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Transfer Pricing

Transfer Pricing

• A transfer price is the price one subunit


charges for a product or service supplied to
another subunit of the same organization.

• Intermediate products are the products


transferred between subunits of an
organization.
Transfer Pricing

• Transfer pricing should help achieve a


company’s strategies and goals.
– fit the organization’s structure
– promote goal congruence
– promote a sustained high level of
management effort
Transfer Pricing and E-commerce

• Intra-company transfer pricing: an enterprise


provides goods or services through a branch situated in
a different country, using an electronic
communications network (Internet or Intranet): e-
commerce, e-tailing;
• Inter-companies transfer pricing: two companies that
are part of the same group (holding-subsidiary,
subsidiary-subsidiary) and that are located in different
jurisdictions enter into an e-commerce transaction
directed to trade goods or services.
Transfer Pricing Trends and Focus
• Trends:
• Increase of Audits in Europe’s large economies
• Specific issues for emerging economies
• Intangibles and cost sharing agreements (CCA)
• Enforcement and Advance Pricing Agreements (APA)
• Documentation and penalties

• Transfer Pricing Focus:


• Restructuring of business models
• Use of low tax jurisdictions
• Low margin and loss making businesses
• Outbound payments for royalties/service (intangibles)
• Use of international comparables
Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices


Market-based transfer prices
• Transfer prices are based on market prices.
When there is a perfectly competitive market for the
goods and services that are bought and sold between
divisions of an organization, the transfer price should
be the market price.
• The transfer price may be slightly lower than the
market price if the selling expenses are lower for
interdivisional transfers,
e.g. because there is no advertising cost for transfers
between divisions.
• There is a problem for managers in that market prices
may fluctuate.
Market-based transfer prices

• Transferring products or services at market prices


generally leads to optimal discussion where three
conditions are satisfied
 The market for the intermediate products is
perfectly competitive
 Inter dependencies of sub units are minimal
 There are no additional cost or benefits to the
company as a whole from buying or selling in the
external market , instead of transacting internally
Market-based transfer prices

• Advantages
– Forces selling division to be competitive with
market conditions
– Does not penalize buying division by charging
a price greater than it would have to pay on the
market
Market-based transfer prices

• Disadvantages
– May lead selling division to ignore negotiation
attempts from buying division and sell directly
to outside customers
• Could cause an internal shortage of materials
• Forces buying division to purchase materials from
the outside
• Overall company profits may fall even though
selling division makes a profit
Cost-Based Pricing Methods

• Managers can develop a price based on the


cost of producing the product or service
– If prices do not cover costs, the company will
fail
• Two pricing methods based on cost
– Gross margin pricing
– Return on assets pricing
Cost-Based Pricing Methods (cont’d)
The Energeez Company buys parts from outside vendors and
assembles them into portable solar panels. In the previous
period, the company produced 14,750 solar panels.
Total costs and unit costs incurred were as follows

No changes in unit costs are expected this period. Desired profit for
the period is $110,625. The company uses assets in producing the
panels and expects a 14% return on those assets
Gross Margin Pricing
• Gross margin
– The difference between sales and the total production
costs of those sales
• Gross margin pricing
– Cost-based pricing approach
• Price is computed using a markup percentage based on a
product’s total production costs
• Markup percentage
– Designed to include all costs other than those used in
the computation of gross margin
– Composed of selling, general, and administrative
expenses and the desired profit
Gross Margin Pricing (cont’d)
• This method can be easily applied
– An accounting system often provides
management with production cost data
Return on Assets Pricing

• Based on earning a profit equal to a


specified rate of return on assets employed
in the operation
– Focuses on a desired minimum rate of return on
assets
• Also called the balance sheet approach to
pricing
Return on Assets Pricing (cont’d)
Negotiated Transfer Prices

Negotiated transfer prices arise from the outcome of a


bargaining process between selling and buying divisions.
• Where subunits of a firm are free to negotiate the transfer
price between themselves and then to decide whether to
buy and sell internally or deal with external parties
• May or may not bear any resemblance to cost or market
data
• Often used when market prices are volatile
• Represent the outcome of a bargaining process between
the selling and buying subunits
Negotiated Transfer Prices
Advantages
• Autonomy ↔ Decentralisation
• Better information about costs and benefits
• Most appropriate where there are market imperfections for
the intermediate product and when managers have equal
bargaining power.
• To be effective, managers must understand how to use cost
and revenue information.

Limitations:
• Can lead to sub-optimal decisions
• Time - consuming
• Divisional profitability may be strongly influenced by the
bargaining skills and powers of the divisional managers.
Comparison of
Transfer-Pricing Methods
Criteria Market- Cost- Based Negotiated
Based
Achieves Goal Yes, when Often, but not Yes
Congruence markets are always
competitive
Useful for Yes, when Difficult unless Yes, but transfer
Evaluating markets are transfer price prices are affected
Subunit competitive exceeds full cost by bargaining
Performance and even then is strengths of the
somewhat buying and selling
arbitrary divisions
Comparison of
Transfer-Pricing Methods
Criteria Market- Cost- Based Negotiated
Based
Motivates Yes Yes, when based on Yes
Management Effort budgeted costs; less
incentive to control
costs if transfers are
based on actual
costs

Preserves Subunit Yes, when markets No, because it is Yes, because it is


Autonomy are competitive rule-based based on
negotiations
between subunits
Comparison of
Transfer-Pricing Methods
Criteria Market- Cost- Based Negotiated
Based
Other Factors No market may Useful for Bargaining and
exist or markets determining full negotiations take
may be cost of products; time and may need
imperfect or in easy to to be reviewed
distress implement repeatedly as
conditions change
Transfer Pricing Strategy

Pricing of goods, services, and


intangible property bought and sold
by operating units or divisions of a
company doing business with an
affiliate in another jurisdiction.
Transfer Pricing Strategy

Four arrangements for pricing goods for intra-


company transfer are as follows:

1. Sales at the local manufacturing cost plus a


standard markup
2. Sales at the cost of the most efficient producer in
the company plus a standard markup
3. Sales at negotiated prices
4. Arm’s-length sales using the same prices as
quoted to independent customers
Benefits of Transfer Pricing Strategy

1. Lowering duty costs by shipping goods into high-


tariff countries at minimal transfer prices so that
duty base and duty are low
2. Reducing income taxes in high-tax countries by
overpricing goods transferred to units in such
countries; profits are eliminated and shifted to low-
tax countries
3. Facilitating dividend repatriation when dividend
repatriation is curtailed by government policy by
inflating prices of goods transferred
Transfer Pricing Risks
• Economic Double Taxation
– Competent Authority Process
• Income Adjustments
• Penalties and Interest
• Internal Defence Costs
– Management Time
– Staff Attrition
• Advisor Defence Costs
• Revenue Authority Information Sharing
Thank
You !!