INTERNATIONAL TAXATION

Introduction
When individuals and companies resident in one country make gains from another country, they
are bound by law to pay taxes both in the country where the gain was made and in the country of
residence of the taxpayer. In the case of Multi-National Corporations (MNC’s) who are
residents in one country but make gains from many countries, a double liability may arise from
income generated in those other countries. There are two main issues in international taxation
that need to be addressed:
- The issue of double taxation for MNCs
- The issue of double taxation for individuals who are resident in one country but make
taxable gain in another country.

Learning Outcomes
You should be able to:
 define double taxation and outline how double taxation affects individuals and
multinational corporations;
 explain the different forms of double taxation;
 understand what tax treaties are and the issues that are normally addressed in tax
treaties;
 enumerate the different ways available for obtaining relief from juridical double
taxation; and
 calculate the relief amount under the different double taxation relief systems.

Double Taxation
Double taxation can be referred to as the imposition of two or more taxes on a particular income,
asset or financial transaction. If the burden of double taxation is too high it may have a
detrimental effect on the movement of capital, technology, persons and on the exchange of goods
and services.
Double taxation can be juridical or economic. Juridical double taxation is the imposition of
income tax on the same income in the hands of the same taxpayer by two or more states or
countries as the case may be. It can arise on the income of MNCs who operate in various
countries and for taxpayers who are resident in one state but derive income from another state or
country in such cases the taxpayer (individual or company) will be subjected to the tax laws in
the two states based on the territorial principle or worldwide principle. The territorial principle
gives the right to a country to impose tax, tax income that is earned within its borders and the
worldwide principle allows a country to tax income received by a corporation domiciled or
individual resident in a country even when such an income was earned outside its border.
Therefore, whenever income is earned in one country and it is received or brought into another
country then a situation of juridical double taxation may arise.

Economic double taxation is the imposition of tax on the same income in the tax base when the
income is in the hands of different taxpayers. Economic double taxation usually affects profits
that are distributed as dividends. These profits which have been subjected to corporation tax will
also be subjected to personal income tax in the hands of the dividend recipient thereby leading to
a situation of economic double taxation.

The effects of double taxation can be mitigated through agreement between countries; these
agreements are called tax treaties.

Tax Treaties
A tax treaty is an agreement between countries that stipulates how taxes will be imposed, shared
or otherwise eliminated on business income earned in the respective countries. The main
objective of a tax treaty is to prevent or eliminate double tax liability on the same income, profit
or gain and remove impediments to international trade and investment by preventing the risk of
double taxation that occurs when two countries impose tax on the same income. Tax treaties are
also known as Tax Information Exchange Agreements (TIEA) and they can be bilateral or multi-
lateral. A bilateral tax treaty is an agreement that exist between two countries (for instance India
has a double taxation avoidance agreement DTAA with 79 countries) while a multi-lateral treaty
is an agreement that exist between more than two countries like the European Union multi-lateral
agreement.
Tax treaty agreements address the following issues:
 The extent to which trading activities can be engaged in participatory countries without
attracting tax liability.
 Which profits/gains will be attributable to permanent establishment?
 Dispute resolution mechanisms.
 Information exchange mechanisms.
 Double taxation relief available for income/gains which are in principle taxable in more
than one country.

A tax treaty usually specifies which of the countries has the primary entitlement to tax an income
so that after the determination of which country has the residency status, taxing rights between
the countries can be allocated. To prevent tax evasion, there should be an information exchange
between countries on taxpayers who have claimed exemption from local taxation on the grounds
of not being a resident of the country where the income arises. Tax treaties grant relief for
juridical double taxation through exemption, credits or deductions.

The Exemption System

Under this system, all or part of the income may be exempted from tax in the source country
when a taxpayer is resident in another country. Through double taxation agreement, it is
possible that the gain may be exempted from tax in the country where it arises while it is taxed in
the country of residence only or a withholding tax is deducted at source and a foreign tax credit
is received in the country of residence to compensate for tax paid. Where double taxation
agreements exist, it is important that a taxpayer declares himself as a non-resident in the foreign
country.
The Credit System
A foreign tax credit is an instrument used to reduce/eliminate double taxation when an income
has been subjected to tax in a different country; the credit is a grant to the tax payer against taxes
that would have been paid.

When tax has been paid in a primary country it can be allowed as a tax credit against tax which is
to be paid in the secondary country. If the tax which ought to be paid in the secondary country is
higher than tax already paid in the primary country, the credit granted will not exceed the amount
of tax that was previously paid and the tax payer must pay the difference. But if the tax
previously paid is higher, then the credit cancels out the lower tax liability but no refund can be
granted against the higher tax liability already paid. Thus, ultimately the taxpayer pays the
higher amount of tax imposed.

The Deduction System

Under this system, tax paid in a foreign country is allowed and a deduction from the income
earned so that the income liable tax is reduced by the amount of tax that has already been paid.
This amount is now considered as the taxable income rather than the whole amount originally
earned.

Illustration
Mr. Adam is a resident of Mexico who has earned income of $20,000 from Canada, if the
personal income tax rate in Mexico and Canada is 35% and 30% respectively, calculate the tax to
be paid in the respective countries and relief available in each of the following instances:
i. Double taxation relief is not available to Mr. Adam
ii. A treaty exists between Canada and Mexico to grant tax exemption in source country.
iii. A treaty exists between Canada and Mexico to grant tax exemption in destination
country.
iv. Mexico will grant a 100% tax credit for tax which has already been paid in Canada.
v. Mexico will grant a 60% tax credit for tax which has already been paid in Canada.
vi. Mexico will grant the tax paid in Canada as a deduction against income earned.
vii. If the tax rate in Mexico is 30% while the rate in Canada is 35%, calculate tax to be paid
if Mexico will grant a 100% tax credit for tax paid in Canada.

Solution
i. $ $
Income Earned 20,000
Canada Tax (30% of 20,000) 6,000
Mexico Tax (35% of 20,000) 7,000
Total Tax Liability ------ (13,000)
------
Residual Income 7,000
--------
Tax Relief NIL

ii. $ $
Income Earned 20,000
Canada Tax (0% of 20,000) -----
Mexico Tax (35% of 20,000) 7,000
Total Tax Liability ------- (7,000)
---------
Residual Income 13,000
--------
Tax Relief 6,000

iii. $ $
Income Earned 20,000
Canada Tax (30% of 20,000) 6,000
Mexico Tax (0% of 20,000) -------

Total Tax Liability (6,000)

---------
 Residual Income 14,000
----------
Tax Relief 7,000

iv. $ $
Income Earned 20,000
Canada Tax (30% of 20,000) 6,000
Mexico Tax (35% of 20,000) 7,000
Less 100% credit for Canada tax (6,000)
-------
Total Tax Liability (7,000)
--------
Residual Income 13,000
--------
Tax Relief 6,000

v. $ $
Income Earned 20,000
Canada Tax (30% of 20,000) 6,000
Mexico Tax (35% of 20,000) 7,000
Less 60% credit for Canada tax (3,600)
(60% of 6,000) --------
Total Tax Liability (9,400)
-------
Residual Income 10,600
--------
Tax Relief 2,400
vi. $ $
Income Earned 20,000
Canada Tax (30% of 20,000) 6,000 (6,000)
--------
Income to be considered from Mexico 14,000
Mexico Tax (35% of 14,000) 4,900 (4,900)
-------- --------
Total Tax Liability 10,900
Residual Income 9,100
-------
Tax Relief 2,100

vii. $ $
Income Earned 20,000
Canada Tax (35% of 20,000) 7,000
Mexico Tax (30% of 20,000) 6,000
Less 100% credit for Canada tax (6,000)
(credit cannot exceed tax owed which is 6,000) ------
Total Tax Liability (7,000)
--------
Residual Income 13,000
---------
Tax Relief 6,000

Foreign Tax Incentives

To accelerate economic development and reap the positive effects of foreign investment, many
countries now offer tax incentives which may include:
 Relief from paying taxes for certain periods.
 Reduced income tax rate.
 Tax deferrals.
 Reduction of various taxes and sometimes no tax at all.
Countries that offer such incentives are called tax havens.

