Chapter 11


Copyright © 2009 by The McGraw-Hill Companies, Inc. All


International Transfer Pricing
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



International Transfer Pricing
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
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.


Discuss transfer pricing methods used in the sales of tangible property. Describe worldwide efforts to enforce transfer pricing regulations. 11-4 . Explain how advance pricing agreements can be used to create certainty in transfer pricing. 6. 7. International Transfer Pricing Learning Objectives 5.

 Transfers also occurs between different subsidiaries of the same parent. while downstream transfers are from parent to subsidiary.  A significant proportion of international transactions are intercompany transfers. Transfer Pricing Background  Transfer pricing is the determination of price on the exchange of goods or services between related parties. 11-5 .  These transfers are also referred to as intercompany transactions.  Upstream transfers go from subsidiary to parent.

Learning Objective 1 11-6 .  An agency problem can occur since division managers make decisions in their self-interest.  It also permits local decision making which provides more responsibility for division managers.  The manager’s self-interest can vary with the best interests of the company. Decentralization and Goal Congruence Decentralization and agency problems  Decentralized companies are organized by division and division managers have significant authority.  This structure decomposes problems into smaller pieces.

 These concepts are relevant to both multinational and purely domestic companies. Learning Objective 1 11-7 . Decentralization and Goal Congruence  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.

 The effectiveness of these performance evaluation systems is influenced by the fairness of transfer prices.  Some performance evaluation systems are based on divisional profits. and Transfer Pricing Performance evaluation systems  Transfer prices directly affect the profits of the divisions involved in an intercompany transaction. Performance Evaluation. Cost Minimization.  The effectiveness of performance evaluation systems affects the satisfaction of managers. Learning Objective 2 11-8 .

 This is referred to as discretionary transfer pricing. Performance Evaluation. by extension.  Manipulating transfer prices between countries is one way for multinational enterprises to achieve cost minimization.  The most common approach is to minimize costs by shifting profits to lower tax rate jurisdictions. cost minimization are important corporate objectives. Learning Objective 2 11-9 . Cost Minimization. and Transfer Pricing Cost minimization  Profit maximization and.

Hijo and Hija.  The cost per unit is $5 for Hijo and Hija sells the units in the U. company. at $15 per unit.Example Padre Inc..  Padre intervenes to set the transfer price at $13 per unit. Hijo is located in Chile and Hija in the U.     Learning Objectives 2 and 3 11-10 .S. Performance Evaluation.S. a U.S.S. and Transfer Pricing Cost minimization -. The tax rate is 17 percent in Chile and 35 percent in the U. Cost Minimization. Hijo transfers 100 units of cosa to Hija at a negotiated transfer price of $10 per unit. has two subsidiaries.

000 500 $500 85 $415 Hija $1.000 260 $740 11-11 . Performance Evaluation.500 1.000 $500 175 $325 Padre $1. and Transfer Pricing Cost minimization -.500 500 $1. Cost Minimization.Example  Divisional profits under the negotiated transfer price: Sales Cost of goods sold Gross profit Income tax effect After-tax profit Learning Objectives 2 and 3 Hijo $1.

000 206 $794 11-12 .500 1. and Transfer Pricing Cost minimization -. Performance Evaluation. Cost Minimization.500 500 $1.300 500 $800 136 $664 Hija $1.300 $200 70 $130 Padre $1.Example  Divisional profits under the discretionary transfer price: Sales Cost of goods sold Gross profit Income tax effect After-tax profit Learning Objectives 2 and 3 Hijo $1.

Cost Minimization.  The performance evaluation objective is better served by the negotiated transfer price. to Chile.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. Performance Evaluation. and Transfer Pricing Cost minimization -.  The cost minimization objective is better served by the discretionary price. Learning Objectives 2 and 3 11-13 .  The overall tax rate decreases from 26 to 20.6 percent.S.

 Under dual pricing. Performance Evaluation. and Transfer Pricing Conflicting objectives and a solution  The previous example illustrates how cost minimization and performance evaluation can conflict. Cost Minimization. the official transfer price used for tax purposes is the discretionary transfer price.  Dual pricing is one solution to this conflict.  A separate set of records used for performance evaluation use the negotiated transfer price. Learning Objective 2 11-14 .

 Reduction of import duties  Increase cash flows out of a devaluing currency  Enhance the competitive position of a foreign operation  Transfer pricing method (cost-based or market-based) depends on specific environmental variables. Performance Evaluation. and Transfer Pricing Other cost minimization objectives  Withholding taxes on dividends can be effectively avoided via setting favorable transfer prices. Cost Minimization.  This essentially changes cash flows from dividends to intercompany revenues and expenses. Learning Objective 3 11-15 .  The same can be done to avoid profit repatriation restrictions.

