WEEK 12

Transfer pricing is the setting of the price for goods and services sold between
controlled (or related) legal entities within an enterprise. For example, if a
subsidiary company sells goods to a parent company, the cost of those goods
paid by the parent to the subsidiary is the transfer price. Legal entities
considered under the control of a single corporation include branches and
companies that are wholly or majority owned ultimately by the parent
corporation. Certain jurisdictions consider entities to be under common control
if they share family members on their boards of directors. Transfer pricing can
be used as a profit allocation method to attribute a multinational
corporation's net profit (or loss) before tax to countries where it does business.
Transfer pricing results in the setting of prices among divisions within an
enterprise.

Transfer pricing multi-nationally has tax advantages, but regulatory

authorities frown upon using transfer pricing for tax avoidance. When transfer
pricing occurs, companies can book profits of goods and services in a different
country that may have a lower tax rate. In some cases, the transfer of goods
and services from one country to another within an interrelated company
transaction can allow a company to avoid tariffs on goods and services
exchanged internationally. The international tax laws are regulated by
the Organization for Economic Cooperation and Development (OECD), and
auditing firms within each international location audit financial statements
accordingly.
Arm’s Length Transaction:

Article 9 of the OECD Model Tax Convention is dedicated to the Arms Length
Principle (ALP). It says that the transfer prices set between the corporate
entities should be in such a way as if they were two independent entities.

A framework has been provided by the OCED in the Transfer Pricing

Guidelines issued by it which provides details regarding the arm’s length price.

ALP is based on real markets and provides the MNE’s and the governments a
single international standard for the contracts that allows various different
government entities to collect their share of tax at the same time creating
enough room for the MNE’s to avoid the double taxation.

Example:

Transfer Prices Defined

Transfer prices refer to the terms and conditions which so-called “associated
enterprises” agree for their “controlled transactions.” Examples of such
transactions are the provision of management services, the supply of goods and
the provision of loans.

According to this widely used OECD definition, enterprises are associated if:

(a) an enterprise participates directly or indirectly in the management, control or

capital of another enterprise or (b) the same persons participate directly or
indirectly in the management, control or capital of two enterprises.
Now we know the concept of associated enterprises. The following example
shows this practice in a graph:

In the picture you see that Enterprise X manufactures pianos in Malaysia.

Enterprise Y distributes these from Hong Kong. Both X and Y are 100% owned
by Enterprise Z. Because Z participates directly in the capital of both X and Y,
they are all associated enterprises.

When selling pianos on the market, Z has no control on the price at which one
piano is sold. Reason is that prices are set by supply and demand. Currently,
the market price for one piano is USD 5,000. However, Z does control any
transactions between X and Y.

Therefore, the internal sale of a piano by X to Y is called a “controlled

transaction.” The price charged for this transaction is what is called a
“transfer price.”

 Why Are Transfer Prices Important?

We now understand what a transfer price is. But why is this relevant?

Let’s go back to our example.

The price at which one piano is sold by X to Y affects their individual financial
results (remember: this is the controlled transaction). If X charges a high price,
X makes more profit. If X charges a low price, Y makes more profit.

From a commercial perspective, the price doesn’t matter. The financial results
of X and Y are consolidated. For shareholder Z, it doesn’t matter which of the
two companies makes the profit. However, from a tax perspective
it does matter.

X is taxed in Malaysia and Y is taxed in Hong Kong. The corporate tax rate in
Hong Kong is 16.5%. In Malaysia, it is 25%. Z wants to see as much profit after
tax as possible. Z can use its influence as a shareholder to set the prices in
such a way that the profits are highest where taxes are lowest.

Some numbers to explain this example:

Say that the direct / indirect costs of manufacturing one piano are USD 1,000.
And say that the average third party piano manufacturer similar to Y realizes a
profit before tax of USD 3,000 when selling one piano to a distributor. We
already know that the market price for one piano is USD 5,000.

Now, we will show 2 scenarios. Scenario 1 shows the profit if the price X
charges to Y for the supply of one piano is similar to the market price (USD
4,000 as this ensures a profit of USD 3,000). The 2nd scenario shows the
potential profit when X charges a non-market price of USD 2,000.

Scenario 1: controlled transaction @ market price of USD 4,000

But what if the transfer price for the sale of one piano is lower? In that case,
the following results can be shown:

Scenario 2: controlled transaction @ non-market price of USD 2,000

In scenario 1, most of the profit is made by X in Malaysia at 25% tax. In
scenario 2, most of the profit shifts to Y in Hong Kong. There, it is taxed at
16.5%. You understand that scenario 2 is preferred by Z. The result is an extra
profit after tax of USD 170 per piano sold.

What Is Dual Pricing?

Dual pricing is the practice of setting different prices in different markets for
the same product or service. This tactic may be used by a business for a variety
of reasons, but it is most often an aggressive move to take market share away
from competitors.

Dual pricing is similar to price discrimination.

How Dual Pricing Works

There are a number of reasons why a company might decide to set different
price points for its products in different markets. An aggressive competitor may
lower its product price dramatically to make a splash in a new market. The
long-term intent is to drive out competitors. The product price will return to its
normal level once the competitors have been priced out of the market. This
practice is illegal under certain circumstances.

At the same time, an adverse currency exchange rate or high shipping costs

may force a price increase in a certain market. The seller must raise prices to
offset its costs of doing business there. Distribution costs may also vary among
markets. A company may use a distributor in some markets, while others rely
on direct sales to consumers. Different prices may be used to even out the
costs of doing business in different markets.

 
Dual pricing is illegal if it is done with the intent of dumping goods in a foreign
market. The distinction is hard to prove, though.
Dual pricing may be demand-based. For example, an airline may offer one
price to an early customer and another, higher price to someone booking at the
last minute. Additionally, businesses in many developing nations that rely on
tourism employ dual pricing strategies. Local residents get lower prices for
goods and services while tourists pay more. In many cases, foreigners may not
know they're being charged a higher price. Those in the know can negotiate.

The price difference may also be imposed by the retailer. An upscale boutique
might charge more for a fancy bar of soap than a dollar store.

Price Effect
The price effect is a concept that looks at the effect of market prices on
consumer demand. The price effect can be an important analysis for
businesses in setting the offering price of their goods and services.

In general, when prices rise, buyers will typically buy less and vice versa when
prices fall. This is demonstrated by a standard price to demand curve.
The income effect is a concept that analyzes the change in consumers’ demand
for goods and services based on their income. It can be looked at broadly
across the economy or directly against demand.

When broadly studying and analyzing the income effect, there are two key
statistical metrics that can be helpful. The monthly Personal Income and
Outlays report details the personal income and personal expenditure levels of
Americans on a monthly basis. The Bureau of Labor Statistics’
monthly Employment Situation report is also an important report for following
hourly wages. While the headline for the Employment Situation focuses on the
number of payrolls added and the monthly unemployment rate, analysts also
look closely at the hourly wage data as well.