Tax Equalisation
Tax equalization is a system developed to neutralize the effects of double taxation for a taxpayer
who works abroad. Tax equalization often arises for workers of MNCs on international
assignments that may be subjected to double taxation because of the international assignment or
transfer. Also known as “Hypo tax”, it involves a situation where the company bears all the
international taxes while the employee pays only the home country tax.

The objective of tax equalization is to ensure that an employee does not suffer financial hardship
as a result of the tax consequences of an international assignment, the employee should pay no
more or no less tax than he would have paid had he not been away from his base. The advantage
of tax equalization is that nobility is promoted because several assignment locations produce no
tax benefit or tax detriment to the employee.

Illustration
Mr. Adebakin is a chartered accountant who works with Akintola Delloit & Co. an international
auditing firm with headquarters in Lagos, Nigeria. In the year 2010, Mr. Adebakin was
seconded from the head office in Lagos to Gambia for a period of four months to oversee the
branch office located in Banjul. During his stay in Banjul, the total emoluments received by him
amounted to $4,800 net of taxes at 40%. For the remaining part of the year his total emoluments
in Nigeria totalled N2,400,000 and this income, in addition to his foreign income will be taxed at
an effective rate of 25% after claiming all allowances.

Mr. Adebakin has applied for a tax credit on foreign tax paid and the tax authority has agreed to
grant a credit of 40% against foreign tax paid. The company Akintola Delloit & Co. has a policy
of tax equalization to neutralize the effect of foreign tax from employees who are sent outside the
country on official duties.
You are required to calculate Mr. Adebakin’s foreign tax, the foreign tax credit granted, his final
tax in Nigeria and the tax equalization amount if the rate of exchange of the naira to the dollar is
N160.

Solution
N N
Foreign Income 1,280,000
Foreign Tax @ 40% 512,000
Nigerian Income 2,400,000
-----------
Total Income 3,680,000
Nigerian Tax at 25% 920,000
Less 40% Foreign Tax Credit (204,800)
--------- (715,200)
Foreign Tax Paid (512,000)
------------
Residual Income 2,452,800
Add Tax Equalization 307,200
---------
Income after tax and equalization 2,760,000
----------
Workings
1. Foreign Income $4,800/0.6 = $8,000 * N160 = N1,280,000
2. Foreign Tax 40% * N1,280,000 = N512,000
3. Foreign Tax Credit 40% * N512,000 = N204,800
4. Tax equalization = Total Tax Paid Less Nigerian Tax
Total Tax Paid N512,000 + N715,200 = N1,277,200
Nigerian Tax N920,000
Tax Equalization N1,227,200 – N920,000 = N307,200
Summary
 There are two main issues in international taxation: double taxation for MNCs and
double taxation for individuals.
 Double taxation is the imposition of two or more taxes on a particular income, asset or
financial transaction.
 The effects of double taxation can be mitigated through tax treaties.
 Tax treaties grant relief for judicial double taxation through exemption, credits or
deductions.
 Foreign tax incentives are used to accelerate economic development.

Students’ Assessment Questions

1. Explain the principles that form the basis upon which countries exercise the rights to
impose double taxation.

2. Outline the various methods that countries can adopt to provide relief from juridical
double taxation.

3. What are tax credits and what role do they play in international taxation?

4. What considerations might cause the operation of tax credits to fall short of their intended
results?

5. Briefly explain the term “Tax Equalization” and the objective that it seeks to achieve.

6. The following are forms of tax incentives except

a) Tax Holidays b) Tax Deferrals
c) Reduced Income Tax Rate d) Tax Referrals

7. Countries that offer tax incentives to attract people and foreign investment are called
a) Tax Coven b) Tax Haven c) Pioneer Countries d) Free Trade Zone
8. Imposition of Taxes by more than one country on same taxpayers’ income is called
a) Economic Double Taxation b) Tax Payer Double Taxation
c) Juridical Double Taxation d) International Double Taxation

9. Which of the following does not offer any relief from economic double taxation?
a) The Franking System b) The Deduction System
c) The classical System d) The Split rate System

10. Another name for Tax Equalization is

a) Foreign Tax b) Tax Transfer c) Tax Reduction d) Hypo Tax
CORPORATE TAX AND DOUBLE TAXATION

Introduction
The tax levied on companies’ profits by various jurisdictions is called corporate tax. The
measure of taxable profit varies from country to country; this is due to different rules used in
calculating the amounts that can be deducted as expenses, interest payments and capital
expenditure. In some countries, book depreciation on capital acquisitions is not deductible,
rather capital allowances are allowed at different rates e.g. in the United Kingdom from 1 st April,
2008 capital allowance at the rate of 20% per annum on a reducing balance basis is allowed. In
developing countries where much reliance is placed on taxation as a source of government
revenue the tax rate may be high compared to countries that are looking to attract foreign
investment.

Comparisons of tax rates around the world are different because of the differences in statutory
rates and effective rates. From 1st April, 2008 the UK rate of corporate tax was reduced from
30% to 28% for companies with taxable profits greater than £1.5m. Companies with taxable
profits under £300,000 pay taxes at a lower rate of 21%. In the developed world, Ireland has the
lower corporate tax rate of 12.5%.
When a country provides no relief for profits that are distributed as dividends even though it has
already been taxed at the corporate level and yet again they are subjected to tax in the hands of
the recipient, it is practising the classical system of taxation.

Learning Outcomes
You should be able to:
 explain how economic double taxation affects corporations;
 explain the different systems for imposing tax on corporate profits;
 calculate the relief amount under the different corporate tax systems, and
 identify the beneficiaries of relief under the different corporate tax system.
The Classical Tax System
This is a system where dividend income is taxed without relief or credit for income tax paid by
the company giving out the dividends. This results in double tax liability on distributed profit,
first at the corporate level in the form of corporate tax and also at the personal level in the form
of personal income tax. This system is used in the United States and it is also known as the
Separate Corporate Tax System.
The classical system leads to a situation of economic double taxation on profits that are
distributed as dividends but different solutions such as tax imputation or tax credits, exemptions,
franking and the split-rate system have been adopted for resolving this issue.

The Imputation System

Under the imputation system, some or all of the tax paid by a company may be imputed to the
shareholder to reduce the tax payable on profit distributed. A tax payer may receive by way of
tax credit some or all of the tax paid by the company as an imputation against tax that should
have been paid by him. In Canada dividends taxable in the hands of eligible shareholders may
qualify for a dividend tax credit to compensate for taxes already paid by the corporation.
Australia and New Zealand also have imputation systems.

