BABCOCK UNIVERSITY,

SCHOOL OF MANAGEMENT SCIENCES

DEPARTMENT OF ACCOUNTING,
ILISHAN-REMO,
OGUN STATE.
ICAN PROFESSIONAL EXAMINATION
COURSE: ADVANCED TAXATION
COURSE CODE: ACCT 534
LECTURE 5
LECTURER: Professor Folajimi Festus.ADEGBIE
TOPIC: TRANSFER PRICING
DEFINITION of 'Transfer Price'
This is the price at which divisions of a company transact with each other. Transactions may
include the trade of supplies or labor between departments. Transfer prices are used when
individual entities of a larger multi-entity firm are treated and measured as separately run
entities. In managerial accounting, when different divisions of a multi-entity company are in
charge of their own profits, they are also responsible for their own "Return on Invested Capital".
Therefore, when divisions are required to transact with each other, a transfer price is used to
determine costs. Transfer prices tend not to differ much from the price in the market because one
of the entities in such a transaction will lose out: they will either be buying for more than the
prevailing market price or selling below the market price, and this will affect their performance.
Transfer Pricing Reference to Organization for Economic Co-operation
and Development OECD

On 19 July 2013 the OECD published an Action Plan on Base Erosion and Profit Shifting
(“BEPS Action Plan”). Action 13 in the BEPS Action Plan states that the OECD will “develop
rules regarding transfer pricing documentation to enhance transparency for tax administration,
taking into consideration the compliance costs for business. The rules to be developed will
include a requirement that MNE’s provide all relevant governments with needed information on
their global allocation of the income, economic activity and taxes paid among countries,
according to a common template.”
The outlined BEPS action is consistent with the directive of the G8 summit meeting held on 17 –
18 June 2013 at Lough Erne. The communiqué issued in connection with that meeting states as
follows:
“Comprehensive and relevant information on the financial position of multinational enterprises
aids all tax administrations effectively to identify and assess tax risks. The information would be
of greatest use to tax authorities, including those of developing countries, if it were presented in a
standardized format focusing on high level information on the global allocation of profits and
taxes paid. We call on the OECD to develop a common template for country-by-country
reporting to tax authorities by major multinational enterprises, taking account of concerns
regarding non-cooperative jurisdictions. This will improve the flow of information between
multinational enterprises and tax authorities in the countries in which multinationals operate to
enhance transparency and improve risk assessment.”
Since first introduced by the United States in 1994, transfer pricing documentation requirements
have spread around the world. While individual country approaches to documentation vary
significantly, the number of countries requiring preparation of transfer pricing documentation
increases every year. The proliferation of transfer pricing documentation requirements, combined
with a dramatic increase in the volume and complexity of international intra-group trade and the
heightened scrutiny of transfer pricing issues by tax authorities, makes transfer pricing
documentation one of the top tax compliance priorities on the agendas of both tax authorities and
businesses.
 Transfer pricing documentation rules are, and will continue to be, elements of local law enacted
in individual countries. However, in today’s globally integrated economy, transfer pricing
documentation should not be seen purely as a local country compliance tool related to
enforcement of the transfer pricing rules in an individual jurisdiction. Rather, transfer pricing
enforcement and compliance should be thought of as an issue with multijurisdictional
ramifications and documentation rules should be developed with this in mind.1 When viewed in
this light, efficient operation of the international transfer pricing system in a global economy
presents an opportunity for international coordination in order to simplify and consolidate the
compliance obligations of business, while at the same time assuring that tax authorities have
ready access to the information necessary to efficiently enforce their transfer pricing laws.
. The existing guidance on documentation contained in the OECD Transfer Pricing Guidelines
for Multinational Enterprises and Tax Administrations (“OECD TPG”) is not sufficient to meet
the transfer pricing compliance requirements of today’s economy.
Chapter V of the OECD Transfer Pricing Guidelines
1. The OECD TPG adopted in 1995 included a chapter on transfer pricing documentation, which
constituted the first attempt to achieve a coordinated approach following the 1994 United States
482 Regulations and associated penalty regime. Chapter V of the OECD TPG “provides general
guidance for tax administrations to take into account in developing rules and/or procedures on
documentation to be obtained from taxpayers in connection with a transfer pricing inquiry. It also
provides guidance to assist taxpayers in identifying documentation that would be most helpful in
showing that their controlled transactions satisfy the arm's length principle and hence in
resolving transfer pricing issues and facilitating tax examinations”.4
2. There is considerable emphasis in Chapter V of the 1995 TPG on the need for reasonableness
in the documentation process from the perspective of both taxpayers and tax administrations, as
well as on the desire for a greater level of cooperation between tax administrations and taxpayers
in addressing documentation issues “in order to avoid excessive documentation requirements
while at the same time providing for adequate information to apply the arm's length principle
reliably”.5
3. The current guidance in Chapter V does not provide for an exhaustive list of documents to be
included in a transfer pricing documentation package, as “it is not possible to define in any
generalised way the precise extent and nature of information that would be reasonable for the tax
administration to require and for the taxpayer to produce at the time of the examination”.6 It
outlines the information that “could be relevant, depending on the individual circumstances”, but
stipulates that the information described “should not be viewed as a minimum compliance
requirement” and “is not intended to set forth an exhaustive list of the information that a tax
administration may be entitled to request”.
4. The 1995 TP Guidelines do not contain any clear guidance with respect to the link between the
process for documenting transfer pricing and the administration of penalties and of the burden of
proof. The 1995 TP Guidelines do not differentiate between documentation that might be useful
to a tax administration in undertaking a transfer pricing risk assessment and the information a tax
administration may wish to review in the course of a full audit of a taxpayer’s transfer pricing
practices
European Union Guidance on Transfer Pricing Documentation
1. In June 2006, the Council of the EU agreed to a Code of Conduct on Transfer Pricing
Documentation for Associated Enterprises in the European Union (“EUTPD”).7 Within the
framework of the OECD TPG, the EUTPD aims at standardizing the documentation that MNEs
doing business in Europe must provide to tax authorities on the pricing of cross-border intra-
group transactions in Europe, while achieving a balance between the tax administrations’ right to
obtain from a taxpayer the information necessary to assess the arm’s length nature of the
taxpayer’s transfer pricing and the compliance costs for the taxpayer.
2. For MNEs, the EUTPD is optional,8 although a company adopting the EUTPD should do so
in a way that is consistent throughout the European Union and from year to year. For European
Union (“EU”) Member States, the EUTPD is a political commitment and it does not affect EU
Member States' rights and obligations or the respective spheres of competence of the EU
Member States and the EU. EU Member States are, however, expected to implement the EUTPD
by legislating for it in the national law or through administrative guidelines, when introducing or
amending legal or administrative documentation requirements. This would enable MNEs to use
the same documentation in all EU Member States.
3. The EUTPD consists of two main elements: the masterfile and the country specific
documentation. In addition, EU Member States retain the right to require a taxpayer to provide
more information and documents than would be contained in the EUTPD, but only upon specific
request or during a tax audit.
4.The key features of the “master file,” as contemplated by the EUTPD, are:
• It would contain common standardized information relevant for all European Union group
members of an MNE.
• It should follow the economic reality of the enterprise and provide a “blueprint” of the
company and its transfer pricing system for all EU Member States concerned.
• It would be available to all EU Member States involved in a specific controlled transaction.
• It would require the taxpayer to provide information on: the MNE group; the business and
business strategy; the controlled transactions involving associated enterprises in the EU and their
comparability analysis; the enterprise's transfer pricing policy; the ownership of intangibles; and
a list of the cost contribution arrangements (“CCAs”), advance pricing arrangements (“APAs”)
and rulings covering transfer pricing aspects as far as group members in the EU are affected.

