Chapter 11

International Transfer
Pricing

McGraw-Hill/Irwin

Copyright 2007 by The McGraw-Hill Companies, Inc. All

rights reserved.

International Transfer Pricing

Chapter Topics

Transfer prices, corporate objectives, national tax laws.

Cost minimization and performance evaluation.
National tax guidelines.
Five specific methods to determine arms-length prices.
Advance pricing agreements (APAs).
Enforcement of transfer pricing regulations.

11-2

International Transfer Pricing

Learning Objectives
1. Describe the importance of transfer pricing in achieving
goal congruence in decentralized organizations.
2. Explain how the objectives of performance evaluation
and cost minimization can conflict in determining
international transfer prices.
3. Show how discretionary transfer pricing can be used to
achieve specific cost minimization objectives.
4. Describe governments reaction to the use of
discretionary transfer pricing by multinational
companies.
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International Transfer Pricing

Learning Objectives
5. Discuss transfer pricing methods used in the sales of
tangible property.
6. Explain how advance pricing agreements can be used
to create certainty in transfer pricing.
7. Describe worldwide efforts to enforce transfer pricing
regulations.

11-4

Transfer Pricing Background

Transfer pricing is the determination of price on the
exchange of goods or services between related parties.
These transfers are also referred to as intercompany
transactions.
Upstream transfers go from subsidiary to parent,
downstream transfers are from parent to subsidiary.
Transfers also occurs between different subsidiaries of
the same parent.
A significant proportion of international transactions are
intercompany transfers.

11-5

Decentralization and Goal Congruence

Decentralization and agency problems
Decentralized companies are organized by division and
division managers have significant authority.
This structure decomposes problems into smaller pieces.
It also permits local decision making which provides
more responsibility for division managers.
An agency problem can occur since division managers
make decisions in their self-interest.
The managers self-interest can vary with the best
interests of the company.

Learning Objective 1

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Decentralization and Goal Congruence

An effective accounting system can alleviate this agency
problem by providing incentives to division managers to
act in the interests of the organization.
This is referred to as goal congruence.
These concepts are relevant to both multinational and
purely domestic companies.

Learning Objective 1

11-7

Performance Evaluation, Cost

Minimization, and Transfer Pricing
Performance evaluation systems
Transfer prices directly affect the profits of the divisions
involved in an intercompany transaction.
Some performance evaluation systems are based on
divisional profits.
The effectiveness of these performance evaluation
systems is influenced by the fairness of transfer prices.
The effectiveness of performance evaluation systems
affects the satisfaction of managers.

Learning Objective 2

11-8

Performance Evaluation, Cost

Minimization, and Transfer Pricing
Cost minimization
Profit maximization and, by extension, cost minimization
are important corporate objectives.
Manipulating transfer prices between countries is one
way for multinational enterprises to achieve cost
minimization.
This is referred to as discretionary transfer pricing.
The most common approach is to minimize costs by
shifting profits to lower tax rate jurisdictions.

Learning Objective 2

11-9

Performance Evaluation, Cost

Minimization, and Transfer Pricing
Cost minimization -- Example
Padre Inc., a U.S. company, has two subsidiaries, Hijo
and Hija.
Hijo is located in Chile and Hija in the U.S.
The tax rate is 17 percent in Chile and 35 percent in the
U.S.
Hijo transfers 100 units of cosa to Hija at a negotiated
transfer price of $10 per unit.
The cost per unit is $5 for Hijo and Hija sells the units in
the U.S. at $15 per unit.
Padre intervenes to set the transfer price at $13 per unit.
Learning Objectives 2 and 3

11-10

Performance Evaluation, Cost

Minimization, and Transfer Pricing
Cost minimization -- Example
Divisional profits under the negotiated transfer price:

Sales
Cost of goods sold
Gross profit
Income tax effect
After-tax profit

Learning Objectives 2 and 3

Hijo
$1,000
500
500
85
415

Hija
$1,500
1,000
500
175
325

Padre
$1,500
500
1,000
260
740

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Performance Evaluation, Cost

Minimization, and Transfer Pricing
Cost minimization -- Example
Divisional profits under the discretionary transfer price:

Sales
Cost of goods sold
Gross profit
Income tax effect
After-tax profit

Learning Objectives 2 and 3

Hijo
$1,300
500
800
136
664

Hija
$1,500
1,300
200
70
130

Padre
$1,500
500
1,000
206
794

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Performance Evaluation, Cost

Minimization, and Transfer Pricing
Cost minimization -- Example
Corporate profits under the discretionary transfer price
are $54 greater relative to the negotiated price.
This results from shifting $300 of pre-tax profits from the
U.S. to Chile.
The overall tax rate decreases from 26 to 20.6 percent.
The performance evaluation objective is better served by
the negotiated transfer price.
The cost minimization objective is better served by the
discretionary price.

Learning Objectives 2 and 3

11-13

Performance Evaluation, Cost

Minimization, and Transfer Pricing
Conflicting objectives and a solution
The previous example illustrates how cost minimization
and performance evaluation can conflict.
Dual pricing is one solution to this conflict.
Under dual pricing, the official transfer price used for tax
purposes is the discretionary transfer price.
A separate set of records used for performance
evaluation use the negotiated transfer price.