The Exemption System

Some countries grant whole exemption by not taxing either at the corporate level or in the hands
of shareholders. This method is adopted by the United States for companies owned by a small
number of shareholders, so-called ‘S’ corporation where the company is not taxed but rather the
shareholders are taxed on the profits of the business. These profits may or may not be
distributed.
Netherlands, Belgium, Sweden and Austria also operate a participation exemption where certain
distributions are exempted from tax in the hands of the shareholder. In addition, capital goods in
shares may not be taxed as long as specified proportion of the company’s share capital is held for
a specified period.
The Split Rate System
Under this system, a different rate of tax is applied to distributed profits as opposed to the rate of
tax on undistributed profits. Austria and Germany operates a double income system on
distributions where only half of the distribution is subject to tax or the equivalent tax rate is
halved.

The Franking System

This is a system practiced by Australia, Tasmania and New Zealand to relieve the incidence of
double taxation of dividends. It involves a system whereby franked credits are attached to
corporate profits to reflect tax paid at the corporate level. If these profits are distributed as
dividends they are reflected as whole amounts and the franked credits are considered as tax paid
by the shareholder receiving the dividend. The implication is that the profits are only taxed once
either at the corporate level or at the individual level.

Illustration
ABC Corporation has earned a profit before tax of N100,000 in 2008. It thereafter distributes
N50,000 as dividends to shareholders and Mr. Johnson receives N14,000 as dividends. Mr.
Johnson has other income amounting to N80,000 and personal income tax rate is estimated at
25% after deduction of all allowances. You are required to calculate the tax to be paid by
Mr. Johnson and ABC Corporation based on the following:
i. Corporate tax rate is 30% and the classical system of taxation is in operation.

ii. 60% of the corporate tax paid is to be imputed to Mr. Johnson.

iii. A split-rate system is in operation where distributed profits are taxed at 15% while
undistributed profits are taxed at 30%.

iv. The tax liability of Mr. Johnson if dividends received from ABC has franked credits
attached to it for corporate tax paid at 30%.

Solution
i. Mr. Johnson calculation of tax liability
 N
Dividend Income 14,000
other Income 80,000

Total Income 94,000

Tax Liability @ 25% of N94,000 = N23,500
ABC Corporation: Calculation of Tax Liability
N
Profit before tax 100,000
Less tax at 30% (30,000)

Dividends Paid 70,000

(50,000)

retained Profit 20,000

ii. Mr. Johnson: Calculation of tax liability

N N
Grossed up Dividend 20,000
Dividend Received (14,000)

Corporate tax paid 6,000

Imputation (60% of 6,000) 3,600
Add: Dividend Received 14,000
Other Income 80,000

Total Income 97,600

Personal Income Tax @25% 24,400

 Less: Imputed Corporate Tax (3,600)

Tax Due 20,800

iii. ABC Corporation: Calculation of Tax Liability

N N
Profit before tax 100,000

Distributed Profit 50,000

Tax @ 15% (7,500) 7,500
Undistributed Profits 50,000
Tax @ 35% (15,000) 15,000

Total Corporate Tax Liability 22,500

iv. The N14,000 received by Mr. Johnson is considered as N20,000 because of the franked
credits of N6,000 attached. This N6,000 can be considered as tax credit against any
tax to be paid by Mr. Johnson.

N N
Earned Income 80,000
Grossed up Dividend 20,000
Total Income 100,000

Personal Income Tax (@ 25% of N100,000) 25,000

Less Franked Credits (6,000)
Tax liability N19,000
Students’ Assessment Questions
1. Outline the various systems for providing relief from economic double taxation.

2. Briefly distinguish between the (a) classical (b) split-rate and (c) imputation tax systems.
Then describe what you feel are the major advantages and disadvantages of each from the
perspective of a multinational corporate tax payer.

3. Briefly explain the term “Franking” and the objective that it seeks to achieve.

4. When a country taxes dividend income without relief for tax paid at the corporate level it
is practising which system of taxation

a) Classical b) Franking system c) Double Taxation d) Split-rate System

5. One of the following is not a method of relieffrom economic double taxation

a) Split-site b) Exemption c) Franking d) Imputation

6. A taxation system where only shareholders and not companies are taxed is known as

a) Adoption b) Exemption c) Inclusion d) Presumption

7. A system of relief where the corporate tax rate on distributed profit is halved is known as

a) Exemption b) Franking c) Imputation d) Split-rate

8. A system of attaching tax credits to corporate profits paid out as dividend is known as

a) Exemption b) Franking c) Imputation d) Split-Rate

9. When corporate profits paid out as dividends end up being taxed just once it is known as

a) Exemption b) Franking c) Imputation d) Split-Rate

10. One of the following countries does not operate a participation exemption relief system

a) Netherlands c) Belgium

b) United States of America d) Austria

DOUBLE TAXATION RELIEF IN NIGERIA

Introduction
Among the various incomes chargeable to tax is income from a source inside or outside Nigeria.
Ordinarily, income brought to Nigeria by a resident would have been subjected to tax in the
foreign country in accordance with that country’s tax law therefore; such income would be taxed
twice. Similarly, income derived by a non-resident will have also been subjected to tax in
Nigeria and could also be taxed in the foreign country whenever received by the tax payer where
he resides.
Residency status is determined not by nationality but by the number of days spent in a country in
a particular year. In Nigeria, any individual who is physically present in the country for a total of
at least 6 months or 183 days is considered a Nigerian resident. While for businesses, any
company that is incorporated in Nigeria is a resident company.

Learning Outcomes
You should be able to:
 understand the conditions for determining the residency status in Nigeria for individuals
and companies;

 identify the countries with which Nigeria has tax treaties and the issues that are addressed
in tax treaties;

 enumerate the different ways available for obtaining relief from double taxation in Nigeria;

 calculate the Nigerian tax rate and commonwealth tax rate for resident and non-resident
Nigerian tax payers; and

 calculate the relief amount under the commonwealth double taxation relief system in
Nigeria.

Double Taxation in Nigeria

For resident taxpayers in Nigeria (individual, or companies), tax is payable on the worldwide
income. The worldwide income from all sources inside or outside Nigeria and tax is chargeable
on such income is whether it is brought into Nigeria or not. For non-resident taxpayers only
income derived from Nigeria or from investment in Nigeria is liable to tax. Double taxation
relief is available to both individuals and companies under the provision of Personal Income Tax
Act (PITA) and Company Income Tax Act (CITA) respectively. The relief is given to
reduce/minimize the effect of excessive taxation on any particular source of income previously
subjected to tax in a country prior to its being brought to Nigeria. However, this relief is granted
only if the income is derived from a country with which Nigeria has a double taxation relief
agreement.

Where there is a double taxation agreement between Nigeria and another country, the relief to be
granted will be based on the provision of that agreement in conjunction with the provision of
Nigerian tax law which is S.38 & 39 of Personal Income Tax Decree (PITD) 104, and S.33 & 34
of CITA. Countries with which Nigeria has double taxation agreement include:
 The Great Britain and Republic of Northern Ireland

 The Islamic Republic of Pakistan

 The Kingdom of Belgium

 The French Republic

 The Government of Canada

 The kingdom of Netherlands

Matters Dealt with in a Double Taxation Agreement

 Taxes to be covered by the agreement e.g. Nigeria Income Tax

 Profit exempted from tax

 Connected business provision e.g. enterprises in the two countries under common control
or where one has control over the other and profits are exempted.

 Appeal procedures
 Methods by which the effect of double taxation is eliminated e.g. tax credit

 Date of the agreement coming into force and termination date

 Diplomatic privileges

 Time limit within which application for relief should be made

 Exchange of information by the tax authorities for the prevention of fraud

Where there is a double taxation agreement, there is a limit to make a claim for allowance by
way of credit. The time limit is two years after the end of the assessment year.

