Management Control Systems Decentralization is one of the approaches that many larye organ, operational effectiveness. However, the main challenges decentralized manner lie in designing responsibility Structur appropriate policies and methods to determine the Performan, centers. In Chapter 2, we discussed the design of Tesponsibili the concepts of controllability and goal congruence, The tech: plays an important role in the smooth functioning of respons; an organization. ALIONS 6 in Oper OF nt ort! 8 OF the respons ting ty Structures 4 : bili IQUE Of transfey ©. ¥th ibility structures Pring Su Many organizations set up business units that cater to the needs within their own fold. For example, one business unit may mai that are used by another business unit to assemble the final Product. Here transfer of goods from the first business unit to the second and the Concept of « pricing’ comes into play. A major determinant of the Tevenue and profits OF a prog center that sells a product to another internal customer is the transfer price. Wher at profit center buying the product is concerned, it is the major determinant of expense incurred. So, the transfer price is an important factor for both the selling ang the buying unit. Of other busi inufacture co transfer In the present chapter, we will discuss the concept of transfer Pricing, the Objectives of a transfer pricing policy in general and specific transfer Pricing objectives ig intemational business, and the factors influencing transfer pricing, We ei a examine the methods of calculating transfer prices, admini: istration of transfer Pricing mechanisms, and the Indian scenario with regard to transfer pricing THE CONCEPT OF TRANSFER PRICING 136 “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.” The concept of transfer price is fundamentally aimed at simulating external market conditions within the organization so that the managers of individual business units are motivated to perform well. However, the transfer price does not usually have a direct accounting impact on the organization’s profits as a whole because its effect on the selling division’s revenue is matched by its effect on the buying division’s costs, However, when the Profits of the selling and buying divisions art taxed at different rates, there is some impact on the organization's profs as 2 whole. Depending on the situs the divisions are comy sell its product to th Product is a key co business units will transfer prices will ation, transfer pricing mechanisms work in different ways. Ifall pletely independent of each other, then the selling division will ¢ buying divisions only at the market price. Sometimes, if a mponent or there is no external supplier for it, the pei be forced to be interdependent. In such situations, cost é. be used, and the selling division will usually be allowed a 4 ‘margin over the cost of the Product. Such variations are discussed later in the ie in the section onthe methods of calculating transfer prices, The ranfe pice that an organization adopts should ain at achieving certain objectives: objectives are discussed in the following section,Se Transfer Pricing aves 0 1 wit” Robert Anthony and Vijay Govindaraj ding tO ‘Acco! is that the “transfer price should be 0 jan, the fun ‘ Aste rch damental principle of i x Similar to the pri marge it te product were sold to outside customers or fainel re would be rom outside »2 The main objective of transfer pricin, ators” ve ig is the proper Bi costs between responsibility centers. If two or iin mee eae responsible for developing and marketing the product, then the res oT fe shared between them. * three objectives that a transfe “ealy, there are i ransfer pricing pol B formance appraisal, and divisional autonomy. oe eet ters are jointly ting profit has to congruence, per! goal + While designing the mecha Goal congruence. inism for transfer pricing, the int Gi idal profit centers should not supersede those of the semiianing aon jonal manager, in maximizing the profits of his/her division, Mould ee , c The divisional | ! engage in decision-making that fails to optimize the organization’s performance. performance opproisol: Transfer pricing should aid in reliable and object assessment of the activities of profit centers. Transfer prices should provide i Pa aseptin o guide decision-making, assess the performance of divisional sees into assess the Value added by profit centers toward the organization asa nae Divisional autonomy: The transfer pricing policy should aim at providing optimum divisional autonomy, thereby allowing the benefits of decentralization to be retained. tach divisional manager should be free to satisfy the requirements of hisher profit center from internal or external sources. There should be no interference in the rocess by which the buying center manager rationally strives to minimize costs and the selling center manager strives to maximize revenues. In reality, it is a difficult proposition to simultaneously meet all these objectives. For example, there may be a situation of excess capacity in the industry. It would not be prudent for the selling profit center to sell to the external market when there is excess industry capacity. However, due to this excess industry capacity, the buying profit center would want to buy from external markets to reduce its costs rather than procure the resources available within the organization. As a result, if divisional autonomy is to be retained and transfer prices are considered for performance appraisal, the bjective of goal congruence may not be achieved. 