transfer pricing- the determination of the price at which transactions between related parties will...
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INTERNATIONAL TRANSFER PRICING
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Transfer Pricing- the determination of the price at which transactions between related parties will be carried out.
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Types of Intercompany Transactions and their Associated Price
Sale of tangible property Sale Price
Use of tangible property rental payment
Use of intangibles royalties, license fees
Intercompany services Mgt fee, service charge
Intercompany Loans Interest rate
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Objectives of Transfer Pricing Performance Evaluation Cost minimization
These objectives might be incongruent
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Transfer Pricing Methods
Cost-Priced Transfer price Market-based Transfer Price Negotiated Price
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Cost-Based Transfer Pricing Advantages
Simple to do Disadvantages
Which measure of cost to use?? Can transfer pricing inefficiencies to
other units
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Market Based Transfer Pricing
Advantages Eliminate the risk of inefficiencies being
transferred. Ensure divisional autonomy
Disadvantage Depends on existence of competitive
markets
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Negotiated Prices
Advantages Freedom to bargain is preserved Divisional autonomy
Disadvantages External markets required Can take a long time Sub-optimization issues Rewards negotiation skill as opposed to
actual productivity
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Most companies:
Use either cost-based or market-based transfer pricing.
Many use a mix of both
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Chan and Lo’s Study (2004): Cost-based methods are preferred
when: Income tax rate differences matter Import duty is being minimized Foreign exchange rules exist Expropriation risks exist
Market-based methods are preferred when: Local partners matter Local government relations matter
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7 Most Important Environmental Variables (USA)
Overall Profit to the company Restrictions on repatriation of
profit/dividends The competitive position of foreign subs Performance evaluation of foreign subs Custom Duties Import restrictions The need for adequate cash flow in
foreign subs
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7 Most Important Environmental Variables (Japan)
Overall corporate profit The competitive position of foreign subs Devaluation/revaluation in countries with
foreign operations. Restrictions on repatriation of
profits/dividends Performance Evaluation of foreign subs The interests of local partners in
foreign subs The need to maintain adequate cash flow in
foreign subs
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Cost Minimization Objectives and Related Transfer Prices
Objective Transfer Pricing Rule Minimize income Tax
Transfer to lower tax rate country Low price Transfer to Higher tax rate country High price
Minimize withholding tax Upstream transfer Low price Downstream transfer High price
Minimize import duties Low price Protect foreign cash flows from currency devaluation High price Avoid repatriation High price Improve competitive position Low Price
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Government Reactions
OECD Transfer Pricing Guidelines- 1979, 1984, 1994
Section 482 of the IRC Based on OECD guidelines IRS may audit transfer prices between
companies controlled by the same taxpayer. Burden of proof on taxpayer Inbound and outbound transactions General rule: “arm’s length prices”. Treasury regs provide specific guidance on
“arms length” prices
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Government Reactions
Treasury Regs Section 1.482 Best method rule- which method
provides the most reliable measure of an arm’s length price Depends on (a) degree of comparability
between intercompany transaction and comparable uncontrolled transactions, and (b) quality of data and assumptions used in analysis.
Separate guidelines for transfers of tangible property, intangible property, intercompany loans, and intercompany services.
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Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Comparable Uncontrolled Price Method Generally considered the best method
when it can be used. Parent sells to Sub in Country X Parent also sells to uncontrolled
customer in the same country Arm’s Length Price = price charged the
uncontrolled customer
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Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Resale Price Method- Parent Sells to Sub in Country X Sub sells to customers in country X Sub’s competitors sell the same product
at 25% markup as % of sales Arm’s length price = Sub’s selling price
to customers less 25% To use this method, final selling price
and appropriate gross profit % must be known.
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Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Cost Plus Method- Parent Sells to Sub in Country X Parent’s competitors sell same product
to customers in County X at 50% markup to cost.
Arms Length Price = Parent’s cost plus 50%
Most appropriate method when there are no uncontrolled sales to compare to and the buyer does more than just distribute goods.
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Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Comparable Profits Method- Parent sells to Sub in Country X Sub sells to Customers in Country X Parent’s competitiors sell similar product
and earn a 15% margin. Arms Length price = price that allows
Parent (or sub) to earn 15% operating profit margin.
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Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Profit Split Method- Parent Sells to Sub in Country X Sub sells to Customers in Country X Total profit = Sub sales price less
Parent’s cost Total profit is split based on profit earned
by each party in an uncontrolled transaction.
Method assumes buyer and seller are really one economic unit.
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Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices
Residual Profit Split Method- Used when parties possess intangibles
that allow them to earn excessive profits, compared to uncontrolled transactions.
Total Profit is split in 2 steps: Allocate market return to parent and sub
for their routine contributions to the relevant business activity.
Allocate residual profit to Parent and Sub on the basis of relative value of intangibles that each contributes to the activity.
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Ernst and Young Study (07-08) reports:
Comparable Uncontrolled Price is most popular (32%)
Cost plus is second (29%) Resale price is third (17%) Comparable profits is fourth (11%)
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Intangible Property
Three identified methods allowed: Comparable uncontrolled Comparable profits Profit split
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Correlative Adjustments
If the IRS adjusts a transfer price, there is no guarantee the foreign government will concur.
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Penalties
20% (40%) or the understatement!!
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Advance Pricing Agreements TPM agreed upon between company
and tax authority. If there is an agreement, IRS agrees
to make No TP adjustments Length negotiation typical…..avg 22
months. 60% of APAs are from foreign Parents
with US subs.