5279268 Transfer Pricing Management Control Systems

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    Transfer Pricing (TP)

    P. GURU PRASAD

    FACULTY

    INC GUNTUR

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    Evaluating Management Control Systems

    Motivation Goal congruence Effort

    Lead to rewards

    Monetary Nonmonetary

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    The concept of Transfer Pricing

    A transfer price is the internal pricecharged by a selling department,division, or subsidiary of a company for araw material, component, or finishedgood or service which is supplied to abuying department, division , or

    subsidiary of the same company.

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    Transfer Prices

    The concept of transfer pricing isfundamentally aimed at simulatingexternal market conditions within theorganization so that the managers ofindividual business units are motivatedto perform well

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    Purpose of Transfer Pricing

    Multinational companies use transfer

    pricing to minimize their worldwide

    taxes, duties, and tariffs.

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    Transfers at Cost

    About half of the major companies in theworld transfer items at cost.

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    Transfer Pricing

    Many organizations set up business units thatcater to the needs of other business unitswithin their own fold. For example, one

    business unit may manufacture componentsthat are used by another business unit toassemble the final product.

    Here , there is a transfer of goods from the first

    business to the second and the concept oftransfer pricing comes into play.

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    Transfer Pricing

    Decentralization is one of the approaches thatmany large organizations use to attainoperational effectiveness. However , the mainchallenges in operating in a decentralized

    manner lie in designing responsibilitystructures and formulating appropriate policiesand methods to determine the performance ofthe responsibility centers.

    The technique of transfer pricing plays animportant role in the smooth functioning ofresponsibility structures in such anorganization

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    Objectives of TP policy

    Goal congruence:- the divisionalmanager in maximizing the profits of hisdivision, should not engage in decision-

    making that fails to optimize theorganizations performance.

    Performance appraisal :-it should aid inreliable and objective assessment of thevalue added activities by profit centerstoward the organization as a whole.

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    Objectives of TP policy

    Divisional autonomy:- each divisionalmanger should be free to satisfy therequirements of his profit center from

    internal or external sources. Thereshould be no interference in the processby other divisions like buying centers

    and selling centers.

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    General Appliance Corporation case study

    The GAC was an integrated manufacturer of alltypes of home appliances. The company had adecentralized , divisional organization consisting

    of four product divisions , four manufacturingdivisions, and six staff offices.

    Each division and staff office was headed by avice president. The staff offices had functional

    authority over their counterparts in the divisions,but they had no direct line authority over thedivisional general managers.

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    General Appliance Corporation case study

    The product division designed, engineered,assembled , and sold various home appliances.They manufactured very few components parts,rather , they assembled the appliances from

    parts purchased either from the manufacturingdivisions or from outside vendors.The manufacturing divisions made

    approximately 75 percent of their sales to theproduct divisions. Parts made by themanufacturing divisions were generally designedby the product divisions, the manufacturingdivisions merely produced the parts tospecification provided to them

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    General Appliance Corporation case study

    The divisions were expected to deal with oneanother as though they were in dependentcompanies. Parts were to be transferred atprices arrived at by negotiation between thedivisions. These prices generally were based on

    the actual prices paid to outside suppliers for thesame or comparable parts.

    These outside prices were adjusted to reflectdifferences in design of the outside part from

    that of the inside part. In general, the divisionsestablished prices by negotiation amongthemselves, but if the divisions could not agreeon a price, they could submit the dispute to thefinance staff for arbitration

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    Arm's length transaction

    Definition

    A transaction between two related oraffiliated parties that is conducted as ifthey were unrelated, so that there is noquestion of a conflict of interest. Orsometimes, a transaction between two

    otherwise unrelated or affiliated parties.

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    Board of Directors

    president

    Financestaff

    Engineeringstaff

    Manufacturingstaff

    IndustrialRelations staff

    Purchasingstaff

    Marketingstaff

    Group vice presidentManufacturing divisions

    Group vice presidentProduct divisions

    ChromeProductdivision

    GearAnd

    Transmissiondivision

    Stamping

    division

    ElectricMotordivision

    ElectricStove

    division

    LaundryEquipment

    division

    MiscellaneousAppliance

    division

    Refrigerating

    division

    Organizational chart

    Of

    GAC

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    Minimize Tax Liability

    For organizations operating in many countries,internal transfer pricing can be a determinantof where profits are to be declared and taxespaid. The fact that different countries havedifferent tax and exchange rates has to betaken into consideration case of transactionswith sister concerns that supply intermediaryproducts.

