Transfer Pricing

1. Transfer Pricing Dr. Clive Vlieland-Boddy

2. 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.

3. 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.

4. Factors Affecting Transfer Pricing • Internal factors: Performance Measurement and Evaluation • External Factors: • Accounting Standard • Income Tax • Custom Duty • Currency Fluctuations • Risk of Expropriation

5. Transfer Pricing

6. Transfer Pricing When divisions transfer products or render services to each other, a transfer pricing is used to charge for the products or services

7. Benefits of Transfer Pricing 1. Divisions can be evaluated asprofit or investment centers. 2. Divisions are forced to control costsand 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.

8. Commonly Used Transfer Prices 1.Market price approachsets the price at which the product transferred could be sold to outside buyers. 2.Negotiated price approachallows decentralized managers to agree (negotiate) among themselves. 3.Cost price approach (variable or full)uses a variety of cost concepts for setting the transfer price.

9. Commonly Used Transfer Prices Variable Cost per Unit $10 Full Cost per Unit $13 Market Price per Unit $20 Negotiated Price

10. Transfer Pricing—Negotiated Price Approach Assumptions 1. Division M produces a product with a variable cost of $10 per unit. Division M has unused capacity. 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?

11. 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

12. 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 market • Negotiated price method

13. Choosing the Right Transfer Price • Is there an outside supplier? • Is the seller’s variable cost less than the market price? • Is the selling unit operating at full capacity?

14. 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

15. Robert Products Inc. INTERNAL TO THE FIRM EXTERNAL FOREIGN Bayside Price = $400 Price = $600 Wales Company Cole Price = $1,250 Variable Cost = $600+$500 =$1,100 London Company Diamond Price = $1,500

16. Cole Division Internal to the firm External to the firm Bayside division 3,500 Units, var cost $250 per unit 3,000 Units, var cost $300 per unit Price =$600 Price = $500 Cole Division Further processing variable cost- $400 Further processing variable cost- $500 price= $1,100 or $1,500 price $1,250 ? Diamond division Wales company

17. Diamond Division Cole Division London Company Bayside division Variable cost-$200 Variable cost - $300 Price= $400 Price =$600 London company Diamond division Further processing variable cost- $500 3,000 Units, price- $1,500 3,000 Units Diamond Division

18. Cole Division If there is an outside supply ----Yes. Is the seller’s variable costs < outside price? Yes. Does seller have excess capacity? No. If contribution from outside purchase > contribution from inside purchase . . .  Decision to Transfer: Sell outside.

19. Transfer Pricing

20. Transfer Pricing The firm benefits more from Option 2.

21. Strategic Factors • International Transfer Pricing Consideration • Tax Rate- minimize taxes locally as well internationally • 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

22. Q2. What Everyone Wanted • Senior Management • System that encourages decisions consistent with long-run profitability • Encourage actions that benefits the overall company’s profitability • Allows managers to distinguish costs relevant for short-run decisions • Transfer prices could be used to support decisions in both marketing and operating divisions, including:

23. Q2. What Everyone Wanted • Division Managers • Transfer prices would report the financial performance of their divisions fairly • 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 changes • Decisions made by managers of marketing divisions would reflect both sales revenue and associated expenses incurred in the operations division • The system must anticipate that division managers would examine the method and take actions that maximized the reported performance of their divisions

24. Global Trends

25. 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 Related Parties

26. 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.

27. 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 regulations • Increasingly aggressive audit environment • Increasing questioning and data gathering for in-depth scrutiny • Recruiting and training of specialist resources to examine more complex transactions • Increasing level of cross country co-operation among tax authorities in audits

28. Global Trends: Changing Approaches • Changing Environment • “New wave” of entrants to enforcement of transfer pricing • “Old guard” making significant changes to approaches • 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 practice (e.g. multiple year data, adjustments, etc) • Threatens resolution of bilateral disputes (MAP proceedings) and increases risk of economic double taxation • Increase in number of cases going for litigation

29. 43% of European and 49% of Asian-Pacific respondents identified transfer pricing as the most important tax issue facing their organization The Most Important Tax Issues 0% 10% 20% 30% 40% Source: Ernst & Young Global Transfer Pricing Survey 2005-06

30. Global Growth in Importance Source: Ernst & Young Global Transfer Pricing Survey 2005-06

31. Asia–Pacific: Transfer Pricing Growth in Importance Result for Asia–Pacific parent company respondents is very similar to the global result for 2005 0% 10% 20% 30% 40% 50% 60% Source: Ernst & Young Global Transfer Pricing Survey 2005-06

32. 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%; • Examples of covered services: • Payroll and processing certain benefits payments • Processing accounts receivable and payable (bookkeeping) • General administrative – ministerial and clerical tasks • Public relations – preparation and dissemination of corporate communications, but not public relations strategy • Meeting coordination • Accounting and audit – compliance • Tax – paying tax and processing returns, but not tax planning • Compliance – regulatory, licenses and permits Evaluates the economic benefits of services availed by the ‘buyer’ in the entire supply chain

33. Country Updates • Singapore • 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 nature • Interest-free loans by Singaporean to affiliates will be subject to TP review • France • Released new instructions and transfer pricing guidelines on November 28, 2006, on a simplified APA procedure for “small and medium-size companies” • Provides for a special cell at the tax authorities to assist small and medium companies in functional analysis, selection of the appropriate transfer pricing method, and, the performance of the benchmarking exercise (at the request of taxpayer) • Eligibility criteria of such companies / taxpayers: fewer than 250 employees, revenue below €50 million, and assets below €43 million. Moreover, the French company must not be owned more than 25 percent by a company exceeding the criteria above • Relaxation of APA submission for small and medium-size groups.

34. Associated Enterprises – Some considerations • 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 enterprise. • Where one entity is “wholly” dependent on the intangibles provided by the other entity. • Where one entity buys 90% or more, of its raw materials from the other enterprise. • Where one entity sells goods / services to the other entity and is in a position to “influence” the price. • Where one entity stands guarantee for the other entity and the guarantee amount is more than 10% of the total borrowings of the other enterprise. • Definition of Associated Enterprise also includes “a permanent establishment”

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