No Double Taxation Agreement

Where there is no double taxation agreement, chargeable income is subject to double taxation
and no relief is available except the country is a Commonwealth country. For commonwealth
nations the rate of double taxation relief may be computed in accordance with S.32 of CITA and
S.38 of PITD as follows:
Nigerian Companies/Resident Individuals
Where the Commonwealth Rate (CWR) of taxation does not exceed one-half of the Nigerian
Rate (NR), then the double taxation relief rate shall be the CWR.
i.e. if CWR < ½ NR; relief is CWR
If the CWR exceeds half of the NR of tax, the rate of relief shall be half of NR
i.e. if CWR > ½ NR; relief is ½ NR
Non-Nigerian companies/Non-Resident Individuals
If the CWR of tax is less than or equal to the NR of tax, the relief shall be at half the CWR
i.e. if CWR < NR; use ½ CWR
In any other case, the rate of relief shall be the amount by which the NR exceeds half of the
CWR.
i.e. CWR > NR; use NR – ½ CWR
Note: CWR = Tax Paid or Payable x 100
Taxable Income or Profit

NR = Tax Paid or Payable x 100

Taxable Income or Profit

Question 1: Professor Big is the Dean of a Faculty in the University of Lagos. He is married
with 4 in-school children and a dependant. In 2002, Professor Big was appointed by the
University of Toronto in Canada as a visiting professor to lecture on Policy Management. The
University of Toronto has agreed to pay him a gross remuneration of $50,000 before deducting
income tax in Canada. In 2002, the professor was paid net income of $37,500 on the salary
payroll of the University of Toronto, after the income tax had been deducted.
Assuming the rate of exchange for both currencies is N50 = $1, you are required to compute the
tax liability of Professor Big in Nigeria after granting him double taxation relief.

Solution:
Professor Big
Computation of Tax Liability in Nigeria for 2002 Year of Assessment
qx N N
Gross Foreign Income in Naira 2,500,000
Less: Reliefs
Personal Allowance (5,000 + 20% of 2,500,000) 505,000
children Allowance (2,500 * 4) 10,000
Dependant Allow (2,000 * 1) 2,000 (517,000)
1,983,000

Tax Table
N
1st 30,000 @ 5% 1,500
Next 30,000 @ 10% 3,000
Next 50,000 @ 15% 7,500
Next 50,000 @ 20% 10,000
Next 1,823,000 @ 25% 455,750
Tax Liability 477,750
Less Double Tax Relief (see note) (300,000)
Tax Payable 177,750
Note:
CWR = 12,500 x 100 = 25%
50,000

NR = 477,750 x 100 = 24%

1,983,000

Since the CWR = 25% is greater than ½ NR = 12% and Prof. Big is resident in Nigeria, the rate
of relief shall be at half of NR which is 12% of N2,500,000 = N300,000 as calculated below:
CWR > ½ NR, use ½ NR
= 12 x 2,500,000 = N300,000
100

Question 2: Mr. Atobijulo is a senior consultant in one big international affiliated firm of
Chartered Accountants with a branch in Lagos. Throughout 2005 and 2006, he was a resident in
London, United Kingdom on secondment from his office in Lagos, on a technical exchange
programme. Mr. Atobijulo is married with 4 children, all of whom are still schooling. He also
has a dependant.

On his return to Nigeria in 2007, he was challenged by the tax authority to account for tax on his
income earned in London in 2006. He argued that he had paid an equivalent tax of N840,000 on
his income of N2,102,000 in London to the British government because he was not a resident in
Nigeria.
Required: Compute the tax liability of Mr. Atobijulo to the Nigerian government if the Nigerian
tax authority did not agree that his foreign tax should be his final tax on the income earned in
London.

Mr. Atobijulo
Computation of Tax Liability in Nigeria for 2006 Year of Assessment
N N
Earned Income 2,102,000
Less: Reliefs
Personal Allowance (5,000 + 20% of 2,102,000) 425,400
Children allowance (2,500 * 4) 10,000
Dependant Allow (2,000 * 1) 2,000 (437,000)
Taxable Income 1,664,600

Tax Table
N
1st 30,000 @ 5% 1,500
Next 30,000 @ 10% 3,000
Next 50,000 @ 15% 7,500
Next 50,000 @ 20% 10,000
Next 1,504,600 @ 25% 376,150
Tax Liability 398,150
Less Double Tax Relief (see note) (84,080)
Tax Payable (Net Tax Due) 314,070
Note:
CWR = 840,000 x 100 = 40%
2,102,000

NR = 398,150 x 100 = 24%

1,664,600
Note: During 2005 and 2006, Mr. Atobijulo was not a resident in Nigeria. Therefore, the rate is
as stated below:
If CWR > NR; relief is NR – ½ CWR
= 24% - ½ x 40%
= 24% - 20%
= 4%
Double Tax Relief
= 4 x 2,102,000 = N84,080
100

Procedures for the Computation of Double Taxation Relief

The following are the procedures for the computation of double taxation relief:
 Determine the global income of the taxpayer by including the income derived from abroad.

 Determine the taxable income of such a taxpayer by adding or deducting balancing

adjustment and allow capital allowances for businesses, relief and allowances for
individuals.

 Determine tax payable by applying the applicable rate of tax to the taxable profit
determined in 2 above. This represents the Nigerian tax.

 Calculate the Nigerian rate of tax by dividing the tax computed above by the total taxable
income i.e. dividing by item 2.

 Calculate the commonwealth rate of tax by dividing the tax paid on the foreign income by
gross amount of the foreign income

 Compare the commonwealth rate of tax with the Nigerian rate of tax to determine the rate
of relief.

 Compute the amount of double taxation relief by multiplying the rate of relief above by the
amount of gross foreign income.

Appendix
Tax Reliefs and Allowances Available
Personal Allowance: From 1998 to date – N5,000 + 20% of earned income
Children Allowance: From 1990 to date – N2,500 per child for a maximum of 4 children.

The following are the conditions that must be satisfied:

 The child must be unmarried

 The child has not attained 16 years of age.

 Where the child has attained 16 years, he or she must be receiving full-time instructions
in a recognised establishment.

 The child must be maintained by the individual claiming the allowance.

Dependant Allowance: With effect from 1998, the maximum relief allowed is N2,000 for a
maximum of 2 relatives.

Tax Table 2001 to date

N Rate
1st 30,000@ 5%
Next 30,000 @ 10%
Next 50,000 @ 15%
Next 50,000 @ 20%
Over 160,000 @ 25%

Summary

 Residency status is important in the taxation of income in Nigeria.

 In Nigeria, any individual who is physically present in the country for a total of at least six
months or 183 days is considered a Nigerian resident.
 For businesses, any company that is incorporated in Nigeria is a resident company.
 Double taxation relief is given to reduce/minimise the effect of excessive taxation.
 Where there is double taxation agreement, there is a limit to make a claim for allowance by
way of credit. The time limit is two years after the end of the assessment year.
 Where there is no double taxation agreement, chargeable income is subject to double
taxation, except the country is a commonwealth country.

Students’ Assessment Questions

1. Philad Nigeria Ltd. has a registered office in Nigeria and a branch office in Woolwich,
London. The company trades in textile materials which have been in high demand. The
adjusted profit for the last four years are given below:

Nigeria London
N £
2007 500,000 1,000
2008 650,000 1,200
2009 700,000 1,250
2010 680,000 1,350
Additional Information:
The average exchange rates are to be assumed as follows:
2007 £ 1 = N215
2008 £ 1 = N225
2009 £ 1 = N230
2010 £ 1 = N250
Tax paid in the UK
2007 = £ 125
2008 = £ 160
2009 = £ 188
2010 = £ 250

Capital Allowance (Nigeria)

N
2007 80,000
2008 80,000
 2009 80,000
2010 80,000
You are required to compute the tax liability of the company on the total profits for the
relevant tax years making adjustment for double taxation.

