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Transfer Pricing

IFM 2015

Concept
It is the pricing of inter-corporate transactions.
There exist vertical and horizontal linkages among these units.
The prices charged on raw material and finished goods sold and
bought from one unit to the other within the MNC is known as
transfer pricing.
These prices are normally either under-invoiced or over-invoiced.
The difference is that arms-length pricing is done between
unrelated parties.
The objectives of the MNC firm determine what should be done
over or under invoicing.
The overall objective is maximization of global profits.
Accordingly, transfer pricing practices emerge.

Setting of Transfer Prices


Transfer Price embraces two elements:
1. Arms length price determined by:
A. Market Price; and
B. Cost of Production.
2. Arbitrary margins built into transfer price
to meet specific firm objectives.

Motives of Transfer Pricing


Three factors:
1. The huge R & D cost has to be recovered through
transfer pricing and this is easy to do if it is done
within the firm. Moreover, the MNC would usually
have a patent and hence can hike up the price and
recover such cost.
2. There are market imperfections due to tax rates,
tariffs, exchange controls, currency risk, etc. Profits
are maximized by transferring value from one unit to
the other thereby maximizing profit.
3. It is also done for working capital management.
The surplus liquidity units funds are transferred to
the deficit liquidity units.

Other motives
4. Reducing tax burden: On account of
corporate tax differentials amongst different
countries MNCs introduce transfer pricing
for manipulating income and avoiding
taxes.
5. Lowering of tariff burden: It is seen that
reduction of tariff burden is often amore
important motive that reduction of tax
burden. However, quantitative restrictions
cannot be handled through transfer pricing.

Methods

1. Uncontrolled market price: this determines the


arms length price. This relates to price charged on
sales to unrelated parties outside the firm. This must
be done in markets that a comparable.
2. Resale price: It is the price which is purchased from
a related seller and sold to a independent buyer. This
done if uncontrolled price is not available.
3. Cost-plus method: This used for determining arms
length price when semi-finished products are sold
amongst related parties.
4. After the arms length price is set then the there is a
arbitrary margin that is built-in to the price depending
on the need for over-invoicing or under-invoicing.

Regulation

Some people think that there should no regulation so


that MNCs need not do such manipulation. However,
it is too idealistic to think of such a possibility.
Direct Regulation: The host government replaces the
transfer price with its own decided price. The intrafirm price is changed. The problem is that for the
host government to do it they must have the
comparable uncontrolled price. The motive of the
government is to regain the lost tax revenue.
This method is successful in intermediate products
which are well known and for which arms length
price is known.

Contd.
This was introduced for the first time in US
in 1973.
It has been found that this method is
completely unsuitable for 40% of the cases.
Many a time host country government fix a
ceiling on royalty payments within the firm.
But this is also resisted by MNCs.
Sometimes arbitration is sued for
overseeing such control and regulation.

Indirect regulation
A. Harmonization of tax and tariff
differentials between home and host
country.
B. Tax holidays.
C. Avoidance of Double Taxation treaties.
D. Taxation of royalty and other intra-firm
payments for compensating for loss of
corporate tax revenue.
E. Apportion consolidated profit on the basis
of some criteria like sales or assets. This is
resisted by MNCs on various ground.