Illegal transfer pricing can occur when affiliated companies trade with each other with the purpose of manipulating different geographic region for taxation purpose.

In a New York Review of Books by Raymond Baker, an example is given as such. When a company A makes a product at a cost of $1000 and then sells it to company B for $1,000, then company A did not make any profit and so there are no taxes being owed. Then company B sells to company C for $2,000 and therefore company B makes a profit of $1,000 but if company B was set up in a country that is a tax haven, then it doesnt have to pay much taxes or only a marginal amount. Company B then sells to Company C in another geographic area but at $1,500 and therefore making a loss of $500 which can be used to claim for tax purposes.

The key is that company A owns both company B and company C and thefore technically has made a profit of $500 and would need to pay taxes on that amount in the country that company A is in. So, when companies start setting artificial prices that are not within market norms for the benefit of tax savings, it can be deem as illegal transfer pricing. 

Tags: economics,transfer pricing by joeh in Business