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 in case of transactions with sister concerns (legal entities) that supply intermediary 1d enable multinational corporations products. Ideally, the transfer pricing policy shoul to minimize tax liability. In the following section, we will examine the significance of transfer pricing in international business. Transfer Pricing Objectives in International Business Apart from the objectives of the transfer pricing policy between responsibility centers in domestic operations, multinational corporations must take into consideration several other factors for arriving at their transfer pricing policy that is applicable between the legal entities (their subsidiaries) in different counine® Included among these factors are foreign exchange rate fluctuations, competitiv® pressures, the impact of taxes and tariffs, and the corporation’s country-specific preferences for investing funds, Let us take a look at some of these factors. 137agement Control Systems Manage exchange rate fluctuations Multinational corporations can reduce exchange rate the currency of a country depreciates, the Purchasin, e risks Y trang Therefore, organizations based in that country may 4 OMT OF thy Py the contrary, if the currency appreciates, tine Wain tO pay gu Uteng EW organizations based in that country. But multinationgy from their subsidiaries for imports and exports and use trans te rate fluctuations. For example, they can import Products and not at the higher price due to depreciation of the local eration Mi fy t Drives 18 ma at their 5; tg d SUrtency, “Mth 5 Handle competitive pressures The subsidiaries of an organization Operating in different ¢ pricing to lower prices to match local. competition, nn ig manufacturers in Europe depend mainly on China, aes €xamp fa Therefore, if an organization has subsidiaries in these countries, ta Indi re silk ata lower cost by transfer pricing. Thus, it will be ale ry en) at finished product to match or undercut local competition, wee the prc Reduce the impact of taxes and tariffs Many multinational corporations make use of transfer pricing to reduce th liability. Organizations try to maximize profits in countries where ay lower, thus reducing the tax liability of the organization as a whole. hea = corporations can also reduce the impact of tariffs on imports through transfer ie When purchasing products from the oversea business unis ofthe onan example, the exporting business unit can quote a lower selling price. This will resi in lower tariffs for the importing business unit, since most duties are levied on ts value of the goods imported. Movement of funds between countries A multinational corporation may prefer to invest its funds in one country rather than another. Transfer pricing provides an indirect way of shifting funds into or out ofa particular country. While trying to achieve these objectives specific to international business, disputes may arise between the multinational corporation and the tax authorities in differen countries. Exhibit 7.1 describes such a dispute between some petroleum companies and the Internal Revenue Service® in the US. Exhibit 7.1 Transfer Pricing Dispute between some Petroleum Companies and the Internal Revenue Service in the US jpute betwee" One of the most talked about cases in transfer pricing involves the dis} 1 Revenv Exxon, Chevron, Mobil, and Texaco on the one hand, and the US Oe wie Service (IRS). This was the largest case of alleged tax evasion in the ‘that these IRS demanded $6.5 billion from these companies. The issue roel al companies, which had significant holdings in Aramco, the Ara i company, were sold crude at a price below the market rate by the make Besides, Saudi Arabia forbade them from selling crude elsewhere a afl ice. As a result, these companies sold crude oil to their non-US refintTransfer Pricing = ice. These affiliates th 7 @ mark-up price S then sold the refined produc ai, Since the produet was sold by non-US affiliates, the resulting ich ie amonsidered part of the revenues of the US arms of these companies. ‘This 0 sited the companies as corporate taxes are high in th athe . e US. Accordi bench ices of the crude sold to non-US affiliates shoul pe cing to the the pri . ld have bee al TRS ping rules, This would have resulted in higher domestic ce enet under ones. and consequent, a higher tax burden Profits for these com , without market pevron and