Transfer pricing

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The price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately. Transfer pricing refers to the pricing of goods and services within a multi-divisional organization. Goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary. The choice of the transfer prices affects the division of the total profit among the parts of the company. It can be advantageous to choose them such that, in terms of bookkeeping, most of the profit is made in a country with low taxes. However, most countries have tax laws and regulations that limit how transfer prices can be set. Most countries adhere to the arm's length principle as defined in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. In the U.S. the pricing of transactions between related parties that are reported for tax purposes are governed by Section 482 of the Internal Revenue Code and the regulations thereunder.

When a firm is selling some of its products to itself, and only to itself (ie.: there is no external market for that particular transfer good), then the picture gets more complicated, but the outcome remains the same. The demand curve remains the same. The optimum price and quantity remain the same. But marginal cost of production can be separated from the firms total marginal costs. Likewise, the marginal revenue associated with the production division can be separated from the marginal revenue for the total firm. This is referred to as the Net Marginal Revenue in production (NMR), and is calculated as the marginal revenue from the firm minus the marginal costs of distribution.

Transfer pricing is one of the most controversial and often least understood of a multinational's operations.

When one part of a multinational organisation in one country transfers (i.e. sells) goods, services or know-how to another part in another country, the price charged for these goods or services is called 'transfer price'. This may be a purely arbitrary figure, meaning by this that it may be unrelated to costs incurred, may be unrelated to operations carried out or to added value. We will see here that the transfer price can be set at a level which reduces or even cancels out the total tax which has to be paid by the multinational.

Example: Consider ourselves to be directors of the multinational. We are sitting in its boardroom at the head office in the home country of the multinational. The Finance Director is reviewing our operations.

He is talking about our trade with another company in another country. We are the parent company, they are one of our subsidiary companies. This means that they belong to us, that in the end we decide what they do and do not do, what happens to their profits.

We, the parent company, are located in the 'home country'. The subsidiary company is located in another country, namely in the 'host country'.

Problem Description:

In a large organization, a central management cannot monitor and control all the operation parameters of every subunit. For this reason, large organizations are usually separated into divisions. Each division is an autonomous unit and its manager has the freedom to take all necessary action. But a decentralized organization has difficulty evaluating the performance of the division managers. Furthermore, the central management of the organization needs to coordinate the actions of the divisions to maximize the organization's total profit. In order to evaluate the performance of each division, a method is needed for measuring the contribution of each division to the total profit of the organization. A common solution to this problemis to set prices for intermediate goods which are transferred from one division to another. These prices are known as transfer prices. Transfer prices are mainly used

to evaluate division managers' performance based on the profits that he generates, to help coordinate the divisions' decisions to achieve the organization's goals - i.e., to ensure goal congruence to enable the divisions to take decisions like the pricing of the final product, to preserve divisions' autonomy. In the classical Transfer Pricing (TP) problem, we usually think of two divisions in a decentralized organization. Division 1 produces an intermediate good and Division 2 transforms it into a final good and sells it in the market. Division 1 ``sells a quantity of the intermediate good to Division 2 at a certain price. This price (the transfer price) is used to place a value on the transaction between the two divisions. The total transaction value is considered as income by the selling division and as expense by the buying division. This allows the net profits of the two divisions to be determined. The division managers are evaluated by the profits that their divisions generate, but the organization's objective is to maximize its total profit. The objectives of the organization and those of the division managers are often incompatible. There fore, the problem of the organization is to determine a pricing rule that serves its own goals, taking into account the objectives of the divisions. This is easy in a world of perfect information, where central management can calculate the optimal transfer prices. The problem is more difficult when there is asymmetry of information (i.e., some information is private). Division managers may wish to conceal some information, in order to manipulate the outcome in their own favor.

In practice the problem is still more complicated. In addition to the asymmetry of information, divisions may have multiple products or may face capacity constraints, the product may have to be manufactured by a chain of more than two divisions, some of the intermediate goods may also be sold in the market, etc. Let us briefly discuss the transfer pricing methods in common use today. We list here only some of the more common methods that appear in the accountancy literature. Cost methods: The transfer price is a certain function of the production cost of the selling division. It may or may not include a fixed cost component. There are several variations of this approach such as cost plus fixed fee, cost plus a fixed percentage of the cost, full cost plus markup, variable cost, marginal cost.