5. Under the EUTPD, the country-specific documentation has the following characteristics:

It would consist of a set of standardized documentation for each of the specific EU Member
States involved.
• It would generally be available only to the specific member state concerned.
• It would contain information relevant to that country only, such as: the business and business
strategy; country-specific controlled transactions and their comparability analysis; particular
transfer pricing methods used; information on internal and/or external comparables, if available;
and, an explanation of how the group’s intercompany transfer pricing policy is implemented and
applied by the local associated enterprise.

6.The master file and the country-specific documentation would, together, constitute the
documentation file for the relevant EU Member States and should provide tax authorities with
greater transparency on the EU transfer pricing system of MNEs. When taxpayers comply in
good faith, in a reasonable manner and within a reasonable time with standardised and consistent
documentation, EU Member States are advised not to impose documentation-related penalties.
7.. While there are several advantages to implementing the EUTPD (e.g. simplification of and
consistent approach to transfer pricing documentation and cost savings through avoiding
duplication of effort), a first survey of the European Commission launched in 2009 indicated
that, at that time, numerous taxpayers had elected not to fully implement the EUTPD guidance.
Some tax publications from the same period suggest the following: 9
• In practice, there may be a lack of clarity as to the acceptability of the EUTPD across EU
Member States. Furthermore, the flexibility given to EU Member States regarding the
implementation of documentation rules could create a degree of uncertainty.
• The variability in local country requirements and the enforcement of local transfer pricing
documentation requirements in some countries could make the masterfile less useful than it
might otherwise be.
• The requirement to disclose all APAs and rulings as part of the masterfile, which is made
available to all tax authorities in the EU, could be seen as a stumbling block for some taxpayers.
• The adoption of the EUTPD does not shelter MNEs from further questioning by the tax
authorities or the obligation to submit more documents when requested.
• The adoption of the EUTPD does not always protect taxpayers against transfer pricing
adjustments. According to some business representatives, the wider dissemination of European-
wide information by taxpayers could lead to increased scrutiny by tax authorities and challenges
on the same issues in multiple countries, as well as an increased risk of being subject to a tax
audit.

Pacific Association of Tax Administrators (PATA) Transfer Pricing Documentation

Package
1.. In March 2003, the Pacific Association of Tax Administrators (“PATA”), whose members
include Australia, Canada, Japan and the United States, released principles under which
taxpayers can create uniform transfer pricing documentation (“PATA documentation package”)
so that one set of documentation would meet the respective transfer pricing documentation
provisions of each of the four member countries.
2. As under the EUTPD rules, the use of the PATA documentation package by a taxpayer is
voluntary and it is intended to be consistent with the general principles outlined in Chapter V of
the OECD TPG.
3. The PATA documentation package provides for three operative principles. According to these,
MNEs need to: make reasonable efforts to establish transfer prices in compliance with the arm's
length principle; maintain contemporaneous documentation of their efforts to comply with the
arm's length principle; and, produce, in a timely manner, that documentation upon request by a
PATA member tax administrator. If these principles are satisfied, use of the PATA documentation
package will protect the taxpayer from domestic transfer pricing penalties that might otherwise
apply in each of the four jurisdictions.
4. The PATA documentation package provides for an exhaustive list of documents (organised in
10 headings and covering 48 specific document areas) that PATA tax administrations view as
necessary in order to provide relief from the otherwise applicable transfer pricing penalties. It is
recognized that in certain instances some of the listed documents will not be needed.
Nevertheless, the tax authorities retain the possibility to request additional information not listed
in the package when necessary to examine an MNE’s conclusions as to the arm’s length nature of
its arrangements.
5. To date, the practical impact of the PATA documentation package seems to be fairly limited as
it does not seem to be widely utilized by MNEs. Some of the concerns raised by business are:
• The PATA member countries reached a consensus on documentation requirements by
demanding everything in the domestic requirements of each of the four countries. Accordingly,
practitioners have noted that the list of required documents is more elaborate than any single
country’s requirements and contains some requirements that may not be relevant and can be
burdensome.
• The PATA documentation package does not seem to incorporate the notions of relevance,
materiality, or the cost of preparing the documentation in relation to the value of the
intercompany transaction under review. The tax authorities decide whether a request for further
specific items of information is reasonable and, therefore, it is unclear whether the comparatively
large documentation burden faced by medium-sized companies will be eased.
• Satisfaction of the PATA documentation package does not preclude PATA member tax
administrations from making transfer pricing adjustments, and assessing any interest due on
those adjustments.
• The definition of “reasonable efforts” is left to the local laws of the PATA member countries.
The views of PATA member countries on what constitutes “reasonable efforts” do not converge
in all cases. Some commentators suggest this undermines the goal of uniformity and certainty for
taxpayers.

Purposes of transfer pricing documentation requirements

Any consideration of the simplification and improvement of transfer pricing documentation
practices around the world should start with a consideration of the purposes for requiring transfer
pricing documentation. It may be that the existing diversity of documentation requirements can
be traced, at least in part, to a failure to agree on and clearly articulate the fundamental reasons
for requiring transfer pricing documentation. Moreover, the development of a stronger consensus
around the identification of the most important purposes served by transfer pricing
documentation may provide direction with regard to the preferred form and content of the
required documentation package.
At least three different reasons can be identified for governments to require the creation and
submission of transfer pricing documentation. These are:
1.To provide governments with the information necessary to conduct an informed transfer
pricing risk assessment at the commencement of a tax audit;
Emphasis has been placed by tax administrations and taxpayers on the development and
implementation of sound tax risk assessment and management systems for purposes of
administering and complying with transfer pricing rules. The emphasis on transfer pricing risk
assessment arises from the fundamental observation that “effective risk identification and
assessment are the key steps which enable tax administrations to select the right cases for
transfer pricing audits or inquiries.” Because tax administrations operate with limited resources,
it is important for them to accurately evaluate at the very outset of a possible audit, whether a
taxpayer’s transfer pricing arrangements warrant in depth review and a commitment of
significant tax enforcement resources, or whether they do not warrant such a detailed
examination.
Different countries use differing means to obtain from the taxpayer the information required for
an effective risk assessment process, including the following:

i.Transfer pricing forms (to be filed with the annual tax return)

