Session 11: Transfer Pricing Flashcards
What is Transfer Pricing?
Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided. Transfer pricing allows for the establishment of prices for the goods and services exchanged between a subsidiary, an affiliate, or commonly controlled companies that are part of the same larger enterprise. Transfer pricing can lead to tax savings for corporations, though tax authorities may contest their claims.
KEY TAKEAWAYS
- Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods or services provided.
- A transfer price is based on market prices in charging another division, subsidiary, or holding company for services rendered.
- However, companies have used inter-company transfer pricing to reduce the tax burden of the parent company.
Companies charge a higher price to divisions in high-tax countries (reducing profit) while charging a lower price (increasing profits) for divisions in low-tax countries.
How does Transfer Pricing Work?
Transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries that operate under common control or ownership. The transfer pricing practice extends to cross-border transactions as well as domestic ones.
A transfer price is used to determine the cost to charge another division, subsidiary, or holding company for services rendered. Typically, transfer prices are priced based on the going market price for that good or service. Transfer pricing can also be applied to intellectual property such as research, patents, and royalties.
Multinational companies (MNC) are legally allowed to use the transfer pricing method for allocating earnings among their various subsidiary and affiliate companies that are part of the parent organization. However, companies at times can also use (or misuse) this practice by altering their taxable income, thus reducing their overall taxes. The transfer pricing mechanism is a way that companies can shift tax liabilities to low-cost tax jurisdictions.
What are the five objectives of Transfer Pricing?
• Goal congruence between divisions and group e.g. re:
– group profit maximisation
– cost management motivation
– inter-division service motivation
• Valid performance measurement for each division e.g. PRP
• Minimal disruption to principle of autonomy
• Tax compliance and minimisation (corporation tax, import duties)
• Minimise administration e.g. inter-group accounting
How is optimal transfer price determined?
The optimal transfer price is based on a number of factors, including the cost of the item and which entity receives the benefit of profits.
If management believes it benefits the corporation as a whole for company A to realize 100% of the profits, the transfer price is set using the market price of the product.
The transfer price does not differ much from the market price.
What are the different types of transfer pricing?
Cost-based TP
Market-price TP
Hybrid solution TP, including:
- Dual Pricing – e.g. market price for selling division; VC for buying division, difference ‘expensed’ to corporate PandL;
- Negotiated – but may be time consuming, and reflect
relative negotiating skills rather than cost and market data;
- If spare capacity, VC + lump sum towards fixed costs/profit, addressing supplying division motivation & profit evaluation;
- VC + Opportunity Cost (OC) e.g. if spare capacity, OC = 0 so TP = VC; otherwise OC = MP-VC=> TP=MP
What are the pros and cons of cost-based transfer pricing?
• Cost based TPs (a) don’t motivate cost management;
(b) May impact upon the prices charged to third parties (ref Birch).
• Conflict of objectives exists and can be difficult to resolve.
What are the pros and cons of market-price transfer pricing?
Pros:
- Likely perceived fair by both divisions=>cost/svs motivation
- Divisional Profit and Autonomy unaffected
- Optimal if a perfectly competitive market
(i. e. sellers/buyers can sell/buy as much as they like at the market price =>no spare capacity) - Arms-length for tax
- When a market price exists, it is a good transfer price because it is equal to the opportunity cost.
Cons:
• Market prices may not exist or be transparent, or could be ‘distressed’ in the short run
• No incentive to max inter-div sales => group profits only
optimised if a perfectly competitive market (i.e. no spare capacity)
What should the process to determine best transfer price solution be?
Assess TP policy versus TP objectives (e.g. goal congruence re:profit maximisation and cost vs motivation, performance measurement, autonomy)
• Objectives may conflict-solution may depend on context
• Surplus capacity or not
• Availability of price / cost data
• Number and materiality of inter-div transactions
• Weighting of achieving various TP objectives
• Consequences of ‘intervening’, as well of ‘not intervening’
• Consider alternative solutions e.g. divisional re-organisation, changed
PRP arrangements
• Solution may be a judgement call
In what instances would one choose variable cost as the transfer price?
In some cases, the transferred product is unique and not sold by the producing division in the open market. Obviously, no market price exists, and some other transfer price must be chosen. The variable cost of producing the transferred good may be the best transfer price in this situation.
In what instances would one choose full cost plus profit as the transfer price?
A significant problem with using variable cost as the transfer price is that the selling division cannot earn a profit on production of the transferred product. Although this pricing method may be more acceptable to the selling division, it may not measure the opportunity cost of producing the transferred product. This can result in decisions that do not maximise profitability for the whole company.
In what instances would one choose negotiated transfer prices?
This is an option that gives full autonomy to the subunit manager – decentralised benefits – and treats the internal unit just as any other client. However, the negotiated price may only be as good as the negotiators involved, and may not adequately reflect the opportunity cost associated with producing goods and transferring them internally.
