1 - 1 International Cost Accounting. 1 - 2 TAX ES AND TRANSFER PRICING n Some MNCs use a reinvoicing...

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International Cost AccountingInternational Cost Accounting

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TAX ES AND TRANSFER PRICINGTAX ES AND TRANSFER PRICING

Some MNCs use a reinvoicing center to avoid taxes.Some MNCs use a reinvoicing center to avoid taxes. A French Subsidiary of a U.S.Parent produces a A French Subsidiary of a U.S.Parent produces a

component at a cost of $100. The French subsidiary component at a cost of $100. The French subsidiary transfers title to a reinvoicing center in Puerto Rico at transfers title to a reinvoicing center in Puerto Rico at a transfer price of $100. Puerto Rico has no income a transfer price of $100. Puerto Rico has no income tax. This center then transfers title to the U.S. tax. This center then transfers title to the U.S. subsidiary of the parent corporation at a transfer price subsidiary of the parent corporation at a transfer price of $200.of $200.

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The U.S. subsidiary sells the component for $200. The The U.S. subsidiary sells the component for $200. The component is not subject to U. S. tax because it is component is not subject to U. S. tax because it is ostensibly sold at cost. Without the reinvoicing center, ostensibly sold at cost. Without the reinvoicing center, if the French subsidiary had set the transfer price at if the French subsidiary had set the transfer price at $200 it would have been subject to the French tax $200 it would have been subject to the French tax (40%). If the transfer price had been set at $100, no (40%). If the transfer price had been set at $100, no French tax would have been paid, but the U.S. sub French tax would have been paid, but the U.S. sub (selling for $200) would have(selling for $200) would have

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realized a profit of $100 that would have been realized a profit of $100 that would have been subject to the U.S. tax of 35%. The reinvoicing subject to the U.S. tax of 35%. The reinvoicing center took title to but never possession of the center took title to but never possession of the product. It is clearly set up to evade corporate product. It is clearly set up to evade corporate income taxes.income taxes.

This is the type of abuse IRS Code Section 482 was This is the type of abuse IRS Code Section 482 was set up to prevent. Section 482 allows, in effect, three set up to prevent. Section 482 allows, in effect, three transfer pricing methods that approximate an arms-transfer pricing methods that approximate an arms-length length

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transaction and a special pricing arrangement.transaction and a special pricing arrangement.These are: (1) Comparable uncontrolled price method; (2) These are: (1) Comparable uncontrolled price method; (2) Resale price method and (3) Cost Plus method. Examples:Resale price method and (3) Cost Plus method. Examples:

1. The U.S. sub purchases a component from the French sub that 1. The U.S. sub purchases a component from the French sub that has a market price of $38.has a market price of $38.Freight and insurance costs are $5. Commissions and Freight and insurance costs are $5. Commissions and marketing costs are $3.80.marketing costs are $3.80.The transfer price may be set at: The transfer price may be set at:

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$38 + $5 - $3.80 = $38 + $5 - $3.80 = $39.20$39.202. Resale Price Method2. Resale Price MethodThe component made in France has no outside The component made in France has no outside

market.market.U.S. sub sells the component for $50 and U.S. sub sells the component for $50 and

normally receives a mark-up of 40% on the cost normally receives a mark-up of 40% on the cost of goods sold. The transfer price would beof goods sold. The transfer price would be

$50/1.40 = $50/1.40 = $35.71$35.713. Cost plus3. Cost plus

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Assume the French subs manufacturing costs are $20. Assume the French subs manufacturing costs are $20. Landing costs are $5. Landing costs are $5.

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The transfer price is set at The transfer price is set at $25$25.. 4. Advanced Pricing Agreement (APA) 4. Advanced Pricing Agreement (APA) This is an advance agreement between the company This is an advance agreement between the company

and the IRS for a specified period of time. It is not and the IRS for a specified period of time. It is not made public. It may be done so that the IRS and the made public. It may be done so that the IRS and the company can agree about valuing certain assets such company can agree about valuing certain assets such as intangibles.as intangibles.