2. Samatuns Limited, a company incorporated in Lagos, Nigeria engages in the sales of

computer accessories. Three years ago, the company’s management board decided to
establish a branch office in New Delhi, India. As a result of the management decision,
the company has been growing tremendously in the market share in Nigeria and India.
The following information relates to the 2010 tax year:

N
Net Profit 1,200,000
Net profit was arrived at after the deduction of the following expenses:

N
Depreciation 200,000
Interest on Loan 120,000
Salaries & Wages 310,000
Electricity Bill 10,000
Rent 250,000
Loss on disposal of Assets 80,000

Additional information:
N
Initial Allowance 100,000
Annual Allowance 75,000
Summary of account statement sent from the branch office in India after conversion to Nigerian
currency.
N
Total Profit 700,000
Annual Allowance 120,000
The company had paid a total sum of N 200,000 as tax on income derived from India to the
Internal Revenue Service (IRS).
Compute:
1. Double taxation relief (in accordance with the provision of CITA) available to the
Nigerian Company in respect of tax paid on income brought into the country.

2. Compute the net tax due by the company for 2010 assessment year

Solution 1
Philad Nigeria Limited
Computation of tax liability for relevant year of assessment

2007 Assessment Year

UK Nigeria Total
N N N
Adjusted Profit 215,000 500,000 715,000
Less: Capital Allowance ------- (80,000) (80,000)
Total Profit 215,000 420,000 635,000

Company tax payable @ 30% 190,500

Deduct Double Taxation Relief (working i) (26,875)
Tax liability 163,625
Education Tax @ 2% 14,300

2008 Assessment Year

UK Nigeria Total
N N N
Adjusted Profit 270,000 650,000 920,000
Less: Capital Allowance ------- (80,000) (80,000)
Total Profit 270,000 570,000 740,000

Company tax payable @ 30% 222,000

Deduct Double Taxation Relief (working ii) (35,991)
Tax liability 186,009
Education Tax @ 2% 18,400

2009 Assessment Year

UK Nigeria Total
N N N
Adjusted Profit 287,500 700,000 987,500
Less: Capital Allowance ------- (80,000) (80,000)
Total Profit 287,500 620,000 907,000

Company tax payable @ 30% 272,250

Deduct Double Taxation Relief (working iii) (43,125)
Tax liability 229,125
Education Tax @ 2% 19,750

2010 Assessment Year

UK Nigeria Total
N N N
Adjusted Profit 337,500 680,000 1,017,500
Less: Capital Allowance ------- (80,000) (80,000)
Total Profit 337,500 600,000 937,500

Company tax payable @ 30% 281,250

Deduct Double Taxation Relief (working iv) (50,625)
Tax liability 230,625
Education Tax @ 2% 20,350
Workings

Year adjusted Profit Tax Paid

2007 N 215 x £ 1,000 = N215,000 N 215 x £ 125 = N 26,875
2008 N 225 x £ 1,200 = N270,000 N 225 x £ 160 = N36,000
2009 N 230 x £ 1,250 = N287,500 N 230 x £ 188 = N43,240
2010 N 250 x £ 1,350 = N337,500 N 250 x £ 250 = N62,500

Computation on Double Taxation Relief

CWR = Tax Paid x 100
Assessable Profit

bi) 26,875 x 100 = 12.5%

215,000

Since CWR < ½ NR, use CWR = 12.5% x N215,000 = N26,875

bii) 36,000 x 100 = 13.33%

270,000

Since CWR < ½ NR, use CWR = 13.33% x N270,000 = N36,000

biii) 43,240 x 100 = 15.04%

287,500

Since CWR < ½ NR, use ½ NR = 15% x N 287,500 = N 43,125

biv) 62,500 x 100 = 18.52%

337,500

Since CWR > ½ NR, use ½ NR = 15% x N 337,500 = N 50,625

Solution 2
SAMATUNS LIMITED
a) Computation of Double Taxation Relief

N
Total Profit 700,000
Less Capital Allowance (120,000)
Taxable Profit 580,000

Tax Paid = N200,000

NR = 30%
½ NR = 15%
CWR = 2000,000 x 100 = 34.48%
580,000

Since CWR > ½ NR, use ½ NR = 15% x N N580,000 = N 87,000

b) Computation of Net Tax Due

India Nigeria Total

N N N
Net Profit 700,000 1,200,00 1,900,000
0
Add: Disallowable Expenses:
Depreciation 200,000 200,000
Loss on Disposal of Asset --------- 80,000 80,000
700,000 1,480,00 2,180,000
0
Less: Capital Allowance
Initial Allowance ------- (100,000) (100,000)
Annual Allowance (120,000) (75,000) (195,000)
Assessable Profit 580,000 1,305,00 1,885,000
0
Company Taxation @ 30% 565,500
Less: Double Taxation Relief (87,000)
Net Tax Liability 478,500
 Education Tax @ 2% of Adjusted 43,600
Profit

TRANSFER PRICING
Introduction
International Transfer prices take place within Multinational Entreprises (MNE). These arise
because of globalisation and international trade and consequently, there are increased
international pricing activities arising from the international enterprises to penetrate the market
especially where there are limited numbers of local producers.
International transfer pricing are used for the following purposes:
 For management accounting purpose, it is used for transaction that takes place between
units within a company.

 For financial reporting and the calculation of taxable income, this involves transactions that
take place between separate companies within a group.

 Multinational Enterprises: transfer pricing is used by Multinational Enterprises for

transactions that take place between units that are separate companies in different countries
and continents.

Learning Outcomes
When you have studied this session, you should be able to:
 Explain the term,‘transfer pricing’ in Nigeria.

 Calculate internal transfer pricing under different internal transfer pricing methodology.

 Outline the merits and demerits of the different transfer pricing methodologies.

Definition
International Transfer within Multinational Enterprises constitutes more than 60% of
international trade. This implies that Multinational Enterprises provide a variety of goods and
services to members within the group. Intra-group services could be administrative, technical,
financial or commercial in nature but once it has been established that a charge for the services is
justified, the amount to be charged for the service needs to be determined. Hence, International
transfer price is defined as the price charged by a selling department, division or subsidiary of
Multinational Enterprises (MNE) for a product or service supplied to a buying department,
division or subsidiary of the same Multinational Enterprises.

The transfer prices adopted by a division or subsidiary of multinational enterprises can directly
affect the profits to be reported by each of these units in their respective host countries, thus
transfer prices present opportunity to shift profit from high tax country to members of related
group in low tax countries. The basic principles that govern transfer pricing in cross-border
transaction is arm’s length principle. The arm’s length principles stipulate that trade terms and
conditions between units of the same group should be that which would have been reported as if
they had not been members of the same group.

