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International Accounting

CHAPTER 4
International Transfer Pricing

Learning Objectives
1. Describe the importance of transfer pricing in achieving goal congruence in
decentralized organizations.
2. Explain how the objectives of performance evaluation and cost minimization can
conflict in determining international transfer prices.
3. Show how discretionary transfer pricing can be used to achieve specific cost
minimization objectives.
4. Describe governments’ reaction to the use of discretionary transfer pricing by
multinational companies.
5. Discuss the transfer pricing methods used in sales of tangible property.
6. Explain how advance pricing agreements can be used to create certainty in transfer
pricing.
7. Describe worldwide efforts to enforce transfer pricing regulations.

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Introduction 3

Transfer pricing is determination of price on the exchange of goods or services between

related parties. Also referred to as intercompany transactions.
Upstream transfers go from subsidiary to parent, while downstream transfers are from
parent to subsidiary. Transfers also occurs between different subsidiaries of the same
parent.
Significant proportion of international transactions are intercompany transfers (In 2016,
represented 42.4% of U.S. total goods trade).
The price at which an intercompany transfer is made determines the level of revenue
generated by the seller, becomes a cost for the buyer, and therefore affects the operating
profit and performance measurement of both related parties.
Appropriate transfer prices can ensure that each division or subsidiary’s profit accurately
reflects its contribution to overall company profits, thus providing a basis for efficient
allocation of resources.

Introduction 4

Examples of Transfer price are presented as follows:

Transaction Price
➢ Sale of tangible property (e.g., raw materials, finished
➢ Sales price
goods, equipment, buildings).

➢ Use of tangible property (leases) (e.g., land, buildings) ➢ Rental or lease payment

➢ Use of intangible property (e.g., patents, trademarks, ➢ Royalty, licensing fee

copyrights).

➢ Intercompany services (e.g., research and development, ➢ Service charge, management

management assistance). fee
➢ Intercompany loans. ➢ Interest rate
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Introduction 5

Two factors that influence transfer price

❑ Objectives that headquarters wishes to achieve such as,
➢ management control and performance evaluation.
➢ Minimization of one or more types of costs.
❑ laws governing the manner in which intercompany transactions that cross borders
may be priced [countries have set up laws to make sure multinational
corporations (MNCs) don’t avoid paying their fair share of taxes.

Introduction 6

Review Question
A multinational corporation may attempt to minimize the taxes it pays in a
country with a high effective tax rate by setting a very high transfer price on
goods transferred to a subsidiary in a high-tax country. Why is this often not
successful?
A) Laws in the foreign country may prohibit such a scheme.
B) The high transfer price would actually increase taxes.
C) Foreign exchange losses will eliminate any tax savings.
D) None of the above

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Decentralization and Goal Congruence 7

Decentralized companies are organized by division (A division may be a profit center,

responsible for revenues and operating expenses, or an investment center, responsible also
for assets). Division managers have decentralized/delegated significant authority.
Potential benefits of decentralization
➢ Allowing local managers to respond quickly to a changing environment.
➢ Decomposes large, complex problems into manageable pieces.
➢ Permits local decision making which provides more responsibility for division
managers.
An agency problem can occur since division managers make decisions in their self-interest.
Manager’s self-interest may vary with the best interests of the company.
❖ An effective accounting system can alleviate this agency problem by providing incentives
to division managers to act in the interests of the organization. This is referred to as goal
congruence.

Decentralization and Goal Congruence 8

❑ In order to achieve the potential benefits of decentralization, transfer

prices should motivate local managers to make decisions that enhance
corporate performance, while at the same time providing a basis for
measuring, evaluating, and rewarding local manager performance in a way
that managers perceive as fair.
❑ Transfer pricing should be consistent with the criteria used for
performance evaluation, motivate divisional managers, achieve goal
congruence, and help manage cash flows.