Mobil settled the ease out of court, whi Chevmvent in favour of Exxon and Texaco in 1993.1 “i Us Supreme Court; however, the Supreme Court de le the decision of the Tax he IRS further appealed to clined to hear the appeal Adapted from Sanders, Squire and Dempsey L.L.P. “Taxes on Pre e ‘ofits of Multinational Pepa and Implications for Russia.” International Tax and Investment enti Onjord Economic Forecasting. — January 2004, 9; rminwwweiticnel.org/publications/Special%é20Report%20-%620ITIC-Ogp. 5sp%20IninI%420Taxes%20Paper"620eng.pdf>. the rors INFLUENCING TRANSFER PRICIN Fat With governments across the world tightening taxation regulations for imports, exports, and foreign exchange remittances, many organizations are setting up specialized in-house transfer pricing departments, rather than leaving the function to their taxation or accounts departments. Some of the conditions necessary for the development of a proper mechanism of transfer pricing are role definition, external advisers, competent managers, equity, information on the prevailing market prices, and proper investment. In reality, it is very difficult to find an ideal situation that will satisfy all these conditions as some organizational and other constraints will always remain. These constraints are classified into external and internal constraints. In this section, we will first discuss the conditions necessary for the development of a proper transfer pricing mechanism and then, the constraints. Role definition The role and scope of the team responsible for transfer pricing should be clearly defined. For example, in certain organizations, the transfer pricing department only draws up the transfer pricing policies; the implementation and day-to-day management are taken care of by the finance and tax departments. This means that economic analysis, documentation, computation, and accounting will be performed by the finance and tax departments and not by the transfer pricing team itself. In contrast, in other organizations, the transfer pricing department undertakes more than a pure Policy role. In such organizations, it is also responsible for some or all of the facets of implementation and running transfer pricing matters on a day-to-day basis. No matter which model an organization follows, there should be no confusion about the functions of the transfer pricing team, There should be a clear demarcation of activities between the transfer pricing team and the accounts and taxation teams and a document setting out each team’s responsibilities should be circulated to all those Involved. This also ensures that all the necessary tasks are allocated. External advisers en Necessary, organizations must be ready to appoint external advisers whose owledge and experience will be valuable to the transfer pricing team and who can porte Tesources not available in-house. External advisers help the organization to ** the bigger picture, something which the in-house team may not be able to do. 139Manage External Constraints 140 Competent managers Organizations need managers who can balance lon, Managers are often accused of sacrificing long-term gre" and approach can prove disastrous for the organization, Tran for shy eg for manipulating profits, and ths gives a wrong picture Pricing ™ Hence, organizations should have competent peopie st kana” yh arbitration, who are capable of determining the appropri il a ais a long-term goals are ‘not sacrificed for short-term a transfer eit mechanism for negotiating contracts, and the mana, et h There na rf w agg jhe decisions should be trained inthe art of negotiation,” MH® take ah * Dg Pr Equity In order to achieve goal congruency, managers of profit Centers profit centers, should ensure that the transfer prices charged i centers are fair. This will create an atmosphere of trust betwee, n Also, the managers of the selling profit centers should be a the sister cg their goods in the external market, while managers of the buyin the freed 7 ™ have the option of buying their goods from the extemal markets yo" become the main determinant of the transfer price. market yi in Peay, Y the sein iy Information on prevailing market prices When a product is transferred from one profit center to another, the no, price for an identical product ean be taken as the basis for exam H price. While taking the market price of the identical product a a refrence and quantity ofthe reference product should be identical to those ofthe prone transfer price is to be fixed. Moreover, the demand and supply inthe mara the time of delivery should also be considered. However, asthe products sal the organization, the expenses on advertising and marketing are lower andthe nats price can be adjusted to reflect the savings that accrue due to these lower expenses, Managers should be fully aware of market conditions and should have all te necessary information regarding available options and the cost and revenues of exh before they take any decision on whether to purchase from outside