ii.Transfer pricing questionnaires

iii.Cooperative approaches with tax authorities

iv.General transfer pricing documentation requirements

2. To assure that taxpayers have given appropriate consideration to transfer pricing

requirements in establishing prices and other conditions for related party transactions and in
reporting the income derived from such transactions in their tax returns;
By requiring taxpayers to articulate solid, consistent and cogent transfer pricing positions,
transfer pricing documentation can help to ensure that a culture of compliance is created.
Extremely aggressive positions can often readily be identified by reviewing the documentation.
Well-prepared documentation will give tax authorities some assurance that the taxpayer has
analysed the positions they report on tax returns, the available comparable company data, and
has reached defensible transfer pricing positions. Moreover, contemporaneous documentation
requirements can restrain taxpayers from developing only after the fact justifications for their
positions.
This objective of mindful compliance is backstopped in many countries in two important ways.
First, countries often require that the documentation requirement be satisfied on a
contemporaneous basis. That is, the transfer pricing documentation, and the thinking that
underlies that documentation, is required to take place at the time of the transaction, or in any
event, prior to filing the tax return for the year. While some countries follow policies allowing
documentation to be prepared any time prior to the commencement of an audit, most follow
some form of requirement designed to force taxpayers to evaluate their compliance with transfer
pricing rules annually, before or at the time of completing and filing their tax return
Second, many countries have constructed transfer pricing penalty regimes in a manner intended
to reward timely preparation of transfer pricing documentation and to create monetary incentives
for timely careful consideration of the taxpayer’s transfer pricing positions. For example, in the
United States, penalties otherwise imposed in connection with large transfer pricing adjustments
will be abated if the taxpayer contemporaneously prepares and timely provides to the tax
authorities adequate and reasonable documentation of its transfer pricing positions
3.To provide governments with all of the information that they require in order to conduct an
appropriately thorough audit of the transfer pricing practices of entities subject to tax in their
jurisdiction.
A third purpose for transfer pricing documentation is to provide tax authorities with the
information they need to conduct a thorough transfer pricing audit. Transfer pricing cases under
examination or audit tend to be fact-intensive. They often involve difficult evaluations of the
comparability of several transactions and markets. They can require detailed consideration of
financial, factual and other industry information. The availability of adequate information from a
variety of sources is critical to facilitating a tax administration’s orderly examination of the
taxpayer’s controlled transactions with associated enterprises and enforcement of the applicable
transfer pricing rules.
Generally, most of the relevant information required for a transfer pricing audit must come from
the taxpayer itself. Governments often express the view that the taxpayer’s control of relevant
information provides it with a significant advantage in a transfer pricing audit. A review of
country legislation and regulations on transfer pricing documentation could easily lead one to
believe that country documentation rules in many jurisdictions primarily pursue an objective of
levelling the audit playing field by assuring that all documents and information necessary for a
full transfer pricing audit are readily available to the tax administration at the time the tax return
is filed or the audit commences.
In situations where a proper risk assessment suggests that a thorough transfer pricing audit is
warranted, it is clearly the case that the tax administration must have the ability to obtain, within
a reasonable period, all of the relevant documents and information in the taxpayer’s possession.
This includes information regarding the taxpayer’s operations and functions, information
regarding potential comparables, including internal comparables, and documents regarding the
operations and financial results of potentially comparable uncontrolled transactions and unrelated
parties. To the extent such information is included in the transfer pricing documentation, special
information and document production procedures can potentially be avoided. It must be
recognised, however, that regardless of how comprehensive transfer pricing documentation
requirements may be, situations will inevitably arise when tax authorities wish to obtain
information not included in the documentation package. Thus, country legislation should always
include powers and processes that will allow the tax authority to obtain information from the
taxpayer beyond what is included in the information relied on in a risk assessment at the
beginning of the audit. The time of preparation of various elements of necessary documentation
will be an issue necessarily considered in designing a documentation system that meets
government needs for information without imposing unnecessary compliance burdens on
taxpayers.

TRANSFER PRICING METHODS

[1] THE COMPARABLE UNCONTROLLED METHOD: This method compares the price
charged for property or services transferred in a controlled transaction to the price charged for
property or services transferred in a comparable uncontrolled transaction in comparable
circumstances. If there is any difference between the two prices, this may indicate that the
conditions of the commercial and financial relations of the associated enterprises are not arm’s
length , and that the price in the uncontrolled transaction may need to be substituted for the price
in the controlled transaction.
An uncontrolled transaction is comparable to a controlled transaction (i.e. it is a comparable
uncontrolled transaction) for purposes of the CUP method if one of two conditions is met:
a.None of the differences (if any) between the transactions being compared or between the
enterprise undertaking those transactions could materially affect the price in the open market; or
b. Reasonably accurate adjustments can be made to eliminate the material effects of such
differences.
The comparable uncontrolled price method can be applied on the basis of the taxpayer’s
transactions with independent enterprises ( internal comparables), or on the basis of transactions
between other independent enterprises (external comparables)
The CUP method is therefore most helpful for establishing an arm’s length price for:
i.sales of commodities traded on a market, subject to the controlled transaction and comparable
uncontrolled transaction(s) taking place in comparable circumstances, including at the same level
of the commercial chain (e.g.sale to a secondary manufacturer, to a distributor, to a retailer ,etc)
and
ii. Some common financial transactions, such as the lending of money.

In effect, market prices (such as commodity prices or rates of interest) may be publicly available
for these types of transactions.

CUP method illustration

Associated Controlled Associated

Enterprises A Nigerian Coffee beans enterprise B
Price:N100 per/ton

Associated A Uncontrolled transaction Independent

Enterprise Nigrian Coffee beans enterprise C
Price;N120 per ton.
First,we need to determine whether the uncontrolled transaction (sale by A to C) is comparable to
the controlled transaction (sale by A TO B).This will be done through comparatibility analysis.
It may be that the difference in the prices of the two transactions reflects a difference in relation
to pne comparatibility factor (for instance, an additional function performed or risk borne by A in
its transaction with C, compared to its transaction with B).In such a case,the effects of such
difference should, to the extent possible, be eliminated through a comparability adjustment. If the
two transactions are comparable, the price difference may indicate that the controlled transaction
is not arm’s length and the tax administration auditing enterprise A may consider a transfer
pricing adjustment of 20.
[2] THE RESALE PRICE METHOD
. The resale price method begins with the price at which a product that has been purchased from
an associated enterprise is resold to an independent enterprise. This price (the “resale price”) is
then reduced by an appropriate gross margin (the “resale price margin”), determined by reference
to gross margins in comparable uncontrolled transactions, representing the amount out of which
the reseller would seek to cover its selling and other operating expenses and, in light of the
functions performed (taking into account assets used and risks assumed), make an appropriate
profit. What is left after subtracting the gross margin can be regarded, after adjustment for other
costs associated with the purchase of the product (e.g. customs duties), as an arm’s length price
for the original transfer of property between the associated enterprises.
. Thus, in a resale price method, the resale price margin (i.e. the gross margin) that the reseller
earns from the controlled transaction is compared with the gross margin from comparable
uncontrolled transactions.
. This method is probably most useful where it is applied to sales and marketing operations such
as those typically carried out by a distributor. In some circumstances, the resale price margin of
the reseller in the controlled transaction may be determined by reference to the resale price
margin that the same reseller earns on items purchased and sold in comparable uncontrolled
transactions (an “internal comparable”). In other circumstances (especially where reliable
internal comparables are not available), the resale price margin may be determined by reference
to the resale price margin earned by independent enterprises in comparable uncontrolled
transactions (“external comparables”).
Resale Price method (illustration)

Sales price to independent customers 1,000 Tested in the resale price method;
Resale margin(i.e.gross margin).(e,g 40%) 400 determined from uncrolled
Cost of goods sold;transfer price ( 600) comparables
Selling and other operating expenses (300)
Operating profit 100 (i.e. purchase price from
Associated enterprise

[3] THE COST PLUS METHOD

The cost plus method begins with the costs incurred by the supplier of property or services in a
controlled transaction for property transferred or services provided to an associated enterprise.
An appropriate mark-up, determined by reference to the mark-up earned by suppliers in
comparable uncontrolled transactions, is then added to these costs, to make an appropriate profit
in light of the functions performed and the market conditions. Such arm’s length mark-up may be
determined by reference to the mark-up that the same supplier earns in comparable uncontrolled
transactions (an “internal comparable”), or by reference to the mark up that would have been
earned in comparable transactions by an independent enterprise (“external comparable”). In
general, the mark-up in a cost plus method will be computed after direct and indirect costs of
production or supply, but before the operating expenses of the enterprise (e.g. overhead
expenses).
Thus, in a cost plus method, the mark-up on costs that the manufacturer or service provider
earns from the controlled transaction is compared with the mark-up on costs from comparable
uncontrolled transactions.
This method probably is most useful where:
i) goods are sold by a manufacturer that does not contribute valuable unique intangible assets or
assume unusual risks in the controlled transaction, such as may be the case under a contract or
toll manufacturing arrangement; or
ii) the controlled transaction is the provision of services for which the provider does not
contribute any valuable unique intangible assets or assume unusual risks.

