1. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11 International Transfer Pricing

2. 11-2 Cost Minimization, and Transfer Pricing Other cost minimization objectives  Withholding taxes,  A parent company might want to avoid receiving cash payment from its foreign subsidiary in the form of dividends, interest, royalties, on which Withholding taxes will be paid to a foreign government.  There was no withholding taxes on payments for purchasing good and services. Learning Objective 3

3. 11-3 Cost Minimization, and Transfer Pricing  The higher the price charged to the foreign subsidiary the more cash can be extracted without paying withholding taxes.  The lower the price charged to the parent the more cash can be extracted without paying withholding taxes  This essentially changes cash flows from dividends to intercompany revenues and expenses. Learning Objective 3

4. 11-4 Cost Minimization, and Transfer Pricing  Import duties  Countries generally assess tariffs on the value based on invoice prices of goods being imported into the country.  One way to reduce Import duties is to transfer goods to a foreign operations in low prices.  Circumvent Profit repatriation restriction  Some countries restrict the amount of profit can be paid as dividends to foreign parent company This is known as Profit repatriation restriction.  When such restriction exist the parent can get around (circumvent) the restriction by setting high prices on goods transferred to the subsidiary and low prices transferred from the subsidiary

5. 11-5 Cost Minimization, and Transfer Pricing  Protect cash flows from currency devaluation  For operations located in countries whose currency is prone to devaluation, the parent may accelerate removing cash out of that country before more devaluation occurs by setting high prices on goods transferred to the subsidiary in this country.

6. 11-6 Cost Minimization, and Transfer Pricing  Enhance the competitive position of a foreign operation.  MNCs are able to use international transfer pricing to maintain competitive position of a foreign operation and penetrate the financial markets by setting low prices on goods transferred to the subsidiary in this country.

7. 11-7 Government Reactions  Governments are aware of risk that multinationals will use transfer pricing to avoid paying income and other taxes.  Most governments publish guidelines regarding acceptable transfer pricing for tax propose.  Across counties these guidelines can conflict, creating the possibility of double taxation when price accepted to the country is disallowed by another.  The Organization for Economic Cooperation and Development (OECD) developed transfer pricing guidelines in 1979 that have been supplemented and mandated several time since then. Learning Objective 4

8. 11-8  The guidelines typically use the notion of an arm’s-length price.  Arm’s-length price is the price that would be agreed upon by unrelated parties engaged in the same or similar transactions under the same or similar conditions in the open market.  The most developed countries have transfer pricing rule depend on (OECD) transfer pricing guidelines.

9. 11-9 Government Reactions Section 482 – U.S. Internal Revenue Code (IRC)  This rule allows the Internal Revenue Service (IRS) to audit international transfer prices.  Penalties of up to 40% of the underpayment of taxes can be imposed on violators.  It applies to both upstream and downstream transactions, and transactions between two subsidiaries of the same parent.  Because same or similar transactions under the same or similar conditions in the open market often do not exist, determination of an Arm’s-length price generally will involve reference to Comparable transactions under Comparable circumstances. Learning Objective 4

10. 11-10 Government Reactions Section 482 – U.S. Internal Revenue Code  A best methods rule requires the use of arm’s-length concept.  Primary factors to consider are :  The degree of comparability to uncontrolled transactions  The quality of the underlying analysis.  The IRS provides for correlative relief to help in situations where the IRS agrees with a company’s transfer pricing but a foreign government does not. Learning Objective 4

11. 11-11 Sale of Tangible Property Five methods  Comparable uncontrolled price method.  Resale price method.  Cost-plus method.  Comparable profits method.  Profit split method. Learning Objective 5

12. 11-12 Sale of Tangible Property Comparable uncontrolled price method  Widely considered the most reliable measure when a comparable uncontrolled transaction exists.  Transfer price is determined based on reference to the company’s sales of the same product to an unrelated buyer.  Reference to transactions between two unrelated parties for the same product are acceptable.  If an uncontrolled transaction is not exactly comparable, an adjustment is allowable. Learning Objective 5

13. 11-13 Sale of Tangible Property Resale price method  Generally used when the affiliate is a sales subsidiary and simply distributes finished goods.  Transfer price is determined by deducting gross profit from the price charged by the sales subsidiary.  Gross profit is determined by reference to uncontrolled parties.  The most important factor in choosing this method is the similarity in function of the affiliated sales subsidiary and the uncontrolled reference company. Learning Objective 5

14. 11-14 Sale of Tangible Property Cost-plus method  Most appropriate when comparable uncontrolled transactions don’t exist and sales subsidiary does more than simply distribute finished goods.  Transfer price is determined buy adding gross profit to the cost of production.  Gross profit is determined by reference to uncontrolled parties.  Factors influencing the comparability of uncontrolled transactions include: complexity of manufacturing process, procurement activities, and testing functions. Learning Objective 5

15. 11-15 Sale of Tangible Property Comparable profits method  Underlying principle is that similar companies should earn similar returns over a period of time.  One of the two related parties in the transactions is chosen for examination.  Transfer price is determined via reference to an objective measure of profit of an uncontrolled company involved in comparable transactions.  Typical measures of profit include: ratio of operating income to operating assets, and operating income to sales. Learning Objective 5

16. 11-16 Sale of Tangible Property Profit split method  Treats the two related parties as one economic unit.  Profit from the eventual sale to an uncontrolled party is allocated between the related parties.  Allocation is based on relative contribution of each party.  Contribution is determined by functions performed, risk assumed, and resources employed.  There are actually two versions: comparable profit split method and residual profit split method. Learning Objective 5

17. 11-17 Sale of Tangible Property Summary  Any particular transfer pricing method used can result in a range of transfer prices.  Companies can use discretion to set prices within the range in order to achieve cost minimization objectives.  Companies can also use discretion in determining the “best” method.  Section 482 does provide detailed guidance on factors to consider in determining comparability to uncontrolled transactions. Learning Objective 5

18. 11-18 Other Transfer Pricing Situations Licenses of intangible property  Section 482 lists six categories of intangibles, including: patents, copyrights, trademarks, franchises, and methods and procedures.  Four methods are available for setting transfer prices:  Comparable uncontrolled transaction method.  Comparable profits method.  Profit split method.  A group of unspecified methods.  Pricing of Intercompany loans and intercompany services are also transfer pricing situations. Learning Objective 5

19. 11-19 Advance Pricing Agreements (APA) Background  An APA is an agreement between a company and a taxing authority regarding an acceptable transfer pricing method.  A unilateral agreement is between a taxpayer and one government, a bilateral agreement involves a taxpayer and two governments.  The primary advantage is assurance that their approach will not be challenged.  The primary disadvantage is the time and cost involved in arriving at the agreement. Learning Objective 6

20. 11-20 Advance Pricing Agreements (APA) Some specifics of national APAs  The U.S. began its APA program in 1991.  An increasing number of other countries have subsequently established programs.  In the U.S. of a total of 434 agreements, approximately 60 percent involve foreign parent companies.  The electronics manufacturing industry is the leading user of APAs. Learning Objective 6

21. 11-21 Worldwide Enforcement  There are a number of documented cases of companies, both U.S. and foreign, deemed to have underpaid taxes in the U.S.  Some of these cases reflect obvious attempts by companies to evade U.S. taxes by manipulating transfer prices.  In one case, a U.S. subsidiary sold bulldozers to its foreign parent for $551 each.  From 1996-2000, over 60 percent of U.S. and foreign multinationals paid no U.S. income tax.  There is a worldwide trend toward strengthening transfer pricing rules. Learning Objective 7