Transfer Pricing - PowerPoint by F6NFUxzs


									Transfer Pricing

Dr. Clive Vlieland-Boddy
Transfer Price: What and Why?
• TP means the value or price at which
  transactions take place amongst related parties.
• TP are the prices at which an enterprise
  transfers physical goods and intangible property
  and provides services to associated enterprises
• TP gain significance because these can be used
  by the controlling party to their advantage to
  minimise tax incidence.
Transfer Price: What and Why?
• Approximately 60% of the total
  transactions across the world are between
  related parties.
• If the transactions are across different tax
  jurisdictions, where tax rates are different,
  shifting is beneficial.
 Factors Affecting Transfer Pricing
• Internal factors: Performance
  Measurement and Evaluation
• External Factors:
  – Accounting Standard
  – Income Tax
  – Custom Duty
  – Currency Fluctuations
  – Risk of Expropriation
Transfer Pricing
      Transfer Pricing
   When divisions transfer products or
 render services to each other, a transfer
pricing is used to charge for the products
                or services
  Benefits of Transfer Pricing
1. Divisions can be evaluated as profit or
   investment centers.
2. Divisions are forced to control costs and
   operate competitively.
3. If divisions are permitted to buy component
   parts wherever they can find the best price
   (either internally or externally), transfer
   pricing will allow a company to maximize
   its profits.
 Commonly Used Transfer Prices
1. Market price approach sets the price at which
   the product transferred could be sold to outside
2. Negotiated price approach allows decentralized
   managers to agree (negotiate) among
3. Cost price approach (variable or full) uses a
   variety of cost concepts for setting the transfer
  Commonly Used Transfer Prices

Variable Cost     Full Cost        Market Price
per Unit $10     per Unit $13      per Unit $20

                Negotiated Price
Transfer Pricing—Negotiated Price Approach
   1. Division M produces a product with a variable
      cost of $10 per unit. Division M has unused
   2. Division N purchases 20,000 units of the same
      product at $20 per unit from an outside source.

     If the division managers agree on a price of
           $15 per unit, how much will each
              division’s income increase?
                  Transfer Pricing
• Definition
   – Determination of exchange price when different business
     units within a firm exchange the products and services
• When it is important
   – Firm with vertical integration, having different value-
     creating activities in the value chain
• Objective
   –   To motivate managers
   –   To provide appropriate incentive for managers
   –   To provide basis for fairly rewarding managers
   –   Minimize taxes locally as well as internationally
   –   To develop strategic partnership
     Transfer Pricing Methods
• Variable Cost Method
  Transfer price = variable cost of selling unit + markup
• Full cost Method
  Transfer price = Variable Cost + allocated fixed cost
• Market Price Method
  Transfer price = current price for the selling unit’s in the
• Negotiated price method
   Choosing the Right Transfer
• Is there an outside supplier?
• Is the seller’s variable cost less than the
  market price?
• Is the selling unit operating at full
    Cole Division Assumptions
• Cole Division will buy components only
  from Bayside division I.e. there is no
  outside supplier
• Cole can sell inside or outside the firm
• Cole division is at full capacity
 Robert Products Inc.


         Diamond   Price = $1,500
                          Cole Division

Internal to the firm                              External to the firm
  3,000 Units, var cost                           3,500 Units, var cost
                               Bayside division   $250 per unit
  $300 per unit

                Price =$600                       Price = $500

 Further processing variable                      Further processing variable
 cost- $500                     Cole Division     cost- $400

 price= $1,100 or                                  price $1,250
          Diamond division                           Wales company
                  Diamond Division
 Cole Division                                     London Company

Variable cost - $300            Bayside division         Variable cost-$200

                      Price =$600                      Price= $400

Further processing                                 London company
variable cost- $500         Diamond division

            3,000 Units                              3,000 Units,
                                                     price- $1,500

                         Diamond Division
            Cole Division
If there is an outside supply ----Yes.
Is the seller’s variable costs < outside price?
Does seller have excess capacity? No.

If contribution from outside purchase >
   contribution from inside purchase . . .

 Decision to Transfer: Sell outside.
                  Transfer Pricing
                                Option -1
                 Cole Division Sells to Diamond Division

              Contribution Income Statement -3,000 units

                              Cole Division   Bayside        Total
Sales ( $1,500, $600)            $1,500         $600         $2,100
Less: Variable Costs
      component cost     #        $600                        $600
      processing cost     #       $500          $300          $800
Contribution Margin/Unit          $400          $300          $700
Total Contribution Margin      $1,200,000     $900,000     $2,100,000
                    Transfer Pricing
                                    Option -2
                  Cole division Sells to Outside Firm ( Wales)

         Contribution Income Statement -3,500 units

                                               Bayside        Bayside
                                    Cole     supplying to   supplying to
                                  Division      Cole          London         Total
Sales ( $1250, $500, $400)         $1,250       $500           $343
Less: Variable Costs                                                         $500
   component cost            ##    $500                                      $821
   processing cost        ##    $400            $250           $171          $771
Contribution Margin/Unit        $350            $250           $171          $771
Total Contribution Margin    $1,225,000        $875,000       $600,000     $2,700,000

