Transfer Pricing (TP)

P. GURU PRASADFACULTY

INC GUNTUR

Evaluating Management Control Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary

The concept of Transfer Pricing

A transfer price is the internal price charged by a selling department, division, or subsidiary of a company for a raw material, component, or finished good or service which is supplied to a buying department, division , or subsidiary of the same company.

Transfer Prices

The concept of transfer pricing is fundamentally aimed at simulating external market conditions within the organization so that the managers of individual business units are motivated to perform well

Purpose of Transfer Pricing

Multinational companies use transferpricing to minimize their worldwidetaxes, duties, and tariffs.

Transfers at Cost

About half of the major companies in the world transfer items at cost.

Transfer Pricing

Many organizations set up business units that cater to the needs of other business units within their own fold. For example, one business unit may manufacture components that are used by another business unit to assemble the final product.

Here , there is a transfer of goods from the first business to the second and the concept of transfer pricing comes into play.

Transfer Pricing

Decentralization is one of the approaches that many large organizations use to attain operational effectiveness. However , the main challenges in operating in a decentralized manner lie in designing responsibility structures and formulating appropriate policies and methods to determine the performance of the responsibility centers.

The technique of transfer pricing plays an important role in the smooth functioning of responsibility structures in such an organization

Objectives of TP policy

Goal congruence:- the divisional manager in maximizing the profits of his division, should not engage in decision-making that fails to optimize the organization’s performance.

Performance appraisal :-it should aid in reliable and objective assessment of the value added activities by profit centers toward the organization as a whole.

Objectives of TP policy

Divisional autonomy:- each divisional manger should be free to satisfy the requirements of his profit center from internal or external sources. There should be no interference in the process by other divisions like buying centers and selling centers.

General Appliance Corporation case study

The GAC was an integrated manufacturer of all types of home appliances. The company had a decentralized , divisional organization consisting of four product divisions , four manufacturing divisions, and six staff offices.

Each division and staff office was headed by a vice president. The staff offices had functional authority over their counterparts in the divisions, but they had no direct line authority over the divisional general managers.

General Appliance Corporation case study

The product division designed, engineered, assembled , and sold various home appliances. They manufactured very few components parts, rather , they assembled the appliances from parts purchased either from the manufacturing divisions or from outside vendors.

The manufacturing divisions made approximately 75 percent of their sales to the product divisions. Parts made by the manufacturing divisions were generally designed by the product divisions, the manufacturing divisions merely produced the parts to specification provided to them

General Appliance Corporation case study

The divisions were expected to deal with one another as though they were in dependent companies. Parts were to be transferred at prices arrived at by negotiation between the divisions. These prices generally were based on the actual prices paid to outside suppliers for the same or comparable parts.

These outside prices were adjusted to reflect differences in design of the outside part from that of the inside part. In general, the divisions established prices by negotiation among themselves, but if the divisions could not agree on a price, they could submit the dispute to the finance staff for arbitration

Arm's length transaction

DefinitionA transaction between two related or

affiliated parties that is conducted as if they were unrelated, so that there is no question of a conflict of interest. Or sometimes, a transaction between two otherwise unrelated or affiliated parties.

Board of Directors

president

Finance staff

Engineeringstaff

Manufacturingstaff

IndustrialRelations staff

Purchasingstaff

Marketing staff

Group vice presidentManufacturing divisions

Group vice presidentProduct divisions

Chrome Productdivision

GearAnd

Transmissiondivision

Stamping division

ElectricMotor division

ElectricStove

division

Laundry Equipment

division

MiscellaneousAppliancedivision

Refrigerating division

Organizational chart Of

GAC

Minimize Tax Liability

For organizations operating in many countries, internal transfer pricing can be a determinant of where profits are to be declared and taxes paid. The fact that different countries have different tax and exchange rates has to be taken into consideration case of transactions with sister concerns that supply intermediary products.

Ideally the transfer pricing policy should enable multinational corporations to minimize tax liability

TP objective in International Business

Manage exchange rate fluctuationsHandle competitive pressuresReduce the impact of taxes and

tariffsMovement of funds between

countries

Manage Exchange Rate Fluctuations

MNCs can reduce exchange rate risks by transfer pricing, when the currency of a country depreciates, the purchasing power of that currency declines. Therefore organizations based in that country may have to pay more for imports.

On the contrary, if the currency appreciates, the revenues from exports will fall for organizations based in that country. But MNCs can depend on their subsidiaries for imports and exports and use transfer prices to manage exchange rate fluctuations.

Handle Competitive Pressures

The subsidiaries of an organization operating in different countries can use transfer pricing to lower prices to match local completion. For example, garment manufactures in Europe depend mainly on china, Japan , and India for silk .

Therefore, if an organization has subsidiaries in these countries, it may mange to get silk at a lower cost by transfer pricing. Thus , it will be able to reduce the price of the finished product to match or undercut local competition

Reduce the Impact of Taxes and Tariffs

Many MNCs make use of transfer pricing to reduce their total tax liability,. Organizations try to maximize profits in countries where corporate taxes are lower, thus reducing the tax liability of the organizations a whole.

For example, the exporting business unit can quote a lower selling price. This will result in lower tariffs for the importing business unit, since most duties are levied on the value of goods imported.

Movement of Funds between Countries

The MNCs may prefer to invest its funds in one country rather than another. Transfer pricing provides an indirect way of shifting funds into or out of a particular country.

