A6. Dividend policy in multinationals and transfer pricing

Question 1

Dividend capacity multinationals

Answer 1

Dividend capacity is the cash generated in any given year that is available to pay to ordinary shareholders (free cash flow to equity).
Dividend capacity=
profits after interest,tax and preference dividends-
debt repayment,share repurchase,investment in assets+
depreciation,any capital raised from new share issues or debt
In multinational context, and additional complication is tat dividend may be paid by foreign subsidiaries to the parent company, and in addition:
Extra tax may be payable on the profits made by foreign subsidiary.
Withholding tax may be due on dividends paid by the foreign subsidiary.

Question 2

Factors affecting dividend policy in multinationals

Answer 2

Factors affecting dividend policy in multinationals (plus general ones).
• Financing. The financing needs of the parent company e.g. dividend payments to external shareholders and capital expenditure in the home countries.
• Agency issues. Dividend payments restrict the financial discretion of foreign managers and allow greater control over their behaviour.
• Timing. A subsidiary may adjust its dividend payments in order to benefit from expected movements in exchange rates, collecting earlier payments from currencies vulnerable to depreciation and later from currencies expected to appreciate.
• Tax. If tax liabilities are triggered by repatriation, these can be deferred by reinvesting earnings abroad. This is more of an issue for subsidiaries in low tax countries, whose dividends trigger significant parent tax obligations.
• Exchange controls. Controls involve suspending or banning payment of dividends to foreign shareholders, such as parent companies in multinationals, who will then have the problem of blocked funds.

Question 3

Tax considerations influence the dividend policies.

Answer 3

Dividend income is taxed differently from Profit and therefore the tax position of the investors can influence their preference. e.g. There is a different tax rate paid on dividends in different countries (somewhere 0% or 5% or 15%). The parent company can reduce its tax liability by receiving larger amounts of dividends from subsidiaries in countries where undistributed earnings are taxed. For subsidiaries of UK companies, all foreign profits are liable to UK corporation tax, with a credit for the tax that has already been paid abroad. The US government does not distinguish between income earned abroad and income earned at home.

Question 4

A Reinvestment Hierarchy (dividend policy)

Answer 4

• Pay your commitments. You need to have the cash flow on hand to cover your current commitments and the commitments over the next six months.
• A reinvestment in yourself. Training and experiences for yourself and your employees will be a long-term investment that pays off every time some of that knowledge or some of those skills are used.
• Reinvesting in your business. Improving infrastructure and customer support, increasing and refining marketing.
These all directly benefit your business. They increase your profits and decrease your expenses, potentially giving you more capital to work with.
• External investments

Question 5

Transfer Pricing.

Answer 5

Transfer pricing is used when divisions of an organisation need to charge other divisions of the same organisation for goods and services, they provide to them. Usually, each division will report its performance separately. Hence, some monetary value must be allocated to record the transfer of these goods or services.
Transfer pricing is not simply buying and selling products between divisions. The term is also used to cover:
• Head office general management charges to subsidiaries for various services
• Specific charges made to subsidiaries by, for example, head office human resource or information technology functions
• Royalty payments
o between parent company and subsidiaries
o among subsidiaries.
• Interest rate on borrowings between group companies.

Question 6

Transfer prices are set using the following techniques:

Answer 6

• Market prices
• Production cost – this can be based on variable or full cost including a mark-up
• Negotiation

Question 7

Cost-Based methods of transfer pricing.

Answer 7

The supplying division has its costs of manufacturing refunded and may also be allowed a mark-up to encourage the transfer. Standard costing should be used where possible to encourage the division providing the transferred good or service (the selling division) to control its own costs.
Variable/marginal cost.
Full cost.
Dual pricing and two-part tariff systems.

Question 8

Cost-Based methods of transfer pricing.

Variable/marginal cost.

Answer 8

The selling division should transfer goods to the buying division at the variable cost (equal to marginal cost) of production is selling division has spare capacity as the marginal cost reflects the true cost to the company of the transfer taking place. Although good economic decisions are likely to result, a transfer price equal to marginal cost has certain drawbacks:
• Selling division will make a loss as its fixed costs cannot be covered. This is demotivating.
• Performance measurement is distorted. Selling division is condemned to making losses while buying division gets an easy ride as it is not charged enough to cover all costs of manufacture. This effect can also distort investment decisions made in each division. For example, buying division will enjoy inflated cash inflows.
• There is little incentive for selling division to be efficient if all marginal costs are covered by the transfer price. Inefficiencies in selling division will be passed up to buying division. Therefore, if marginal cost is going to be used as a transfer price, at least make it standard marginal cost, so that efficiencies and inefficiencies stay within the divisions responsible for them.

Question 9

Cost-Based methods of transfer pricing.

Full cost.