Factors Necessitating Transfer Prices

Globalization and international trade increased international pricing activities because of the
activities of Multinational Enterprises to penetrate markets, where there are limited numbers of
local producers. The choice of appropriate transfer prices by multinational enterprises is based
on two types of reporting which are as follows:
 Those associated with internal reporting

 Those associated with external reporting

Internal Reporting
Transfer pricing is used as follows:
 Performance: Transfer pricing is used to evaluate the performance of units of a
multinational enterprises in the management of the business by both local managers and
by the central managers of the multinational enterprises. It is used to report on
controllable performance of a manager of units, division or profit centre. It is also used
to measure performance against budget or other yardstick of achievement.
 Decision making: Transfer price is used to set price in order to achieve goal congruence
so that the goal pursued by the individual unit managers are consistent with the goals of
the enterprise as a whole. For example, suppose that a product in one unit with an
incremental cost of N500.00 is offered for sale to another unit at a transfer price of
N750.00. The receiving unit can add value at a cost of N300.00 and sell it for N1,000.00.
The receiving unit manager will not accept the transfer price because it incurred loss of N
50.00 even though the gain to the enterprise as a whole is N200.00.

External Reporting
The transfer price that would be adopted by multinational enterprise is influenced by the
following factors.
 Competition: Transfer pricing is used to depress reported income in highly profitable
units so as to mislead the potential competitors. Competitors in that line of production are
discouraged by the relative low profit to be earned. This is done through over-invoicing.

 Taxation: Multinational enterprises reduce their total tax liability by transfer pricing
policy that reduce reported income in countries with high tax rates and increase reported
income in countries with low tax rates. This is also achieved through over or under-
invoicing.

 Foreign exchange exposure: Transfer pricing is used by multinational enterprises to

control the timing and terms of payments. The central management of multinational
enterprise determines whether the buying or selling units bear the exchange risk by
specifying the currency to be used for payment between units in different countries.

 Import duties: Transfer price is used to reduce the effect of high import duties. This is
done through the adoption of low transfer pricing. Some countries operate a strict
exchange controls that restrict the level of dividends that can be remitted from a unit
operating in a foreign country. High transfer prices can be used to avoid the negative effect
of these controls.

 Minority interests: Transfer prices are used to boost reported income in order to impress
the local lender where the multinational enterprise raise fund locally. Also where a multi-
 national enterprise has a subsidiary with local partner, it will be in the interest of the
multinational enterprise to use transfer pricing policies that depress income in that
subsidiary to the benefit of the whole enterprise.

Methods of Internal Transfer Pricing

There are three major approaches for establishing a transfer pricing, namely:
 Cost base method

 Market prices method

 Negotiated transfer prices method

Cost Base Method

This is when the selling department sells to the buying department at the cost of production. The
selling department can determine their cost in any of the following ways:
 Full cost: This is the total cost of production. It involves the cost of bringing the goods
and services to the final destination by the selling department. The cost will include
production cost, selling and administrative cost.

 Variable cost: This is the cost that involves the marginal cost recovered. Fixed cost is
completely ignored. This method is appropriate where there is excess capacity in the
selling department.

 Standard cost: It is the predetermined amount which ensures that the inefficiency of the
selling department in the production is not passed to the buying department. Under this
method it can be derived by adding a fixed percentage of actual cost of the cost e.g 25%
of actual cost to the cost of production.

Merits of the cost method

 It is simple and saves time.

 It facilitates the valuation of stock.

  It enhances decision making.

Demerits
 Inflation may cause the cost to be high and rejected by the buying department.

Market Price Method

This is the price at which the other competitors would be ready to supply the goods and services
to the buying department. The implication is that the units will treat each other as if they are not
units of the same group.
Merits
 Market prices used are objective.

 No time is wasted by management during the bargaining process.

Demerits
 Accurate market information may not be available.

 Market prices make valuation of stock difficult.

Negotiated Price Method

This is when both the buying and selling departments agree to the price of the transaction in
advance.
Merit
 It reduces misunderstanding and conflicts between the selling and buying department.

Illustration
University of Lagos has two departments named Distance Learning Institute and School of
Postgraduate Studies. Distance Learning Institute produce 8,000 students at a cost of N12,000
per student while the cost per student in school of postgraduate is N2,000. The market price is
N19,000 and N22,000 per student for Distance Learning and School of Postgraduate Studies
respectively. The Distance Learning Institute transfers 75% of its products to School of
Postgraduate Studies and others to the open market. There are no opening and closing stock.
Required: Prepare operating statement if:
a) The transfer price from Distance Learning Institute to School of Postgraduate is at cost
price.

b) The transfer price from Distance Learning Institute to School of Postgraduate is at cost
price plus 25%.

c) The transfer price from Distance Learning Institute to School of Postgraduate is at market
price.

d) The transfer price from Distance Learning Institute to School of Postgraduate is at

negotiated price of N16,000.

Solution
A. Transfer Price At Cost

DLI SPGS TOTAL

N’000 N’000 N’000
Open market sale 38,000 132,000 170,000
Transfer sales 72,000 -
TOTAL SALES 110,000 132,000
Cost (96,000) (12,000)
Transfer cost - (72,000) (108,000)
Profit 14,000 48,000 62,000

B. Transfer Price At Cost Plus 25%

DLI SPGS TOTAL
N’000 N’000 N’000
Open market sale 38,000 132,000 170,000
Transfer sales 90,000 -
TOTAL SALES 128,000 132,000
Cost (96,000) (12,000)
Transfer cost - (90,000) (108,000)
 Profit 32,000 30,000 62,000

C. Transfer Price At Market Price

DLI SPGS TOTAL
N’000 N’000 N’000
Open market sale 38,000 132,000 170,000
Transfer sales 114,000 -
TOTAL SALES 152,000 132,000
Cost (96,000) (12,000)
Transfer cost - (114,000) (108,000)
Profit 56,000 6,000 62,000

D. Transfer Price At Negotiated Price

DLI SPGS TOTAL
N’000 N’000 N’000
Open market sale 38,000 132,000 170,000
Transfer sales 96,000 -
TOTAL SALES 134,000 132,000
Cost (96,000) (12,000)
Transfer cost - (96,000) (108,000)
Profit 38,000 24,000 62,000

Summary
This defines transfer pricing and let us know that globalization and multinational trade has
increased the activities of transfer pricing. Also transfer pricing gives the enterprises the
opportunity to manipulate the regulatory environment of the countries where they operate.
Domestically, the primary objective of transfer pricing is the maintenance of equity among the
various units in the Multinational Enterprises group in other to facilitate the performance
evaluation base on decentralization.

Students’ Assessment Questions

1. What is International Transfer pricing?

2. What are the factors necessitating transfer pricing among the Multinational Enterprises?

3. The basic principle that governs transfer pricing in cross border transactions is known as

a) Cross Border Principle c) Far Away Principle

b) Objectivity Principle d) Arm’s Length Principle

4. International transfer pricing presents an opportunity for multinational enterprises to

a) Stipulate trade term with partners

b) Report the profits of subsidiaries

c) Shift tax from high tax countries to low tax countries

d) To penetrate the market of local producers

5. One of the following is not a method for establishing internal transfer prices

a) Cost Based Methods c) Selling Price Based Method

b) Market Price Method d) Negotiated Transfer Price Method

6. One of the following is not an approach to determining transfer pricing under the cost
based method

a) Partial Cost b) Variable Cost c) Full Cost d) Standard Cost

7. A major advantage of the market price method is

a) It is subjective c) It is simple
 b) It is objective d) It is accurate

8. Whenever there is excess capacity in the selling department the appropriate cost based
transfer pricing method is

a) Partial Cost b) Variable Cost c) Full Cost d) Standard Cost

9. The reduction of misunderstanding and conflict is a major benefit of which pricing

method

a) Cost Based Methods c) Selling Price Based Method

b) Market Price Method d) Negotiated Transfer Price Method

INTERNATIONAL TRANSFER PRICING METHODOLOGY

Introduction
A transfer price is the price that a division of an organization charges for product sold or
transferred, or for services rendered to another division within the same organizational group.
Diewarts, Alterman and Eden (2005) estimate that intra-firm trade equals 40% of international
trade, this means that a large portion of international trade occurs between related parties.
Guttman (1999) also posits that more than 60% of international trade occurs through intra-firm
trade between related or controlled of multi-national corporations.