Cost plus method Illustration

Cost of raw materials 200
Other direct and indirect production costs 100 Tested in the cost plus method;
Total cost base 300 determined from uncontrolled
Mark-up on costs (e.g.20%) 60 comparables
Transfer price 360 (i.e.Sale price to associated
Overheads and other operating expenses (40) enterprises)
Operating profit 20

[4] THE TRANSACTIONAL NET MARGIN METHOD (TNMM)

The transactional net margin method (“TNMM”) examines a net profit indicator, i.e. a ratio of
net profit relative to an appropriate base (e.g. costs, sales, assets), that a taxpayer realises from a
controlled transaction (or from transactions that are appropriate to aggregate) with the net profit
earned in comparable uncontrolled transactions. The arm’s length net profit indicator of the
taxpayer from the controlled transaction(s) may be determined by reference to the net profit
indicator that the same taxpayer earns in comparable uncontrolled transactions (internal
comparables), or by reference to the net profit indicator earned in comparable transactions by an
independent enterprise (external comparables).
In cases where the net profit is weighed to costs or sales, the TNMM operates in a manner
similar to the cost plus and resale price methods respectively, except that it compares the net
profit arising from controlled and uncontrolled transactions (after relevant operating expenses
have been deducted) instead of comparing a gross profit on resale or gross mark up on costs.
Most often, the net profit indicator that is tested in a TNMM is the operating profit (before
interest, extraordinary items and income taxes).
In general, it is observed that in applying a TNMM, the net profit is weighted to costs for
manufacturing and service activities; to sales for sales activities; and to assets for asset-intensive
activities.
The selected financial indicator should be one that:
a. Reflects the value of the functions performed by the tested party (i.e. the party to the
controlled transaction for which a financial indicator is tested), taking account of its assets and
risks;

b. Is reasonably independent from transfer pricing formulation, i.e. it should be based on

objective data (such as sales to unrelated parties), not on data relating to the remuneration of
controlled transactions (such as sales to associated enterprises); and

c. Is capable of being measured in a reasonably reliable and consistent manner at the level of the
controlled transaction and of the comparable uncontrolled transaction(s).

Functional comparability is generally found to be of greater importance than product

comparability in applying the transactional net margin method.

Difference between a resale price and a TNMM for a distributor

(Illustration)
Sales revenue (sales to independent customer) 1,000
Cost of goods sold(purchase from associated enterprises) (400) Tested in a resale
Gross profit(e.g.60% of sales) 600 Price method
Selling and other operating expenses (400)
Operating profit(20% of sales) 200 Tested in a TNMM
Financial items +10
Exceptional items (30)
Pretax profit(EBT-earnings before taxes) 180
Income tax (60)
Net profit 120
Dividends/retained earnings
Difference between a cost plus and a TNMM for a contract manufacturer (illustration)
N
Cost of raw materials 200
Other direct and indirect production costs 100
Total cost base 300 Tested in a Cost Plus
Mark up on cost(e.g.20% of costs) 60 Method
Transfer price 360
Overheads and other operating expenses (45) Tested in a TNMM
Operating profit(e.g.5% of costs) 15

[5] THE TRANSACTIONAL PROFIT SPLIT METHOD

The transactional profit split method first identifies the combined profits to be split for the
associated enterprises from the controlled transactions in which the associated enterprises are
engaged. In some cases, the combined profits will be the total profits from the controlled
transactions in question. In other cases, the combined profits will be a residual profit intended to
represent the profit that cannot readily be assigned to one of the parties from the application of
another transfer pricing method, such as the profit arising from valuable, unique intangibles.
Note that the combined profits may be a loss in some circumstances.
The transactional profit split method then splits the combined profits between the associated
enterprises on an economically valid basis that approximates the division of profits that would
have been anticipated between independent enterprises. Where possible, this economically valid
basis may be supported by independent market data (e.g. division of profits observed in
uncontrolled joint-venture agreements). Most often, however, it will be supported by internal
data. The types of such internal data that may be relevant will depend on the facts and
circumstances of the case and may include, for example, allocation keys relating to the respective
sales, research and development expenses, operating expenses, assets or headcounts of the
associated enterprises. The splitting factor should reflect the respective contributions of the
parties to the creation of income from the controlled transaction and be reasonably independent
from transfer pricing formulation. This means that it should, to the greatest extent possible, be
based on objective data (such as sales to unrelated parties), rather than on data relating to the
remuneration of controlled transactions (such as sales to associated enterprises).
TRANSACTION PROFIT SPLIT (ILLUSTRATION)

ASSOCIATED ASSOCIATED
ENTERPRISES A ENTERPRISES B
Contribution by A Contribution by B
To the controlled CONTROLLED TRANSACTION to the controlled
Transaction x% =>profit transaction y%

Share of the profit from share of the profit from

The controlled transaction the controlled transaction
Attributed to A:x% attributed to B:y%
SELECTION OF THE MOST APPROPRIATE TRANSFER PRICING METHOD TO
THE CIRCUMSTANCES OF THE CASE
The selection of a transfer pricing method always aims at finding the most appropriate method
for a particular case. No one method is suitable in every possible situation, nor is it necessary to
prove that a particular method is not suitable under the circumstances.
The selection process of the most appropriate method for a particular case should take account
of the following four criteria
i. The respective strengths and weaknesses of the OECD recognized methods;

ii. The appropriateness of the method considered in view of the nature of the controlled
transaction, determined in particular through a functional analysis;

iii. The availability of reliable information (in particular on uncontrolled comparables) needed to
apply the selected method and / or other methods; and

iv. The degree of comparability between controlled and uncontrolled transactions, including the
reliability of comparability adjustments that may be needed to eliminate material differences
between them.

CONNECTED TAXABLE PERSONS

(1) Where a connected taxable person has entered into a transaction or a series of transactions to
which these Regulations apply, the person shall ensure that the taxable profits resulting from the
transaction or transactions is in a manner that is consistent with the arm‘s length principle.
(2) Where a connected taxable person fails to comply with the provisions of this regulation, the
Service shall make adjustments where necessary if it Considers that the conditions imposed by
connected taxable persons in controlled transactions are not in accordance or consistent with the
―arm‘s Length principle

In these Regulations, a connected taxable person‘ includes persons, individuals, entities,

companies, partnerships, joint ventures, trusts or associations (collectively referred to as
connected taxable persons‘) and includes the persons referred to in :
(i) REGULATIONS 13(2)(d), 18(2)(b) and 22(2)(b) of the Companies Income Tax Act, 2004 (as
amended);[transactions between persons one of whom either has control over the other or, in the
case of individuals, who are related to each other or between persons, shall be deemed to be
artificial or fictitious if in the opinion of the Board those transactions have not been made by
persons engaged in the same or similar activities dealing with one another at arm’s length]
(ii) section 15(2) of the Petroleum Profit Tax Act, CAP P13, Laws of the Federation of Nigeria,
2004 (as amended);[Where a trade or business of petroleum operations carried on in nigeria by a
company incorporated under any law in force in Nigeria is sold or transferred to a Nigerian
company for the purposes of better organization of that trade or business or the transfer of its
management to Nigeria and any asset employed in that trade or business is sold or transferred,
then, if the Board is satisfied that one of those company has control over the other or that both
companies are controlled by some other person or are members of a recognized group or
companies, the provisions of subsection 2 of date of transfer, first accounting period and asset
transfer shall have effect.
(iii) section 17(3)(b) of the Personal Income Tax Act, CAP P8, Laws of the Federation of
Nigeria, 2004; Where a tax authority is of the opinion that any disposition(i.e.any
trust,grant,covenant,agreement or arrangement) is not in fact given effect to,or that any
transaction which reduces or would reduce the amount of any tax payable is artificial or
fictitious, the tax authority may disregard the disposition or direct that such adjustments shall be
made as respects the income of an individual, an executor or a trustee,as the tax authority
considers appropriate so as to counteract the reduction of liability to tax effected,or reduction
which would otherwise be effected by the transaction.
Advance Pricing of Agreements.
(1) A connected taxable person may request that the Service enter into an Advance Pricing
Agreement (APA) to establish an appropriate set of criteria for determining whether the person
has complied with the arm‘s length principle for certain future controlled transactions undertaken
by the person over a fixed period of time provided that such agreement shall be consistent with
the requirements established by this regulation.
(2) A request under sub-regulation (1) of this regulation shall be accompanied by –