    Ideally the transfer pricing policy shouldenable multinational corporations to minimizetax liability

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    TP objective in International Business

    Manage exchange rate fluctuations

    Handle competitive pressuresReduce the impact of taxes and

    tariffs

    Movement of funds betweencountries

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    Manage Exchange Rate Fluctuations

    MNCs can reduce exchange rate risks bytransfer pricing, when the currency of acountry depreciates, the purchasing power ofthat currency declines. Therefore

    organizations based in that country may haveto pay more for imports.On the contrary, if the currency appreciates,

    the revenues from exports will fall fororganizations based in that country. ButMNCs can depend on their subsidiaries forimports and exports and use transfer prices tomanage exchange rate fluctuations.

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    Handle Competitive Pressures

    The subsidiaries of an organization operatingin different countries can use transfer pricingto lower prices to match local completion. Forexample, garment manufactures in Europedepend mainly on china, Japan , and India forsilk .

    Therefore, if an organization has subsidiariesin these countries, it may mange to get silk ata lower cost by transfer pricing. Thus , it will beable to reduce the price of the finished productto match or undercut local competition

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    Reduce the Impact of Taxes and Tariffs

    Many MNCs make use of transfer pricing toreduce their total tax liability,. Organizations tryto maximize profits in countries wherecorporate taxes are lower, thus reducing thetax liability of the organizations a whole.

    For example, the exporting business unit canquote a lower selling price. This will result inlower tariffs for the importing business unit,since most duties are levied on the value ofgoods imported.

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    Movement of Funds between Countries

    The MNCs may prefer to invest its funds inone country rather than another. Transferpricing provides an indirect way of shifting

    funds into or out of a particular country.While trying to achieve these objectives

    specific to international business, disputesmay arise between the multinational

    corporations and the tax authorities in differentcountries

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    Factors Influencing TP

    The conditions necessary for the developmentof a proper mechanism of TP are

    Role definition

    External advisersCompetent mangers

    Equity,

    Information on the prevailing market pricesAnd proper investment

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    Methods of Calculating TP

    Market based pricing method

    Cost based pricing method

    Negotiated pricing methodResale price method

    Alternative methods

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    Transfer Pricing Methods (1)

    When choosing the best transfer pricing method, theavailable methods should be considered in thefollowing order:

    1. Comparable Uncontrolled Price (CUP);

    2. Resale Price or Cost Plus (C+);

    3. Profit Split or Transactional Net Margin (TNM).

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    Market-Based Transfer Prices

    If there is a competitive market for the productor service being transferred internally, using

    the market price as a transfer price will

    generally lead to the desired goal

    congruence and managerial effort.

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    Market-Based Transfer Prices

    The major drawback to market-basedprices is that market prices are notalways available for items transferred

    internally.

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    Market Based Pricing Method

    An organization X in India that sells textile fiberto its subsidiary organization Y in Bangladesh.If the rate charged by X in India is the same as

    the current market price as if the transactionis taking place between two unrelatedorganizations then the method of estimatingtransfer pricing is know as market based

    pricing method or the comparable uncontrolledprice (CUP)- Ranbaxy and Cipla follow the cupmethod

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    Transfers at Cost

    Variable costs

    Full cost

    Full cost plus a profit markup

    Standard costs

    Actual costs

    What are some examples?

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    Cost Based Pricing Method

    Indian organization X sells textile fiber toits subsidiary Y in Bangladesh and therate charged by X is the total cost o

    manufacturing the fiber plus somemargin or mark-up percentage, then thismethod of estimating the transfer price is

    known as cost-based transfer pricing

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    Negotiated Transfer Prices

    Companies heavilycommitted to segmentautonomy often allow

    managers to negotiatetransfer prices.

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    Negotiated Pricing Method

    The buying and selling divisionsnegotiate a mutually acceptable transferprice. Since each division is responsible

    for its own performance, this willencourage cost minimization andencourage the parties to seek a transfer

    price that yields them an appropriatereturn.

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    Resale Price Method

    The resale price method is similar to thecost based pricing method. In thismethod, the transfer price is determined

    by calculating back from the transitiontaking place at the next level of thesupply chain, by deducting a suitablemark-up from the price at which the

    internal buyer sells the item to anunrelated third party.

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    Alternative Methods

    A petroleum company has three divisions:the crude oil division, the refinery division,and the sales division. The crude oil

    division extracts the crude oil and sells itto the refinery division, which refines thecrude through a process of fractional

    distillation. The output of the refinery isthen sold in the market by the saledivision.

