1. International Transfer Pricing

2. Transfer Pricing- the determination of the price at which transactions between related parties will be carried out.

3. Types of Intercompany Transactions and their Associated Price
Sale of tangible property Sale Price
Use of tangible property rental payment
Use of intangibles royalties, license fees
Intercompany services Mgt fee, service charge
Intercompany Loans Interest rate

4. Objectives of Transfer Pricing
Performance Evaluation
Cost minimization
These objectives might be incongruent

5. Transfer Pricing Methods
Cost-Priced Transfer price
Market-based Transfer Price
Negotiated Price

6. Cost-Based Transfer Pricing
Advantages
Simple to do
Disadvantages
Which measure of cost to use??
Can transfer pricing inefficiencies to other units

7. Market Based Transfer Pricing
Advantages
Eliminate the risk of inefficiencies being transferred.
Ensure divisional autonomy
Disadvantage
Depends on existence of competitive markets

8. Negotiated Prices Advantages Disadvantages
Freedom to bargain is preserved
Divisional autonomy
Disadvantages
External markets required
Can take a long time
Sub-optimization issues
Rewards negotiation skill as opposed to actual productivity

9. Most companies:
Use either cost-based or market-based transfer pricing.
Many use a mix of both

10. Chan and Lo’s Study (2004): Cost-based methods are preferred when:
Income tax rate differences matter
Import duty is being minimized
Foreign exchange rules exist
Expropriation risks exist
Market-based methods are preferred when:
Local partners matter
Local government relations matter

11. 7 Most Important Environmental Variables (USA)
Overall Profit to the company
Restrictions on repatriation of profit/dividends
The competitive position of foreign subs
Performance evaluation of foreign subs
Custom Duties
Import restrictions
The need for adequate cash flow in foreign subs

12. 7 Most Important Environmental Variables (Japan)
Overall corporate profit
The competitive position of foreign subs
Devaluation/revaluation in countries with foreign operations.
Restrictions on repatriation of profits/dividends
Performance Evaluation of foreign subs
The interests of local partners in foreign subs
The need to maintain adequate cash flow in foreign subs

13. Cost Minimization Objectives and Related Transfer Prices
Objective Transfer Pricing Rule
Minimize income Tax
Transfer to lower tax rate country Low price
Transfer to Higher tax rate country High price
Minimize withholding tax
Upstream transfer Low price
Downstream transfer High price
Minimize import duties Low price
Protect foreign cash flows from
currency devaluation High price
Avoid repatriation High price
Improve competitive position Low Price

14. Government Reactions
OECD Transfer Pricing Guidelines- 1979, 1984, 1994
Section 482 of the IRC
Based on OECD guidelines
IRS may audit transfer prices between companies controlled by the same taxpayer.
Burden of proof on taxpayer
Inbound and outbound transactions
General rule: “arm’s length prices”.
Treasury regs provide specific guidance on “arms length” prices

15. Government Reactions Treasury Regs Section 1.482
Best method rule- which method provides the most reliable measure of an arm’s length price
Depends on (a) degree of comparability between intercompany transaction and comparable uncontrolled transactions, and (b) quality of data and assumptions used in analysis.
Separate guidelines for transfers of tangible property, intangible property, intercompany loans, and intercompany services.

16. Comparable Uncontrolled Price Method
Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Comparable Uncontrolled Price Method
Generally considered the best method when it can be used.
Parent sells to Sub in Country X
Parent also sells to uncontrolled customer in the same country
Arm’s Length Price = price charged the uncontrolled customer

17. Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Resale Price Method-
Parent Sells to Sub in Country X
Sub sells to customers in country X
Sub’s competitors sell the same product at 25% markup as % of sales
Arm’s length price = Sub’s selling price to customers less 25%
To use this method, final selling price and appropriate gross profit % must be known.

18. Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Cost Plus Method-
Parent Sells to Sub in Country X
Parent’s competitors sell same product to customers in County X at 50% markup to cost.
Arms Length Price = Parent’s cost plus 50%
Most appropriate method when there are no uncontrolled sales to compare to and the buyer does more than just distribute goods.

19. Comparable Profits Method-
Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Comparable Profits Method-
Parent sells to Sub in Country X
Sub sells to Customers in Country X
Parent’s competitiors sell similar product and earn a 15% margin.
Arms Length price = price that allows Parent (or sub) to earn 15% operating profit margin.

20. Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Profit Split Method-
Parent Sells to Sub in Country X
Sub sells to Customers in Country X
Total profit = Sub sales price less Parent’s cost
Total profit is split based on profit earned by each party in an uncontrolled transaction.
Method assumes buyer and seller are really one economic unit.

21. Residual Profit Split Method-
Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Residual Profit Split Method-
Used when parties possess intangibles that allow them to earn excessive profits, compared to uncontrolled transactions.
Total Profit is split in 2 steps:
Allocate market return to parent and sub for their routine contributions to the relevant business activity.
Allocate residual profit to Parent and Sub on the basis of relative value of intangibles that each contributes to the activity.

22. Ernst and Young Study (07-08) reports:
Comparable Uncontrolled Price is most popular (32%)
Cost plus is second (29%)
Resale price is third (17%)
Comparable profits is fourth (11%)

23. Intangible Property Three identified methods allowed:
Comparable uncontrolled
Comparable profits
Profit split

24. Correlative Adjustments
If the IRS adjusts a transfer price, there is no guarantee the foreign government will concur.

25. Penalties
20% (40%) or the understatement!!

26. Advance Pricing Agreements
TPM agreed upon between company and tax authority.
If there is an agreement, IRS agrees to make No TP adjustments
Length negotiation typical…..avg 22 months.
60% of APAs are from foreign Parents with US subs.