Lecture 3 Notes
Transfer pricing (Intercompany Transactions)
the determination of price at which transactions between related parties are carried out
Treatment is the same as a sale to an outside customer.
› Revenue to the selling unit
› Cost to the buying unit
› Upstream transfers go from subsidiary to parent, while downstream transfers are from
parent to subsidiary
Profit maximization and, by extension, cost minimization are important corporate
objectives.
Manipulating transfer prices between countries is one way for MNCs to achieve cost
minimization
The most common approach is to minimize costs by shifting profits to lower tax rate
jurisdictions.
Decentralization
Decentralized companies are organized by division and division managers have significant
authority
It allows local managers to respond quickly to changing environment
This structure decomposes problems into smaller pieces
Motivates local managers who otherwise will be frustrated if asked only to implement
decision of others
Disadvantage = An agency problem can occur since division managers make decisions in
their self-interest instead of the interests of the organization
Agency Problem (An agency problem is a conflict of interest inherent in any relationship
where one party is expected to act in another's best interests.)
Performance Evaluation Systems and management control
Transfer prices directly affect the profits of the divisions involved in an intercompany
transaction. Some performance evaluation systems are based on divisional profits.
Effectiveness of these performance evaluation systems is influenced by the fairness of
transfer prices.
Effectiveness of performance evaluation systems affects the satisfaction of managers.
The performance evaluation objective is better served by the negotiated transfer price.
The cost minimization objective is better served by the discretionary price.
SOLUTION forDual pricing (using two different TP) = use of discretionary and negotiated TP for tax
and performance evaluation purposes respectively
Decentralization and Goal Congruence
The system used for evaluating the performance of division managers is important for GC.
Transfer pricing affects operating profit and performance measurement of
divisions/subsidiaries/business units
Objective of Transfer pricing
The transfer pricing issue is even more troublesome when it involves multinational divisions
located in "tax haven" countries.
Other cost minimization objectives
› Avoidance of withholding taxes
› Avoidance of profit repatriation restrictions
› Minimization of import duties
› Protect cash flows from currency devaluations
› Improve competitive position of foreign operation
Role of Transfer Pricing in GC
Appropriate transfer prices can ensure that each division or subsidiary’s profit accurately reflects its
contribution to overall company profits.
› Transfer Pricing Methods:
Cost-based transfer price
Market-based transfer price
Negotiated transfer price
Government Reactions and Ethical Concerns
Governments are aware of risk that multinationals will use transfer pricing to avoid paying
income and other taxes.
Most governments publish guidelines regarding acceptable transfer pricing.
The guidelines typically use the notion of an arm’slength price.
Arm’s-length price is the price that would be agreed upon by unrelated parties
Transfer Pricing Methods for Tangible Property (according to U.S. Treasury Regulations)*
1. Comparable uncontrolled price method (CUP).
Transfer price is determined based on reference to the company’s sales of the same product
to an unrelated buyer.
Reference to transactions between two unrelated parties for the same product are
acceptable.
2. Resale price method.
Generally used when the affiliate is a sales subsidiary and simply distributes finished goods ›
Transfer price is determined by deducting gross profit of the reseller from the price charged
by the sales subsidiary (selling division). › Gross profit is determined by reference to
uncontrolled parties. › The most important factor in choosing this method is the similarity in
function of the affiliated sales subsidiary and the uncontrolled reference company › Other
factors includes – inventory levels and turnover rates, contractual terms (warranties, credit
terms etc), sales, marketing and advertising programs, level of market
3. Cost-plus method.
Most appropriate when comparable uncontrolled transactions don’t exist and sales
subsidiary does more than simply distribute finished goods › Transfer price is determined by
adding mark-up to the cost of production. › Mark-up/gross profit is determined by reference
to uncontrolled parties. › Factors influencing the comparability of uncontrolled transactions
include: complexity of manufacturing process, procurement activities, and testing functions
4. Comparable profits method.
Underlying principle is that similarly situated tax payers should earn similar returns over a
period of time › One of the two related parties in the transactions is chosen for examination
› Transfer price is determined via reference to an objective measure of profit of an
uncontrolled company involved in comparable transactions. › Typical measures of profit
include: ratio of operating income to operating assets and operating income to sales.
5. Profit split method
Treats the two related parties as one economic unit. › Profit from the eventual sale to an
uncontrolled party is allocated between the related parties. › Allocation is based on relative
contribution of each party. › Contribution is determined by functions performed, risk
assumed, and resources employed. › There are actually two versions; (i) comparable profit
split method and (ii) residual profit split method.