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For example, a U.S. firm may develop a product and For example, a U.S. firm may develop a product and license its Puerto Rican subsidiary to produce it. The license its Puerto Rican subsidiary to produce it. The product would then be purchased by the parent for product would then be purchased by the parent for sale in the U.S., and a royalty would be charged to the sale in the U.S., and a royalty would be charged to the subsidiary. The royalty rate would be taxable income subsidiary. The royalty rate would be taxable income to the parent, but at a low rate.to the parent, but at a low rate.

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Because the transaction was similarBecause the transaction was similar

to other third party transactions the IRS could not to other third party transactions the IRS could not challenge it. The IRS added a super royalty provision challenge it. The IRS added a super royalty provision to Section 482 linking the transfer price of the to Section 482 linking the transfer price of the intangible to the income attributable to the intangible. intangible to the income attributable to the intangible. Because this “ income” is difficult to measure the TP Because this “ income” is difficult to measure the TP is often negotiated using an APA. is often negotiated using an APA.

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The example in the textbook illustrates how taxes can The example in the textbook illustrates how taxes can distort incentives. Recall that the market method for distort incentives. Recall that the market method for transfer pricing satisfies all the criteria for an transfer pricing satisfies all the criteria for an acceptable transfer price. Assuming the market is acceptable transfer price. Assuming the market is perfectly competitive for the intermediate product the perfectly competitive for the intermediate product the tax saving resulting from use of the cost plus method tax saving resulting from use of the cost plus method would encourage use of that method. would encourage use of that method.

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International TradeInternational Trade

– ImportsImports– When multinational corporations (MNCs) import When multinational corporations (MNCs) import

materials for use in production, a tariffmaterials for use in production, a tariff– (tax, duty) is levied by the federal government.(tax, duty) is levied by the federal government.– This tax becomes part of the cost of materials. This tax becomes part of the cost of materials.

Companies look for ways to reduce these taxes. One Companies look for ways to reduce these taxes. One way is to alter the materials by adding more U.S. way is to alter the materials by adding more U.S. content and gain more content and gain more

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.. International Trade... International Trade.

– favorable tariff status. Another way is to utilize a favorable tariff status. Another way is to utilize a foreign trade zone.foreign trade zone.

– Foreign Trade Zone (FTZ)Foreign Trade Zone (FTZ) – FTZs are areas that are physically on U.S. soil but are FTZs are areas that are physically on U.S. soil but are

considered to be outside U.S. commerce. Companies considered to be outside U.S. commerce. Companies in FTZs can manufacture or warehouse. They also do in FTZs can manufacture or warehouse. They also do not have to pay duty on imports subject to their not have to pay duty on imports subject to their

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International Trade...International Trade...

– being reported to the U.S. Customs and remaining being reported to the U.S. Customs and remaining within designated FTZs. If the items leave the FTZ within designated FTZs. If the items leave the FTZ bound for non-U.S. destinations, there is no tariff bound for non-U.S. destinations, there is no tariff (duty). If they leave the FTZ for U.S. destinations, (duty). If they leave the FTZ for U.S. destinations, then a tariff is due. FTZs must be located near a U.S. then a tariff is due. FTZs must be located near a U.S. customs port of entry. Goods imported into an FTZ customs port of entry. Goods imported into an FTZ are tariff free until they leave the zone.are tariff free until they leave the zone.

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International Trade...International Trade...

– This has important implications for companies that This has important implications for companies that import raw materials. Since duty is not due until the import raw materials. Since duty is not due until the imported materials leave the zone, the company imported materials leave the zone, the company postpones payment and any associated loss of postpones payment and any associated loss of working capital. Further, the company in the FTZ working capital. Further, the company in the FTZ does not pay duty on defective material not does not pay duty on defective material not

– included in the finished product. This results included in the finished product. This results

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in savings from not having to pay for defective in savings from not having to pay for defective material and not having to pay the carrying cost of the material and not having to pay the carrying cost of the duty. See example on page 400 of handout. duty. See example on page 400 of handout.

