 Transfer pricing

 Determination of price on the exchange of goods or services between related

parties
 Also referred to as intercompany transactions
 Upstream transfers go from subsidiary to parent, while downstream transfers
are from parent to subsidiary
 Transfers also occurs between different subsidiaries of the same parent
 Significant proportion of international transactions are intercompany transfers
(In 2016, represented 42.4% of U.S. total goods trade)

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2 factors that influence transfer price
1) Objectives that headquarters wishes to achieve such as
management control and performance evaluation
 Minimization of one or more types of costs
 Sometimes these objectives conflict
2) laws governing the manner in which intercompany transactions
that cross borders may be priced [countries have set up laws to
make sure multinational corporations (MNCs) don’t avoid paying
their fair share of taxes

9-3
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 Padre Inc., a U.S. company, has two subsidiaries, Hijo and Hija.
Hijo is located in Chile and Hija in the U.S. The tax rate is 17
percent in Chile and 35 percent in the U.S. Hijo transfers 100 units
of cosa to Hija at a negotiated transfer price of $10 per unit. The
cost per unit is $5 for Hijo, and Hija sells the units in the U.S. at
$15 per unit. Padre intervenes to set the transfer price at $13 per
unit.

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 Decentralized companies are organized by division and division managers have
significant authority
 Permits local decision making which provides more responsibility for division
managers
 An agency problem can occur since division managers make decisions in their
self-interest
 Manager’s self-interest can vary with the best interests of the company
 An effective accounting system can alleviate this agency problem by
providing incentives to division managers to act in the interests of the
organization
 This is referred to as goal congruence
 These concepts are relevant to both multinational and purely domestic
companies 9-5
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1) Cost-based Transfer Price: transfer price based on cost to produce; could
include fixed costs and possibly a mark-up (cost plus pricing)
 Potential problems
 What cost to use (variable cost, standard cost, absorption cost etc.)
 No incentive for selling division to manage costs [standard costing can help
address this problem]
2) Market-based Transfer Price: transfer price based on price charged to unrelated
parties
 Avoids inefficiencies of one division impacting other division
 Helps ensure divisional autonomy

9-6
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 Market-based transfer price
 Must have efficient market to get ‘good’ market price
 Unfinished or unique items may not have market price

 Negotiated price: transfer price is result of negotiation between ‘buyer’ and

‘seller’
 Preserves autonomy of divisions
 Must have external market
 Can take a long time to get negotiated price
 Agree price may reduce overall production

 Study shows 41% use cost-based; 46% use market-based and 13% use
negotiation
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 2 Possible Objectives
 Performance Evaluation
 Cost Minimization

 Performance evaluation systems

 Transfer prices directly affect the profits of the divisions involved in
an intercompany transaction
 Some are based on divisional profits
 Effectiveness of these is influenced by the fairness of transfer prices
 Effectiveness of these affects the satisfaction of managers
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 Cost minimization
 Profit maximization and, by extension, cost minimization are
important corporate objectives
 Manipulating transfer prices between countries is one way for
multinational enterprises to achieve cost minimization
 This is referred to as discretionary transfer pricing
 The most common approach is to minimize costs by shifting profits
to lower tax rate jurisdictions

9-9
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 Another objective: minimize import duties through low import price
 Circumvent profit repatriation restrictions…some countries have
limits on amount sub can transfer out of country to foreign
parent…reduce income of sub and increase income of parent
 Improvement of Foreign Operation competitiveness…use low
transfer price to reduce ‘cost’ to foreign operation thus giving
advantage versus foreign local competitors.

9-10
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 Cost-based methods when following are important:
 Difference in income tax rates
 Minimization of import duties
 Foreign exchange controls and risks
 Restrictions on profit repatriation
 Risk of expropriation and nationalization
 Market-based methods when
 Interest of local partners
 Good relationship with local (foreign) government

9-11
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 OECD Guidelines
 Basic rule: must be at “arm’s-length prices”
 Need to document “arm’s-length” nature of price
 Only a model don’t have any legal force
 OECD “Country-by-Country Reporting”

9-12
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 Agreement between IRS and Company to apply agreed-on transfer pricing method to
specified transactions
 IRS will attempt to negotiate terms of APA with foreign taxing authorities creating bilateral
APA
 Other countries have adopted APA’s
 Canada
 France
 United Kingdom
 Netherlands
 China
 Germany
 Japan
 Mexico
 Several others 9-13
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 Most companies have strengthened transfer pricing rules
 Documentation policies
 Increased penalties
 Cost of fighting vs. potential savings

 Risk of taxing authorities examining transfer pricing

 Increased tax liability
 Potential double taxation
 Penalties/interest on overdue tax
 Uncertainty on group’s worldwide tax burden
 Relationships with local tax authorities

9-14
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 EY survey
 2/3 MNC’s experience transfer price audit
 ¼ of audits resulted in adjustment by tax authority
 1/5 of adjustments included penalties

 Transfers and Industries at higher risk of audit

 Imports more so than exports
 Royalties
 Services
 Pharmaceuticals most at risk since all 3 involved

9-15
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 Red flags causing increased chance of audit
 Low profits or constant losses
 Price changes
 Royalty changes
 Poor relationship with tax authorities (aggressive tax planning)

9-16
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