Transfer Pricing (TP) P. GURU PRASAD FACULTY INC GUNTUR
Evaluating Management Control Systems
Motivation
Goal congruence
Effort
Lead to rewards
Monetary
Nonmonetary
The concept of Transfer Pricing
A transfer price is the internal price charged by a selling department, division, or subsidiary of a company for a raw material, component, or finished good or service which is supplied to a buying department, division , or subsidiary of the same company.
Transfer Prices
The concept of transfer pricing is fundamentally aimed at simulating external market conditions within the organization so that the managers of individual business units are motivated to perform well
Purpose of Transfer Pricing Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.
Transfers at Cost
About half of the major companies in the world transfer items at cost.
Transfer Pricing Many organizations set up business units that cater to the needs of other business units within their own fold. For example, one business unit may manufacture components that are used by another business unit to assemble the final product. Here , there is a transfer of goods from the first business to the second and the concept of transfer pricing comes into play.
Transfer Pricing Decentralization is one of the approaches that many large organizations use to attain operational effectiveness. However , the main challenges in operating in a decentralized manner lie in designing responsibility structures and formulating appropriate policies and methods to determine the performance of the responsibility centers. The technique of transfer pricing plays an important role in the smooth functioning of responsibility structures in such an organization
Objectives of TP policy
Goal congruence:- the divisional
manager in maximizing the profits of his division, should not engage in decisionmaking that fails to optimize the organization’s performance. Performance appraisal :-it should aid in reliable and objective assessment of the value added activities by profit centers toward the organization as a whole.
Objectives of TP policy
Divisional autonomy:- each divisional
manger should be free to satisfy the requirements of his sources. profit center from internal or external There should be no interference in the process by other divisions like buying centers and selling centers.
General Appliance Corporation case study The GAC was an integrated manufacturer of all types of home appliances. The company had a decentralized , divisional organization consisting of four product divisions , four manufacturing divisions, and six staff offices. Each division and staff office was headed by a vice president. The staff offices had functional authority over their counterparts in the divisions, but they had no direct line authority over the divisional general managers.
General Appliance Corporation case study The product division designed, engineered, assembled , and sold various home appliances. They manufactured very few components parts, rather , they assembled the appliances from parts purchased either from the manufacturing divisions or from outside vendors. The manufacturing divisions made approximately 75 percent of their sales to the product divisions. Parts made by the manufacturing divisions were generally designed by the product divisions, the manufacturing divisions merely produced the parts to
specification provided to them
General Appliance Corporation case study
The divisions were expected to deal with one another as though they were in dependent companies. Parts were to be transferred at prices arrived at by negotiation between the
divisions. were based on the actual These prices prices paid togenerally outside suppliers for the same or comparable parts. These outside prices were adjusted to reflect differences in design of the outside part from that of the inside part. In general, the divisions established prices by negotiation among themselves, but if the divisions could not agree on a price, they could submit the dispute to the finance staff for arbitration
Arm's length transaction Definition A transaction between two related or
affiliated parties that is conducted as if they were unrelated, so that there is no question of a conflict of interest. Or sometimes, a transaction between two otherwise unrelated or affiliated parties.
Organizational chart Of GAC
Board of Directors
president
Finance
Engineering Manufacturing
staff
staff
staff
Group vice president Manufacturing divisions Chrome Product division Gear And Transmission division
Electric Motor division Stamping division
Industrial
Purchasing
Marketing
Relations staff
staff
staff
Group vice president Product divisions Electric Stove division Refrigerating division
Laundry Equipment division Miscellaneous Appliance division
Minimize Tax Liability
For organizations operating in many countries, internal transfer pricing can be a determinant of where profits are to be declared and taxes
paid. The fact that different countries have different tax and exchange rates has to be taken into consideration case of transactions with sister concerns that supply intermediary products. Ideally the transfer pricing policy should enable multinational corporations to minimize tax liability
TP objective in International Business
Manage exchange rate fluctuations Handle competitive pressures Reduce the impact of taxes and tariffs Movement of funds between countries
Manage Exchange Rate Fluctuations MNCs can reduce exchange rate risks by transfer pricing, when the currency of a country depreciates, the purchasing power of that currency declines. Therefore organizations based in that country may have to pay more for imports. On the contrary, if the currency appreciates, the revenues from exports will fall for organizations based in that country. But MNCs can depend on their subsidiaries for imports and exports and use transfer prices to manage exchange rate fluctuations.
Handle Competitive Pressures
The subsidiaries of an organization operating in different countries can use transfer pricing to lower prices to match local completion. For
example, garment manufactures in Europe depend mainly on china, Japan , and India for silk . Therefore, if an organization has subsidiaries in these countries, it may mange to get silk at a lower cost by transfer pricing. Thus , it will be able to reduce the price of the finished product to match or undercut local competition
Reduce the Impact of Taxes and Tariffs
Many MNCs make use of transfer pricing to reduce their total tax liability,. Organizations try to maximize profits in countries where
corporate taxes are lower, thus reducing the tax liability of the organizations a whole. For example, the exporting business unit can quote a lower selling price. This will result in lower tariffs for the importing business unit, since most duties are levied on the value of goods imported.
Movement of Funds between Countries The MNCs may prefer to invest its funds in one country rather than another. Transfer pricing provides an indirect way of shifting funds into or out of a particular country. While trying to achieve these objectives specific to international business, disputes may arise between the multinational corporations and the tax authorities in different countries
Factors Influencing TP The conditions necessary for the development of a proper mechanism of TP are Role definition External advisers Competent mangers Equity, Information on the prevailing market prices And proper investment
Methods of Calculating TP Market based pricing method Cost based pricing method
Negotiated pricing method Resale price method Alternative methods
Transfer Pricing Methods (1) When choosing the best transfer pricing method, the available methods should be considered in the following order: 1. Comparable Uncontrolled Price (CUP); 2. Resale Price or Cost Plus (C+); 3. Profit Split or Transactional Net Margin (TNM). 24
Market-Based Transfer Prices
If there is a competitive market for the product or service being transferred internally, using the market price as a transfer price will generally lead to the desired goal congruence and managerial effort.