Learning Objective 2

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Performance Evaluation, Cost

Minimization, and Transfer Pricing
Other cost minimization objectives
Withholding taxes, on dividends, can be effectively
avoided via setting favorable transfer prices.
The same can be done to avoid profit repatriation
restrictions.
This essentially changes cash flows from dividends to
intercompany revenues and expenses.
Reduction of import duties.
Increase cash flows out of a devaluing currency.
Enhance the competitive position of a foreign operation.

Learning Objective 3

11-15

Government Reactions
Governments are aware of risk that multinationals will
use transfer pricing to avoid paying income and other
taxes.
Most governments publish guidelines regarding
acceptable transfer pricing.
The guidelines typically use the notion of an arms-length
price.
Arms-length price is the price that would be agreed upon
by unrelated parties.

Learning Objective 4

11-16

Government Reactions
Section 482 U.S. Internal Revenue Code
This rule allows the Internal Revenue Service to audit
international transfer prices.
Penalties of up to 40% of the underpayment of taxes can
be imposed on violators.
It applies to both upstream and downstream
transactions, and transactions between two subsidiaries
of the same parent.

Learning Objective 4

11-17

Government Reactions
Section 482 U.S. Internal Revenue Code
A best methods rule requires the use of arms-length
concept.
Primary factors to consider are the degree of
comparability to uncontrolled transactions and the quality
of the underlying analysis.
The IRS provides for correlative relief to help in
situations where the IRS agrees with a companys
transfer pricing but a foreign government does not.

Learning Objective 4

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Sale of Tangible Property

Five methods

Comparable uncontrolled price method.

Resale price method.
Cost-plus method.
Comparable profits method.
Profit split method.

Learning Objective 5

11-19

Sale of Tangible Property

Comparable uncontrolled price method
Widely considered the most reliable measure when a
comparable uncontrolled transaction exists.
Transfer price is determined based on reference to the
companys sales of the same product to an unrelated
buyer.
Reference to transactions between two unrelated parties
for the same product are acceptable.
If an uncontrolled transaction is not exactly comparable,
an adjustment is allowable.

Learning Objective 5

11-20

Sale of Tangible Property

Resale price method
Generally used when the affiliate is a sales subsidiary
and simply distributes finished goods.
Transfer price is determined by deducting gross profit
from the price charged by the sales subsidiary.
Gross profit is determined by reference to uncontrolled
parties.
The most important factor in choosing this method is the
similarity in function of the affiliated sales subsidiary and
the uncontrolled reference company.

Learning Objective 5

11-21

Sale of Tangible Property

Cost-plus method
Most appropriate when comparable uncontrolled
transactions dont exist and sales subsidiary does more
than simply distribute finished goods.
Transfer price is determined buy adding gross profit to
the cost of production.
Gross profit is determined by reference to uncontrolled
parties.
Factors influencing the comparability of uncontrolled
transactions include: complexity of manufacturing
process, procurement activities, and testing functions.
Learning Objective 5

11-22

Sale of Tangible Property

Comparable profits method
Underlying principle is that similar companies should
earn similar returns over a period of time.
One of the two related parties in the transactions is
chosen for examination.
Transfer price is determined via reference to an objective
measure of profit of an uncontrolled company involved in
comparable transactions.
Typical measures of profit include: ratio of operating
income to operating assets, and operating income to
sales.
Learning Objective 5

11-23

Sale of Tangible Property

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.
There are actually two versions: comparable profit split
method and residual profit split method.

Learning Objective 5

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Sale of Tangible Property

Summary
Any particular transfer pricing method used can result in
a range of transfer prices.
Companies can use discretion to set prices within the
range in order to achieve cost minimization objectives.
Companies can also use discretion in determining the
best method.
Section 482 does provide detailed guidance on factors to
consider in determining comparability to uncontrolled
transactions.

Learning Objective 5

11-25

Other Transfer Pricing Situations

Licenses of intangible property
Section 482 lists six categories of intangibles, including:
patents, copyrights, trademarks, franchises, and
methods and procedures.
Four methods are available for setting transfer prices:

Comparable uncontrolled transaction method.

Comparable profits method.
Profit split method.
A group of unspecified methods.

Pricing of Intercompany loans and intercompany

services are also transfer pricing situations.

Learning Objective 5

11-26

Advance Pricing Agreements (APA)

Background
An APA is an agreement between a company and a
taxing authority regarding an acceptable transfer pricing
method.
A unilateral agreement is between a taxpayer and one
government, a bilateral agreement involves a taxpayer
and two governments.
The primary advantage is assurance that their approach
will not be challenged.
The primary disadvantage is the time and cost involved
in arriving at the agreement.
Learning Objective 6

11-27

Advance Pricing Agreements (APA)

Some specifics of national APAs
The U.S. began its APA program in 1991.
An increasing number of other countries have
subsequently established programs.
In the U.S. of a total of 434 agreements, approximately
60 percent involve foreign parent companies.
The electronics manufacturing industry is the leading
user of APAs.

Learning Objective 6

11-28

Worldwide Enforcement
There are a number of documented cases of companies,
both U.S. and foreign, deemed to have underpaid taxes
in the U.S.
Some of these cases reflect obvious attempts by
companies to evade U.S. taxes by manipulating transfer
prices.
In one case, a U.S. subsidiary sold bulldozers to its
foreign parent for $551 each.
From 1996-2000, over 60 percent of U.S. and foreign
multinationals paid no U.S. income tax.
There is a worldwide trend toward strengthening transfer
pricing rules.
Learning Objective 7

11-29