Learning Objective 4 11-16 .  The guidelines typically use the notion of an arm’s-length price. Government Reactions  Governments are aware of risk that multinationals will use transfer pricing to avoid paying income and other taxes.  Arm’s-length price is the price that would be agreed upon by unrelated parties.  Most governments publish guidelines regarding acceptable transfer pricing.

S.  Important because most MNCs are either headquartered in or have significant business activities in the U.  It applies to both upstream and downstream transactions. Transfer Pricing Rules (IRC Section 482)  This rule allows the Internal Revenue Service to audit international transfer prices. and transactions between two subsidiaries of the same parent. transfer pricing reforms have influenced other countries’ regulations.  Penalties of up to 40% of the underpayment of taxes can be imposed on violators. Government Reactions U.S. Learning Objective 4 11-17 .S.  U.

Learning Objective 4 11-18 . Transfer Pricing Rules (IRC Section 482)  A best methods rule requires the use of arm’s-length concept.  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.S. Government Reactions U.  Primary factors to consider are the degree of comparability to uncontrolled transactions and the quality of the underlying analysis.

 Sale of Tangible Property Five methods      Comparable uncontrolled price method Resale price method Cost-plus method Comparable profits method Profit split method Learning Objective 5 11-19 .

an adjustment is allowable.  If an uncontrolled transaction is not exactly comparable. 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. Learning Objective 5 11-20 .

 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. Learning Objective 5 11-21 .

 Gross profit is determined by reference to uncontrolled parties. Learning Objective 5 11-22 .  Factors influencing the comparability of uncontrolled transactions include: complexity of manufacturing process. procurement activities. 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. and testing functions.

 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. Learning Objective 5 11-23 .  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 operating income to sales.

 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. Learning Objective 5 11-24 .  There are actually two versions: comparable profit split method and residual profit split method. risk assumed.  Contribution is determined by functions performed.  Allocation is based on relative contribution of each party. and resources employed.

 Companies can also use discretion in determining the “best” method. an analysis of the economic and legal factors as well as an explanation of why one method was selected over alternatives).g.  Section 482 does provide detailed guidance on factors to consider in determining comparability to uncontrolled transactions.  Substantial reporting and record-keeping requirements Learning Objective 5 11-25 . 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.  Taxpayer must provide contemporaneous (within 30 days) documentation justifying method selected. covering at least eight specified items (e.

 Other Transfer Pricing Situations Licenses of intangible property  Section 482 lists six categories of intangibles. trademarks. including: patents.  Four methods are available for setting transfer prices:     Comparable uncontrolled transaction method Comparable profits method Profit split method A group of unspecified methods  Pricing of intercompany loans and intercompany services are also transfer pricing situations. and methods and procedures. Learning Objective 5 11-26 . copyrights. franchises.

 The primary disadvantage is the time and cost involved in arriving at the agreement.  The primary advantage is assurance that their approach will not be challenged.  A unilateral agreement is between a taxpayer and one government. Advance Pricing Agreements (APA) Background  An APA is an agreement between a company and a taxing authority regarding an acceptable transfer pricing method. while a bilateral agreement involves a taxpayer and two governments. Learning Objective 6 11-27 .

of a total of 58 agreements executed in 2003..  The computer and electronics manufacturing industry is the leading user of APAs. Advance Pricing Agreements (APA) Some specifics of national APAs  The U. began its APA program in 1991.  In the U.  An increasing number of other countries have subsequently established programs.S.S. Learning Objective 6 11-28 . approximately 60 percent involve foreign parent companies.

a U.S.  Some of these cases reflect obvious attempts by companies to evade U. subsidiary sold bulldozers to its foreign parent for $551 each.  From 1996-2000. income tax. and foreign.S.S. taxes by manipulating transfer prices. and foreign multinationals paid no U.S. deemed to have underpaid taxes in the U. Worldwide Enforcement  There are a number of documented cases of companies.  In one case. over 60 percent of U.  There is a worldwide trend toward strengthening transfer pricing rules. Learning Objective 7 11-29 . both U.S.S.

with penalties imposed in 15% of those cases. complicated disputes and increased scrutiny by local authorities a company may just pay the additional tax. Worldwide Enforcement  Tax authorities view transfer pricing as a “soft target”.  In 2007 an Ernst & Young survey showed that 50% of respondents had experienced a transfer price audit somewhere in the world since 2003.  78% thought an audit was likely in the next two years.  More than 25% of completed audits resulted in a tax adjustment. Learning Objective 7 11-30 .  To avoid lengthy.