Market-Based Transfer Prices
The major drawback to market-based prices is that market prices are not always available for items transferred internally.
Market Based Pricing Method
An organization X in India that sells textile fiber to its subsidiary organization Y in Bangladesh. If the rate charged by X in India is the same as the current market price – as if the transaction is taking place between two unrelated organizations – then the method of estimating transfer pricing is know as market based pricing method or the comparable uncontrolled price (CUP)- Ranbaxy and Cipla follow the cup method
Transfers at Cost What are some examples? Full cost plus a profit markup Variable costs Standard costs Actual costs Full cost
Cost Based Pricing Method
Indian organization X sells textile fiber to its subsidiary Y in Bangladesh and the rate charged bytheX isfiber the total o manufacturing plus cost some margin or mark-up percentage, then this method of estimating the transfer price is known as cost-based transfer pricing
Negotiated Transfer Prices
Companies heavily committed to segment autonomy allow managers often to negotiate transfer prices.
Negotiated Pricing Method
The buying and selling divisions negotiate a mutually acceptable transfer price. Sinceperformance, each divisionthis is responsible for its own will encourage cost minimization and encourage the parties to seek a transfer price that yields them an appropriate return.
Resale Price Method
The resale price method is similar to the cost based pricing method. In this method, the transfer price is determined by calculating back from the transition taking place at the next level of the supply chain, by deducting a suitable mark-up from the price at which the internal buyer sells the item to an unrelated third party.
Alternative Methods
A petroleum company has three divisions: the crude oil division, the refinery division, and the sales division. Theoil crude division extracts the crude and oil sells it to the refinery division, which refines the crude through a process of fractional distillation. The output of the refinery is then sold in the market by the sale division.
Alternative Methods
In this situation, the sales division may underestimate the costs incurred during extraction and processing. So it might sell the final product at a price that is not high enough to recover fixed costs. Due to this the sales division may earn revenues but the company as a whole may incur losses. In order to prevent these kinds of problems, such companies adopt some other methods of calculating transfer price like two step method, profit sharing and two sets of process methods
Alternative Methods
Two step pricing:- fixed cost component and variable cost component. In a transaction of goods between two divisions, the cost of production for the selling division is Rs. X per unit and the fixed cost per month is Rs. Y and the margin decided is Rs. Z per month. If “n” units of these goods are sold, then the transfer price for the month will be (nX+Y+Z). Or if the margin is included with the variable component, say Rs. A per unit, then the transfer price will be (nX+nA+Y).
Alternative Methods
Profit sharing or split method:- all the
business units share the operating profit.
Two setstoof pricing :- revenueunit is at the credited the manufacturing
market sales price while the buying unit is charged for the total standard costs. The difference between the outside sales price and the standard cost is charged to the parent firm’s account
Variable-Cost Pricing
In situations where idle capacity exists, variable cost would generally be the better basis for transfer pricing and would lead to the optimum decision for the firm as a whole.
Variable-Cost Pricing
When market prices cannot be used, versions of “cost-plus-a-profit” are often used as a fair substitute.
Transfer Pricing Methods (2) Type of Transaction
Possible method
Manufacturing of goods
CUP, C+, Profit split
Sale of goods
CUP, Resale price, Profit split, TNM CUP, C+, TNM
Provision of services
Financing (loans, deposits, CUP, Profit split, TNM guarantees) Transfer of intangibles CUP, C+ (technology, brand, know –how) 39
Implementing the TP
Articulation and communication of the transfer pricing strategy
Documentation of the TP process and inter-organization agreements Involvement of multi-disciplinary team Negotiation and conflict resolution
Potential Misuse of TP
TP is a very important issue from the point of view of management control. The can misuse TP to their firms tax liabilities, as well asminimize to project a wrong image about their financial health and thus mislead the stakeholders.
The Indian Perspective
Liberalization of the Indian economy has led to a phenomenal growth in the industrial and services sector. Due to the availability of cheap skilled labor, India has become a favorite destination for labor-intensive service industries like BPO and software. This has resulted in increased cross border related party transactions between India and other nations.
TP Tax Guidelines
This has made transfer pricing very important from the taxation point of view. The Indian government has introduced detailed transfer
pricing regulations with effect from April ,2001, to reduce tax avoidance by organizations operating in India. The regulations have largely been designed along the lines of the Transfer Pricing Guidelines issued by the Organization for Economic Cooperation and Development (OECD).
The GlaxoSmithKline TP Dispute The US Internal Revenue Service (IRS) demanded back taxes from GSK, a large UKbased drug manufacturer, for misusing transfer pricing to minimize its tax liabilities to the US government. The US affiliate of the company charge with overpaying for product supplies during the period 1989 to 2000 and in subsequent year, while at the same time charging lower rates for the marketing services that it supplied, thus understating GSK’s income subjected to Us
taxation during the period.
The GlaxoSmithKline TP Dispute The IRS wanted the pharmaceutical Giant to pay taxes, penalties and interest. The dispute was to go to trail in February 2007. according to experts, the IRS’s decision to take GSK to court was a manifestation of the new thinking in transfer pricing regulations proposed by the IRS in September 2003. GSK decided to settle the issue to avoid future fund outflow toward legal proceedings. On September 11, 2006, GSK announced that it was settling the dispute by paying $3.1 billion to
the IRS.
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