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Decentralization and Goal Congruence 9

Review Question
What is the primary characteristic of a decentralized organization?
A) Size of divisions
B) Number of divisions
C) Delegation of decision making authority
D) Diversity of foreign operations

Transfer Pricing Methods 10

1) Cost-based Transfer Price: transfer price based on cost to produce a good or service; could be
variable production cost, variable plus fixed production cost, or full cost. The transfer price
often includes a profit margin for the seller (a “cost-plus” price).
❑ Potential problems.
➢ What cost to use (variable cost, standard cost, absorbed cost, etc.).
➢ No incentive for selling division to manage costs [standard costing can help address this problem].
2) Market-based Transfer Price: transfer price based on price charged to unrelated parties by
related parties or other companies.
➢ Avoids inefficiencies of one division impacting other division.
➢ Helps ensure divisional autonomy and provide a good basis for evaluating subsidiary performance.
❑ Potential problems.
➢ Must have efficient market to get “good” market price.
➢ Unfinished or unique items may not have market price.

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Transfer Pricing Methods 11

3) Negotiated price: transfer price is result of negotiation between “buyer” and “seller”.
➢ Preserves autonomy of divisions.
➢ Must have external market.
❑ Potential problems.
➢ Can take a long time to get negotiated price.
➢ a manager’s measure of performance may be more a function of a manager’s ability to
negotiate than of his or her ability to control costs and generate profit.

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Transfer Pricing Methods 12

Management accounting theory suggests that different pricing methods are appropriate
in different situations.
❑ Market-based transfer prices lead to optimal decisions when
1. The market for the product is perfectly competitive,
2. Interdependencies between the related parties are minimal, and
3. There is no advantage or disadvantage to buying and selling the product internally
rather than externally.
❑ Prices based on full cost can approximate market-based prices when
➢ The determination of market price is not feasible.
❑ Prices that have been negotiated by buyer and seller rather than being mandated by
upper management have the advantage of allowing the related parties to maintain their
decentralized authority.

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Decentralization and Goal Congruence 13

Review Question
What is the primary advantage of a negotiated transfer price?
A) It is objectively determined.
B) It reflects managers' ability to control cost.
C) It is based on arms-length transactions with unrelated parties.
D) It preserves managerial autonomy to make decisions.

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(To be continued)

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15

International Accounting

CHAPTER 4
International Transfer Pricing

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Objectives of International Transfer Pricing 16

2 Possible Objectives.
1. Performance Evaluation.
2. Cost Minimization.
1- Performance evaluation systems.
▪ Transfer prices directly affect the profits of the divisions involved in an
intercompany transaction.
▪ Some are based on divisional profits.
▪ Effectiveness of these is influenced by the fairness of transfer prices.
▪ Effectiveness of these affects the satisfaction of managers.

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Objectives of International Transfer Pricing 17

❑ Assume that Alpha Company (a manufacturer) and Beta Company (a retailer) are both
subsidiaries of Parent Company, located in the United States. Alpha produces DVD
players at a cost of $100 each and sells them both to Beta and to unrelated customers.
Beta purchases DVD players from Alpha and from unrelated suppliers and sells them for
$160 each. The total gross profit earned by both producer and retailer is $60 per DVD
player.
❑ Alpha Company can sell DVD players to unrelated customers for $127.50 per unit, and
Beta Company can purchase DVD players from unrelated suppliers at $132.50. The
manager of Alpha should be happy selling DVD players to Beta for $127.50 per unit or
more, and the manager of Beta should be happy purchasing DVD players from Alpha for
$132.50 per unit or less. A transfer price somewhere between $127.50 and $132.50 per
unit would be acceptable to both managers, as well as to Parent Company.

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Objectives of International Transfer Pricing 18

❑ Assuming that a transfer price of $130.00 per unit is agreed on by the managers of Alpha
and Beta, the impact on income for Alpha Company, Beta Company, and Parent
Company (after eliminating the intercompany transaction) is as follows:
Alpha Beta Parent
• Sales $130.00 $160.00 $160.00
• Cost of goods sold 100.00 130.00 100.00
• Gross profit$ 30.00 $ 30.00 $ 60.00
• Income tax effect 6.30 (21%) 6.30 (21%) 12.60
• After-tax profit $ 23.70 $ 23.70 $ 47.40

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Objectives of International Transfer Pricing 19