Other advantages of FTZs Other advantages of FTZs

Imports that do not comply with U.S. standards can Imports that do not comply with U.S. standards can be imported into an FTZ andbe imported into an FTZ and

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modified to comply without being subject to a fine.modified to comply without being subject to a fine. In an FTZ a company can assemble high tariff In an FTZ a company can assemble high tariff

component parts into a lower tariff finished product. component parts into a lower tariff finished product. Adding domestic labor content during assembly Adding domestic labor content during assembly makes the high tariff foreign parts eligible for more makes the high tariff foreign parts eligible for more favorable tariff treatment.favorable tariff treatment.

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Owners of FTZs are usually city or county Owners of FTZs are usually city or county authorities. They have the authority to reallocate authorities. They have the authority to reallocate FTZ areas to other foreign trade sub zones if it can be FTZ areas to other foreign trade sub zones if it can be justified. See example page 401 handout. Remember justified. See example page 401 handout. Remember there are a number of foreign auto plants that are there are a number of foreign auto plants that are FTZs. The U.S. has at times considered curtailing FTZs. The U.S. has at times considered curtailing these FTZs in effect using them as a trade weapon these FTZs in effect using them as a trade weapon against the home country.against the home country.

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Exports Exports The sale of a company’s products to The sale of a company’s products to foreign countries. Products can be sold directly to foreign countries. Products can be sold directly to

customers in a foreign country. Or the company may customers in a foreign country. Or the company may work with a distributor in a foreign country. It could work with a distributor in a foreign country. It could also buy an established business (create a wholly also buy an established business (create a wholly owned subsidiary or branch). owned subsidiary or branch).

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Wholly Owned SubsidiaryWholly Owned Subsidiary The parent company buys a foreign company.The parent company buys a foreign company. It is relatively simple because the foreign company It is relatively simple because the foreign company

usually has an outlet for the productusually has an outlet for the product

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See Whirlpool example on page 402 of handout. See Whirlpool example on page 402 of handout. Some companies move a business function to Some companies move a business function to another country. another country. OutsourcingOutsourcing is the payment by a is the payment by a company for a business function that was formerly company for a business function that was formerly done in house. When a company out sources to buy done in house. When a company out sources to buy technical expertise this is known as technical expertise this is known as advantageous advantageous outsourcingoutsourcing. Outsourcing also allows . Outsourcing also allows

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companies to work around the clock. See TI companies to work around the clock. See TI example on page 402. example on page 402.

Joint VenturesJoint Ventures A type of partnership in which A type of partnership in which investors co-own the enterprise. A JV is necessary investors co-own the enterprise. A JV is necessary when the type of expertise needed by the MNC is when the type of expertise needed by the MNC is not for sale. For example, China, India and not for sale. For example, China, India and Thailand do not allow MNCs to purchase Thailand do not allow MNCs to purchase companies or set up subsidiaries so JVs are companies or set up subsidiaries so JVs are required. See page 403 for examples of JVs.required. See page 403 for examples of JVs.

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Foreign Currency ExchangeForeign Currency Exchange

Currency Risk ManagementCurrency Risk Management Transaction risk-future cash transactions will be Transaction risk-future cash transactions will be

affected by changing exchange rates.affected by changing exchange rates. Economic risk-the present value of future cash flows Economic risk-the present value of future cash flows

will be affected by exchange rate fluctuations.will be affected by exchange rate fluctuations. Translation risk-the degree to which financialTranslation risk-the degree to which financial

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statements are exposed to exchange rate changes.statements are exposed to exchange rate changes.

TerminologyTerminology

Spot rate: the exchange rate of one currency for another Spot rate: the exchange rate of one currency for another today. Eg. $1U.S. = $1.56 Canadiantoday. Eg. $1U.S. = $1.56 Canadian

Appreciation: One currency can buy more of another Appreciation: One currency can buy more of another currency. Ex. $1U.S. = $1.56 Canadian today. Next currency. Ex. $1U.S. = $1.56 Canadian today. Next week $1 U.S. = $1.80 Canadian.week $1 U.S. = $1.80 Canadian.

Depreciation: One currency can buy less of a Depreciation: One currency can buy less of a

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– another currency. Ex. $1U.S. = $1.56 Canadian today. Next another currency. Ex. $1U.S. = $1.56 Canadian today. Next week $1 U.S. = $1.40 Canadian.week $1 U.S. = $1.40 Canadian.

– Transaction RiskTransaction Risk– Exchange rate gains and losses for receivables and payables. Exchange rate gains and losses for receivables and payables.

