1. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6 International Transfer Pricing

2. 11-2 International Transfer Pricing Chapter Topics  Transfer prices, corporate objectives, national tax laws.  Cost minimization and performance evaluation.  National tax guidelines.  Five specific methods to determine arm’s-length prices.  Advance pricing agreements (APAs).  Enforcement of transfer pricing regulations.

3. 11-3 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 prices. 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.

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

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

6. 11-6 Transfer Pricing Background  The U.S. Census Bureau, U.S. Department of Commerce, announced today that in 2009 related-party trade accounted for over 40 percent ($1,048 billion) of total goods trade ($2,615 billion).

7. 11-7 Transfer Pricing Background  The basic question that must be addressed:- At what price should intercompany transfers be made? Two factors heavily influence the manner in which Transfer Pricing are determined: 1.The objective that headquarter wishes to achieve through its Transfer Pricing  Performance evaluation and control  Cost minimize 2.The law that existing in most countries governing the manner in which intercompany transactions crossing the border may be priced. So MNCs must walk a fine line between achieving corporate objectives and complying with applicable rules and regulations

8. 11-8 Decentralization and Goal Congruence  Business enterprises are often organized by divisions.  A division may be a profit center or investment center.  Top management delegates or Decentralize authority and responsibility to division managers, so they have significant authority.  Advantages of Decentralization :  This structure decomposes problems into smaller pieces.  It also permits local decision making which provides more responsibility for division managers.  It also motivating local mangers.  disadvantages of Decentralization  division managers may make decisions in their self-interest. Learning Objective 1

9. 11-9 Decentralization and Goal Congruence Decentralization and agency problems  An agency problem can occur since division managers make decisions in their self-interest.  The manager’s self-interest can vary with the best interests of the company. Learning Objective 1

10. 11-10 Decentralization and Goal Congruence 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.  These concepts are relevant to both multinational and purely domestic companies.  The system used for the evaluating performance of division managers is an important in achieving Goal Congruence. Learning Objective 1

11. 11-11 Performance Evaluation, Cost Minimization, and Transfer Pricing Performance evaluation systems  Transfer prices directly affect the profits of the divisions involved in an intercompany transaction.  Some performance evaluation systems are based on divisional profits.  The effectiveness of these performance evaluation systems is influenced by the fairness of transfer prices.  Appropriate transfer prices can insure that each subsidiary profit accurately reflects its contribution in parent profit, thus providing basis for efficient allocation of resources.  The effectiveness of performance evaluation systems affects the satisfaction of managers. Learning Objective 2

12. 11-12 Transfer Pricing Methods  The Methods used in setting transfer prices in an international context are essentially the same as those used in demotic context :  Cost-based transfer price  Cost-plus based transfer price  market-based transfer price  Negotiated price

13. 11-13 Cost-based transfer price  Cost-based transfer price  Cost-plus based transfer price  Cost can be determined as variable production cost, variable plus fixed production cost, full cost. Based on either actual or budgeted amounts (standard cost)  Transfer price often include a margin of profit for the seller (Cost-plus based transfer price).

14. 11-14 Cost-based transfer price  This Method has two problems:- 1.The first related to the issue of which measure of cost to use. 2.Inefficient in one division or subsidiary may be transferred to other units. (The use of standard cost may be alleviate this problems ).

15. 11-15 Market-based transfer price  transfer price charged a related party is either ;  Based in the price that would be charged to an unrelated customer or.  Determined by reference to sales of similar product or services by other companies.

16. 11-16 Market-based transfer price  This Method has two advantages:-  Market-based system avoid the problems associated with cost-based system of transferring Inefficiency.  Market-based system help ensure divisional autonomy and provide a good basis for evaluating performance.  This Method has one major problem:-  The efficient working for a market based system depends on the existence of competitive market.

17. 11-17 Negotiated price.  The transfer price is the result of Negotiation between buyer and seller.  This Method gives the subsidiaries managers the freedom to bargain with one another, Thereby preserving the autonomy of subsidiary managers.  This is important to be existence of an objective basis to Negotiate  One problem of this system that’s Negotiation take long time.  Another problem that the price agreed on may be a result of the ability one to Negotiate more than another.

18. 11-18 Objectives of International Transfer pricing  There are two expected Objectives  Performance Evaluation  Cost Minimization

19. 11-19 Performance Evaluation, Cost Minimization, and Transfer Pricing Performance Evaluation  To fairly Evaluation of the Performance of two parties involved in intercompany transactions, the transfer price should be acceptable to them.  To be acceptable price must be determined by  Reference to outside market price, or by,  Allowing the two parties to negotiate a price.  For domestic Transfer Pricing the only goal is Performance Evaluation Learning Objective 2

20. 11-20 Performance Evaluation, Cost Minimization, and Transfer Pricing Cost minimization  Profit maximization and, by extension, cost minimization are important corporate objectives.  Manipulating transfer prices between countries is one way for multinational enterprises to achieve cost minimization.  This is referred to as discretionary transfer pricing.  The most common approach is to minimize costs by shifting profits to lower tax rate jurisdictions. Learning Objective 2

21. 11-21 Performance Evaluation, Cost Minimization, and Transfer Pricing Cost minimization -- Example  Padre Inc., a U.S. company, has two subsidiaries, Alpha and Beta.  Income tax rate is 35%  Alpha is manufactory / sells DVD  Beta is retailer / buy and sells DVD  Alpha require $130 to 135 price per unit  Beta can pay $127 to 132 price per unit so $130 is good to both (negotiated price) Learning Objectives 2 and 3

22. 11-22 AlphaBetaPadre Sales130160160 COGS100130100 Gross profit303060 Income tax10.510.521 Net income19.519.539

23. 11-23 15  Now assume that Alpha located in Tiwan and beta located in USA.  Income tax rate in tiwan is 25%.  What you think about the reaction of Padre? Padre intervenes to set the transfer price at 150

24. 11-24 AlphaBetaPadre Sales150160160 COGS100150100 Gross profit501060 Income tax12.53.516.5 Net income37.56.544

25. 11-25  The chief executive officer of parent company is pleased with this result.  The president of alpha company also happy  The president of Beta company so sad.

26. 11-26 Performance Evaluation, Cost Minimization, and Transfer Pricing Conflicting objectives and a solution  The previous example illustrates how cost minimization and performance evaluation can conflict.  Dual pricing is one solution to this conflict.  Under dual pricing, the official transfer price used for tax purposes is the discretionary transfer price.  A separate set of records used for performance evaluation use the negotiated transfer price. Learning Objective 2