suppliers or to resort to in-house sources. For example, managers should be aware of the altematve available and the relevant costs of and revenues from each alternative. Proper investment The transfer pricing department must be well funded and should coordinate well wih other departments in the same organization, the transfer pricing departments of othe business units, as well as with the top management. It is very important for a enterprise to comply with transfer pricing jurisdiction and to maintain documentation of transfer pricing in order to deal satisfactorily with any legal issues that may anise. This is a costly process. inert In practice, it is often not possible, either because of external factors oF i a ot Policies of the organization, to ensure that all these conditions are fulfills instance, very few organizations ensure that the selling/buying divisions are &" freedom to sell to or source products from outside entities. nt Constraints which are imposed by the external environment, like sd regulations, climatic conditions (especially for agro-based products), and 1% cannot be controlled by the organization are called external constraints. Ex Such constraints are limited markets and excess/shortage of industry capacl')Transfer Pricing and selling the goods of the profit centers tet nonexistent. Such a situation PAH atic Wb oats EH De easy , where there is likely to be little independent prea ey integrated seducts. Again, if an organization is the sole pectic capacity for Drowned product then, by definition, outside eapaci Se iatne ease of MNCS, if inra-organization trade rian ines in diferent countries, the interests of the Satine ore ts of one or more of the countries. In oh aaa oe = inne 1 ‘on to source internally become limited, For eae an organization in the US that wants to buy an intermediate product f ple, e UK at a transfer price that is much lower than the it Anis msaction will record & Very low or even zero profit for the organizati ea Te and ts will reduce its tax liability. Therefore, the UK anied nig a tw tis eansaction below market price. In such a case, the organization in the US 10 option but to pay a price closer to the market price. will have rtage of industry capacity ; of excess capacity or a shortage of capacity in the industry in zation operates. In such situations, the business units may not consider ties available to them. An example of such a situation is when there is buying center is not able to procure from outside cause the price in the market is high whereas the selling profit center is selling in the outside market. The reverse of this situation occurs when there is excess capacity in the industry. The buying profit center may purchase from outside vendors even though there is capacity available within the organization. One thing is common in both these situations — the organization, as a whole, is not optimizing its profits. In the first case, the buying center js not able to maximize its output because it does not have sufficient inputs and in the second, the selling center will be maintaining higher inventories. When there is an excess or shortage of industrial capacity, the sourcing decisions taken by the organization are of critical importance. An organization may allow its buying profit center to buy goods from outside if it is getting a better deal in tems of quality, price, and service. Similarly, a selling profit center may be allowed to sell its products in the open market if it gets a higher profit by doing so. Otherwise, the organization may appoint a central body to arbitrate on such issues. Whatever be the case, the management should try to take decisions that optimize the profits of the organization. arket for buyin exist. Ir ns or Subsi ct with the interes! for the organizatt This Excess OF sho! ‘There may be a situation which an organi: all the opportuni a shortage in the industry and the lotenal Constraints The constraints imposed and controlled by the organization itself are called internal constraints, An internal constraint may arise when the existence of excess internal capacity forces the buying center not to purchase from outside sources. This goes against the condition of equity discussed earlier vAnotner situation could be wnere 1 organization makes a significant investment in facilities; then, it will not buy the 80ods from outside sources even though outside capacity exists (unless the outside Price is so low as to be equal to, or less than, the variable cost of producing the items in-house; however, this is likely to happen Very rarely, ifat all) 141Management Control Systems Because ofthese constrains, itis very dificult to inpem ent mechanism in any organization. So, managements ae ye fon Pettey price, which is acceptable to both the selling and buying 1 Orced 4, ete Cost-based price will be discussed in the next section, “METS a g,° Son fe an METHODS OF CALCULATING TRANSFER PRICES ES The methods used to calculate the transfer price ditty fi : organization. Organizations should evaluate all the methods on ” Otganiy that is most suitable for them. The four commonly use a ioe doy tng at 6 transfer price are: the market-based pricing method, the eae of cit % the negotiated pricing method, and the resale price method The sed Pricing mug Market-based Pricing Method or Comparable Uncontrolled Price (cup methods for transfer price caluation ~ lke the twowiep me sharing or profit split method, and two sets of Prices méthod sing Meth, Wing suitable for vertically integrated organizations, at cout ett re ) Organizations that use this method price the goods and Services thy Meh their profit centers at a level equal to the prevailing open market = poy ea and services, This method provides the best evidence of an ami te for example, an organization X'in India that sells textile fos oo" Tae organization Y in Bangladesh, Ifthe rate charged by X in Ind yy current market price — as if the transaction is taking place between Pate 8 organizations ~ then the method of estimating transfer pricing is ny md based pricing method or the CUP method, Pharmaceutical companies ike cy a x) Ranbaxy in India follow the CUP method of transfer pricing. pe) The market-based pricing method has two main advantages. Fr the dvsing operate as independent profit centers with the managers of these unie a completely responsible for the performance of their business unis. Tt nae their motivation, and also makes it easier for the top Management to assess the performance of the individual divisions. Second, tax and customs authorities fore market price method because it is more transparent and they can cross-check the price details provided by the organization by comparing them with markt prices oa ite, In practice, however, the use of the market price as a benchmark is difficult becuse often, there is no competitive market which can provide a comparable price. Thisis due to the fact that there is usually a variation in prices between one market aed another due to differences in exchange rates, transportation costs, local taxes ad tariffs, etc. In addition, an organization may set its selling price based on the suppl and demand conditions prevalent in a specific market. For some types of comples capital equipment, an external market may not exist at all. In sum, these factors ea that a unique market price, which an organization can use to set a transfer price not always exist. Cost-based Pricing Method or Cost Plus (CP) Method 142 3 cost ofthe The cost-based pricing method calculates transfer prices onthe basis of Oy Product or service. These costs are available from the cost accounting TT is organization. For example, ifthe same Indian organization X sels Dg subsidiary Y in Bangladesh and the rte charged by X is, he OA oud manufacturing the fiber plus some margin or mark-up percentage, the estimating the transfer price is known as cost-based transfer pricing:Jn general, forthe purpose of applying a g into three categories: direct maintenance that can be allocated among ser that include selling, administrative, getermine the cost properly. It sho accounting principles for that particula produced. When using this method, the o the costs and the margin percentage and ope big ering expenses S Very important to Costs A problem that arises in the cost-based Pricing method is decidi used — actual costs or standard costs, Non anand Ng What costs are to be standard cost is developed based on the standard cost siren. t®,Petered. A the basis of historical costs and the transfer price is eating vision or on margin to this. The standard price is modified when there ie nnsss¢), ing @ profit the prices of materials or in wage rates, Using the @ considerable change in ; Se sta inefficiencies ofthe selling divisions from being passed on ae ae Prevents the visions, mally, When actual costs are used, the inefficiencies of to the buying division. Moreover, there will be to reduce the actual cost because if it does so, there will not be any increase in the division’s the selling division can be passed on 0 motivation for the selling division the transfer price will be reduced and margin, Profit mark-up After deciding upon the cost, the next question to be answered concerns the profit mark-up. The selling division may either use a percentage of the ae applicable to the product or a percentage of the cost. The disadvantage with using a percentage of investment is that the selling division will have a tendency to employ new assets irrespective of their requirements, since the cost of new equipment will be included in the margin and the selling division will be able to reap higher profits, Apart from this, organizations also have to decide on the treatment of fixed costs and research and development costs. The cost-based pricing method is generally accepted by the tax and customs authorities of a country since it provides some indication that the transfer price approximates the real cost of an item. Cost-based approaches are, however, not as transparent