While trying to achieve these objectives specific to international business, disputes may arise between the multinational corporations and the tax authorities in different countries

Factors Influencing TP

The conditions necessary for the development of a proper mechanism of TP are

Role definition External advisers Competent mangers Equity, Information on the prevailing market prices And proper investment

Methods of Calculating TP

Market based pricing methodCost based pricing methodNegotiated pricing methodResale price methodAlternative methods

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Transfer Pricing Methods (1)

When choosing the best transfer pricing method, the available methods should be considered in the following order:

1. Comparable Uncontrolled Price (CUP);

2. Resale Price or Cost Plus (C+);

3. Profit Split or Transactional Net Margin (TNM).

Market-Based Transfer Prices

If there is a competitive market for the productor service being transferred internally, usingthe market price as a transfer price willgenerally lead to the desired goalcongruence and managerial effort.

Market-Based Transfer Prices

The major drawback to market-based prices is that market prices are not always available for items transferred internally.

Market Based Pricing Method

An organization X in India that sells textile fiber to its subsidiary organization Y in Bangladesh. If the rate charged by X in India is the same as the current market price – as if the transaction is taking place between two unrelated organizations – then the method of estimating transfer pricing is know as market based pricing method or the comparable uncontrolled price (CUP)- Ranbaxy and Cipla follow the cup method

Transfers at Cost

Variable costs

Full cost

Full cost plus a profit markup

Standard costsActual costs

What are some examples?

Cost Based Pricing Method

Indian organization X sells textile fiber to its subsidiary Y in Bangladesh and the rate charged by X is the total cost of manufacturing the fiber plus some margin or mark-up percentage, then this method of estimating the transfer price is known as cost-based transfer pricing

Negotiated Transfer Prices

Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices.

Negotiated Pricing Method

The buying and selling divisions negotiate a mutually acceptable transfer price. Since each division is responsible for its own performance, this will encourage cost minimization and encourage the parties to seek a transfer price that yields them an appropriate return.

Resale Price Method

The resale price method is similar to the cost based pricing method. In this method, the transfer price is determined by calculating back from the transition taking place at the next level of the supply chain, by deducting a suitable mark-up from the price at which the internal buyer sells the item to an unrelated third party.

Alternative Methods

A petroleum company has three divisions: the crude oil division, the refinery division, and the sales division. The crude oil division extracts the crude oil and sells it to the refinery division, which refines the crude through a process of fractional distillation. The output of the refinery is then sold in the market by the sale division.

Alternative Methods

In this situation, the sales division may underestimate the costs incurred during extraction and processing. So it might sell the final product at a price that is not high enough to recover fixed costs. Due to this the sales division may earn revenues but the company as a whole may incur losses. In order to prevent these kinds of problems, such companies adopt some other methods of calculating transfer price like two step method, profit sharing and two sets of process methods

Alternative Methods

Two step pricing:- fixed cost component and variable cost component. In a transaction of goods between two divisions, the cost of production for the selling division is Rs. X per unit and the fixed cost per month is Rs. Y and the margin decided is Rs. Z per month. If “n” units of these goods are sold, then the transfer price for the month will be (nX+Y+Z). Or if the margin is included with the variable component, say Rs. A per unit, then the transfer price will be (nX+nA+Y).

Alternative Methods

Profit sharing or split method:- all the business units share the operating profit.

Two sets of pricing:- revenue is credited to the manufacturing unit at the market sales price while the buying unit is charged for the total standard costs. The difference between the outside sales price and the standard cost is charged to the parent firm’s account

Variable-Cost Pricing

In situations where idle capacity exists,variable cost would generally be thebetter basis for transfer pricing andwould lead to the optimum decisionfor the firm as a whole.

Variable-Cost Pricing

When market prices cannot be used, versions of “cost-plus-a-profit” are often used as a fair substitute.

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Transfer Pricing Methods (2)

Type of Transaction Possible methodManufacturing of goods CUP, C+, Profit split

Sale of goods CUP, Resale price, Profit split, TNM

Provision of services CUP, C+, TNM

Financing (loans, deposits, guarantees)

CUP, Profit split, TNM

Transfer of intangibles (technology, brand, know –how)

CUP, C+

Implementing the TP

Articulation and communication of the transfer pricing strategy

Documentation of the TP process and inter-organization agreements

Involvement of multi-disciplinary teamNegotiation and conflict resolution

Potential Misuse of TP

TP is a very important issue from the point of view of management control. The firms can misuse TP to minimize their tax liabilities, as well as to project a wrong image about their financial health and thus mislead the stakeholders.

The Indian PerspectiveLiberalization of the Indian economy has

led to a phenomenal growth in the industrial and services sector. Due to the availability of cheap skilled labor, India has become a favorite destination for labor-intensive service industries like BPO and software. This has resulted in increased cross border related party transactions between India and other nations.

TP Tax Guidelines

This has made transfer pricing very important from the taxation point of view. The Indian government has introduced detailed transfer pricing regulations with effect from April ,2001, to reduce tax avoidance by organizations operating in India.

The regulations have largely been designed along the lines of the Transfer Pricing Guidelines issued by the Organization for Economic Cooperation and Development (OECD).

The GlaxoSmithKline TP Dispute

The US Internal Revenue Service (IRS) demanded back taxes from GSK, a large UK-based drug manufacturer, for misusing transfer pricing to minimize its tax liabilities to the US government.

The US affiliate of the company charge with overpaying for product supplies during the period 1989 to 2000 and in subsequent year, while at the same time charging lower rates for the marketing services that it supplied, thus understating GSK’s income subjected to Us taxation during the period.

The GlaxoSmithKline TP Dispute

The IRS wanted the pharmaceutical Giant to pay taxes, penalties and interest.

The dispute was to go to trail in February 2007. according to experts, the IRS’s decision to take GSK to court was a manifestation of the new thinking in transfer pricing regulations proposed by the IRS in September 2003.

GSK decided to settle the issue to avoid future fund outflow toward legal proceedings. On September 11, 2006, GSK announced that it was settling the dispute by paying $3.1 billion to the IRS.

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