1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Twelve International Transfer Pricing Copyright © 2012 The McGraw-Hill Companies, All Rights Reserved

2. 12-2 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.

3. 12-3 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. 12-4 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. 12-5 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, while 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 (in 2009 represented 40% of U.S. total goods trade).

6. 12-6 Decentralization and agency problems Decentralized companies are organized by division and division managers have significant authority. This structure decomposes problems into smaller pieces. It also permits local decision making which provides more responsibility for division managers. 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

7. 12-7 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. Learning Objective 1

8. 12-8 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. The effectiveness of performance evaluation systems affects the satisfaction of managers. Learning Objective 2

9. 12-9 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

10. 12-10 Cost minimization – Example Padre Inc., a U.S. company, has two subsidiaries, Hijo and Hija. Hijo is located in Chile and Hija in the U.S. The tax rate is 17 percent in Chile and 35 percent in the U.S. Hijo transfers 100 units of cosa to Hija at a negotiated transfer price of $10 per unit. The cost per unit is $5 for Hijo and Hija sells the units in the U.S. at $15 per unit. Padre intervenes to set the transfer price at $13 per unit. Learning Objectives 2 and 3

11. 12-11 Cost minimization – Example Divisional profits under the negotiated transfer price: Hijo Hija Padre Sales$1,000 $1,500 $1,500 Cost of goods sold 500 1,000 500 Gross profit $500 $500 $1,000 Income tax effect 85 175 260 After-tax profit $415 $325 $740 Learning Objectives 2 and 3

12. 12-12 Cost minimization – Example Divisional profits under the discretionary transfer price: Hijo Hija Padre Sales$1,300 $1,500 $1,500 Cost of goods sold 500 1,300 500 Gross profit $800 $200 $1,000 Income tax effect 136 70 206 After-tax profit $664 $130 $794 Learning Objectives 2 and 3

13. 12-13 Cost minimization – 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.S. to Chile. The overall tax rate decreases from 26 to 20.6 percent. The performance evaluation objective is better served by the negotiated transfer price. The cost minimization objective is better served by the discretionary price. Learning Objectives 2 and 3

14. 12-14 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

15. 12-15 Other cost minimization objectives Withholding taxes on dividends can be effectively avoided via setting favorable transfer prices. The same can be done to avoid profit repatriation restrictions. This essentially changes cash flows from dividends to intercompany revenues and expenses. 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. Learning Objective 3

16. 12-16 Governments are aware of risk that multinationals will use transfer pricing to avoid paying income and other taxes. Most governments publish guidelines regarding acceptable transfer pricing. The guidelines typically use the notion of an arm ’ s-length price. Arm ’ s-length price is the price that would be agreed upon by unrelated parties. Learning Objective 4

17. 12-17 U.S. Transfer Pricing Rules (IRC Section 482) This rule allows the Internal Revenue Service to audit international transfer prices. Penalties of up to 40% of the underpayment of taxes can be imposed on violators. It applies to both upstream and downstream transactions, and transactions between two subsidiaries of the same parent. Important because most MNCs are either headquartered in or have significant business activities in the U.S. U.S. transfer pricing reforms have influenced other countries ’ regulations. Learning Objective 4

18. 12-18 U.S. Transfer Pricing Rules (IRC Section 482) A best methods rule requires the use of arm ’ s-length concept. Primary factors to consider are the degree of comparability to uncontrolled transactions and the quality of the underlying analysis. 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. Learning Objective 4

19. 12-19 Five methods Comparable uncontrolled price method. Resale price method. Cost-plus method. Comparable profits method. Profit split method. Learning Objective 5

20. 12-20 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. If an uncontrolled transaction is not exactly comparable, an adjustment is allowable. Learning Objective 5

21. 12-21 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

22. 12-22 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. Gross profit is determined by reference to uncontrolled parties. Factors influencing the comparability of uncontrolled transactions include: complexity of manufacturing process, procurement activities, and testing functions. Learning Objective 5

23. 12-23 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. 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. Learning Objective 5

24. 12-24 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. Allocation is based on relative contribution of each party. Contribution is determined by functions performed, risk assumed, and resources employed. There are actually two versions: comparable profit split method and residual profit split method. Learning Objective 5

25. 12-25 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. Companies can also use discretion in determining the “ best ” method. Section 482 does provide detailed guidance on factors to consider in determining comparability to uncontrolled transactions. Taxpayer must provide contemporaneous (within 30 days) documentation justifying method selected, covering at least eight specified items (e.g. an analysis of the economic and legal factors as well as an explanation of why one method was selected over alternatives). Substantial reporting and record-keeping requirements. Learning Objective 5

26. 12-26 Licenses of intangible property Section 482 lists six categories of intangibles, including: patents, copyrights, trademarks, franchises, and methods and procedures. 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. Learning Objective 5

27. 12-27 Background An APA is an agreement between a company and a taxing authority regarding an acceptable transfer pricing method. A unilateral agreement is between a taxpayer and one government, while a bilateral agreement involves a taxpayer and two governments. The primary advantage is assurance that their approach will not be challenged. The primary disadvantage is the time and cost involved in arriving at the agreement. Learning Objective 6

28. 12-28 Some specifics of national APAs The U.S. began its APA program in 1991. An increasing number of other countries have subsequently established programs. In the U.S., of a total of 61 agreements executed in 2009, approximately 74 percent involve foreign parent companies. The computer and electronics manufacturing industry is the leading user of APAs. Learning Objective 6

29. 12-29 There are a number of documented cases of companies, both U.S. and foreign, deemed to have underpaid taxes in the U.S. Some of these cases reflect obvious attempts by companies to evade U.S. taxes by manipulating transfer prices. In one case, a U.S. subsidiary sold bulldozers to its foreign parent for $551 each. From 1996-2000, over 60 percent of U.S. and foreign multinationals paid no U.S. income tax. There is a worldwide trend toward strengthening transfer pricing rules. Learning Objective 7

30. 12-30 Tax authorities view transfer pricing as a “ soft target ”. To avoid lengthy, complicated disputes and increased scrutiny by local authorities a company may just pay the additional tax. 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, with penalties imposed in 15% of those cases. Learning Objective 7