Lecture 3 Flashcards
Transfer price (aka intercompany transactions)
When business units/divisions in an organization buy goods and services from one another, the value or amount recorded in a firm’s accounting records as revenue to the selling unit and cost to the buying unit.
Although this is recorded as revenue to one unit and cost to another, both units are part of the organization and the transfer price has no impact on the firm.
As the exchange takes place within the organization, the firm has considerable discretion in setting the transfer price.
Factors that influence transfer pricing: (3)
- Country laws governing the intercompany transactions.
- Cost minimization (profit maximization)
○ Manipulating transfer prices between countries is one way for MNCs to achieve cost minimization —> Discretionary Transfer Pricing - Performance evaluation and management control
○ Cost minimization and performance evaluation often clash due to the agency problem- this can create a conflict of interest in determining the international transfer price.
- Cost minimization (profit maximization)
Define Discretionary Transfer Pricing
Manipulating transfer prices between countries is one way for MNCs to achieve cost minimization.
It is called “discretionary” because it is at the discretion of the company.
The most common approach is to minimize costs by shifting profits to lower tax rate jurisdictions.
Describe decentralized companies (1) and why firms choose this organizational structure (3):
Decentralized companies are firms which are organized by division, and each division manager has significant authority (more autonomy).
This allows local managers to react quickly to a changing environment.
Following this structure, the company is able to decompose problems into smaller pieces.
This also motivates local managers as managers would be frustrated if asked only to implement decisions from HQ.
Give a disadvantage of decentralized companies:
Often a firm’s subsidiary is judged based on their individual performance. This can generate an agency problem as managers in the subsidiary may have a larger interest in the success of the subsidiary instead of the overall company.
How do transfer prices impact Performance Evaluation Systems and Management Control
- Transfer prices directly affects the profits of the divisions involved in an intercompany transaction - some performance evaluation systems are based on these divisional profits.
○ Effectiveness of these performance evaluation systems is influenced by the fairness of transfer prices.
§ Effectiveness of performance evaluation systems affects the satisfaction of managers.
How can firms resolve the challenges of Performance Evaluation vs Cost Minimization to ensure managers in different divisions are satisfied?
Dual Pricing- this is where there are 2 transfer prices:
- Discretionary Transfer Price: This is the price that would be used to adhere to the cost minimization objective.
- Negotiated Transfer Price: This would be the negotiated price between managers in the relevant divisions to ensure there is a fair Performance Evaluation.
How can firms alleviate the agency problem for decentralized firms? (3)
Goal Congruence (GC)- this is where the firm would provide incentives to division managers to act in the interests of the organization:
- The system that is used for evaluating the performance of division managers is importance for Goal Congruence.
○ The transfer pricing would affect both the operating profit, and the performance measurement of divisions/subsidiaries/business units.
What are the objectives of transfer pricing? (5)
The transfer pricing issue is even more troublesome when it involves multinational divisions located in “tax haven” countries.
- Other cost minimization objectives
1. Avoidance of withholding taxes
§ Withholding taxes- these are taxes a company would need to pay based on certain criteria.
§ Companies can reduce or avoid these taxes by either:
□ Inflating the transfer price in a transaction from Country A to Country B—> Moving the profits to Country A.
□ Deflating the transfer price in a transaction from Country A to Country B—> Moving the profits to Country B.
This would depend on which country has a higher tax rate.
2. Avoidance of profit repatriation restrictions
§ Some countries restrict the amount of profit that can be paid as a dividend to a parent company
§ Parent companies can avoid these restrictions by increasing the transfer prices
3. Minimization of import duties
§ If you want to bring certain goods into the country, you have to pay taxes on it.
§ The lower the price of the goods, the lower the taxes in the country.
4. Protect cash flows from currency devaluations
§ Companies that operate in countries where the currency is being devalued, can either accelerate their cash flow into a more stable currency with transfer prices (called leads), or they can delay payments through transfer pricing if the currency is expected to appreciate (called lags).