❑ Now assume that Alpha Company is located in Taiwan and Beta Company is located in the
United States. Because the income tax rate in Taiwan is only 17 percent, compared with a U.S.
income tax rate of 21 percent, Parent Company would like as much of the $60.00 gross profit to
be earned by Alpha as possible. Rather than allowing the two managers to negotiate a price
based on external market values, assume that Parent Company intervenes and establishes a
“discretionary” transfer price of $150.00 per unit. Given this price, the impact of the
intercompany transaction on income for the three companies is as follows:
Alpha Beta Parent
• Sales $150.00 $160.00 $160.00
• Cost of goods sold 100.00 150.00 100.00
• Gross profit$ 50.00 $ 10.00 $ 60.00
• Income tax effect 8.50 (17%) 2.10 (21%) 10.60
• After-tax profit $ 41.50 $ 7.90 $ 49.40

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Objectives of International Transfer Pricing 20

❑ The chief executive officer of Parent Company is pleased with this result, because consolidated
income for Parent Company increases by $2.00 per unit, as will cash flow when Alpha Company
and Beta Company remit their after-tax profits to Parent Company as dividends.
❑ The president of Alpha Company is also happy with this transfer price. As is true for all managers
in the organization, a portion of the president's compensation is linked to profit, and this use of
discretionary transfer pricing will result in a nice bonus for her/him at yearend.
❑ However, the president of Beta Company is less than pleased with this situation. His/her profit is
less than if he were allowed to purchase from unrelated suppliers. He doubts he will receive a
bonus for the year, and he is beginning to think about seeking employment elsewhere.
❑ Moreover, Beta Company’s profit clearly is understated, (Alpha company’s profit clearly
overstated) which could lead top managers to make erroneous decisions with respect to Beta
and Alpha.

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Objectives of International Transfer Pricing 21

2- Cost minimization
• Profit maximization and, by extension, cost minimization are important corporate
objectives.
• Manipulating transfer prices between countries is one way for multinational enterprises
to achieve cost minimization.
This is referred to as discretionary transfer pricing.
• The most common approach is to minimize costs by shifting profits to lower tax rate
jurisdictions.
• This objective can be achieved by establishing an arbitrarily high price when transferring
to a higher-tax country. Conversely, this objective is also met by selling at a low price
when transferring to a lower-tax country.

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Objectives of International Transfer Pricing 22

Other Cost-Minimization Objectives

1- Minimization of Import Duties (Tariffs)
Countries generally assess tariffs on the value (based on invoice prices) of goods being imported into the
country. These are known as ad valorem import duties. One way to reduce ad valorem import duties is to
transfer goods to a foreign operation at lower prices.
2- Avoiding withholding taxes.
A parent company might want to avoid receiving cash payments from its foreign subsidiaries in the form
of dividends, interest, and royalties on which withholding taxes will be paid to the foreign government.
Instead, cash can be transferred in the form of the sales price for goods and services provided to the
foreign subsidiary by its parent or other affiliates.
3- Circumvent profit repatriation restrictions.
some countries have limits on the amount sub can transfer out of the country to a foreign
parent…reduce the income of sub and increase the income of the parent.
4- Protection of cash flow from currency devaluation
high transfer price pulls currency away from weak currency.

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Objectives of International Transfer Pricing 23

Other Cost-Minimization Objectives

5- Improvement of Foreign Operation competitiveness: Use low transfer price to reduce “cost” to foreign
operation thus giving advantage versus foreign local competitors.

Objective Transfer Pricing Rule

Minimize income taxes
Transferring to a country with higher tax rate High price
Transferring to a country with lower tax rate Low price
Minimize withholding taxes
Downstream transfer High price
Upstream transfer Low price
Minimize import duties Low price
Protect foreign cash flows from currency devaluation High price
Avoid repatriation restrictions High price
Improve competitive position of foreign operation Low price

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Interaction of Transfer Pricing Method and Objectives 24

Transfer pricing method (cost-based or market-based) depends on specific

environmental variables
Cost-based methods are preferred when the following variables are important
➢ Differences in income tax rates
➢ Minimization of import duties
➢ Foreign exchange controls and risks
➢ Restrictions on profit repatriation
➢ Risk of expropriation and nationalization
Market-based methods are preferred when the following variables are important
➢ Interests of local partners
➢ Good relationship with local government

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Government Reactions 25

❑ Governments are aware of risk that multinationals will use transfer pricing to avoid
paying income and other taxes.
❑ Most governments publish guidelines regarding acceptable transfer pricing.
❑ The guidelines typically use the notion of an arm’s-length price.
o Arm’s-length price is the price that would be charged between independent parties
in the same circumstances.

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(To be continued)

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