International Transfer Pricing

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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.

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.

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.

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.

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.

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%)

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

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

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

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.