as they may appear. An organization can easily manipulate its cost accounts to alter the magnitude of the transfer price. Negotiated Pricing (NP) Method In this method of transfer pricing, 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 ee 4 transfer price that yields them an appropriate return. However, tax authorities re Teservations about this method because it gives organizations greater scope to manipulate the transfer prices and thus minimize their tax liability. Rese Price (RP) Method The resale price (RP) method is similar to the cost-b method, see i is determined by calculating back SE eee taking place at the next level of the supply chain, by deducting» ut ee from the price at which the internal buyer sells ie Hem Smee Taki il ier, assume ‘aking the example described earlier, ie sst-based pricing method. In thisManagement Cont trol Systems sells the fiber obtained from organization X jn Ing ni manufacturer, at a price A. Using the resale pri Ha, (0 a thing organization X t0 subsidiary Y wil be arived gt rn, then mark-up percentage from the price A Y deducting ans tog in . 8 suitahy, Mice pth However, this method of estimation of transfer lg where the reseller does not add much value to the wesc ™° ap ty Yalue added, the greater will be the difficulty in come’ tt setiy it percentage, mating the yi Then % Margin "ne Alternative Methods for Transfer Price Calculation ity A. typical transfer pricing problem is enc is encounte organizations in industries Tike petroleum and cs ie by vetiaty extracted and processed further to produce the final product," tay ity there is no proper transfer pricing mechanism in place, ibs d I such organ product to outside customers may not be aware ofthe fixe asl’ ed costs the fng Tnternal purchase price. For example, a petro ae crude oil division, the refinery division, a ee has thee dc rtrtts the crude ol and sls Ttto the refinery division, sje” Tol dn through a process of fractional distillation. The output, anh Which refines the Greece by ie saleeeivorwn ihe selon the les ince” © be mae peeeee ac Ue aed asl naursl ricer hae might sell the final product ata price that isnot high enough tee SE Pe De aeanestie lea taney Gal evens is one em, Sere aces i atesente reve ieac ind ofirobletns, auch couracet oe ™ ther methods of calculating transfer price like two-step pricing oft ge Dro shang two sets of prices. Two-Step Pricing Two-step pricing takes into consideration two components of cost ~ a y cetronent anda fixed component, and a profit margin. The pt margins one or both these components. The variable cost component is equal to the cuit production of each unit. The fixed cost component comprises the cost of the facilites required for production such as eleetcity, capital equipments and rent of shop fo. The fixed cost is generally charged ona monthly basis. nsaction 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 adie 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 wit the variable component, say Rs. A per unit, then the transfer price will be (nX + 04+ Y). Profit Sharing or Profit Split (PS) Method between units are much too integrated i. f intangibles makes it imposs © establish comparability with market conditions. Under this method, the 3 transferred to the marketing unit at the standard variable cost. After t et finally sold, the business unis share the profit eamed on the bass ofthe cnt made by each of them. The profit to be split is generally the operating Pry oie the deduction of interest and taxes. In some cases, it mi be Oe pe pl ® g10ss profit, But this method may lead to disagreement over the way th i vFrided between the concerned divisions. As the profis HT vp unit. ABM between the units, it does not accurately reflect the profitability Oe pe mask manufacturing unit may consider this unfair as its share will depe unit's ability to sell and the actual selling price. ag For example, in a trat This method is applied when the transactions be evaluated separately and the existence oTransfer Pricing two sets of prices < methods revenue iS credited to the manufacturing a under ae pening unit is charged for tp tipelat a ee ee price Wie. ouside sales, price av CGS Hn cout “en pees newer tion's accounl. These charges are later nto Seer atibotoate cosa ated ae statements. This method is u nr Te Sean comerags bene the buying, and selling units, whieh eannot be eee cone disadvan this method are; itis difficult to ae metre each time & Transfer of goods is made; and it risiviet det ea scout ce only on internal transfers (where they are assured « Me eat a ween of outside sales. pf a good mark-up) at ‘ table 7 1 provides a summary of the different methods of transfer pricing. is able 7.1: Methods for Calculating Transfer Pic =.No Methods Remarks Peery — < 1 Market-Based Pricing | Organizations transfer goods and servi Method or between their profit centers at a price equal vie Comparable prevailing open market price for those goods oad Uncontrolled Price services. This method provides the best evident ee ice ee L of an arm’s length price: B - 5 | Cost-Based Pricing Transfer prices are calculated on the basis of the Method or Cost Plus cost of the goods or service. This method is (CP) Method applicable when market price of the goods or | service is not available. 