See examples on page 405 and 406 of the handout.See examples on page 405 and 406 of the handout.– Hedging: The use of forward exchange contracts to ensure Hedging: The use of forward exchange contracts to ensure

against foreign currencyagainst foreign currency

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gains and losses. See examples on page 407.gains and losses. See examples on page 407.

The premium expense needs to be netted against the The premium expense needs to be netted against the difference between what would have been paid or difference between what would have been paid or received without the hedge to determine if the hedge received without the hedge to determine if the hedge was profitable. Even if the result is negative it still was profitable. Even if the result is negative it still may be considered successful because it reduced risk may be considered successful because it reduced risk (anxiety and worry).(anxiety and worry).

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If you are owed a receivable in foreign currency do If you are owed a receivable in foreign currency do you want the dollar to appreciate or depreciate you want the dollar to appreciate or depreciate relative to the foreign currency?relative to the foreign currency?

What if you owe a payable?What if you owe a payable?

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Foreign Currency Exchange..Foreign Currency Exchange..

– Economic RiskEconomic Risk– This occurs when exchange rates change the cost of This occurs when exchange rates change the cost of

competing products in different countries. Eg. The competing products in different countries. Eg. The exchange rate changes the price for heavy equipment exchange rate changes the price for heavy equipment in Japan from $80,000 to $74,286 while the price in in Japan from $80,000 to $74,286 while the price in the U.S. remains at $80,000. This was caused by the the U.S. remains at $80,000. This was caused by the dollar appreciating relative to the yen. In thisdollar appreciating relative to the yen. In this

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– case a strong dollar makes the U.S. less competitive case a strong dollar makes the U.S. less competitive internationally. A strong dollar often contributes to internationally. A strong dollar often contributes to a large trade deficit. a large trade deficit.

– Economic risk can be managed by hedgingEconomic risk can be managed by hedging. See . See example of page 406. It should also be managed by example of page 406. It should also be managed by awareness in budgeting and financial planning. E.g. awareness in budgeting and financial planning. E.g. by giving consideration to exchange rate by giving consideration to exchange rate fluctuations.fluctuations.

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– Translation RiskTranslation Risk– This occurs when financial statements are translated This occurs when financial statements are translated

in the parent currency and there has been significant in the parent currency and there has been significant depreciation or appreciation between the parent depreciation or appreciation between the parent currency and the home country currency. See currency and the home country currency. See example on page 409. This can be managed by a example on page 409. This can be managed by a common sense approach. Look at the financial common sense approach. Look at the financial statements statements

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– before translation and after translation to determine before translation and after translation to determine the economic impact in the home country. The the economic impact in the home country. The objective of denominating internal reports in the objective of denominating internal reports in the parent currency is toparent currency is to

– measure all figures on the same basis. However, measure all figures on the same basis. However, when making comparisons over time local currency when making comparisons over time local currency statements should be placed alongside parent statements should be placed alongside parent denominated reports.denominated reports.

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– In sum transaction and economic risk can be managed In sum transaction and economic risk can be managed by hedging. Translation risk is managed by common by hedging. Translation risk is managed by common sense on a case by case basis.sense on a case by case basis.

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Measuring Performance in an MNCMeasuring Performance in an MNC

The evaluation of the manager of an MNC sub unit The evaluation of the manager of an MNC sub unit (division) should be separated from the evaluation of (division) should be separated from the evaluation of the division. The manager’s evaluation should not the division. The manager’s evaluation should not include factors over which he/she exercises no include factors over which he/she exercises no control. These factors include currency fluctuations control. These factors include currency fluctuations and taxes.and taxes.

Managers should be evaluated on the basis of Managers should be evaluated on the basis of revenues and costs incurred. revenues and costs incurred.

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Once the manager is evaluated the sub financial Once the manager is evaluated the sub financial statements can be restated to the home currency and statements can be restated to the home currency and uncontrollable costs can be allocated.uncontrollable costs can be allocated.

