5279268 Transfer Pricing Management Control Systems

8/8/2019 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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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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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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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)
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5279268 Transfer Pricing Management Control Systems

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