(a) a description of the activities of the taxable person to be addressed by the Advance Pricing
Agreement, including –
(i) a detailed description of the controlled transactions to be included within the scope of the
Advance Pricing Agreement;
(ii) an analysis of functions to be performed, assets to be employed and risks to be assumed by
the parties to the covered transactions; and
(iii) the proposed duration of the Advance Pricing Agreement.
(b) a proposal by the taxable person for the determination of the transfer prices for the
transactions to be covered by the Advance
Pricing Agreement, including the following information –
(i) an analysis of the comparability factors;
(ii) the selection of the most appropriate transfer pricing
method to the circumstances of the controlled transactions;
and
(iii) the critical assumptions as to future events under which the determination is proposed.
(c) the identification of any other country or countries that the person wishes to participate in the
Advanced Pricing Agreement;
(d) the cumulative amount resulting from the transaction in every year of assessment not less
than N250,000,000.00 (two hundred and fifty million Naira) of a connected taxable person‘s
total deductible costs or total taxable revenues; and
(e) any other relevant information that the Service may require to complete its analysis of the
Advance Pricing Agreement request.
(3) The Service may accept, modify or reject a request made by a connected taxable person under
sub-regulation (1) of this regulation after taking into account matters specified in sub-regulation
(2) of this regulation and the expected benefits from an Advance Pricing Agreement.
(4) The Service may in addition to the provisions of sub-regulation (3) of this regulation specify
the basis for acceptance, modification or rejection of a request.
(5) The Service may enter into an Advance Pricing Agreement with a taxable person either alone
or together with the competent authority of countries of the connected taxable person.
(6) Where the Service approves or modifies a proposal under sub-regulation (3) of this
regulation, the Service may enter into an Advance Pricing Agreement which shall provide,
among other things, a confirmation to a connected taxable person that no Transfer Pricing
Adjustment will be made under sub-regulation (3) of this regulation to controlled transactions
covered by the Agreement where the transactions are consistent with the terms of the Agreement.
(7) An Advance Pricing Agreement entered into under this regulation shall apply to the
controlled transactions for a period not exceeding three years as specified in the Advance Pricing
Agreement.
(8) The Service may cancel an Advance Pricing Agreement by notice if –
(a) the connected taxable person has failed to materially comply with a fundamental term of the
Advance Pricing Agreement;
(b) there has been a material breach of one or more of the critical assumptions underlying the
Advance Pricing Agreement;
(c) there is a change in the tax law that is materially relevant to the Advance Pricing Agreement;
or
(d) the Advance Pricing Agreement was entered into based on a misrepresentation, mistake or
omission by the connected taxable person.
(9) A connected taxable person may cancel an Advance Pricing Agreement by a notice given to
the Service where –
(a) there is a material change in the premise upon which the advance pricing request was made;
(b) the Advance Pricing Agreement is no longer relevant based on significant changes to the
structure of the controlled transaction; or
(c) there is a change in tax law applicable in the jurisdiction of the controlled transaction that is
materially relevant to the Advance Pricing Agreement.
(10) The Service shall treat as confidential any trade secret or other commercially sensitive
information or documentation provided to the Service in the course of negotiating or entering
into an Advance Pricing Agreement.
(11) Termination of an Advance Pricing Agreement under paragraphs (8) and (9) of this
regulation takes effect in the case of –
(a) paragraphs 8(a) and (c) of this regulation, from the date specified by the Service in the notice
of cancellation;
(b) paragraphs 8(b) of this regulation, from the date the material breach occurred;
(c) paragraphs 8(d) of this regulation, from the date the Advance Pricing Agreement was entered
into; and
(d) paragraphs 9 of this regulation, from the date specified in the notice of cancellation.
.
COMPARABILITY FACTORS IN THE PROCESS OF TP BENCHMARKING
(1) For the purpose of determining whether the pricing and other conditions of a controlled
transaction are consistent with the arm‘s length principle, the taxpayer shall, in the first instance,
ensure that the transaction is comparable with a similar or identical transaction between two
independent persons carrying on business under sufficiently comparable conditions.
(2) The Service shall have the power to review or challenge the assessment of the taxpayer made
pursuant to the provisions of sub-regulation (1) of this regulation.
(3) An uncontrolled transaction is comparable to a controlled transaction within the meaning of
this regulation –
(a) where there are no significant differences between the uncontrolled transaction and a
controlled transaction under comparable circumstances which could materially affect the
conditions being examined under the appropriate transfer pricing method; or
(b) where such differences exist, reasonably accurate adjustments are made in order to eliminate
the effects of such differences, or reduce the effects of such differences, to the extent that all
material differences are eliminated.
(4) In determining whether two or more transactions are comparable the following factors shall
be considered to the extent that they are economically relevant to the facts and circumstances of
the transactions –
(a) the characteristics of the goods, property or services transferred or supplied;
(b) the functions undertaken by the person entering into the transaction taking into account the
assets used and risks assumed;
(c) the contractual terms of the transactions;
(d) the economic circumstances under which the transactions were undertaken; and
(e) the business strategies pursued by the connected taxable persons to the controlled
transaction.

Documentation requirements for transfer pricing benchmarking

(1) A connected taxable person shall record, in writing or on any other electronic device or
medium, sufficient information or data with an analysis of such information and data to verify
that the pricing of controlled transactions is consistent with the arm‘s length principle and the
connected taxable person shall make such information available to the Service upon written
request by the Service.
(2) The obligation of the taxpayer to provide the information referred to in sub-regulation (1) of
this regulation, with analysis, is established without prejudice to the authority of the Service to
request for additional information which in the course of audit procedures it deems necessary to
effectively carry out its functions.
(3) The documentation referred to in this regulation must be prepared taking into account the
complexity and volume of transactions.
(4). The Service shall have the authority to specify the items of documentation required to be
provided to it upon request.
(5) The documentation referred to in sub-regulation (1) of this regulation shall be in place prior
to the due date for filing the income tax return for the year in which the documented transactions
occurred.
(6) The TP Declaration Form as set out in the Schedule to these Regulations shall be appended to
the tax return for the year to which it relates.
(7) The information, data and analysis referred to in sub-regulation (1) of this regulation must be
provided to the Service upon request within twenty-one days.
(8) The Service may upon reasonable request made to it by a connected taxable person extend
the time within which the documents referred to in sub-regulation (7) of this regulation is to be
provided.
(9) The documentation retained by a connected taxable person shall be adequate to enable the
Service verify that the controlled transaction is consistent with the arm‘s length principle.
(10) The burden of proof that the conditions of the controlled transactions are consistent with the
arm‘s length principle shall be that of the taxable person and the taxable person will be regarded
as satisfying this burden of proof if it provides documentation consistent with this regulation to
support the consistency with the arm‘s length principle of the taxable profits derived from its
controlled transactions.
(11) For each year of assessment a connected taxable person shall, without notice or demand,
make a disclosure on the TP Disclosure Form or on any other form as may be prescribed by the
Service, details of transactions that are subject to these Regulations.

