The new European Union probe into the tax deals of some multinational firms with a handful of European countries shines a spotlight on a narrow element of international tax law: transfer pricing.

Transfer pricing is, at its root, a relatively simple method for determining in which country a multinational company makes its profit. To help them do that, companies set prices at which they transfer goods and services between entities they own.

The idea is that if a company factory makes a widget in country A, and then ships and sells it through a company store in country B, the company only has to pay taxes in country B on the profit it makes from its markup over a reasonable "transfer price" for that widget—not the whole sticker price of the widget. The guiding principle, companies say, is for companies to pay income taxes only once on value they've created.

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What is Transfer Pricing?
But transfer pricing has become a flashpoint as governments bemoan the way big multinational firms use them to shift costs between units and avoid paying large amounts of corporate income tax within their borders. In principle, companies should assign "arms-length" transfer prices to their goods—as if they were selling to or buying from an independent entity. This can be difficult to do. That's especially the case when the "good" being transferred is, say, a license to exploit intellectual property in a particular country.

Moreover, many countries have different rules they use to assess transfer prices, leading to mismatches that companies can exploit as they assign their costs to different units. The Organization for Economic Cooperation and Development has overall guidelines for transfer pricing, including techniques such as "comparable uncontrolled price" and "the resale method," but disputes remain.

The OECD, a year ago, released an action plan to address the broader problem it describes as "base erosion and profit shifting," essentially the fact that countries can exploit differences in countries' tax laws to avoid paying much income tax in any jurisdiction. But work continues on implementing the plan.