it more operational responsibility - and more profit potential - but also a fair share of the costs, including tariffs.

Regardless of the path chosen, documentation must be updated. Intercompany agreements, transfer pricing policies, and supporting justifications should reflect the revised economic realities. A mismatch between documentation and actual business conditions can quickly raise red flags with regulators.