TRANSFER PRICING IN DIVISIONALIZED COMPANIES

What is transfer pricing?
i.Transfer pricing is the process of determining, reporting and acting on the imputed values of
goods and services exchanged between divisions.
ii.A transfer price is defined as the monetary value attached to goods and services, which are
being manufactured, by a particular division or a decision making unit and then transferred to
another division for the purpose of being utilized for the divisional final product.
iii.CIMA defined transfer price as the price at which goods or services are transferred from the
person or department to another or from one member of a group to another.
To avoid transfer-pricing problem of arbitrary pricing between divisions and for the purpose of
optimal decision making by the various divisional management, the central management should
properly define a transfer pricing policy to be used on a consistent basis by all the divisions
within the decentralized organization.
Conditions for the application of transfer pricing policy:
1.An organization must adopt a divisionalised structure rather than a centralized structure.
2.Each division must be vested with absolute authority on all the areas of decision-making i.e.
autonomous in nature.
3.The division must be identified as either as a profit center or an investment center but not as a
cost center.
4.One of the divisions must be manufacturing a component or a sub-assembly, which the other
division will require for the purpose of its final product.
5. The two divisional management’s must be eager to transact business with each other.

Objectives of transfer pricing systems

1.Goal Congruence:
A transfer pricing policy should enhance decision made at the divisional management level that
would not only be beneficial to the division but to the whole organization. The prices should be
set in such in such a way that the divisional management’s desire to maximize divisional returns
is consistent with the objectives of the company as a whole. The transfer prices should
discourage sub-optimality decision-making.
Sub-optimally means the subjugation of corporate goals for divisional goals.
2. Performance appraisal:
An ideal transfer price must be capable of being relied upon as a premise for evaluating
divisional performances in terms of efficiency level and effectiveness.
The transfer prices should form part of management information sysytem, which will accomplish
the following:
1 .Guide decision making
2. Realistic assessment of the performance of each divisional manager.
3. Evaluate the contribution made by the division to overall company profits.
4. Assess the worth of a division as an economic unit.
3. Divisional Autonomy:
The transfer prices should preserve the autonomy of divisions so that the benefits of
decentralization (motivation, training ground for higher responsibilities, better decision making,
fast response to local problems, initiative etc) are maintained.

Transfer pricing methods

1.Cost based transfer-pricing method:
The division selling its product to the buying division at either the cost it has incurred or at the
cost plus mark-up. Cost could be any of the following:
• Full cost: The selling division recovers all production cost including fixed overheads as
well as selling and administration cost.
• Variable cost; the transfer price ensures that at least variable or marginal cost are
recovered, fixed overheads are ignored completely. This method is especially appropriate
whenever there is excess capacity either in the selling division or in the buying division.
• Standard cost: The transfer price is based on pre-determined amount, which ensures that
the inefficiency of the selling division in production is not unnecessarily passed on to the
buying division.
• Cost Plus Mark-up: Here a specific percentage is applied to cost of production and this
automatically guarantees the selling division some amount of profit whenever there is
transfer.

Advantages of cost based transfer-pricing method:

1.it eliminates the complexities associated with stock valuation especially when preparing group
accounts, as there is no unrealistic profit on stock.
2.it is very useful for optimal decision-making purposes especially the marginal cost variant
whenever there is excess capacity in the selling division.
3.A transfer price could be fixed and agreed in advance without being subject to external
fluctuation especially when the standard cost variant is used.
4.prices can easily be obtained from the costing system.

Disadvantages of cost based transfer-pricing Method

1.It may lead to unpredictable month by month fluctuation unless standard cost variant is used.
2. Cost of the selling division may be rejected on the ground that it is inefficient especially when
full cost is used.
3.When transfer is made at cost plus, the selling division is guaranteed a certain level of profit
and this may encourage inefficiency to be perpetuated for a long time.
4.It treats the divisions as cost centers rather than profit or investment centers. Therefore,
measures such as Return on Investment (ROI) and Residual Income (RI) cannot be used for
evaluation purposes.
2.Market based Transfer pricing Method:
Under this approach, the relevant transfer price to charge between the selling and buying
divisional managers will represent the prevailing market price or the ruling price within the
market as at the date of the transaction. The buying and the selling divisions will be operating at
arms-length as if they are not members of the same group.
Advantages:
1.There is goal congruence as any decision taken by the divisional management. Using market
based transfer pricing method would not only be in the interest of the division but also that of the
whole organization as well.
2.Divisional autonomy is maintained.
3.It is most adequate for measuring performance and motivating managers.
4.Market prices are objective and verifiable.
5.it cannot lead to controversy as to the efficiency or inefficiency of the selling division.

Disadvantages
1.Accurate information about the market price may not be readily available.
2.The use of market price may act as a disincentive to use any spare capacity especially in the
selling division whenever there are excess capacities even though the marginal cost variant could
have been desirable for use in that situation.
3.The approach will complicate the process of stock valuation as a result of the need to eliminate
the unrealistic profit on stock.
3.Negotiated Transfer Pricing Method:
The relevant Transfer pricing to charge between the selling and buying divisional managers will
represent the outcome of negotiation between the two divisional managers i.e the organization
will encourage the two divisional managers to agree on the appropriate transfer price to charge.
This will however be influenced by the prevailing market price of the product.

Advantages of negotiated Transfer Pricing Method

1.The motivation impact is always stringer because it gives managers a high degree of control
and involvement when prices are set.
2.Less disputes on transfer prices because many factors would have been considered such as the
full and marginal production cost, market prices, impact on profit of each of the divisions etc.
Disadvantages of Negotiated Transfer Pricing Method:
1.Neqotiation may be time consuming
2.The negotiated price may be influenced by the negotiating abilities, personality and fluency of
the managers.
3.The group interest may be subordinated to individual interest.
4.Arbitrary Transfer Pricing Method;
The relevant transfer price to charge between the selling and buying divisional managers will be
determined by the central management with or without the consent of the divisional managers.
Individual division may have some contribution but no control over prices actually set.
Advantages of arbitrary pricing method:
1.The method will guarantee the concept of goal congruence.
2.It is not based on market fluctuation.
3.it eliminates the unusual time being wasted under the negotiated method.
4.The approach is considered ideal for planning purpose because it is specific in nature.
Disadvantages of Arbitrary pricing method:
1.Profit and cost consciousness may suffer where the arbitrary fixed price is not considered
realistic.
2.The divisional managers are not encouraged to use their initiative in pricing decision.
3.The approach negates divisional autonomy.
4.It is difficult for the approach to motivate the selling divisional manager.

