The influence of Value Based Management on Transfer Pricing

1. The influence of Value Based Management on Transfer Pricing Prof. Dr. Michael von Wuntsch

2. I. Transfer Pricing

3. Definition • A considerable proportion of the world trade occurs within MNCs • Separate units are responsible of their own profits they also have to calculate their own Return on Invested Capital • Transfer Price= the price set for transactions within the divisions of a MNC

4. If we have a decentralized organization and we take two divisions: • Division 1= produces an intermediate good • Division 2= transforms it into a final good and sells it in the market Intermediate good Division 1 Division 2 TRANSFER PRICE Revenue Expense

5. Legal Background • The most important legal institutions that provide a legal background to Transfer Pricing are the OECD and the IRS • They are both devoted to the arm‘s length principle

6. Legal Background • Arm‘s length principle: • the prices set on transactions between related parties should be determined as if those parties were independent • the principle is easily applicable when comparable tansactions can be found on the market • However, there are transactions for which a term of comparison can not be found on the market

7. Transfer Pricing Methods • According to the OECD Guidelines there are two types of methods: • Traditional Transaction Methods • they analyse the transactions and based on this analysis the TP is determined • they are the most direct way of determining TP • Transactional Profit Methods • They are based on the analysis of the profits that associated companies earn from a controlled transaction

8. Traditional Transaction Methods • The Comparable Uncontrolled Price Method (CUP) • TP for controlled transactions = TP for comparableuncontrolled transactions • The Resale Price Method • TP = selling price - the gross margin that would be charged by unrelated firms in the same circumstances • The Cost Plus Method • TP = standard cost of production of the related seller + cost mark-up that unrelated sellers would charge

9. Transactional Profit Methods • Profit Split Method • Determine the overall profit from a controlled transaction and then split this profit between the two parties according to each party‘s contribution • Transactional Net Margin Method • According to this method the net profit margin that related enterprises could earn should be comparable with that of unrelated enterprises

10. Transfer Pricing controversy • By manipulating Transfer Prices MNCs can avoid taxes, tariffs on imported goods or avoid foreign exchange restrictions

11. CUP Average price per ton (and product) 576 € Price differences can result from volume of sales; quality; transportation; competition; intangible assets involved. Adjustments: 32 € Duties 28 € Total 60 € Transfer Price 516 €

12. Resale Price Method Net sales of reseller (with 15% commission) 4,000 € Arm`s length commission: 15% 600 € Reseller gives warranty for products after sale and conducts sales promotion. Promotional costs 10 € Warranty costs 22 € Total Adjustments: 32 € Adjusted sales commission 632 € Transfer Price 3,368 €

13. Cost Price Method Direct costs 1,000 € Indirect costs (50%) 500 € Total costs 1,500 € Profi margin (10%) 150 € Transfer Price 1,650 € Price based on indirect costs = 30% 1,300 €

14. II. Value Based Management

15. Definition • VBM is an approach to management whereby the company’s overall aspirations, analytical techniques, and management processes are aligned to help the company maximize its value by focusing management decision making on the key drivers of shareholder value • VBM is based on two elements the value creation objective the management processes and systems

16. The Value Creation Objective • Shareholders are interested in increasing the value of their shares • their interests should be represented by having as a goal for the company to maximize shareholder value

17. Management processes • Represent the processes developed by managers in order to bring the value creation objective in the day to day activities of the corporation • There are four main management processes that are important for VBM: • strategy • performance targets • action plans and budgets • performance measurement and incentive systems

18. Discounted Cash Flow Method = valuation method widely used in the context of VBM • Value of a business= the present value of all the cash flows that the business is expected to bring in the future and that are estimated over an unlimited period of time • The DCF method is preffered to other methods because it creates an objective picture

19. Calculating the Value • There are two main variables to be calculated: • The future expected cash flows • The discount rate to be used Value = Where: CFi = the cash flow forecasted for an unlimited time period, from 1 to n r = the discount rate used to translate future cash into its present value

20. The Continuing Value • After determining the length of the forecast for the rest of the period a CV can be calculated: T CV 1 2 3 4 5 6 7 8 n=∞ From T on, we calculate the Continuing Value

21. Taxation and VBM • An effective tax management can have a positive impact on shareholder value • VBM all decisions should be taken taking into consideration the goal of maximizing shareholder value • Taxation influences decisions managers take in a VBM environment

22. III. The influence of Transfer Pricing on the Value of a business

23. Example: Scenario A Country A Tax rate= 60% Selling price=300,000 Country B Tax rate= 20% Production Cost= 100,000 TP= 200,000 WACC=10%

24. Example: Scenario B Country A Tax rate= 60% Selling price=300,000 Country B Tax rate= 20% Production Cost= 100,000 TP= 250,000 WACC=10%

25. Income shifting • 84%of the developing countries felt that the foreign affiliates operating in their countries used income shifting to avoid tax liability (UNCTAD Survey) • A significant percentage of the examinations of transfer pricing transactions end with an adjustment (Ernst & Young) • In a survey conducted by Ernst and Young in 2005, 53% of the interviewed companies were found to set aside a provisionfor transfer pricing risk in their financial statements

26. Conclusion • TP can be used as a tool to shift profits between countries • TP policies also influence the value of a company • The goal of governments and tax authorities is to minimize their losses and fight tax avoidance • According to a survey of Ernst &Young, a majority of companies strongly believe that transfer pricing will present challenges in the future

27. Transfer Price Documentation in Germany and the U.S. – Trying to avoid Double Taxation

28. Goals of documentation • Goals of Tax Administrations (IRS): • Checking correct profit per firm (in a group) • Protecting tax revenues • Goals of Companies: • Guaranteeing tax planning strategy of firm • Avoiding financial risks

29. Documentation Requirements in Germany Independent expert must be able to understand and evaluate the case conditions and the price determination.

30. Documentation Requirements in the U.S. • Taxpayer must proof that chosen transfer prices • are reasonable • reflect trust in comparability

31. Price Adjustments & Double Taxation National Provisions of Respective States on Profit Adjustments can be applied according to Art. 9 sect. 1 DTC Germany - U.S.

32. Documentation & Double Taxation • But, a proper and acceptable documentation is of advantage for the firm because: • a refutable presumption of higher prices and income is • not possible anymore, • a reasonable price spread can not lead to price • adjustments against the tax payer anymore.

34. Penalties • Documentationoftransferpricescanavoid • penalties !

35. Institutional Response to TP