Transfer Pricing

Question 1

What is transfer pricing?

Answer 1

Some profit centres will supply goods and services to others
The price at which this inter-divisional trading occurs is the transfer price
The transfer is treated as an internal sale and an internal purchase within the organisation
It provides sales income to the supplying division and is a purchase cost for the receiving division
The sales income in one division is offset by the purchase cost in the other division
The transfer affects the profits of the two divisions but has no effect on the profit of the organisation as a whole

Question 2

How do you set a transfer price?

Answer 2

The transfer price is significant because:
It determines how the total profit is shared between the two divisions
It could affect decisions by divisional managers about whether they are willing to buy or sell from another division

Both divisions must benefit from the transaction if inter-divisional sales are to take place
Transfer prices have to be established and agreed

Question 3

Should inter-divisional trading be encouraged?

Answer 3

Interdivisional trading should be encouraged:
Preference for a selling division to sell internally
Preference for a buying division to buy internally
However there should be the option to buy or sell externally too if there is a good commercial reason for this

Question 4

What are the objectives of transfer pricing?

Answer 4

Goal congruence
Performance measurement
Maintaining divisional autonomy
Minimising global tax liability
Recording the movement of goods and services
Fair allocation of profits between divisions

Question 5

What is the cost bases for setting transfer pricing?

Answer 5

Could be:
Marginal cost to the selling division
Marginal cost plus mark-up
Full cost to selling division
Full cost plus mark-up
(actual or budgeted)

Question 6

What is the Market bases for setting transfer pricing?

Answer 6

Might be agreed if there is an intermediate market for the transferred item
An intermediate market is a term used to describe an external market for the good or service
Transfer price likely to be the price for the item in the external market
Could be at a discount to account for savings in selling costs

Question 7

What is the negotiated bases for setting transfer pricing?

Answer 7

Determined by negotiation between 2 centres
Two-part tariffs
Dual transfer prices
Prices negotiated to take account of spare capacity

Question 8

What are the general rules of transfer pricing?

Answer 8

All goods and services should be transferred at opportunity cost
Transfer price should be a fair measure of performance
3 possible situations:
There is a competitive market for an intermediate product
There are production constraints and selling division has no surplus capacity
Selling division has selling/surplus capacity

Question 9

What is the application of general rules?

Answer 9

1. Where there is a perfectly competitive market for an intermediate product:
   Optimum TP = Market price + any small adjustments
2. Where there are production constraints and the division has no surplus capacity
   Optimum TP = marginal cost + shadow price
3. Where there is surplus capacity
   Optimum TP = Marginal cost

Question 10

Competitive market transfer pricing =

Answer 10

Optimum TP = Market price + any small adjustments

Question 11

Surplus capacity transfer pricing =

Answer 11

Optimum TP = Marginal cost
This may not be fair however for supplying division therefore solutions are:
2 part tariff
Cost-plus pricing
Dual pricing

Question 12

Part tariff transfer pricing =

Answer 12

The transfer price is marginal cost
Also a fixed sum is paid per annum or period

Question 13

Cost plus pricing transfer pricing =

Answer 13

Marginal cost per mark up

Question 14

Dual pricing transfer pricing =

Answer 14

One transfer price is recorded by the supplying division and a different transfer price is recorded by the buying division
Adjustment held in HQ account

Question 15

How does tax effect transfer pricing?

Answer 15

A group’s tax liability can be minimised by using transfer pricing by:
Reducing the profitability of its subsidiaries in high-tax countries
Increasing the profitability of its subsidiaries in low tax countries

Double taxation agreements between countries means that companies pay tax on transactions in one country only
However if companies set unrealistic transfer prices in order to minimise tax they may have to pay tax in both countries

Question 16

Taxation issue of transfer pricing?

Answer 16

If a group has subsidiaries in different countries with different tax rates the overall group tax bill can be reduced by manipulating transfer prices
Marketing subsidiaries can be set up in countries with low corporation tax and transfer products at a low transfer price
Example - Double Irish

Question 17

Government action on transfer pricing?

Answer 17

Governments are aware of the effect of transfer pricing on profits
Many countries require justification of transfer prices between divisions
Some governments hope to attract businesses with tax laws that are favourable – tax havens:
Low rate of tax
A low withholding tax on dividends paid to foreign holding companies
Tax treaties with other countries
No exchange controls
A stable economy

Question 18

How do companies use transfer pricing to manage cash flows?

Answer 18

Some governments place legal restriction on dividend payments by companies to foreign parent companies
In this situation a multinational may sell goods or services to a subsidiary at very high transfer prices to facilitate movement of cash
However this is not possible where country’s tax laws require an arms length approach to transfer pricing

Question 19

Currency management through transfer pricing?

Answer 19

A decision has to be made about the currency for transfer prices
As exchange rates can be volatile subsidiaries may make unexpected profit or losses from movements in the exchange rates
The company as a whole should manage its exposures to currency risks
A multinational might set transfer prices in a currency so that any currency losses arise in the subsidiary in high tax countries and any currency profits arise in countries with lower tax rates

Question 20

Problems of transfer pricing for companies with overseas divisions?

Answer 20

Exchange rate fluctuation
Taxation in different countries
Import tariffs/custom duties
Exchange controls
Anti-dumping legislation
Repatriation of funds