Answer 9

Under this approach, the full cost (including fixed overheads absorbed) incurred by the supplying division in making the ‘intermediate’ product is charged to the receiving division. The drawback to this is that the division supplying the product makes no profit on its work so is not motivated to supply internally. If a full cost-plus approach is used, a profit margin is also included in this transfer price. The selling division will therefore gain some profit at the expense of the buying division. Buying division may look at external suppliers instead.

Question 10

Cost-Based methods of transfer pricing.

Dual pricing and two-part tariff systems.

Answer 10

This involves setting transfer prices at variable cost and once a year there is a transfer of a fixed fee to the selling division representing an allowance for its fixed costs. This should allow the selling division to cover its fixed costs and make a profit.

Question 11

Actual cost versus standard cost.

Answer 11

When a transfer price is based on cost, standard cost should be used, not actual cost. A transfer at actual cost would give the supplying division no incentive to control costs because all of the costs could be passed on to the receiving division. Actual cost-plus transfer prices might even encourage the manager of the supplying division to overspend, because this would increase divisional profit, even though the organisation as a whole suffers. Standard cost-based transfer prices should encourage the supplying division to become more efficient. The problem with this approach is that it penalizes the supplying division if the standard cost is unattainable, while it penalizes the receiving division if it is too easily attainable.

Question 12

Market-based approaches to transfer pricing.

Answer 12

Where a market price exists, it can be used as the basis for a transfer. If the selling division is at full capacity, then the revenue it loses as a result of an internal transfer shows the true cost (revenue foregone) to the division of an internal transfer. If a division would have to incur marketing costs to sell externally then the market price should be adjusted to reflect the fact that an internal transfer would not incur this cost. So, the transfer price becomes lower.

Question 13

Opportunity cost approach to transfer pricing.

Answer 13

Transfer price is calculated as marginal cost to selling division + opportunity cost of resources used. Opportunity cost is contribution lost from the external sale foregone or, if no external market for the intermediate product exists, the opportunity cost (or shadow price) is the opportunity lost by not using resources on alternative products.

Question 14

Advantages of market value transfer prices.

Answer 14

• Divisional autonomy. A transferor division should be given the freedom to sell output on the open market, rather than to transfer it within the company. ‘Arm’s length’ transfer prices, which give profit centre managers the freedom to negotiate prices with other profit centres as though they were independent companies, will tend to result in a market-based transfer price.
• Corporate profit maximisation. In most cases where the transfer price is at market price, internal transfers should be expected, because the buying division is likely to benefit from a better quality of service, greater flexibility, and dependability of supply. Both divisions may benefit from cheaper costs of administration, selling and transport. A market price as the transfer price would therefore result in decisions which would be in the best interests of the company or group as a whole.
• Divisional performance measurement. Where a market price exists, but the transfer price is a different amount (say, at standard cost plus), divisional managers will argue about the volume of internal transfers (as selling will want to sell all on open market, buying will resent this loss of cheap supplies etc).

Question 15

The disadvantages of market value transfer prices

Answer 15

• The market price may be a temporary one, induced by adverse economic conditions, or dumping, or the market price might depend on the volume of output supplied to the external market by the profit centre.
• A transfer price at market value might, under some circumstances, act as a disincentive to use up any spare capacity in the divisions. A price based on incremental cost, in contrast, might provide an incentive to use up the spare resources in order to provide a marginal contribution to profit.
• Many products do not have an equivalent market price so that the price of a similar, but not identical, product might have to be chosen. In such circumstances, the option to sell or buy on the open market does not really exist.
• There might be an imperfect external market for the transferred item, so that if the transferring division tried to sell more externally, it would have to reduce its selling price.
• Internal transfers are often cheaper than external sales, with savings in selling costs, bad debt risks and possibly transport costs. It would therefore seem reasonable for the buying division to expect a discount on the external market price, and to negotiate for such a discount.

Question 16

Negotiated Transfer Prices.

Answer 16

In some cases, the divisions of a company are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with outside parties. Negotiated transfer prices are often employed when market prices are volatile, and change occurs constantly. The negotiated transfer price is the outcome of a bargaining process between the supplying and receiving division.

Question 17

Multinational transfer pricing

Answer 17

Multinational transfer pricing is the process of deciding on appropriate prices for the goods and services sold intra­group across national borders.

Question 18

Motivations for transfer pricing. Internal factors.

Answer 18

In deciding on their transfer pricing policies, multinationals take into account many factors.
Internal factors.
• Management incentives. If transfer prices used for internal measures of performance by individual affiliates deviate from the true economic prices, and managers are evaluated and rewarded on the basis of the distorted profitability, then it may result in corporate managers behaving in an irresponsible way.
• Performance evaluation. When different affiliates within a multinational are treated as standalone profit centres, transfer prices are needed internally by the multinational to determine profitability of the individual divisions. Transfer prices which deviate too much from the actual prices will make it difficult to properly monitor the performance of an affiliated unit.
• Cost allocation. When units within the multinational are run as cost centres, subsidiaries are charged share of the costs of providing the group service function, so that the service provider covers its costs plus a small mark-up. Lower or higher transfer prices may result in a subsidiary bearing less or more of the overheads.
• Financing. Transfer pricing may be used to boost the profitability of a subsidiary, with the parent company undercharging the subsidiary. Such a boost in profitability and its credit rating may be needed by the subsidiary in order to succeed in obtaining funds from host country.

