Professional Documents
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Marshall School of Business
Marshall School of Business
Marshall School of Business
Purpose of Case
This case was written to illustrate a transfer pricing problem in a service
setting, here an
investment management company. The issues and solutions are not as
obvious as in a
manufacturing setting where one division produces parts that are
transferred to another division
for further processing.
The case is a disguised version of a real conflict in which emotions were
running high.
The case exposes students to a broad range of issues that can be raised
when negotiating transfer
pricing. These include cost allocation methods, managers’ interests and
perceptions,
organizational roles and conflicts, taxes, ownership structure and manager
compensation, and
ethics. The case also illustrates that there are often no obvious, clean
solutions to transfer
pricing problems.
Case Analysis
The Company’s Profit Model
Addressing the transfer pricing problem requires an understanding of how
Global
Investors (GI) creates value. The basic business model is essentially as
follows:
1. Sales to institutional investors were done primarily by corporate sales
staff. Almost all
sales to individual investors were made by independent broker/dealers.
2. Deciding how to invest the clients’ money was largely a centralized
function performed
by highly-trained specialists in New York or contractors hired by
corporate. The local
subsidiaries had people who traded financial assets following
headquarters’ guidelines.
3. Some corporate specialists focused on improving cost efficiencies, such
as by
generating economies of scale in trading activities and by improved use of
technology.
But then the situation gets a bit muddled:
1. Client service was largely a local function. If the client was based in the
UK, the service
was performed primarily by the London office.
2. Two of the subsidiaries—those based in Tokyo and London—had built
up small staffs
of advisors who specialized in providing investment advice for clients
wanting to invest
locally and who developed local funds which did not necessarily follow
the investment
strategies developed by headquarters.
But in all cases, local clients were assigned a New York-based client
service contact and
received investment information from GI headquarters. This raises the
question, then, of how
much value is being provided by the local subsidiaries vs. headquarters? It
is difficult to tell
without doing a study. The relative value created by each function and
each location could vary
markedly across clients.
Transfer Pricing Alternatives
Alternative 1—Current transfer pricing system
The case states that GI’s current measurement system treated the
subsidiaries as costfocused profit centers, instead of mere cost centers,
because each is assigned a revenue figure
(Reimbursement from Parent) that provides a 110% reimbursement of
their direct controllable
costs. Thus, on the operating income line, each subsidiary looks like it is
earning a profit (see
case Exhibit 5).
The current measurement system provided some real advantages for GI. It
ensured that
the subsidiaries would look financially sound to local regulators and
clients. It gave the
impression to tax authorities that each subsidiary was earning a profit. And
it was simple.
But the current system had some drawbacks. Alistair Hoskins, CEO of the
London
subsidiary, was the most vocal in pressing for change. He seemed to have
several concerns. He
was concerned that if the London subsidiary was ever sold, it might be
valued simply at a
multiple of earnings or earnings before interest, tax, depreciation and
amortization (EBITDA).
He believed that the subsidiary generated more profit than it was given
credit for. He was also
concerned that GI would face serious consequences if the local regulatory
authorities learned
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© Pearson Education Limited 2007
Kenneth A. Merchant and Wim A. Van der Stede, Management Control
Systems, 2nd Edition,
Instructor’s Manual
that the subsidiaries’ real profits were higher than were being reported. To
date, GI had never
had to undergo a tax audit, so the tax authorities had never detected this
problem.1
The transfer pricing alternatives proposed, which are outlined in detail in
the case, are
remarkable in their arbitrariness.
Alternative 2—Hoskins’ first proposal
Hoskins’ first proposal was to allocate revenues to subsidiaries based on a
proportion of
the assets under management and to have the subsidiaries pay corporate a
royalty of 50% of
revenues for the use of their trading strategy advice. No justification was
provided for the 50%
royalty rate. This measurement method would make all the subsidiaries
look hugely profitable.
That, in itself, would provide some tax savings for GI because the New
York tax rates were
higher than those GI faced in any other tax jurisdiction.
Alternative 3—Davis’ first proposal
Jack Davis, the corporate Operations VP, rejected Hoskins’ method. He
argued that to a
large extent the subsidiaries were just following instructions from
headquarters. And, further,
many of the funds the subsidiaries were managing belonged to New York
clients. He proposed
instead to allocate revenues based on the origin of the clients, not the
current location providing
the service. This transfer pricing method would cause all the subsidiaries
to report large losses
on their operating income line.
