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24 Cards in this Set
- Front
- Back
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Transfer pricing / upstream & downstream
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is the determination of price on the exchange of goods or services between related parties.
These transfers are also referred to as intercompany transactions. Upstream transfers go from subsidiary to parent, while downstream transfers are from parent to subsidiary. Transfers also occurs between different subsidiaries of the same parent. A significant proportion of international transactions are intercompany transfers. |
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Decentralization
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- companies are organized by division and division managers have significant authority.
This structure decomposes problems into smaller pieces. It also permits local decision making which provides more responsibility for division managers. |
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An agency problem
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can occur since division managers make decisions in their self-interest.
The manager’s self-interest can vary with the best interests of the company. |
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goal congruence
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An effective accounting system can alleviate this agency problem by providing incentives to division managers to act in the interests of the organization.
These concepts are relevant to both multinational and purely domestic companies. |
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Performance evaluation systems
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Transfer prices directly affect the profits of the divisions involved in an intercompany transaction.
Some performance evaluation systems are based on divisional profits. The effectiveness of these performance evaluation systems is influenced by the fairness of transfer prices. The effectiveness of performance evaluation systems affects the satisfaction of managers: if he feels that he treated unfair, he will not perform well. |
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cost minimization
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Manipulating transfer prices between countries is one way for multinational enterprises to achieve cost minimization => profit maximinization.
This is referred to as discretionary transfer pricing. The most common approach is to minimize costs by shifting profits to lower tax rate jurisdictions. !!! The performance evaluation objective is better served by the negotiated transfer price. The cost minimization objective is better served by the discretionary price |
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Dual pricing
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cost minimization and performance evaluation can conflict.
Dual pricing is one solution to this conflict. Under dual pricing, the official transfer price used for tax purposes is the discretionary transfer price. A separate set of records used for performance evaluation use the negotiated transfer price. |
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Other cost minimization objectives / Transfer Pricing Rule / HIGH PRICING
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HIGH PRICE
- Minimize income taxes / when transferring to a country with higher tax rate - Minimize withholding tax / downstream sales => This essentially changes cash flows from dividends to intercompany revenues and expenses. - to avoid profit repatriation restrictions - Increase cash flows out of a devaluing currency Transfer pricing method (cost-based or market-based) depends on specific environmental variables. |
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Dual pricing
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cost minimization and performance evaluation can conflict.
Dual pricing is one solution to this conflict. Under dual pricing, the official transfer price used for tax purposes is the discretionary transfer price. A separate set of records used for performance evaluation use the negotiated transfer price. |
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Other cost minimization objectives / Transfer pricing rules / LOW pricing
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LOW PRICE
- Minimize income taxes / when transferring to a country with lower tax rate - Minimize withholding tax / Upstream transfer - Reduction of import duties - Enhance the competitive position of a foreign operation |
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Top factors influencing transfer pricing in US
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(1992)
1. Overall profit to the company 2. Repatriation restrictions on profits and dividends. 3. Competitive position of subsidiaries in foreign countries 4. Tax and tax litigations differences between countries 5. import duty rates 10. Performance evaluation |
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Arm’s-length price
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- is the prices which would have been agreed upon between unrelated parties engaged in the same or similar transactions under the same or similar conditions in the open market.
=> used for guidelines (created by GOV) in order to control TP and set acceptable TP level. Determination of arm-length prices involves references to equivalent transactions under comparable circumstances The U.S. taxpayers are required to use the transfer pricing method that “under the facts and circumstances provides the most reliable measure of an arm’s-length price”. The IRS allows a number of transfer prices, if they fall within an “arm’s-length range”. The company should consider two factors before choosing the appropriate method: the degree of comparability between intercompany and unrelated transactions, and the quality of data used for the estimation. Governments are aware of risk that multinationals will use transfer pricing to avoid paying income and other taxes. |
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U.S. Transfer Pricing Rules (IRC Section 482)
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This rule allows the Internal Revenue Service 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. Important because most MNCs are either headquartered in or have significant business activities in the U.S. U.S. transfer pricing reforms have influenced other countries’ regulations. A best methods rule requires the use of arm’s-length concept. Primary factors to consider are the degree of comparability to uncontrolled transactions and 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. (avoid double taxation) |
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Sale of tangible Property / 5 methods
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Five methods allowed by IRS to determine the arm's- length price in a sale of inventory and fixed assets)
1 Comparable uncontrolled price method 2 Resale price method 3 Cost-plus method 4 Comparable profits method 5 Profit split method |
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1. Comparable uncontrolled price method
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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. (locally for parent or subsidiary) OR Reference to transactions between two unrelated parties for the same product For an evaluation of reliability of this method the company should use the list of factors provided by the Treasury Regulations. Each factor must be considered. Sometimes adjustment to the uncontrolled price is allowed in order to enhance the degree of comparability. |
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Resale price method
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- related to Revenue center!
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. An appropriate gross profit is determined by analyzing the gross profit margin that would be earned in comparable uncontrolled transactions. The degree of comparability is not as significant for this method as for the first one. For the similarity evaluation the company should analyze functions performed by the subsidiary and unrelated distributors in making sales. The most important factor in choosing this method is the similarity in function of the affiliated sales subsidiary and the uncontrolled reference company. |
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Cost-plus method
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TP = cost x (100%+ %mark up on cost).
Most appropriate when comparable uncontrolled transactions don’t exist and sales subsidiary does more than simply distribute finished goods Transfer price is determined by 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. This method is usually used in cases involving the production of sold goods, and most helpful when there are no comparable unrelated sales. |
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Comparable profits method
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TP = selling p - operating local cost - average operating profit of unrelated party
Under this method an arm’s - length price is determined by analyzing a profitability earned by the unrelated party on comparable, uncontrolled sales. The manager can use such profit indicators as the ratio of operating income to operating assets, the ratio of gross profit to operating expenses, or the ratio of operating profit to sales. 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. . |
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Profit split method
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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: 1 comparable profit split method (the profit is determined by analyzing the operating profit earned by each member in the comparable, unrelated transaction. For evaluation of the comparability degree the company should use each factor from the list provided by the Treasury Regulations ) 2 residual profit split method. (is appropriate if controlled parties own valuable intangible assets, which help to generate more profits compare to uncontrolled transactions ) |
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Sale of Tangible Assets / Summary
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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. !!! Taxpayer must provide contemporaneous (within 30 days) documentation justifying method selected, covering at least eight specified items (e.g. an analysis of the economic and legal factors as well as an explanation of why one method was selected over alternatives). Substantial reporting and record-keeping requirements |
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Advanced Pricing Agreement
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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, while 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. 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 58 agreements executed in 2003, approximately 60 percent involve foreign parent companies. The computer and electronics manufacturing industry is the leading user of APAs. |
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Penalties
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the IRS can adjust the company’s tax liability and also additional penalties 20-40% of the underpayment in taxes will be imposed.
20% - of the underpayment in taxes- for a substantial valuation misstatement = when transfer price 200% or more (50% or less) of the price determined under Section 482 40% - for a gross valuation misstatement = 400% or more (25% or less ) |
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Evaluation of centers
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More:
4. Investment 1.Profit center Less 2.Revenue center 3. Cost center |
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Transfer price formula
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TP = Unavoidable VC + CM
if TP > price of buying from outsider, division would be not interested in buying from insider. if excess capacity, CM = 0, only should cover unavoidable VC TP range = between TP & price of buying from outsiders. |