Market price methods: If there is a market for the intermediate good, then the market price is used as the transfer price. Often the transfer price is the market price minus the selling expenses.

Dual price methods: The price that the selling division receives is not equal to the price that the buying division pays - and is usually higher. This mechanism generates a deficit, which is set off by central management. Because central management sets the optimal transfer price, and hence sets the transaction volume to be optimal, this mechanism yields higher performance than other methods. However, it is not commonly used because it requires central management to be involved in the complex process of price-setting. The Ronen-McKinney mechanism and the Groves-Loeb mechanism are the motivation behind this method.

Negotiated transfer prices: The transfer price is reached by negotiation between the relevant division managers. The advantage of this method is that it preserves the divisions' autonomy. Its problem is the sensitivity of the outcome to the managers' negotiation skills.

Each method in this list can be applied in various ways. For example, the markup in the cost-plus method can be determined as a percentage of the cost, which equals a certain return on investment of either the division or the organization. The transfer pricing mechanism that an organization applies may have a critical impact on the organization's performance. Although the transfer pricing problem has been studied for many years it is still consider ed an open problem.

PAYING SOME TAX

Case 1 The subsidiary company buys goods at £100 each. They repack them and then export them from their country to our country, selling them to us at a price of £200 each. They are transferring them to us for a transfer price of £200.

So they have made a profit of £200-£100=£100 and we are getting them at a price of £200. This case is illustrated by Figure 1 (Case 1).

Transfer Pricing

Having imported them at £200 each we sell them for £300 and thus make a profit of £300-£200=£100.

Our overall profit is thus £100 in the subsidiary company's host country and another £100 in the multinational's home country, a total of £200.

However, we need to consider the tax these companies have to pay on their profits, as the rates of tax (company or corporation tax) is different in the two countries.

The subsidiary has to pay corporation tax of 20% of the £100 profit and so the tax amounts to £20. Our home-country corporation tax is 60% of the £100 profit, and so our tax amounts to £60.

Overall, tax paid is £20+£60=£80 and this reduces our before-tax profit of £200 to an after-tax profit of £200-£80=£120.

The subsidiary contributed £80 to this profit, while our own operations contributed £40. The after-tax profit generated by us, that is by the parent company in the home country, was smaller because we paid corporation tax of 60% which compares with the subsidiary's 20%

All the numbers given so far are illustrated by Figure 1 (Case 1). Our Finance Director points out that as the overall after-tax profit is 40% of the selling price we should be pleased with the outcome.

However, we can tell the subsidiary what to charge and can make the transfer price whatever we like. The transfer price is arbitrary, depending as it does only on agreement between ourselves and the subsidiary, and thus on ourselves.

Case 2 Consider Case 2 (see Figure 1). The transfer price is now £280 (compared with the previous £200). This has the effect of shifting before-tax profits from the parent company's home country (corporation tax 60%) to the subsidiary's host country (corporation tax 20%).

Overall, we now pay less tax (£36+£12=£48) and as the before-tax profit is unchanged (£200), the after-tax profit becomes £200-£48=£152 and that is much more than the corresponding profit of £120 we made with a transfer price of £200.

The subsidiary contributes £144 to this while our own contribution is £8.

Our overall after-tax profit is now 51% of the selling price.

Merely by changing the transfer price to an arbitrary higher figure of £280 we have increased our overall after-tax profit from £120 to £152, increased it by a staggering 27%.

PAYING NO TAX

Case 3 As the transfer price is arbitrary, it can be £300 (see Figure 1, Case 3). This means that we are buying and selling at the same price of £300.

Overall tax paid is now £40 and our after-tax profit becomes £160.

The subsidiary contributes £160 to this while our own contribution is £0.

So what we have done is to shift all our profits to the subsidiary and do not need to pay tax in the home country.

But we need not stop there. The parent company can shift even more of its profits to the subsidiary. It can make a loss and this is illustrated by Case 4.