               The firm benefits more from Option 2.
            Strategic Factors
• International Transfer Pricing Consideration
  – Tax Rate- minimize taxes locally as well
  – Exchange Rate
  – Custom Charges
  – Risk of expropriation
  – Currency Restriction
• Strategic relationship
  – Assist bayside division to grow
  – Gain entrance in the new country
  – Supplier’s quality or name
     Q2. What Everyone Wanted
Senior Management
1.   System that encourages decisions consistent with long-run
     •      Encourage actions that benefits the overall company’s
2.   Allows managers to distinguish costs relevant for short-run
3.   Transfer prices could be used to support decisions in both
     marketing and operating divisions, including:

         Marketing                    Operations
         - Product Mix                - Inventory levels
         - New Product Introduction   - Batch sizes
         - Product deletion           - Process Improvements
         - Pricing                    - Capacity management
                                      - Outsourcing: make vs. buy
     Q2. What Everyone Wanted
Division Managers
1.   Transfer prices would report the financial performance of their divisions
2.   Managers could influence the reported performance of their divisions by
     making business decisions within their scope of authority
     •   Performance should reflect changes in product mix, improved
         efficiency, investment in new equipment, and organizational
3.   Decisions made by managers of marketing divisions would reflect both
     sales revenue and associated expenses incurred in the operations
4.   The system must anticipate that division managers would examine the
     method and take actions that maximized the reported performance of
     their divisions
Global Trends
               Related Parties
• Control by ownership
   – 50% of the voting right
• Control over composition of board of directors
   – Power to appoint or remove the directors
• Control of substantial interest
   – 20% or more interest in the voting power
        Arm’s Length Price
• Price which two independent firms would
  agree on.
• Price which is generally charged in a
  transaction between persons other than
  associated enterprises.
 Transfer Pricing: The Most
    Important Tax Issue
• Overall
  – TP continues to be, and will remain,
    the most important tax issue facing
    Multinational Enterprises (MNEs)
• More and more countries have
  introduced comprehensive
  documentation and penalty
• Increasingly aggressive audit
    Global Trends: Changing
• Changing Environment
  – “New wave” of entrants to enforcement of
    transfer pricing
  – “Old guard” making significant changes to
• Trends
  – ‘In principle’ acceptance of arm’s length
    principle on a consistent basis with
    Organization for Economic Co-operation and
    Development (OECD) norms and guidelines
  – However, Major divergence of approaches in
     The Most Important Tax

     Transfer                                      39%
 Tax Planning                                      32%
       Double                                       9%
 Value Added                                        8%
           Tax    0%       10% 20%     30%         40%
43% of European and 49% of Asian-
Pacific respondents identified transfer             3%
  Foreign Tax Source: Ernst important tax 3%         issue
pricing as the most& Young Global Transfer Pricing Survey 2005-06
      Credits their organization
Global Growth in Importance

         Source: Ernst & Young Global Transfer Pricing Survey 2005-06
  Asia–Pacific: Transfer Pricing
         Growth in Importance
    Not Very
   Not at All
                0%   10%   20%   30%   40%   50%   60%

    Result for Asia–Pacific parent
     company respondents is very
               Source: Ernst & Young Global Transfer for
     similar to the global resultPricing Survey 2005-06
         Country Updates
    United States
    – Introduced on July 31, 2006 temporary
      regulations on Inter-company services
      transactions and allocation of income from
      intangibles. Key features of the new
      regulations are:
        • Evaluates arm’s length price for certain
          “covered” services using total Services
          Costs either with ‘no’ markup or low
          median comparable mark-up of 7%;
     Evaluates the economic benefits of services availed by the ‘buyer’ in
        • Examples of covered services:
                          the entire supply chain

            – Payroll and processing certain benefits payments
            – Processing accounts receivable and payable
         Country Updates
    – Introduced Transfer pricing guidelines in
      February 2006. Salient features are:
      • General acceptance to arm’s length principle
        outlined in OECD guidelines
      • Provision of APA / MAP mechanism to minimize
        / eliminate economic double taxation (detailed
        guidelines yet to be issued)
      • Acceptance of 5% mark-up for inter-company
        services, provided ‘routine’ and ‘non-core’ in
      • Interest-free loans by Singaporean to affiliates
        will be subject to TP review
• France
  Associated Enterprises – Some
   – Very wide definition and includes enterprises
     “economically” related
        – Where one entity or one or more persons,
            directly or indirectly, or through one or more
            intermediaries, participates in the management
            or control or capital of the other enterprise
            (26% criteria)
        – Where Loan provided by one enterprise
            constitutes 51% of the assets of the other
        – Where one entity is “wholly” dependent on the
            intangibles provided by the other entity.
        – Where one entity buys 90% or more, of its raw
August 2003                                                34
            materials from the other enterprise.
Bye for now!      I’m ready for
                some leisure time.

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