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 PriceUse of tangible property rental paymentUse of intangibles royalties, license feesIntercompany services Mgt fee, service chargeIntercompany Loans Interest rate
4 Objectives of Transfer Pricing Performance EvaluationCost minimizationThese objectives might be incongruent
5 Transfer Pricing Methods Cost-Priced Transfer priceMarket-based Transfer PriceNegotiated Price
6 Cost-Based Transfer Pricing AdvantagesSimple to doDisadvantagesWhich measure of cost to use??Can transfer pricing inefficiencies to other units
7 Market Based Transfer Pricing AdvantagesEliminate the risk of inefficiencies being transferred.Ensure divisional autonomyDisadvantageDepends on existence of competitive markets
8 Negotiated Prices Advantages Disadvantages Freedom to bargain is preservedDivisional autonomyDisadvantagesExternal markets requiredCan take a long timeSub-optimization issuesRewards 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 matterImport duty is being minimizedForeign exchange rules existExpropriation risks existMarket-based methods are preferred when:Local partners matterLocal government relations matter
11 7 Most Important Environmental Variables (USA) Overall Profit to the companyRestrictions on repatriation of profit/dividendsThe competitive position of foreign subsPerformance evaluation of foreign subsCustom DutiesImport restrictionsThe need for adequate cash flow in foreign subs
12 7 Most Important Environmental Variables (Japan) Overall corporate profitThe competitive position of foreign subsDevaluation/revaluation in countries with foreign operations.Restrictions on repatriation of profits/dividendsPerformance Evaluation of foreign subsThe interests of local partners in foreign subsThe need to maintain adequate cash flow in foreign subs
13 Cost Minimization Objectives and Related Transfer Prices Objective Transfer Pricing RuleMinimize income TaxTransfer to lower tax rate country Low priceTransfer to Higher tax rate country High priceMinimize withholding taxUpstream transfer Low priceDownstream transfer High priceMinimize import duties Low priceProtect foreign cash flows fromcurrency devaluation High priceAvoid repatriation High priceImprove competitive position Low Price
14 Government ReactionsOECD Transfer Pricing Guidelines- 1979, 1984, 1994Section 482 of the IRCBased on OECD guidelinesIRS may audit transfer prices between companies controlled by the same taxpayer.Burden of proof on taxpayerInbound and outbound transactionsGeneral 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 priceDepends 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 PricesComparable Uncontrolled Price MethodGenerally considered the best method when it can be used.Parent sells to Sub in Country XParent also sells to uncontrolled customer in the same countryArm’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 XSub sells to customers in country XSub’s competitors sell the same product at 25% markup as % of salesArm’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 XParent’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 PricesComparable Profits Method-Parent sells to Sub in Country XSub sells to Customers in Country XParent’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 XSub sells to Customers in Country XTotal profit = Sub sales price less Parent’s costTotal 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 PricesResidual 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%)
26 Advance Pricing Agreements TPM agreed upon between company and tax authority.If there is an agreement, IRS agrees to make No TP adjustmentsLength negotiation typical…..avg 22 months.60% of APAs are from foreign Parents with US subs.