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Transfer pricing

Dr. Haider Shah

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Learning Objectives?

o To have an overview of transfer pricing system

o To understand TP’s effects on divisional performance

o To have an overview of international TP

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Transfer Pricing

Transfer pricing refers to the pricing of goods and services within a multi-divisional organization. Goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary.

Production centre

components

Co. AAssembly centre

Co. B

Assembly centre

Co. C

£10

£10Assembly centre

Co. A

£6

Receiving Division

Supplying Division

Receiving Divisions

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Transfer Pricing

A transfer price is the price one subunit chargesfor a product or service supplied to another

subunit of the same organization.

Intermediate products are the productstransferred between subunits of an organization.

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Transfer Pricing- objectivesTransfer pricing should help achievea company’s strategies and goals by

–intentionally moving profits between divisions

– promoting goal congruence & a sustained high level of management effort

- providing information for: making good economic decisions evaluating the managerial and economic performance of the divisions.- ensuring that divisional autonomy is not undermined.

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Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices Marginal cost Full cost Cost plus markup

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Example: Oslo & Bergen

Expected sales of the final product Net selling price (£) Quantity sold Units

100 1 000 90 2 000 80 3 000 70 4 000 60 5 000 50 6 000

Oslo = Supplying division (No external market for the intermediate product)Bergen = Receiving division (converts intermediate to final product)

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The costs of each division are: Oslo

Bergen (£) (£)

Variable cost per unit 11 7

Fixed costs attributable to the products 60 000 90 000

The transfer price of the intermediate product hasbeen set at £35 based on a full cost plus mark-up.

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10© 2000 Colin Drury

Example: Oslo & Bergen (cont.)

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21.7c

© 2000 Colin Drury

Example: Oslo & Bergen (cont.)

12© 2000 Colin Drury

£35 TPOslo Bergen Company

£23 TP

(Full cost without mark-up)

4000 units

£11 TP

(MC price)

5000 units

13© 2000 Colin Drury

1. Adopt a dual rate TP system Based on two transfer prices Full cost plus a mark-up for Supplying Division MC of transfers for Receiving division Profit on inter-group trading removed by an accounting adjustment.

Resolving transfer pricing conflicts

2. Transfer at MC plus a lump sum fee

Supplying division to cover its fixed costs and earn a profit through the fixed fee charged for the period.

Receiving division to consider full cost of providing intermediate products/services

Not widely used because:1. Use of two TP ’s causes confusion2. Seen as artificial3. Divisions protected from competition4. Reported inter-divisional profits can be misleading

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Domestic TP Recommendations

Use standard costs for cost-based TPs

Competitive market for the intermediate product

No market / imperfect market for the intermediate product

Use MC + lumpsum(negotiated)

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Comparison of Methods

Achieves Goal Congruence

Market Price: Yes, if markets competitive

Cost-Based: Often, but not always

Negotiated: Yes

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Comparison of Methods

Useful for Evaluating Subunit Performance

Market Price: Yes, if markets competitive

Cost-Based: Difficult, unless transferprice exceeds full cost

Negotiated: Yes

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Comparison of Methods

Motivates Management Effort

Market Price: Yes

Cost-Based: Yes, if based on budgetedcosts; less incentive ifbased on actual cost

Negotiated: Yes

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Comparison of Methods

Preserves Subunit Autonomy

Market Price:

Cost-Based:

Negotiated: Yes

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Comparison of Methods

Other Factors

Market Price: No market may exist

Cost-Based: Useful for determiningfull-cost; easy to implement

Negotiated: Bargaining takes time andmay need to be reviewed

Common transfer pricing problems

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1. Performance problems

2. Interpersonal disputes

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4. Demand fluctuation

5. Product pricing

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International Transfer-Pricing

Where divisions are located in different countries taxation implications become important

TP has the potential to ensure that most of the profits on inter-divisional transfers are allocated to the low taxation country.

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International transfer pricing

Motivation is to use highest possible TP so receiving division will have high costs and low profits whereas supplying division will have high revenues and high profits.

TP can also have an impact on ___________and dividend repatriations.

Fiscal authorities react by anti-avoidance legislation e.g. OECD guidelines based on Arm ’s Length pricing principle.

Supplying Division

Country A (Tax rate = 25%)

Receiving Division

Country B (Tax rate = 40%)

Arm ’s Length Principle

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Drawing by David Rooney

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The parties to a transaction are independent and on an equal footing.

If they had done a transaction with a non-related organisation, they would have charged same price.

Arm ’s Length Principle

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References & further Reading

Drury. C. Textbook, chapter 21

Ken Garrett (1992), Transfer pricing explained Parts one and two , Accountancy , September/October

Emmanuel, Clive R. (1999), "Income Shifting and International Transfer Pricing: A Three-Country Example"Abacus, 35 (3), pp 252-266

Elliott, J. and Emmanuel, C. (2000), International Transfer Pricing: Searching for Patterns, European Management Journal , Vol. 18, No. 2, pp. 216–222