In taxation and accounting, transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control. Because of the potential for cross-border controlled transactions to distort taxable income, tax authorities in many countries can adjust intra-group transfer prices that differ from what would have been charged by unrelated enterprises dealing at arm's length.
The rules of nearly all countries permit related parties to set prices in any manner, but permit the tax authorities to adjust those prices (for purposes of computing tax liability) where the prices charged are outside an arm's length range. Most, if not all, governments permit adjustments by the tax authority even where there is no intent to avoid or evade tax. The rules generally require that market level, functions, risks, and terms of sale of unrelated party transactions or activities be reasonably comparable to such items with respect to the related party transactions or profitability being tested.
USA Penalty Rule:
The burden of proof is on taxpayers to demonstrate arm's length transactions or face substantial penalties. The regulations impose a 20% non-deductible transactional penalty on a tax underpayment attributable to a transfer price that is 200% or more, or 50% or less than the arm's length price. The penalty is increased to 40% if the reported transfer price is 400°/0 or more, or 25% or less than the arm's length price. A net adjustment penalty could also apply if the net adjustment exceeds the lesser of $5 million or 10% of the taxpayer's gross receipts. However, the regulations provide rules that prevent the transactional penalty and net adjustment penalty from applying to the same underpayment.