3 Negotiated Pricing The buying and selling divisions negotiate a (NP) Method mutually acceptable transfer price. 4 _ | Resale Price (RP) ‘Transfer price is determined by calculating back Method from the transaction 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. This method is more appropriate where the reseller does not add much value to the goods before selling. 5 | Two-Step Pricing There are two ‘components of pricing ~ 2 variable Method component and a fixed component. This method is suitable for vertically integrated organizations. 6 | Profit Sharing or The transfer price comprises @ standard variable Profit Split (PS) cost plus a share of actual profit on sales. This Method method is applied when the transactions between units are much too integrated to be evaluated separately and the existence of intangibles makes it impossible t© ‘establish comparability with Method Teele eal a Ulan) Two Sets of Prices ith the market sales harged for the total s used when there the buying and ved by any The selling un! price and the b standard costs. This method i are frequent conflicts between selling units and they cannot be reso! method. ying unit is © Compil y piled from various sources. 145Management Control Systems PRICES The administration of transfer pricing involy cess, bec 3g implementation process, because any erTOrs in the A lose, egg Mon unintentional, are viewed as grave offenses inthe Se ig to the organization. In this section, we will OF lay ther discuss inj, fi Im and its potential for misuse, iplem, Implementing Transfer Pricing . 146 Implementing a transfer pricing mechanism Involves articyy of the transfer pricing strategy, documentation of the Proves ation ang Com, organization agreements, involvement of mnultdiseiis between the heads of various units, and arbitration and an team, nn conflicts arise. nflict esol Articulation and communication of the transfer Pricing strat, The first step involves identifying the inter-organization transact ny prices. Next, the regulatory transfer-pricing policies that will be sh in obey transaction have to be determined. A decision has to be taken oe ty regulatory transfer pricing policies should be diffrent om the ae the sake of taxation or other legal issues, These policies sail ng communicated tothe concerned managers to prevent confesien cay oy a the Documentation of the transfer Pricing process and inter-organ; i agreements Mating Documentation of all transfer pricing policies is Very important for any or from the regulatory compliance point of view. It is not only the policies, bu. als the interdepartmental and inter-organization agreements governing all ‘transactions tig have to be explicitly documented to avoid the risk of being questioned by authorities. The roles and responsibilities of all the partes involved shoud be cle defined in the agreements. Moreover, the agreements should be flexible enough io operate even under conditions of market uncertainty. Involvement of multi-disciplinary team Proficiency in many areas like financial accounting, tax and legal exis Knowledge of economics, and direct experience in operational functions such RUD. manufacturing, marketing, and distribution are required to successfully handle one Pricing issues. Therefore, the involvement of a multdisciplinary team in the na Pricing department will help the organization to efficiently practice transfer pres Negotiation and conflict resolution i {In most organizations, the business units negotiate among themselves Ee decisions pertaining to transfer prices. Transfer pricing decisions are Oe managers of the respective units who establish the buying and selling ee to involvement of headquarters in the matter, There are two reasons Os wy! i line managers ofthe business units may feel powerless if they ae re bate tansfer prices, and this may demotivate them, Second, i the ree feos Units are poor, then the unit managers may argue that it interference of the ‘op management in fixing the transfer price.Transfer Pricing But there May be times when business units transfer prices. In such situations, the “iene Not able to rea i arbitrating on disputes relating to transfer S follow man . with the headquarters. It may assign a iebeccy responsiblity unit manages and mise an agreement os eeciie Wie tig may be fone with the following responsibilticg: gee’, Alemative review sourcing changes, and to change the transfer ol tanster ye 4 committee reanzations can have a formal or infortal price rules whenever Pues 0 tafe price mechanism and t0 resolve mal Stem of submit a written case to the arbitrator, who felon Ina informal system, most of the presentations are ie it an Agreement on the Set procedure for or arbitration rests