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Chapter 12:

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

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 2012, represented 42% of
U.S. total goods trade)

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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
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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 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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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

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:

Hijo Hija Padre


Sales $1,000 $1,500 $1,500
Cost of goods sold 500 1,000 500
Gross profit $ 500 $ 500 $1,000
Income tax effect 85 175 260
After-tax profit $ 415 $ 325 $ 740

12-10
Performance Evaluation, Cost Minimization,
and Transfer Pricing
Cost minimization – Example
 Divisional profits under the discretionary transfer price:

Hijo Hija Padre


Sales $1,300 $1,500 $1,500
Cost of goods sold 500 1,300 500
Gross profit $ 800 $ 200 $1,000
Income tax effect 136 70 206
After-tax profit $ 664 $ 130 $ 794

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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
12-12
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

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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
 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

acceptable transfer pricing


 The guidelines typically use the notion of an arm’s-length
price
 Arm’s-length price is the price that would be agreed upon
by unrelated parties

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

(on a gross valuation misstatement) can be imposed


on violators
 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
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

comparable uncontrolled transaction exists


 Transfer price is determined based on reference to the

company’s 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

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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

12-21
Sale of Tangible Property
Cost-plus method
 Most appropriate when comparable uncontrolled

transactions don’t 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

12-22
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 gross profit to


operating expenses

12-23
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

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)

 It is an agreement between a company and the IRS


regarding an acceptable transfer pricing method
 A unilateral agreement is between a taxpayer and

the IRS, while a bilateral agreement involves the IRS


and one or more foreign tax authorities
 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

12-27
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 42 agreements executed in

2011, approximately 62 percent involve foreign


parent companies
 The computer and electronics product manufacturing

industry have been the leading users of APAs

12-28
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 2010, an Ernst & Young survey showed that more

than two thirds of MNC respondents had experienced


a transfer price audit somewhere in the world since
2006
 More than 25% of completed audits resulted in a tax

adjustment, with penalties imposed in almost 20% of


those cases

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

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 1998-2005, 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


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End of Chapter 12

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