Examples of Factors that differ:Examples of Factors that differ: Legal- Potted plants cannot enter the U.S. but florists Legal- Potted plants cannot enter the U.S. but florists

have a high demand for poinsettias at Christmas time. have a high demand for poinsettias at Christmas time. See page 411 See page 411

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Cultural: The most common form of credit in Brazil Cultural: The most common form of credit in Brazil is postdated checks. This required adjustments by is postdated checks. This required adjustments by Wal-Mart.Wal-Mart.

Infrastructure: Clothing manufacturers in developing Infrastructure: Clothing manufacturers in developing countries had to put in roads and communication countries had to put in roads and communication equipment in the area where the manufacturing plant equipment in the area where the manufacturing plant was located. They also had to provide training.was located. They also had to provide training.

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– Comparison of Divisional Performance:Comparison of Divisional Performance:– In order to measure divisional performance in In order to measure divisional performance in

different countries adjustments must often be made. different countries adjustments must often be made. Eg. The example on page 412 illustrates how this Eg. The example on page 412 illustrates how this type of measurement should be done on a case by type of measurement should be done on a case by case basis. In this case the Canadian firm used case basis. In this case the Canadian firm used historical cost and the Brazilian firm adjusted for historical cost and the Brazilian firm adjusted for inflation. Therefore, the return on investment inflation. Therefore, the return on investment

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measurements were not comparable. It is necessary measurements were not comparable. It is necessary to get behind the numbers and make appropriate to get behind the numbers and make appropriate adjustments so that comparability is established adjustments so that comparability is established before performance can be effectively measured.before performance can be effectively measured.

Exhibit 11-2 on page 413 details the environmental Exhibit 11-2 on page 413 details the environmental factors affecting performance evaluation in MNCs.factors affecting performance evaluation in MNCs.

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One example of different environmental factors is One example of different environmental factors is differences in GAPP. E.g. differences in GAPP. E.g. Canadian GAAP allows a Canadian GAAP allows a company to net cash against an existing line of credit company to net cash against an existing line of credit on the B.S.on the B.S. As a result Canadian balance sheets may As a result Canadian balance sheets may show no cash.show no cash.

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Other Factors:Other Factors: Look at the last paragraph at the top of page 414 to Look at the last paragraph at the top of page 414 to

see how variance analysis used to be handled in the see how variance analysis used to be handled in the Soviet Union. Is this going on in Russia today? What Soviet Union. Is this going on in Russia today? What about other former eastern block countries or about other former eastern block countries or anywhere for that matter?anywhere for that matter?

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EthicsEthics

This is often a subjective area. Ethics vary from This is often a subjective area. Ethics vary from country to country. E.g. a service fee in one country country to country. E.g. a service fee in one country is a bribe in another. is a bribe in another.

Prerequisites for an ethical business environment:Prerequisites for an ethical business environment: societal stability, legitimacy and accountability of societal stability, legitimacy and accountability of

government, confidence in the system. government, confidence in the system.

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EthicsEthics

Enforcing contracts requires some type of strong Enforcing contracts requires some type of strong underlying system such as a legal system or cultural underlying system such as a legal system or cultural system. In the U.S. deviations from a contract are system. In the U.S. deviations from a contract are enforced by a strong legal system. In Japan enforced by a strong legal system. In Japan deviations are enforced by a strong cultural system.deviations are enforced by a strong cultural system.

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EthicsEthics

Other examples of differences are:Other examples of differences are:

Russian tax laws may change frequently with little or Russian tax laws may change frequently with little or no notice to the MNC and they are usually retroactive. no notice to the MNC and they are usually retroactive. See example.See example.

Child labor laws differ between and among countries. Child labor laws differ between and among countries.

Insider trading is illegal in the U.S. but legal in Insider trading is illegal in the U.S. but legal in Europe.Europe.

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EthicsEthics

Sometimes making the “ethically” correct decision Sometimes making the “ethically” correct decision can have an adverse impact on the individuals in the can have an adverse impact on the individuals in the home country. See the Walmart example on page home country. See the Walmart example on page 419. Guideline questions: Is the action right legally? 419. Guideline questions: Is the action right legally? And then, is the action right morally?And then, is the action right morally?

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1 - 1 International Cost Accounting. 1 - 2 TAX ES AND TRANSFER PRICING n Some MNCs use a reinvoicing...

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