alk to the business T necessary, arbitration to formal systey id decides on Administer the ™, both parties the price. tn an management can use vari Sara, taricad SS se Conflict resolution tech 2 f 4 lem solving. Forci mniques ik: Forcing and smo © forcing or . V , whereas bargainit avoidance, Wh ‘gaining and problem solving indicate wed reflect conflict onflict resolutio n, Transfer pricing — potential for misuse Transfer pricing is a very important issu . control. Organizations can misuse eee att of view well as to project a wrong image about their financial he: ic their tax liabilities, as stakeholders. Exhibit 7.2 describes the dispute between oe and thus mislead the Internal Revenue Service (IRS). This incident is an anes inlet ire, and the US efforts to minimize its tax liabilities may be challenge ae ae a company’s However, with stringent government regulations, such eee STi es come rare. of management Exhibit 7.2 The GlaxoSmithKline Transfer Pricing Dispute The US Internal Revenue Service (IRS) demanded back taxes from GlaxoSmithKline (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 was charged with overpaying for product supplies during the period 1989 to 2000 and in subsequent years, 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 IRS wanted the pharmaceutical giant to pay taxes, penalties, and interest. The dispute was to go to trial 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 regulation proposed by the IRS in September 2003. GSK decided to settle the issue to avoid future funi 006, GSK announced proceedings. On September 11, 2 0 dispute by paying $3.1 billion to the IRS. According to commissioner, “The settlement of this case jg an important develof a strong message of our resolve to continue to deal with this issue: mlarticle.cfin/301201 4 outflow toward legal that it was settling the Mark W. Everson, LRS. development and sent elaed>; ond other Adapied from -ee ee Transfer Pricing ‘A transfer price is defined as the int i division, or subsidiary of an organizati i zation goods or service supplied to a bu g ying dey organization. The main objective Ot eaenattiment, division, or uh oF fn ‘of revenues and costs between ransfer pricing is to OF Subsidiary of th oe adopted by an organization Bains cea’ centers ft inthe proper distributes aim at ach S. The transfe ution .formance appraisal, and divis‘ nieving the objec fer pricing po uate Seta fee autonomy cian of goal compre fer pric ence ‘ompetitive pressures, fiat scams Of managing exchan, wut beneficial : es and movement Per ies the impact of th Tate fluctuations ie - entities, inds betwe eS and handling en countries, ariffs on the legal al pric © charges for a raw pees OY 8 sell W Material, common = department In order to establish a proper mecha i nism of transfer te fulfilled. These are role definition, competent he in — wel See market prices, Proper aaa ie reality, it gi pls : ry : ult to find an ideal situation that will s Gate tee and some external or internal constraints will always re nr main, ricin Pricing, certain conditions have to Ser, equity, Organizations commonly use four method: the market-based pricing method or ees cas the cost-based pricing method or Cost Plus (CP) SMe nae method, and the resale price (RP) method. Due to the aire eee vertically integrated organizations, these organizations may al th ieee methods for transfer price calculation like the two-step pa 2 he ane or profit split method, and the two sets of prices method. Ce Implementation of transfer prices is even more difficult than their formul Organizations need to articulate and communicate the transfer pricing a f ai the related parties, maintain all relevant documentation, involve inline teams in the implementation, and provide negotiation and conflict eG overcome problems and avoid the misuse of transfer prices n of the Indian economy has led to a phenomenal growth in the The liberalizatio industrial and services sector. The availability of cheap skilled labor has resulted in id other nations. This increased cross-border related party transactions between India an has made transfer pricing very important from the taxation point of view. The Indian pricing regulations with effect from April government has introduced detailed transfer 1, 2001, to reduce tax avoidance by organizations operating in India. ee Se End Notes: Management Accounting: 1994, pl. "Pass, Christ ” e ' ss Christopher. “Transfer Pricing in Mi Itinational Companies "zine for Chartered Management AccounaIS: Vol. 72 Issue 8, September : ; D. Shields. Handbook of 2 Chapman, Christopher S.; Anthony G. Hopwood; ite ‘Management Accounting Research. Elsevier. Vol. 2, ay i 6 a 03 50-0. i jing, Thomson arin} » Lucey, Terence. Management ‘Accounting, EK tne : the force ofthe other. ‘ falso known as te In finance, the exchange rate ( es how much one currency is worth it = pooner Tate) between two ‘currencies specifi nt For example, an exchange rate of 40 se es (UsD, $) means that Rs 40 will buy one us! 149