Question 19

Motivations for transfer pricing. External factors.

Answer 19

• Tariffs. Border taxes (tariffs and export taxes) are often levied on cross border trade. Where the tax is levied on an ad valorem basis, the higher the transfer price, the larger the tax paid per unit. Whether a multinational will follow high transfer price strategy or not may depend on its impact on the tax burden.
• Rules of origin rule. Need to meet the rule of origin that applies to cross border flows within a free trade area. Since border taxes are eliminated within the area, rules of origin must be used to determine eligibility for duty-free status. Over- or under- invoicing inputs is one way to avoid custom duties levied on products that do not meet the rule.
• Exchange control and quotas. Transfer pricing can be used to avoid currency controls in the host country (constraint on profit repatriation could be avoided by parent charging higher prices for raw materials).
• Taxation. Multinationals use transfer pricing to channel profits out of high tax rate countries into lower ones. A parent sells goods at lower prices to subsidiaries in lower tax rate countries and buy from them at higher prices. Most profits are therefore reported in a low-tax country.

Question 20

Good transfer price

Answer 20

A good transfer price should have the following characteristics (objectives):
• Preserve divisional autonomy: almost inevitably, divisionalisation is accompanied by a degree of decentralization in decision making so that specific managers and teams are put in charge of each division and must run it to the best of their ability. Divisional managers are therefore likely to resent being told by head office which products they should make and sell. Ideally, divisions should be given a simple, understandable objective such as maximizing divisional profit.
• Maintain motivation for managers. Be perceived as being fair for the purposes of performance evaluation and investment decisions.
• Assess divisional performance objectively. Permit each division to make a profit: profits are motivating and allow divisional performance to be measured using positive ROI or positive RI
• Ensure goal congruence. Encourage divisions to make decisions which maximize group profits: the transfer price will achieve this if the decisions which maximize divisional profit also happen to maximize group profit – this is known as goal congruence. Furthermore, all divisions must want to do the same thing. There’s no point transferring out if the next division doesn’t want to transfer in. In practice it is difficult to achieve all four aims.

Question 21

Potential benefits of operating a transfer pricing system within a divisionalised company include the following:

Answer 21

• Leads to goal congruence - motivates divisional managers to make decisions, which improve divisional profit and improve profit of the organisation as a whole.
• Hence it prevents dysfunctional decision making.
• Transfer prices set at a level that enables divisional performance to be measured ‘commercially’.
• Divisional autonomy - A good transfer pricing system helps to ensure that a balance is kept between divisional autonomy to provide incentives and motivation, and centralised authority to ensure that the divisions are all working towards the same goals of the organisation.

Question 22

Which is the optimal transfer price?

Answer 22

• Minimum (fixed by the supplying division):
o Transfer price ≥ variable cost of supplying division + any lost contribution
• Maximum (fixed by receiving division):
o Transfer price ≤ the lower of net marginal revenue of the receiving division and the external purchase price
When unit variable costs and/or unit selling prices are not constant, there will be a profit-maximising level of output and the ideal transfer price will only be found by negotiation and careful analysis: -
• Establish the output and sales quantities that will optimise the profits of the company or group as a whole.
Establish the transfer price at which both profit centres would maximise their profits at this company-optimising output level. There may be a range of prices within which both profit centres can agree on the output level that would maximise their individual profits and the profits of the company as a whole. Any price within the range would then be ‘ideal’

Question 23

Transfer pricing regulation.

Answer 23

Transfer pricing is a normal and legitimate activity. Transfer price manipulation, on the other hand, exists when transfer prices are used to evade or avoid payment of taxes and tariffs. Authorities have based transfer pricing regulations on the concept of the arm’s length standard in order to reduce transfer price manipulation. Arm’s length standard means that intra-firm trade of multinational should be priced as if they took place between unrelated parties acting at arm’s length in competitive market. The main method of establishing ‘arm’s length’ transfer price is the comparable uncontrolled price (CUP) method which looks for a comparable product to the transaction in question (similar product in comparable transaction with unrelated party or similar product between two unrelated parties). A market-based transfer price is likely to be acceptable to regulatory authorities.

Question 24

Ethical issues in transfer pricing.

Answer 24

There are a number of potential ethical issues for the multinational company to consider when formulating its transfer pricing strategy:
• Social responsibility, reducing amounts paid in customs duties and tax.
• Bypassing a country’s financial regulation via remittance of dividends.
• Not operating as a ‘responsible citizen’ in foreign country.
• Reputational loss.
• Bad publicity.
• Tax evasion.