INTERNATIONAL TRANSFER PRICING

Chapter 11

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

International Transfer Pricing

Chapter Topics

Transfer prices, corporate objectives, national tax laws

Cost minimization and performance evaluation
U.S. transfer pricing rules
Five specific methods to determine arms-length prices
Advance pricing agreements (APAs)
Enforcement of transfer pricing regulations

11-2

International Transfer Pricing

Learning Objectives
1. Describe the importance of transfer pricing in achieving goal
congruence in decentralized organizations.
2. Explain how the objectives of performance evaluation and cost
minimization can conflict in determining international transfer
prices.
3. Show how discretionary transfer pricing can be used to achieve
specific cost minimization objectives.
4. Describe governments reaction to the use of discretionary transfer
pricing by multinational companies.

11-3

International Transfer Pricing

Learning Objectives
5. Discuss transfer pricing methods used in the sales of tangible
property.
6. Explain how advance pricing agreements can be used to create
certainty in transfer pricing.
7. Describe worldwide efforts to enforce transfer pricing regulations.

11-4

Transfer Pricing Background

Transfer pricing is the determination of price on the exchange of
goods or services between related parties.
These transfers are 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.
A significant proportion of international transactions are
intercompany transfers.

11-5

Decentralization and Goal

Congruence
Decentralization and agency problems
Decentralized companies are organized by division and division
managers have significant authority.
This structure decomposes problems into smaller pieces.
It also 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.
The managers self-interest can vary with the best interests of the
company.
Learning Objective 1

11-6

Decentralization and Goal

Congruence
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.

Learning Objective 1

11-7

Performance Evaluation, Cost

Minimization, and Transfer Pricing

Performance evaluation systems

Transfer prices directly affect the profits of the divisions involved in

an intercompany transaction.
Some performance evaluation systems are based on divisional
profits.
The effectiveness of these performance evaluation systems is
influenced by the fairness of transfer prices.
The effectiveness of performance evaluation systems affects the
satisfaction of managers.

Learning Objective 2

11-8

Performance Evaluation, Cost

Minimization, and Transfer Pricing

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.

Learning Objective 2

11-9

Performance Evaluation, Cost

Minimization, and Transfer Pricing

Cost minimization -- Example

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.

Learning Objectives 2 and 3

11-10

Performance Evaluation, Cost

Minimization, and Transfer Pricing

Cost minimization -- Example

Divisional profits under the negotiated transfer price:

Sales
Cost of goods sold
Gross profit
Income tax effect
After-tax profit

Learning Objectives 2 and 3

Hijo
$1,000
500
$500
85
$415

Hija
$1,500
1,000
$500
175
$325

Padre
$1,500
500
$1,000
260
$740

11-11

Performance Evaluation, Cost

Minimization, and Transfer Pricing

Cost minimization -- Example

Divisional profits under the discretionary transfer price:

Sales
Cost of goods sold
Gross profit
Income tax effect
After-tax profit

Learning Objectives 2 and 3

Hijo
$1,300
500
$800
136
$664

Hija
$1,500
1,300
$200
70
$130

Padre
$1,500
500
$1,000
206
$794

11-12

Performance Evaluation, Cost

Minimization, and Transfer Pricing

Cost minimization -- Example

Corporate profits under the discretionary transfer price are $54

greater relative to the negotiated price.
This results from shifting $300 of pre-tax profits from the U.S. to
Chile.
The overall tax rate decreases from 26 to 20.6 percent.
The performance evaluation objective is better served by the
negotiated transfer price.
The cost minimization objective is better served by the discretionary
price.
Learning Objectives 2 and 3

11-13

Performance Evaluation, Cost

Minimization, and Transfer Pricing

Conflicting objectives and a solution

The previous example illustrates how cost minimization and

performance evaluation can conflict.
Dual pricing is one solution to this conflict.
Under dual pricing, the official transfer price used for tax purposes
is the discretionary transfer price.
A separate set of records used for performance evaluation use the
negotiated transfer price.

Learning Objective 2

11-14

Performance Evaluation, Cost

Minimization, and Transfer Pricing

Other cost minimization objectives

Withholding taxes on dividends can be effectively avoided via

setting favorable transfer prices.
The same can be done to avoid profit repatriation restrictions.
This essentially changes cash flows from dividends to
intercompany revenues and expenses.
Reduction of import duties
Increase cash flows out of a devaluing currency
Enhance the competitive position of a foreign operation
Transfer pricing method (cost-based or market-based) depends on
specific environmental variables.
Learning Objective 3

11-15

Government Reactions
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 arms-length price.
Arms-length price is the price that would be agreed upon by
unrelated parties.