TRANSFER PRICE BASED ON OPPORTUNITY COSTS

Opportunity cost rule can be used for transfer price.
The rule says;
Transfer Price Per Unit= Standard Variable cost in the producing division + the opportunity cost
to the organization as whole for supplying the unit internally.
The opportunity cost comprise:
a. The maximum contribution foregone by the supplying division in transferring internally
rather than selling goods externally.
b. The contribution forgone by not using the same facilities in the producing division for their
next best alternative use.
*** if there is no external market for the item being transferred ,and no alternative uses for the
division’s facilities, the transfer price = standard variable cost of production.
***if there is an external market for the item being transferred ,and not alternative uses for the
division, the transfer price =the market price.
Identifying the Optimal transfer price:
• The ideal transfer price should reflect the opportunity cost of sale to the supply division
and the opportunity cost to the buying division.
• Where a perfect external market price exists and unit variable costs and unit selling prices
are constant, the opportunity cost of transfer will be (.i.) External market price or (ii)
External market price less savings in selling cost.
• In the absence of a perfect external market price for the transferred item, but when unit
variable costs are constant, and the sales price per unit of the end-product is constant, the
ideal transfer price should reflect the opportunity cost of the resources consumed by the
supply division to make and supply the item.
i.in some cases eg.where the supplying division has spare capacity, this may simply
be the standard variable cost of production.
ii. When there is a scarce production resource, the transfer price might be the variable
cost of production plus the contribution forgone by using the scarce resource instead of putting it
to its most profitable alternative use.
iii. In other words, the transfer price should be
Standard variable cost + opportunity cost of making the transfer.

d. When unit variable costs and/or unit selling prices are not constant, either in the
intermediate market or the end-market, a more difficult problem arises, There will be a profit –
maximizing level of output and the ideal transfer price will only be found by sensible negotiation
and careful analysis.
• The starting point should be to establish the output and sales quantities that will
optimize the profits of the company ot group as a whole.
• Having done this, the next step is establish the transfer price at which both
profit centers, the supply division and the buying division, would maximize
their profits at this company-optimizing output level.

Illustration 1
DIVIDEND MANUFACTURING PLC
Central Division of Dividend Manufacturing Plc is a mono-product division, which sells
externally and can also transfer to other divisions within the organization.
Central Division has been set a performance target of a budgeted residual income of #300,000
for the coming financial year.
Additional information on Central Division:
• Maximum production /Sales capacity=120,000 units.
• Sales to external customers =80,000 units at N20 each.
• Variable cost per unit= N14
• Fixed cost directly attributable to the division==N60,000
• Capital employed:N1,600,000 with a cost of 15%.
The Western Division of the Dividend Manufacturing plc has asked the Central Division to quote
a transfer price for 40,000 units.
a. You are required to calculate the transfer price per unit, which Central Division should quote
to Western Division in order that its budgeted residual income target will be achieved.
b. You are required to explain why the transfer price calculated in a may lead to sub-optimal
decision making from a group viewpoint.
Solution
DIVIDEND MANUFACTURING PLC
DETERMINATION OF TRANSFER PRICE TO BE QUOTED BY CENTRAL
DIVISION TO WESTERN DIVISION.

a..
N
Imputed interest charge to division
(N1,600,000 ×15%) 240,000
Residual income target 300,000
Fixed costs 60,000

Target contribution 600,000

Contribution from units sold externally
(80,000×N(20-14) 480,000

Contribution required from internal transfers 120,000

Transfer price per unit N

From 40,000units = N120,000 3
40,000

Plus variable cost 14

Transfer Price 17

b. A sub-optimal situation will arise if Western Division discovers a source of external supply of
the units at a price which is between N14 and N17.Unless Western Division is forced
internally ,a sub-optimal decision would result because Western Division would be paying more
for the units than it costs to manufacture internally.
To avoid this situation, the transfer price should be set at
Variable cost +Opportunity cost.
Up to 40,000 units, the opportunity cost is zero because Central Division has excess capacity.
The transfer price should then be set at N14 and this would not be a sub-optimal decision.
Illustration 2
UTC Nig. Plc, an aluminium manufacturing company, has three autonomous divisions X, Y, and
Z.Division X is responsible for manufacturing aluminium flat sheets, which become the raw
materials for division Y. From the flat sheets, Division Y makes aluminium windows and doors.
Division Z is responsible for marketing the entire company’s final products.
The company’s management feels that the divisions should be evaluated as separate profit
centers and that each center should be credited with an equitable share of contributions. The
company’s transfer pricing policy stipulates that proportionate efforts are to be measured by the
ratio of the division’s variable cost to the total variable cost of the centers.
Budgeted sales for 1996 is N25,000,000 with total variable cost of N15,000,000 for the
centers. The details of the variable and fixed costs by divisions are given as follows:
X Y Z
N N N
Variable costs 4,500,000 3,000,000 7,500,000
Fixed costs 2,500,000 1,500,000 2,000,000
Total 7,000,000 4,500,000 9,500,000

You are required to:

• Determine budgeted transfer values using the agreed pricing method.
• Division x is considering a cost saving device which will reduce its variables costs by
20%. This will not have any effect on other costs or budgeted sales. Determine the
transfer values using the new cost data.
• Compare the divisional contributions and profit in (a) and (b) above and comment briefly
on the possible divisional managerial attitudes to the changes in divisional performance
measurement.

SOLUTION
a. UTC NIG.PLC
Computation of budgeted transfer values using the agreed transfer pricing method.

Notes X Y Z TOTAL
N’000 N’000 N’000 N’000
Transfer cost - 7,500 12,500 -
Variable cost 4,500 3,000 7,500 15,000
Share of contribution (1) 3,000 2,000 5,000 10,000

7,500 12,500 25,000 25,000

Note 1 Calculation of contribution

Budgeted sales 25,000,000

Less: Variable cost: 15,000,000
Contribution 10,000,000

Share of contribution
X……4,500× N10,000,000 = N3,000,000
15,000

Y……3,000 × N10,000,000 = N2,000,000

15,000

Z……7,500 × N10,000,000 = N5,000,000

15,000

b. Computation of budgeted Transfer Values Using The Agreed Transfer Pricing Method:

Note X Y Z TOTAL
N’000 N’000 N’000
Transfer costs 6,382.98 11,702.13
Variable cost 3,600 3,000 7,500 14,100
Share of contribution (2) 2,782.98 2,319.15 5,797.87 10,900

Transfer values 6,382.98 11,702.13 25,000.00 25,000

Note 2 N

Variable cost of division X 4,500,000

Less:20% cost reduction(20%×4,500,000) 900,000

3,600,000
Revised total variable cost would then be N14.1m
(N3.6m+N3.0m+N7.5m)
Therefore contribution sales = N25,000,000

Less variable cost = N14,100,000

Contribution N10,900,000

N’000
X 3,600
×10,900, 2,782.98
14,100

Y 3,000 × 10,900 2,319.15

14,100

Z 7,500 ×10,900 5,797.87

14,100 10,900

c.(i) Comparing of Divisional Contributions

X Y Z
N’000 N’000 N’000
Before cost saving in
Div X 3,000 2,000 5,000
After cost saving in
Div X 2,782.98 2,319.15 5,797.87

PERCENTAGE
INCREASE/(DECREASE) (7.23) 15.96 15.96

(ii) COMPARISON OF DIVISIONAL PROFITS

NOTE X Y Z
(3) N’000 N’000 N’000
Before cost saving
In Dix X 500 500 3,000

After cost saving

In Div X 282.98 819.15 3,797.89

Percentage Increase/(Decrease) (43.40) (61.83) (26.60)

Comments:
1,The contribution for division X has declined by 7.25% resulting in a 43.4% decline in the
division profits.
2.The contribution for division Y increased by 15.96% and 61.83% increase in profits.
3.The contribution for division Z increased by 15.96% and 26.6% increase in profits.
Aggregately, division Y benefited most from the cost saving device adopted by division X.
Division X is worse off from the reduction scheme in its variable cost. The effect of this transfer
pricing policy will be inimical on the innovation ability of division X’s managers and conflicts
will be created as “monkeys will be working for baboons to eat” Divisions Y and Z will surely
welcome the cost reduction exercise.

