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INTERNATIONAL TRANSFER PRICING

Transfer Pricing- the determination of the

price at which transactions between related parties will be carried out.

Types of Intercompany Transactions and their Associated Price


Sale of tangible property Use of tangible property

Sale Price rental royalties, license fees Mgt fee, service Interest rate

payment Use of intangibles


Intercompany services

charge Intercompany Loans

Objectives of Transfer Pricing


Performance Evaluation Cost minimization

These objectives might be incongruent

Transfer Pricing Methods


Cost-Priced Transfer price Market-based Transfer Price Negotiated Price

Cost-Based Transfer Pricing


Advantages
Simple to do

Disadvantages
Which measure of cost to use?? Can transfer pricing inefficiencies to other units

Market Based Transfer Pricing


Advantages
Eliminate the risk of inefficiencies being

transferred. Ensure divisional autonomy

Disadvantage
Depends on existence of competitive markets

Negotiated Prices
Advantages
Freedom to bargain is preserved Divisional autonomy

Disadvantages
External markets required Can take a long time Sub-optimization issues Rewards negotiation skill as opposed to actual

productivity

Most companies:
Use either cost-based or market-based

transfer pricing. Many use a mix of both

Chan and Los Study (2004):


Cost-based methods are preferred when:
Income tax rate differences matter Import duty is being minimized Foreign exchange rules exist Expropriation risks exist

Market-based methods are preferred when:


Local partners matter Local government relations matter

7 Most Important Environmental Variables (USA)


Overall Profit to the company Restrictions on repatriation of

profit/dividends The competitive position of foreign subs Performance evaluation of foreign subs Custom Duties Import restrictions The need for adequate cash flow in foreign subs

7 Most Important Environmental Variables (Japan)


Overall corporate profit The competitive position of foreign subs Devaluation/revaluation in countries with foreign operations. Restrictions on repatriation of profits/dividends Performance Evaluation of foreign subs The interests of local partners in foreign subs The need to maintain adequate cash flow in foreign subs

Cost Minimization Objectives and Related Transfer Prices

Objective Transfer Pricing Rule Minimize income Tax Transfer to lower tax rate country Low price Transfer to Higher tax rate country High price Minimize withholding tax Upstream transfer Low price Downstream transfer High price Minimize import duties Low price Protect foreign cash flows from currency devaluation High price Avoid repatriation High price Improve competitive position Low Price

Government Reactions
OECD Transfer Pricing Guidelines- 1979, 1984, 1994 Section 482 of the IRC
Based on OECD guidelines IRS may audit transfer prices between companies

controlled by the same taxpayer. Burden of proof on taxpayer Inbound and outbound transactions General rule: arms length prices. Treasury regs provide specific guidance on arms length prices

Government Reactions
Treasury Regs Section 1.482
Best method rule- which method provides the

most reliable measure of an arms length price


Depends on (a) degree of comparability between intercompany transaction and comparable uncontrolled transactions, and (b) quality of data and assumptions used in analysis.
Separate guidelines for transfers of tangible

property, intangible property, intercompany loans, and intercompany services.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arms Length Prices Comparable Uncontrolled Price Method
Generally considered the best method when it can

be used. Parent sells to Sub in Country X Parent also sells to uncontrolled customer in the same country Arms Length Price = price charged the uncontrolled customer

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arms Length Prices Resale Price Method Parent Sells to Sub in Country X Sub sells to customers in country X Subs competitors sell the same product at 25%

markup as % of sales Arms length price = Subs selling price to customers less 25% To use this method, final selling price and appropriate gross profit % must be known.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arms Length Prices
Cost Plus Method Parent Sells to Sub in Country X Parents competitors sell same product to

customers in County X at 50% markup to cost. Arms Length Price = Parents cost plus 50% Most appropriate method when there are no uncontrolled sales to compare to and the buyer does more than just distribute goods.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arms Length Prices Comparable Profits Method Parent sells to Sub in Country X Sub sells to Customers in Country X Parents competitiors sell similar product and earn

a 15% margin. Arms Length price = price that allows Parent (or sub) to earn 15% operating profit margin.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arms Length Prices Profit Split Method Parent Sells to Sub in Country X Sub sells to Customers in Country X Total profit = Sub sales price less Parents cost Total profit is split based on profit earned by each

party in an uncontrolled transaction. Method assumes buyer and seller are really one economic unit.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arms Length Prices Residual Profit Split Method Used when parties possess intangibles that allow

them to earn excessive profits, compared to uncontrolled transactions. Total Profit is split in 2 steps:
Allocate market return to parent and sub for their routine contributions to the relevant business activity. Allocate residual profit to Parent and Sub on the basis of relative value of intangibles that each contributes to the activity.

Ernst and Young Study (07-08) reports:


Comparable Uncontrolled Price is most

popular (32%) Cost plus is second (29%) Resale price is third (17%) Comparable profits is fourth (11%)

Intangible Property
Three identified methods allowed:
Comparable uncontrolled Comparable profits Profit split

Correlative Adjustments
If the IRS adjusts a transfer price, there is no

guarantee the foreign government will concur.

Penalties
20% (40%) or the understatement!!

Advance Pricing Agreements


TPM agreed upon between company and tax

authority. If there is an agreement, IRS agrees to make No TP adjustments Length negotiation typical..avg 22 months. 60% of APAs are from foreign Parents with US subs.