GETTING TAX REPAYMENTS

Case 4 This case shows what happens if the transfer price is increased to £400. The subsidiary makes a profit of £300 and we make a loss of £100 on each item.

This loss can be used by us to reduce our tax liability on other profitable operations carried out by the parent company in the home country. As a result we pay correspondingly less tax.

The subsidiary pays corporation tax of £60 on their profits while we, the parent company, reduce our tax bill by £60, in effect getting a rebate of £60.

Hence the overall result is that we pay no tax at all on this transaction and our after-tax profit becomes £200.

We can take this one step further and make the Transfer Price £500 (see Case 5).

Case 5 The subsidiary now makes a profit of £400 and we make a loss of £200.

The subsidiary pays corporation tax of £80 on their profits while we, the parent company, reduce our tax bill by £120, in effect getting a rebate of £120.

Hence the overall result is that we get a tax rebate of £120 in the home country, pay £80 corporation tax in the host country, and are thus left with a tax rebate of £40 on this transaction. Adding this to our profit increases the after-tax profit from £200 to £240.

TAX AVOIDANCE

TAX AVOIDANCE INCREASES PROFITS So by increasing the purely arbitrary transfer price we doubled our after-tax profit, increasing it by 100%.

This was done without any change to our procedures, operations or added value, was done by merely changing book entries.

So where do these additional profits come from?

They arise from tax avoidance. In other words it is possible for a multinational company to minimise its liability for corporation tax by transfer pricing.

This is legal until governments legislate to prevent this practice.

But note that in the cases we discussed, the tax paid to the host-country government increased, while the tax paid to the home-country government decreased, case by case. In other words, one government's loss is the other government's gain.

So one government can be expected to want to legislate against unfair transfer pricing practices, while the other government can be expected to object to, and to resist, such legislation.

TAX AVOIDANCE TRANSFERS THE TAX OBLIGATION The parent company operates in the home country. The government of that country or state spend money on behalf of its citizens - providing education, health care, social security, protection against crime and security against attack from outside. It collects much of the money it needs from citizens and companies by means of a tax on income - those who earn most pay most, those who earn least pay least. This tax is called Corporation Tax when it is collected from companies (corporations) and Income Tax when it is collected from individuals.

Say a multinational has increased its profits by tax avoidance. As the government's expenses have not changed it must make up this shortfall elsewhere. From its other tax payers, say from its citizens. So its citizens pay more tax, the government can now spend the same amount as before, the multinational's profits have increased.

In other words, the multinational's increased profits arise from money which is in effect collected by the government by taxation from its taxpayers.

The multinational, and this means the owners and directors of the multinational, are thus in effect taxing the people and in this way increasing the multinational's profits and thus their own incomes and wealth.

A matter far removed from earning reasonable profits from providing needed quality goods and services at reasonable prices in open competition with other corporations.

Many multinationals have grown to a size where they threaten or dominate the economic and financial independence and well-being of many countries. Multinationals are accountable to their directors and owners for profitability and growth instead of being accountable to elected representatives of the people for acting for or against the national interest.

Studies published in the USA, for example, tell us much about the extent to which multinationals can avoid paying tax on their profits. These present a disturbing picture.

It seems that at times some top companies pay no federal income tax or obtain an overall rebate. Tax allowances appear to add well over $100bn each year to the accounts of US corporations, and are thus given to owners and directors.

It has become common knowledge that multinational enterprises can operate against national interests.

That multinationals <1> can gain so much profit from tax avoidance, that is from in effect taxing the population, is a case in point.

Multinationals need to be made accountable to elected representatives of the people, for their policies and for acting for or against the national interest.

Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations .

Many factors other than transfer pricing influence the profitability of multinationals, but transfer pricing is significant for both tax administrations and taxpayers because it affects the allocation of profits from intra-group transactions between the different tax jurisdictions in which a multinational operates.

The OECD transfer pricing guidelines were first issued in 1979 and have become internationally respected. They maintain the arm's length principle of treating related enterprises within a multinational group and affirm traditional transaction methods as the preferred way of implementing the principle

See also

• Transparency (market)