A wide variety of goods and services are usually provided by members of Multi-National
Companies (MNCs) to other members within the group. Intra-group services could be
administrative, technical, financial or commercial in nature but once it has been established that a
charge for the service is justified, the amount to be charged for the service needs to be
determined. Thus, international transfer price refers to the prices at which tangible and
intangible property and services are traded across international borders between related parties.

Transfer prices are determined internally by the various divisions within the MNCs. To the
selling division the transfer price is revenue, while it is a cost to the buying division. The
transfer prices adopted by a division or subsidiary of an MNC can directly affect the profits to be
reported by each of these parties in their respective host countries, thus transfer prices present
opportunities to shift profits from high tax countries to members of a related group in low tax
countries. Because transfer price is a tool to divide group profits amongst various divisions, it
can be manipulated to avoid or evade taxes. There is a great concern over its effect on the tax
liability of MNCs and consequently the tax collected by host countries; therefore many
governments are now taking steps to monitor transfer prices so as to prevent abuse.

Learning Outcomes
The student should be able to:
 Explain the transfer pricing methodologies under the two international transfer systems of
the OECD.

 enumerate on the Arm’s Length Principle and the implication on transfer pricing

 Determine the appropriate internal transfer pricing methodology to be adopted for different
production situations.

 outline the procedure for review and audit of international transfer prices

 calculate the transfer prices under the traditional transaction methodology

The Arm’s Length Principle (ALP)

The basic rule governing the treatment of cross-border transaction is the 1995 Organisation for
Economic Cooperation and Development (OECD) guidelines on ALP. The ALP requires that
trade terms and conditions between non-arm’s length parties would have been that which would
be expected of parties dealing at arm’s length. The objective is to ensure that when members of
a controlled group engage in transactions with each other, income reported would substantially
be the same amount as that which would have been reported if they had not been members of the
same group.
The implication of the ALP is that it treats a group of parties not dealing at arm’s length as if
they operate as separate entities rather than as inseparable parts of a simple unified business.
When pricing is not in accordance with what would reflect a fair dealing between unrelated
parties it is referred to as “international profit shifting”.

Transfer Pricing and Tax Considerations

It is expected that a taxpayer should make reasonable efforts to determine and use the arm’s
length transfer price or allocation in respect of controlled transactions. In reviewing the
taxpayer’s transactions to ensure that it adheres to the ALP, the prices and margins in controlled
transactions are compared with similar transactions between arm’s length parties. Where
differences exist in the amount, the applicable tax authority may initiate a transfer pricing review
and subsequently a transfer pricing audit with possible adjustments and penalties.

Adjustment to reflect the amount that would have been determined for the taxpayer if the
transactions had been uncontrolled could result in an increase or decrease to taxpayer’s income,
taxpayer’s loss or taxpayers capital expenditure of the year. Businesses with significant levels of
related party international dealings in tax haven countries where little or no economic value is
added or, who are consistently returning losses are at the greatest risk of transfer pricing review.
Where transfer pricing adjustments result in double taxation, a taxpayer may request relief if it is
provided for in the tax regulations. In addition to adjustments, penalties may apply especially
where it is deemed that the taxpayer did not make reasonable efforts to determine and use the
ALP transfer price or allocations.

When MNC’s fail to disclose information concerning transfer prices they may face stiff penalties
from the tax authority. For example in Mexico, transfer payment to members of a related group
may be derived as a form of penalty if the firm does not show evidence of ALP in transfer
pricing. Also in Australia the transfer pricing laws permits that the tax authority may assign a
transfer price when MNC’s provide inadequate or incomplete information as to process adopted
in determining their transfer prices.

In order to reduce the risk of an audit and the avoidance of disputes with tax authorities it is
necessary to document steps taken to adhere to the ALP. Generally, it is required that the
following information about related party dealings should be disclosed.
 Nature and amount of certain categories of transactions

 Details of interest free loans

 Receipts of payments of non-monetary considerations

 Details of arm’s length methodologies used

 Documentation used to support the selection and application of the arm’s length
methodology

 Details of disposals of any interest in a capital asset

Because major problems still exist as to showing documentation of how prices in related party
dealings were set. Some countries like Canada have set up advance pricing arrangements (APA)
programs to assist taxpayers in determining transfer pricing acceptable. The APA stipulates a
mutually acceptable transfer pricing method to be used in specified international transactions for
a future period with or without provisions to renew.

Transfer Pricing Review and Audit

Transfer pricing review and audit are used to regulate and correct the process of transfer pricing
in MNCs. A review involves examining the following:
 The nature and extent of a business international dealing with related party

 The quality of the process established by the business to show compliance with the ALP
for tax purposes.

 The quality of the businesses documentation of those dealings and the outcomes of the
dealings

When the risk from the review is high, an audit is initiated to determine the differences that exist
between the transaction and an arm’s length transaction. Where material differences exist,
assessment action to determine adjustments and penalties where necessary is taken.

Problems of Using the Arm’s Length Principle

Sometimes it may be impractical to determine pricing for transactions in controlled transactions
because there may be no market for the intra-firm product. In the absence of an easily
observable market for the transfer, product difficulties can arise as to what constitutes a fair
transfer pricing. In such cases, data from an independent firm can be used to set an appropriate
competitive price that can be used as an effective benchmark.

In some instances, a problem arises as to the means of determining the appropriate transfer
pricing for transactions that have been bunched together because they are so closely linked or
continuous in nature. In such instances, evaluating transactions on a separate basis for each
transaction generally provides the most reliable estimate of an arm’s length price rather than an
aggregate price for the bundle of transactions. Considerations in separating the transactions will
depend on the following:
 Intangibles associated with various transactions

 Availability of quality information on comparable transactions

 Additional cost associated with valuing the transactions separately and the functional
comparability of the transactions

It may be difficult also to obtain information on arm’s length transfer price for individual
products or transactions where the industry practice may be to set one price for a combination of
transactions. In all the above cases where comparable prices in the open market may not exist,
adjustments can be made to achieve comparability but the degree of accuracy may affect the
reliability of the adjusted arm’s length price.

International Transfer Pricing Methodology

Different methods of arm’s length transfer pricing applications exist from MNC’s. They can be
divided into two broad categories:
The traditional transaction methods which includes:
 The comparable uncontrolled price method (CUP)
 The resale price method
 The cost plus method
The transactional profit method which includes:
 The profit split method
 The transactional net margin method
 The comparable profits method

The Comparable Uncontrolled Price Method (CUP)

The CUP involves the comparison of the prices of comparable property or service in transactions
between unrelated parties or between the enterprise and an unrelated third party. The CUP
method requires both functional and product comparability therefore, it is important to ensure
that before applying the CUP method, the terms and conditions in the uncontrolled transaction
are similar to the terms and conditions of the controlled transaction.
Transactions may still serve as comparable even when differences exist between it and an arm’s
length transfer if the difference can be accurately measured and appropriate adjustments are
made to eliminate the effects of those differences.

The Resale Price Method

The resale price method involves a reduction in the resale price to an arm’s length party by a
comparable gross profit margin. The resale price method is most appropriate in situations where
the purchasing division will still add value to the transferred item.