Learning Objective 4

11-16

Government Reactions
U.S. Transfer Pricing Rules (IRC Section 482)
This rule allows the Internal Revenue Service to audit international
transfer prices.
Penalties of up to 40% of the underpayment of taxes can be
imposed on violators.
It applies to both upstream and downstream transactions, and
transactions between two subsidiaries of the same parent.
Important because most MNCs are either headquartered in or have
significant business activities in the U.S.
U.S. transfer pricing reforms have influenced other countries
regulations.
Learning Objective 4

11-17

Government Reactions
U.S. Transfer Pricing Rules (IRC Section 482)
A best methods rule requires the use of arms-length concept.
Primary factors to consider are the degree of comparability to
uncontrolled transactions and the quality of the underlying analysis.
The IRS provides for correlative relief to help in situations where
the IRS agrees with a companys transfer pricing but a foreign
government does not.

Learning Objective 4

11-18

Sale of Tangible Property

Five methods

Comparable uncontrolled price method

Resale price method
Cost-plus method
Comparable profits method
Profit split method

Learning Objective 5

11-19

Sale of Tangible Property

Comparable uncontrolled price method
Widely considered the most reliable measure when a comparable
uncontrolled transaction exists
Transfer price is determined based on reference to the companys
sales of the same product to an unrelated buyer.
Reference to transactions between two unrelated parties for the
same product are acceptable.
If an uncontrolled transaction is not exactly comparable, an
adjustment is allowable.

Learning Objective 5

11-20

Sale of Tangible Property

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 from the
price charged by the sales subsidiary.
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.

Learning Objective 5

11-21

Sale of Tangible Property

Cost-plus method
Most appropriate when comparable uncontrolled transactions dont
exist and sales subsidiary does more than simply distribute finished
goods
Transfer price is determined by adding gross profit to the cost of
production.
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.
Learning Objective 5

11-22

Sale of Tangible Property

Comparable profits method
Underlying principle is that similar companies 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.
Learning Objective 5

11-23

Sale of Tangible Property

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: comparable profit split method and
residual profit split method.

Learning Objective 5

11-24

Sale of Tangible Property

Summary
Any particular transfer pricing method used can result in a range of transfer
prices.
Companies can use discretion to set prices within the range in order to
achieve cost minimization objectives.
Companies can also use discretion in determining the best method.
Section 482 does provide detailed guidance on factors to consider in
determining comparability to uncontrolled transactions.
Taxpayer must provide contemporaneous (within 30 days) documentation
justifying method selected, covering at least eight specified items (e.g. an
analysis of the economic and legal factors as well as an explanation of why
one method was selected over alternatives).
Substantial reporting and record-keeping requirements

Learning Objective 5

11-25

Other Transfer Pricing Situations

Licenses of intangible property
Section 482 lists six categories of intangibles, including: patents,
copyrights, trademarks, franchises, and methods and procedures.
Four methods are available for setting transfer prices:

Comparable uncontrolled transaction method

Comparable profits method
Profit split method
A group of unspecified methods

Pricing of intercompany loans and intercompany services are also

transfer pricing situations.
Learning Objective 5

11-26

Advance Pricing Agreements (APA)

Background
An APA is an agreement between a company and a taxing authority
regarding an acceptable transfer pricing method.
A unilateral agreement is between a taxpayer and one government,
while a bilateral agreement involves a taxpayer and two
governments.
The primary advantage is assurance that their approach will not be
challenged.
The primary disadvantage is the time and cost involved in arriving
at the agreement.
Learning Objective 6

11-27

Advance Pricing Agreements (APA)

Some specifics of national APAs
The U.S. began its APA program in 1991.
An increasing number of other countries have subsequently
established programs.
In the U.S., of a total of 58 agreements executed in 2003,
approximately 60 percent involve foreign parent companies.
The computer and electronics manufacturing industry is the leading
user of APAs.

Learning Objective 6

11-28

Worldwide Enforcement
There are a number of documented cases of companies, both U.S.
and foreign, deemed to have underpaid taxes in the U.S.
Some of these cases reflect obvious attempts by companies to
evade U.S. taxes by manipulating transfer prices.
In one case, a U.S. subsidiary sold bulldozers to its foreign parent
for $551 each.
From 1996-2000, over 60 percent of U.S. and foreign multinationals
paid no U.S. income tax.
There is a worldwide trend toward strengthening transfer pricing
rules.

Learning Objective 7

11-29

Worldwide Enforcement
Tax authorities view transfer pricing as a soft target.
To avoid lengthy, complicated disputes and increased scrutiny by
local authorities a company may just pay the additional tax.
In 2007 an Ernst & Young survey showed that 50% of respondents
had experienced a transfer price audit somewhere in the world
since 2003.
78% thought an audit was likely in the next two years.
More than 25% of completed audits resulted in a tax adjustment,
with penalties imposed in 15% of those cases.

Learning Objective 7

11-30