5. Improve competitive position of foreign operation
§ When you want to compete in foreign markets, a parent company may want to acquire a large market share for the subsidiary.
□ The parent company can improve the environment for their subsidiary by deflating their transfer price to the subsidiary, giving them good margins and a good financial position. This would help the subsidiary gain a larger market share at a faster rate.
Role of Transfer pricing in Goal Congruence:
- Appropriate transfer prices can ensure that each division or subsidiary’s profit accurately reflects its contribution to overall company profits.
Name 3 types of transfer pricing methods:
- Cost-based transfer price
- Market-based transfer price
- Negotiated transfer price
When would “Cost-based” transfer pricing be preferred? (5)
- Differences in income tax rates
- Minimization of import duties
- Foreign exchange controls and risks
- Restrictions on profit repatriation
- Risk of expropriation and nationalization
When would “Market-based” transfer pricing be preferred? (2)
- Interests of local players.
- Good relationship with local government.
Government reactions and ethical concerns related to transfer pricing:
Governments are aware of risk that multinationals will use transfer pricing to avoid paying income and other taxes.
- Most government publish guidelines regarding acceptable transfer pricing.
○ The guidelines typically refer to “arms-length pricing”
Define “Arms-Length” pricing
The price that would be agreed upon by unrelated parties.
Define the “best-method rule”
This requires the use of arms-length concept
- Primary factors to consider are the degree of “comparability” to uncontrolled transactions and the quality of underlying analysis.
What are the transfer pricing methods for Tangible Property?
- Comparable uncontrolled price method (CUP)
- Resale price method
- Cost-plus method
- Comparable profits method
- Profit split method
Comparable uncontrolled price method (CUP)
- Transfer price is determined based on reference to the company’s sales of the same product to an unrelated buyer.
○ The company would reference transactions between two unrelated parties for the same product in order to make this method acceptable.
○ However, there are specific factors to be considered while comparing products.
What are the specific factors to be considered while comparing products in the CUP price method? (7)
- Quality of the product
- Contractual terms
- Level of market
- Geographic market
- Date of transaction
- Foreign currency risks
- Alternatives realistically available to the buyer and seller.
When should the Resale Price method be used and how is that transfer price determined?
This is used when the affiliate is a sales subsidiary and simply distributes finished goods.
- The transfer price is determined by deducting the gross profit of the reseller from the price charged by the sales subsidiary.
- Gross profit is determined by reference to uncontrolled parties.
The most important factor of this method is the similarity in function of the affiliated sales subsidiary and the uncontrolled reference company.
When should the Cost-Plus method be used and how is that transfer price determined?
Best suited when comparable uncontrolled transactions don’t exist and sales subsidiary does more than simply distribute finished goods.
- Transfer price is determined by adding mark-up to the cost of the product.
○ Mark-up/gross profit is determined by reference to uncontrolled parties.
- This may be influenced by the complexity of the manufacturing process, procurement activities, and testing functions.
What are the 2 conditions for companies to use the Cost-Plus method?
- There should not be any other comparable transactions in the market.
- The sales subsidiary should be adding significant value to the product (such as assembling intermediary goods)
What is the theoretical approach behind the Comparable Profits method?
Underlying principle: Similarly situated tax payers should earn similar returns over a period of time.
- 1 of the 2 related parties is chosen for examination.
○ The transfer price is determined via reference to an “objective measure of profit” of an uncontrolled company involved in comparable transactions.
§ Objective measures of profit include:
□ Ratio of operating income to operating assets.
□ Ratio of operating income to sales.
So if a company were to find the maximum transfer price when buying a product, they would calculate an acceptable operating profit (i.e. 5%), and once the operating expenses have been deducted from the total sales, the maximum transfer price would be (total sales - operating expenses) - transfer price = 5% of Total Sales.
What is the theoretical approach behind the Profit Split Method?
The 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.
What are the 2 versions of the Profit Split Method?
- Comparable profit split method
- Residual profit split method