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    Alternative Methods

    In this situation, the sales division mayunderestimate the costs incurred duringextraction and processing. So it might sell thefinal product at a price that is not high enoughto recover fixed costs. Due to this the salesdivision may earn revenues but the companyas a whole may incur losses. In order toprevent these kinds of problems, such

    companies adopt some other methods ofcalculating transfer price like two step method,profit sharing and two sets of process methods

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    Alternative Methods

    Two step pricing:- fixed cost component andvariable cost component. In a transaction ofgoods between two divisions, the cost ofproduction for the selling division is Rs. X perunit and the fixed cost per month is Rs. Y andthe margin decided is Rs. Z per month. If nunits of these goods are sold, then the transfer

    price for the month will be (nX+Y+Z). Or if themargin is included with the variable component,say Rs. A per unit, then the transfer price will be(nX+nA+Y).

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    Alternative Methods

    Profit sharing or split method:- all thebusiness units share the operating profit.

    Two sets of pricing:- revenue is

    credited to the manufacturing unit at themarket sales price while the buying unitis charged for the total standard costs.The difference between the outsidesales price and the standard cost ischarged to the parent firms account

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    Variable-Cost Pricing

    In situations where idle capacity exists,variable cost would generally be the

    better basis for transfer pricing and

    would lead to the optimum decision

    for the firm as a whole.

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    Variable-Cost Pricing

    When market prices cannot be used,versions of cost-plus-a-profit are oftenused as a fair substitute.

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    Transfer Pricing Methods (2)

    CUP, C+Transfer of intangibles(technology, brand, know how)

    CUP, Profit split, TNMFinancing (loans, deposits,

    guarantees)

    CUP, C+, TNMProvision of services

    CUP, Resale price,Profit split, TNM

    Sale of goods

    CUP, C+, Profit splitManufacturing of goods

    Possible methodType of Transaction

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    Implementing the TP

    Articulation and communication of thetransfer pricing strategy

    Documentation of the TP process andinter-organization agreements

    Involvement of multi-disciplinary team

    Negotiation and conflict resolution

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    Potential Misuse of TP

    TP is a very important issue from thepoint of view of management control.The firms can misuse TP to minimize

    their tax liabilities, as well as to project awrong image about their financial healthand thus mislead the stakeholders.

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    The Indian Perspective

    Liberalization of the Indian economy hasled to a phenomenal growth in theindustrial and services sector. Due to

    the availability of cheap skilled labor,India has become a favorite destinationfor labor-intensive service industries likeBPO and software. This has resulted inincreased cross border related partytransactions between India and othernations.

    TP T G id li

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    TP Tax Guidelines

    This has made transfer pricing very importantfrom the taxation point of view. The Indiangovernment has introduced detailed transferpricing regulations with effect from April ,2001, to

    reduce tax avoidance by organizations operatingin India.

    The regulations have largely been designed

    along the lines of the Transfer Pricing Guidelinesissued by the Organization for EconomicCooperation and Development (OECD).

    Th Gl S ithKli TP Di t

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    The GlaxoSmithKline TP Dispute

    The US Internal Revenue Service (IRS)demanded back taxes from GSK, a large UK-based drug manufacturer, for misusing transferpricing to minimize its tax liabilities to the US

    government.The US affiliate of the company charge with

    overpaying for product supplies during theperiod 1989 to 2000 and in subsequent year,

    while at the same time charging lower rates forthe marketing services that it supplied, thusunderstating GSKs income subjected to Ustaxation during the period.

    Th Gl S ithKli TP Di t

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    The GlaxoSmithKline TP Dispute

    The IRS wanted the pharmaceutical Giant to paytaxes, penalties and interest.The dispute was to go to trail in February 2007.

    according to experts, the IRSs decision to take

    GSK to court was a manifestation of the newthinking in transfer pricing regulations proposedby the IRS in September 2003.

    GSK decided to settle the issue to avoid future

    fund outflow toward legal proceedings. OnSeptember 11, 2006, GSK announced that itwas settling the dispute by paying $3.1 billion tothe IRS.

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    Try to do this

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    THANK YOUProcrastination isn't the problem, it's the

    solution. So procrastinate now, don't put itoff. Ellen DeGeneres

    US comedian and actress

    My wife and I were happy for twentyyears. Then we met. Rodney Dangerfield

    US actor & comedian (1921 - 2004)

    http://www.quotationspage.com/quotes/Ellen_DeGeneres/http://www.quotationspage.com/quotes/Rodney_Dangerfield/http://www.quotationspage.com/quotes/Rodney_Dangerfield/http://www.quotationspage.com/quotes/Ellen_DeGeneres/