Transfer pricing Dr. Haider Shah

Learning Objectives? To have an overview of transfer pricing system To understand TP’s effects on divisional performance To have an overview of international TP

Transfer Pricing Transfer pricing refers to the pricing of goods and services within a multi-divisional organization. Goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary. Co. B £10 Co. A Assembly centre Receiving Division Production centre £6 components Receiving Divisions Co. A Co. C Supplying Division £10 Assembly centre Assembly centre

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- objectives Transfer pricing should help achieve a company’s strategies and goals by –intentionally moving profits between divisions – promoting goal congruence & a sustained high level of management effort - providing information for: making good economic decisions evaluating the managerial and economic performance of the divisions. - ensuring that divisional autonomy is not undermined.

Transfer-Pricing Methods Market-based transfer prices Cost-based transfer prices Marginal cost Full cost Cost plus markup

Example: Oslo & Bergen Expected sales of the final product Oslo = Supplying division (No external market for the intermediate product) Bergen = Receiving division (converts intermediate to final product) Expected sales of the final product Net selling price (£) Quantity sold Units 100 1 000 90 2 000 80 3 000 70 4 000 60 5 000 50 6 000

The costs of each division are: Oslo Bergen (£) (£) Variable cost per unit 11 7 Fixed costs attributable to the products 60 000 90 000 The transfer price of the intermediate product has been set at £35 based on a full cost plus mark-up.

Example: Oslo & Bergen (cont.) © 2000 Colin Drury

Example: Oslo & Bergen (cont.) © 2000 Colin Drury

Bergen Company Oslo £35 TP £23 TP 4000 units £11 TP 5000 units (Full cost without mark-up) £11 TP 5000 units (MC price) © 2000 Colin Drury

Resolving transfer pricing conflicts 1. Adopt a dual rate TP system Based on two transfer prices Full cost plus a mark-up for Supplying Division MC of transfers for Receiving division Profit on inter-group trading removed by an accounting adjustment. Not widely used because: 1. Use of two TP ’s causes confusion 2. Seen as artificial 3. Divisions protected from competition 4. Reported inter-divisional profits can be misleading 2. Transfer at MC plus a lump sum fee Supplying division to cover its fixed costs and earn a profit through the fixed fee charged for the period. Receiving division to consider full cost of providing intermediate products/services © 2000 Colin Drury

Domestic TP Recommendations Competitive market for the intermediate product No market / imperfect market for the intermediate product Use MC + lumpsum (negotiated) Use standard costs for cost-based TPs

Achieves Goal Congruence Comparison of Methods Achieves Goal Congruence Market Price: Yes, if markets competitive Cost-Based: Often, but not always Negotiated: Yes

Useful for Evaluating Subunit Performance Comparison of Methods Useful for Evaluating Subunit Performance Market Price: Yes, if markets competitive Cost-Based: Difficult, unless transfer price exceeds full cost Negotiated: Yes

Comparison of Methods Motivates Management Effort Market Price: Yes Cost-Based: Yes, if based on budgeted costs; less incentive if based on actual cost Negotiated: Yes

Preserves Subunit Autonomy Comparison of Methods Preserves Subunit Autonomy Market Price: Cost-Based: Negotiated: Yes

Comparison of Methods Other Factors Market Price: No market may exist Cost-Based: Useful for determining full-cost; easy to implement Negotiated: Bargaining takes time and may need to be reviewed

Common transfer pricing problems 1. Performance problems 2. Interpersonal disputes 3. 4. Demand fluctuation 5. Product pricing

International Transfer-Pricing Where divisions are located in different countries taxation implications become important TP has the potential to ensure that most of the profits on inter-divisional transfers are allocated to the low taxation country.

International transfer pricing Supplying Division Receiving Division Country A (Tax rate = 25%) Country B (Tax rate = 40%) Motivation is to use highest possible TP so receiving division will have high costs and low profits whereas supplying division will have high revenues and high profits. TP can also have an impact on ___________and dividend repatriations. Fiscal authorities react by anti-avoidance legislation e.g. OECD guidelines based on Arm ’s Length pricing principle.

Arm ’s Length Principle Drawing by David Rooney

Arm ’s Length Principle The parties to a transaction are independent and on an equal footing. If they had done a transaction with a non-related organisation, they would have charged same price.

References & further Reading Drury. C. Textbook, chapter 21 Ken Garrett (1992), Transfer pricing explained Parts one and two , Accountancy , September/October Emmanuel, Clive R. (1999), "Income Shifting and International Transfer Pricing: A Three-Country Example"Abacus, 35 (3), pp 252-266 Elliott, J. and Emmanuel, C. (2000), International Transfer Pricing: Searching for Patterns, European Management Journal , Vol. 18, No. 2, pp. 216–222