Alternative 4—Hoskins’ second proposal
Hoskins then did some industry benchmarking and found that the
“industry standard”
was to split fee revenues equally between Client Services and Investment
Management. We
inquired GI management as to the rationale behind this standard, and no
one could explain it to
us. The primary rationale seemed to be a general recognition that both
functions created value,
but that it was too difficult or too costly to measure the relative proportions
of value creation.
Hoskins interpreted the method to mean that the Client Service revenue
should be allocated
based on the origin of the clients, and the Investment Management revenue
should be allocated
based on a proportion of the assets being managed. He proposed still to
pay a 50% royalty to
corporate for the Investment Management revenue. This alternative, too,
would have made each
subsidiary look quite profitable.
Alternative 5—Davis’ second proposal
Davis’ counter-proposal tweaked with this 50–50 proposal. He proposed to
leave all of
the Investment Management revenue in New York, since the investment
strategies were almost
exclusively developed at headquarters. But the subsidiaries would be
reimbursed for their
Investment Management-related costs, plus a 10% mark-up. This alternate
would have caused
most of the subsidiaries, including London, to report losses, as is shown in
case Exhibit 6. Not
surprisingly, Hoskins rejected this approach.
1
This was a significant business risk for GI because if an audit would take
place, the authorities would
learn that the profits earned in each tax jurisdiction were not being
generated by a series of “arm’s-length
transactions”. Is it ethical for GI managers to be willing to report clearly
flawed measures and to tolerate
this risk?
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© Pearson Education Limited 2007
Kenneth A. Merchant and Wim A. Van der Stede, Management Control
Systems, 2nd Edition,
Instructor’s Manual
Other Alternatives
Many more possibilities can be discussed. It might be productive to
entertain student
options and to see how those other transfer pricing options impact the
operating income reported
by the subsidiaries (modifying case Exhibit 5). Here are some alternatives
that students might
suggest:
• Utilize Hoskins’ second proposal, but allow for the negotiation of the
royalty rate
provided to headquarters for their trading strategy advice. Royalty rate
adjustments
could be based on the degree of customization of the trading strategies to
local client
needs.
• Utilize Davis’ second proposal, but give the subsidiaries full recognition
of the
investment management revenue generated by the local funds that follow
trading
strategies that differ from those developed at the headquarters.
• Recognize the full revenue at the subsidiary level and search for market
data (such as
the Lipper data for investment management and sub-advisory fees) to
determine the rate
that the subsidiaries should pay to the headquarters for their investment
strategies and
advisory services.2 This method also would provide evidence of an arm’s-
length
relationship. But would such an approach be (too) costly to implement
(such as due to
extensive benchmarking data collection efforts)?
Sidebar
If instructors wish, and time permits, students could also be asked to
discuss the cost
allocations from cost centers to business units. Useful proposals might
include the following:
• Allocate costs directly from cost centers to business units, once only
(thus eliminating
allocations from cost centers to cost centers). This should simplify the
calculations and
remove the need for using the more complex reciprocal allocation method
to arrive at
the final cost allocations to each business unit.
• Rather than rely on the individual judgment of cost center managers,
base cost center
allocations on actual business unit usage, which could be documented in a
Service
Level Agreement (SLA) between the cost center and the affected business
units. An
added feature of SLAs is that they could be used as part of the due
diligence process for
the Global Transfer Pricing taxation review by GI’s auditor, which must be
carried out
before the arrangements are finalized, to ensure the taxation consequences
are
satisfactorily dealt with.
The first proposal emphasizes simplification; the second one
documentation for tax
compliance.
In addressing Suggested Assignment Question No. 1, it is important to
have the
students recognize all of the purposes served by the company’s
performance measurement
system and, in particular, its transfer pricing system, including:
2
http://www.lipperweb.com/products/prod_category_list.asp.
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© Pearson Education Limited 2007
Kenneth A. Merchant and Wim A. Van der Stede, Management Control
Systems, 2nd Edition,
Instructor’s Manual
Pedagogy
As with most case classes, instructors must make a decision as to how
structured to
make the class. With an experienced group of students, just asking the
suggested assignment
questions should stimulate an active discussion. With a less experienced
group, the instructor
may want to address the points raised in this teaching note in order.
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