Transfer pricing lies at the heart of the international tax regime because that regime is based on the distinction between residents and nonresidents. The easiest way to avoid residence-based taxation is to shift income from a resident to a nonresident, and the easiest way to do that is transfer pricing.

We will introduce the idea of transfer pricing through an example. Consider a situation with two corporations, called P and S, where P owns S. P manufactures widgets at a cost of 20 and sells them to S, and then S distributes the widgets at a cost of 20 and sells them to unrelated customers for 100. First let us calculate the total profit on this transaction. Total profit is calculated by taking the ultimate amount paid (in this example, 100) and deducting from it the various costs (in this case, distribution costs of 20 and manufacturing costs of 20). Thus the total profit in this case is 60. If P and S are in the same country, the situation is simple because they are both subject to tax on this profit in the same way at the same rate. If they are both in the United States, they both file an income tax return showing 100 of gross income minus 40 of deductions equals 60 of taxable income, and they would pay the 35 percent tax on that taxable income.