International
Transfer
Pricing
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter Topics
Transfer prices, corporate objectives, national tax
laws
Cost minimization and performance evaluation
U.S. transfer pricing rules
Five specific methods to determine arm’s-length prices
Advance pricing agreements (APAs)
Enforcement of transfer pricing regulations
12-2
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
5. Discuss the transfer pricing methods used in sales of
tangible property
12-3
Learning Objectives
6. Explain how advance pricing agreements can be
used to create certainty in transfer pricing
7. Describe worldwide efforts to enforce transfer
pricing regulations
12-4
Introduction
Transfer pricing
Determination of price on the exchange of goods or
12-5
Decentralization and Goal Congruence
Decentralized companies are organized by division
and division managers have significant authority
Decomposes problems into smaller pieces
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
12-6
Performance Evaluation, Cost Minimization,
and Transfer Pricing
Performance evaluation systems
Transfer prices directly affect the profits of the
transfer prices
Effectiveness of these affects the satisfaction of
managers
12-7
Performance Evaluation, Cost Minimization,
and Transfer Pricing
Cost minimization
Profit maximization and, by extension, cost
12-8
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.
12-9
Performance Evaluation, Cost Minimization,
and Transfer Pricing
Cost minimization – Example
Divisional profits under the negotiated transfer price:
12-10
Performance Evaluation, Cost Minimization,
and Transfer Pricing
Cost minimization – Example
Divisional profits under the discretionary transfer price:
12-11
Performance Evaluation, Cost Minimization,
and Transfer Pricing
Cost minimization – Example
Corporate profits under the discretionary transfer
12-13
Performance Evaluation, Cost Minimization,
and Transfer Pricing
Other cost minimization objectives
Withholding taxes on dividends can be effectively
restrictions
This essentially changes cash flows from dividends to
intercompany revenues and expenses
Minimization of import duties(Tariffs)
Increase cash flows out of a devaluing currency
Enhance the competitive position of a foreign
operation
12-14
Interaction of Transfer Pricing Method and
Objectives
Transfer pricing method (cost-based or market-
based) depends on specific environmental
variables
Cost-based methods are preferred when the following
variables are important
Differences 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 are preferred when the
following variables are important
Interests of local partners
Good relationship with local government
12-15
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
12-16
U.S. Transfer Pricing Rules (IRC Section
482)
Allows the Internal Revenue Service to audit
international transfer prices
Penalties of up to 40% of the underpayment of taxes
countries’ regulations
12-17
U.S. Transfer Pricing Rules (IRC Section
482)
A “best-method rule” requires the use of arm’s-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 company’s
transfer pricing but a foreign government does not
12-18
Sale of Tangible Property
Treasury Regulations require the use of one of five
specified methods to determine the arm’s-length price
Comparable uncontrolled price method
Resale price method
Cost-plus method
Comparable profits method
Profit split method
12-19
Sale of Tangible Property
Comparable uncontrolled price method
Widely considered the most reliable measure when a
12-20
Sale of Tangible Property
Resale price method
Generally used when the affiliate is a sales subsidiary
uncontrolled parties
The most important factor in choosing this method is the
12-21
Sale of Tangible Property
Cost-plus method
Most appropriate when comparable uncontrolled
uncontrolled parties
Factors influencing the comparability of uncontrolled
12-22
Sale of Tangible Property
Comparable profits method
Underlying principle is that similar companies should
12-23
Sale of Tangible Property
Profit split method
Treats the two related parties as one economic unit
12-24
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
12-25
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
Unspecified methods
Pricing of intercompany loans and intercompany
services are also transfer pricing situations
12-26
Advance Pricing Agreements (APA)
12-27
Advance Pricing Agreements (APA)
Some specifics of national APAs
The U.S. began its APA program in 1991
12-28
Worldwide Enforcement
Tax authorities view transfer pricing as a “soft target”
To avoid lengthy, complicated disputes and increased
12-29
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
12-31