The Cost Plus Method

Under this method, the cost price or cost of production is marked up by adding an appropriate
margin for gross profit. The margin established must be that which would be reasonably
expected as a reward for the functions performed, assets used or risks assumed. The cost plus
method is usually used where goods are manufactured or assembled and sold to related parties.

The Comparable Profits Method

This involves determining and adding to the cost, the profit that would have been earned by
similar businesses in an uncontrolled comparable transaction under similar circumstances.

Profit Split Method

The method involves determining and sharing the likely profit on the transaction between the
parties involved in the transaction. The profit accruing to each of the party in the controlled
transaction must be evaluated to ensure that it reflects their contributions to the combined
operating profit or loss.

The Transaction Net Margin Method (TNMM)

The method involves applying the net profit margin from similar arm’s length transaction to an
appropriate base such as cost, sales, or asset. The appropriate base is chosen taking into
consideration the nature of the business activity and it is applied to only one party of the related
group, usually the least complex party that does not contribute valuable or unique intangible
assets.

Transfer pricing is not an exact science, so the application of transfer pricing methodology will
produce a range of results. To ensure that the most objective price is chosen. The selection of
the appropriate method should be based on:
 The availability of quality information in comparable transactions

 The reliability of comparable transactions in the range used to establish the arm’s length
price or allocation

 The factors present in the controlled transactions

 Intangibles associated with the various transactions

The traditional transaction methods are preferable while transactional profits methods are usually
used as methods of last resort.

Illustration 1
Arshivin Enterprises Limited is a Multi-national company incorporated in India with subsidiaries
located in Pakistan and Sri Lanka. The parent company produces a component part which it
ships to the subsidiary in Pakistan for further production and sales. The component is produced
at a cost of $8 per piece in India and further production cost $2 in Pakistan. If the tax are in
India, Pakistan and Sri Lanka is 25%, 40% and 45% respectively, you are required to compute
the profit earned and tax paid if:
i. The subsidiary in Pakistan purchases 10,000 units of the component from the parent
company at a cost of $10 and after further production sells 5,000 units in Pakistan at $20
and transfers 5,000 units to Sri Lanka at a price of $17 for sales at $22.

ii. Same as in i above but transfer price to Pakistan and Sri Lanka is $15 and $20 respectively.

Solution I
Parent Sub (Pakistan) Sub Consolidated
(Sri Lanka)
$ $ $ $
Selling price 100,000 185,000 110,000

Cost of goods sold (80,000) (120,000) (85,000)

--------- -------- --------

profit before tax 20,000 65,000 25,000 110,000

Tax (5,000) (26,000) (7,500) (38,500)

---------- -------- -------- --------

Profit after tax 15,000 39,000 17,500 71,500

---------- --------- ---------- ---------

Solution II
Parent Sub (Pakistan) Sub Consolidated
(Sri Lanka)
$ $ $ $
Selling price 150,000 200,000 110,000
Cost of goods sold 80,000 170,000 100,000
---------- -------- --------
Profit before tax 70,000 30,000 10,000 110,000
 Tax (17,500) (12,000) (4,500) (34,000)
---------- -------- -------- --------
Profit after tax 52,500 18,000 5,500 76,000
---------- --------- ---------- ---------
In this illustration, setting a higher transfer price moves more of the profit before tax to the lower
tax country. Thus transfer pricing presents opportunities to minimize tax burdens by shifting
profits from high tax countries to low tax countries.

Illustration 2
If it has been determined that the resale price of the component part to an unrelated third party
would be $12 and for the finished product it would be $18 and the usual gross profit margin for
Arshivin Enterprises is 30% on sales. You are required to:
i. Determine the transfer prices that would have been used to price the transfers under each
of the traditional transaction methods and

ii. Recommend the transfer price that would be appropriate for each of the transfers

Solution I
a) The comparable uncontrolled price recommends that the transfer price for goods between
related parties should be that which would have been determined if the transaction had
been between unrelated parties. Therefore, the parent company’s transfer price to the
Pakistan subsidiary should have been $12 while the transfer price to the Sri Lanka
subsidiary should have been $18.

b) The resale price method suggests that the resale price should be reduced by an
appropriate gross profit margin. Since the gross profit margin for Arshivin Enterprises is
30%, the transfer price would be:

The resale price – gross profit margin

Transfer price to Pakistan $12 – 30% ($12) = $8.40
Transfer price to Sri Lanka $18 – 30% ($18) = $12.60
c) The cost plus method recommends that the transfer price should be the cost price marked
up with the appropriate margin for gross profit. Therefore the transfer price should be:

The cost price + 3/7 of cost price

Transfer price to Pakistan $8 + 3/7 ($8) = $11.43
Transfer price to Sri Lanka ($11.43 + $2) + 3/7 ($11.43 + $2) = $19.19

Solution II
The recommended transfer price for the transfer to the Pakistan subsidiary is the resale price
transfer price of $8.40 which is appropriate where the related company will still add value to the
product and the recommended transfer price for the transfers to Sri Lanka is $19.19 which is the
cost plus price.

Summary

 A transfer price is the price that a division of an organization charges for product sold or
transferred, or for services rendered to another division within the same organizational
group.
 The 1995 Organisation for Economic Cooperation and Development (OECD) guideline
on Arm’s Length Principle (ALP) is the basic rule governing the treatment of cross-
border transaction.
 It is important to document the steps taken to adhere to the ALP in transfer pricing.
 Transfer pricing review and audit are used to regulate and correct the process of
transferpricing in MNCs
 A number of problems are experienced in using the ALP.
 The traditional transaction methods include comparable uncontrolled price method; the
resale price method; and the cost plus method.
 The transactional profit methods include profit split method; the transactional net margin
method and the comparable profits method.
Students’ Assessment Questions

1. What is the role of transfer pricing in international operations?

2. International transfer pricing evokes serious concern among various countries’ tax
authorities, why?

3. Elucidate on 3 major issues that may complicate transfer pricing decisions.

4. Explain the term “arm’s length price”.

5. Identify and explain the major bases for pricing inter-company transfers.

6. XYZ Enterprises is a manufacturing company in Country A which incurs costs of

$10,000,000 for goods that are sold to its sales affiliate in Country B for $12,000,000.
The sales affiliate resells these goods to final customers for $18,000,000 after incurring
further expenses of $1,000,000. Countries A and B levy a corporate income tax of 30%
and 50% respectively on taxable income in their jurisdictions. If XYZ Enterprises
increases the transfer price to $15,000,000, what effect would this have on taxes?

7. Given the facts as enumerated above, what would be the tax effects of the foregoing
pricing action if corporate income tax rates were 30% in Country A and 40% in Country
B?

8. If the uncontrolled selling price of the goods in Country A is $12,500,00 and the gross
profit margin for the company is 25%. Calculate the transfer price to country B under the
resale price method and the cost plus method.

9. Which of these is not a traditional transaction method of International Transfer Pricing

Methodology?
(a) The Comparable Uncontrolled Price method
 (b) The Comparable Profits method
(c) The Cost Plus Method
(d) The Resale price Method

10. Which of the following transfer pricing methodology best suits transactions that should
reflect the contributions to the combined operating profit and loss between related
parties?
(a) The Resale price Method
(b) The Transaction net Margin Method
(c) The Cost Plus Method
(d) The Profit Split Method

11. When goods are to be assembled and sold to third parties, the best transfer methodology
is ______________.
(a) Profit Split method
(b) The Cost Plus method
(c) The Resale Price Method
(d) The Comparable Profits Method