Download Transfer pricing (Ch.20)

Transfer Pricing
Intercompany fund flow mechanisms: costs and benefits.
A multinational corporation unbundles its total flow of funds between each pair
of subsidiaries into separate components associated with resources transferred as:
i) products
ii) capital
iii) services
iv) technology
E.g. Dividends, interest and loan repayments capital invested as equity or
debt
Fees loyalties or corporate overhead 
corporate services,
trademarks or licences.
Different channels (for moving money and profits internationally).
i) transfer pricing
ii) fee and royalty adjustments
iii) leading and lagging
iv) intercompany loans
v) Dividend-adjustment and investing in the form of debt vs equity.
Tax factors: total tax payments on intercompany fund transfers depend on the tax
regulation of both the host and recipient nations.
Transfer Pricing
Home and host country governments’ policing mechanisms to review transfer
pricing policies (arm’s length pricing) Sec 482, US Revenue code.
Each government normally presumes that MNCs use transfer pricing to the
country’s detriment.
Uses: 1) reducing taxes
2) reducing tariffs
3) avoiding exchange controls.
1) Reducing taxes: affiliates A & B
A
100,000 CBs at $10/unit
Transfer price
B
Sells them at $22/unit
Unrelated customer
(TP=$15)
Low markup
A
Rev
1500
COGS
1000
Gross pft
500
Other exp
100
Inc. bef. tax
400
Tax (30%/50%)
420/360
Net Income
280
($000)
B
2200
1500
700
100
600
120
(TP= $18)
High markup
A
1800
1000
800
100
700
300
300
B
2200
2200
400
100
300
210
490
A+B
2200
1000
1200
200
1000
150
150
580/640
In effect, profits are being shifted from a higher to a lower tax jurisdiction.
Objective : Minimize taxes.
Basic thumb rule:
2)
AB, tA, tB : marginal tax rates respectively.
If tA  tB set as low transfer price as possible.
If tA  tB set as high tranfer prices as possible.
Reducing tariffs
Tariffs complicate the decision rule.
E.g. B pays ad valorem tariffs of 10% (import duties).
(TP=$15)
Low markup
A
Rev
1500
COGS
1000
Imp dty(10%) --Gross pft
500
Other exp
100
Inc. bef. tax
400
Tx(30%/50%) 120
Net Income
280
($000)
B
2200
1500
150
550
100
450
225
225
(TP= $18)
High markup
A
1800
1000
---800
100
700
210
490
B
2200
2200
180
220
100
120
60
60
A+B
2200
1000
150
1050/1020
200
850/820
345/270
505/550
In general, the higher the ad valorem tariffs relative to the income tax differential, the
more likely it is that a low transfer price is desirable.
Costs (legal fess, executive times and penalties).
If the transfer price is too high: tax authorities in B see revenues foregone.
If the transfer price is too low: both governments may intervene.
A’s government sees tax evasion; B’s government sees dumping.
Arm’s length prices—3 principal methods
1) Comparable uncontrolled price method.
2) Resale price method
3) Cost-plus method
3 principal methods for establishing an arm’s length prices in order of their general
acceptability to tax authorities are:
1.
Comparable uncontrolled price method:
--- prices used in comparable bona-fide transactions between enterprises that are
independent of each other, or
--- between the MNE groupand other unrelated parties.
In principle, this method is the most appropriate to use; in theory it is the easiest.
In practice, however, it may be difficult or impractical to apply.
Comparability: adjustments can be made easily for freight and insurance but
cannot be made accurate for trademarks.
2.
Resale price method:
--- reduce the price at which it is resold to an independent purchases by an
appropriate markup (ie, an amount that covers the resellers’ costs and profit).
This method is probably applicable to marketing operations. However,
determining an appropriate markup can be difficult, esp when the reseller adds
substantially to the value of the product.
A  B(reseller)

third party
3.
Cost-plus method: adds an app. Profit markup to the sellers’ cost to arrive an an
arms-length price. Ths method is useful in specific situations, as when
semifinished products are sold between related parties or one entity is essentially
acting as a subcontractor for a related entity.
Semifinished
AB
product


(subcontractor)
Practice by MNCs
In light of section 482, and similar authority by most other nations, current practice by
MNCs appears to be setting standard prices for standardized products.
However, innovative nature of MNCs, trade between related parties in high-tech custommade components and subassemblies no comparable sales to unrelated buyers. As
trade in intangible services becomes more important, monitoring transer pricing to shift
their overall taxable income from one jurisdiction to another.
One means of dealing with the US government’s crackdown on alleged transfer pricing
abuses is greater reliance on advance pricing agreements (APAs). These agreements
allow the MNC, the IRS and the foreign tax authority to work out, in advance, a method
to calculate transfer prices. These agreements are expensive, they can take quite a long
time to negotiate, and they involve a great deal of disclosure on the part of the MNC; but
if a company wants assurance that its transfer pricing is in order, the APA is a useful tool.
NOTE:
1.
2.
Transfer pricing can be used to avoid currency controls.
MNCs can use transfer pricing to increase their share of profits from joint
ventures.