Working 3 computation of profits (before cost reduction)

X Y Z
N N N
Turnover 3,000 x 25,000 7,500 5,000 12,500
10,000

Less Variable cost 4,500 3,000 7,500

Contribution (note 1) 3,000 2,000 5,000

Less Fixed cost 2,500 1,500 2,000

500 500 3,000

Computation of Profit after cost reduction

X Y Z
N N N
Turnover 2,782.98
10,900 X25,000 6,382.98 5,319.15 13,297.87

Less variable cost 3,600 3,000 7,500

Contribution (note 2) 2,782.98 2,319.15 5,797.87

 Fixed cost 2,500.00 1,500.00 2,000.00

Profit 282.98 819.15 3,797.87

Illustration 3
Technology Nig.Ltd has two divisions. South division manufactures an intermediate product for
which there is no intermediate external market. North division incorporates this intermediate
product into a final product that it sells. Once unit of the intermediate product is used in the
production of the final product .The expected units of the final product which North division
estimates it can sell at various selling prices are as follows:

Net selling Price Quantity sold

N units
100 1,000
• 2,000
• 3,000
70 4,000
60 5,000
50 6,000
The costs of each division are as follows:
South North
N N
Variable cost per unit 11 7
Fixed costs per annum 60,000 90,000

The transfer price is N35 for the intermediate product, and is determined on a full cost plus basis.
You are required to:
{a} Prepare profit statements for each division and the company as whole for the
various selling prices.
{b}State which selling price maximizes the profit of North division and the company’s
as a whole, and comment on why latter selling price is not selected by North division.
{c}State which transfer pricing policy will maximize the company’s profit under a
divisional organization.

SOLUTION
[ a] The contributions for each company ant the company as a whole for the various selling
prices are as follows:
SOUTH DIVISION:
Output Level Total Various Total
(Units) revenues costs Contribution
TP @N35 @N11 N
 1,000 35,000 11,000 24,000
2,000 70,000 22,000 48,000
3,000 105,000 33,000 72,000
4,000 140,000 44,000 96,000
5,000 175,000 55,000 120,000
6,000 210,000 66,000 144,000
NORTH DIVISION:
Output Level
(Units) SP Total Variable Total Cost Total
Revenues cost of transfers contribution
N N @N7 @N35 N
1,000 100 100,000 7,000 35,000 58,000
2,000 90 180,000 14,000 70,000 96,000
3,000 80 240,000 21,000 105,000 114,000
4,000 70 280,000 28,000 140,000 112,000
5,000 60 300,000 35,000 175,000 90,000
6,000 50 300,000 42,000 210,000 48,000

Whole Company
Output Level
(Units) SP TotalCompanyCompany
Revenues Variable cost Contribution
N N @N18 N

1,000 100 100,000 18,000 82,000

2,000 90 180,000 36,000 144,000
3,000 80 240,000 54,000 186,000
4,000 70 280,000 72,000 208,000
5,000 60 300,000 90,000 210,000
6,000 50 300,000 108,000 192,000
[b] Based on the statements in [a] North Division should select a selling price of N80 per unit.
This selling price produces a maximum divisional contribution of N114,000.It is in the best
interest of the company as a whole if a selling price of N60 per unit is selected. If North division
selects a selling price of N60 per unit instead of N80 per unit its overall marginal cost would
increase by N84,000 i.e. {2,000×N7) +{N175,000-N105,000}
[c] Where there is no market for the intermediate product and the supplying division has no
capacity constraints, the correct transfer price is the marginal cost of the supplying division for
that output at which marginal cost equals the receiving division’s net marginal revenue from
converting the intermediate product. When unit variable cost is constant and fixed costs remain
unchanged, this rule will result in a transfer price that is equal to the supplying division’s unit
variable cost. Therefore the transfer price will be set at N11 per unit when the variable cost
transfer pricing rule is applied. North Ltd.Will be faced with the following marginal cost and
revenue schedules.
Output (Units) Marginal Cost SP Total Marginal
@N18 Revenue Cost
N N
1,000 18,000 100 100,000 100,000
2,000 18,000 90 180,000 80,000
3,000 18,000 80 240,000 60,000
4,000 18,000 70 280,000 40,000
5,000 18,000 60 300,000 20,000
6,000 18,000 50 300,000 Nil

Note: Marginal cost=Transfer Price of N11 per unit plus conversion variable cost of N7 per unit.
North Ltd. Will select the optimum output level for the group as a whole (i.e.5, 000 units), and
the optimal selling price of #60 will be selected. A transfer price equal to the variable cost per
unit of the supplying division will result in the profits of the group being allocated to North, and
South will incur a loss equal to the fixed costs. Consequently, a divisional profit incentive cannot
be applied to the supplying division.

ILLUSTRATION 4
{a} The Nigerian Government, worried by the rising incidence of Transfer Pricing abuses by
Multinational and Group Companies, issued the Federal Inland Revenue Service (FIRS),Income
Tax (Transfer Pricing Regulations)2012.
Explain FOUR objectives of the guidelines.
[b] On 22 August,2014,your client HYDRO CARBONS OIL & GAS LIMITED ,a subsidiary of
a Multinational Company with head office in Germany, received a letter from the Transfer
Pricing office of the Federal Inland Revenue Service (FIRS) requesting the Company to forward
amongst other requirements the following:
i. The Company’s Transfer Pricing Policy;and
ii. Tranasfer Pricing Disclosure and Declaration Forms.
The Managing Director on reading the contents of the letter became worried as he could not
understand the essence of such requests.
As the Tax Consultant to the Company, you are required to:
• Explain what Transfer Pricing Policy is
• Outline TEN items to be included in the Transfer Pricing Disclosure and Declarations
forms.
SOLUTION
[a] The Income Tax(Transfer Pricing Regulations) 2012 issued by the Federal Inland Revenue
Service and gazetted in September 2012 as Income Tax Transfer Pricing Regulations Act of 2012
stated the objectives as:
{i} To ensure that Nigeria is able to tax on an appropriate taxable basis corre4sponding to the
economic activities deployed by taxable persons in Nigeria, included in their transactions and
dealings with associated enterprises.
{ii} To provide the Nigerian authorities the tools to fight tax evasion through over or under-
pricing of controlled transactions between associated enterprises.
{iii} To reduce the risk of economic double taxation.
{iv} To provide a level playing field between multinational enterprises and independent
enterprises doing business within Nigeria;and
{v} To provide taxable persons with certainty of transfer pricing treatment in Nigeria.

[b] HYDRO CARBONS OIL & GAS LIMITED

{i} Transfer Pricing Policy
This is a document required to be filed with the Transfer Pricing Unit of the FIRS. It contains
information that guides the conduct of related parties’ transactions within a group of Companies.
There are two types of Transfer Pricing Policies namely:
i.Group Transfer Pricing Policy
ii.Local Transfer Pricing Policy.
{ii] TRANSFER PRICING DISCOSURE AND DECLARATION FORMS CONTENTS
FOR SUBMISSION TO THE FIRS
The FIRS also requires affected Companies, in addition to developing appropriate Transfer
Pricing Policies, to provide relevant information in specified manner in Transfer Pricing
Disclosure and Declaration Forms which must contain the following:
1. Particulars of reporting companies or Entity.
2. Particulars of immediate Parent Companies
3. Particulars of Directors of Reporting Companies.
4. Particulars of five major Shareholders of Reporting Companies and Related Parties.
5. Ownership Structure of Reporting Entity and Related Parties.
6. Particulars of External Auditors of reporting entity.
7. Particulars of Subsidiary and other other connected companies.
8.Particulars of Tax Consultants of the reporting entity.
9.Particulars of Company Secretary of the reporting entity.
10.Particulars of the person making the declaration.