Chapter 9. International Transfer Pricing

CHAPTER 9:
TRANSFER PRICING
Hanoi, 2020
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LEARNING OBJECTIVES
1. Describe the importance of transfer pricing in achieving

goal congruence in decentralized organizations
2. Explain how the objectives of performance evaluation
and cost minimization can conflict in determining
international transfer prices
3. Show how discretionary transfer pricing can be used to
achieve specific cost minimization objectives
4. Describe governments’ reaction to the use of
discretionary transfer pricing by multinational
companies.
INTERNATIONAL SCHOOL
INTRODUCTION
Transfer pricing
• Determination of price at which transactions between related
parties will be carried out.
– Upstream transfers go from subsidiary to parent, while
downstream transfers are from parent to subsidiary
– Transfers also occurs between different subsidiaries of the
same parent
– Transfers between related parties are also known as
intercompany transactions
– Significant proportion of international transactions are
intercompany transfers (In 2012, represented 42% of U.S.
total goods trade)
DECENTRALIZATION AND GOAL
CONGRUENCE
• Business enterprises often are organized by division.

• Decentralization has many advantages:
- Allowing local managers to respond quickly to a changing
environment.
- Dividing large, complex problems into manageable pieces.
- Motivating local managers who otherwise will be frustrated
if asked only to implement the decisions of others
• An effective accounting system can alleviate this agency
problem by providing incentives to division managers to act
in the interests of the organization  This is referred to as
goal congruence.
TRANSFER PRICING METHODS
1. Cost-based transfer price: The transfer price is based

on the cost to produce a good or service.
2. Market-based transfer price: The transfer price charged
a related party is either based on the price.
3. Negotiated price: The transfer price is the result of
negotiation between buyer and seller and may be
unrelated to either cost or market value.
Management accounting theory suggests that different

pricing methods are appropriate in different situations.
OBJECTIVES OF INTERNATIONAL
TRANSFER PRICING
There are two possible objectives to consider in determining
the
appropriate: (1) performance evaluation and (2) cost
minimization
(1) Performance evaluation systems
• Transfer prices directly affect the profits of the divisions
involved in an intercompany transaction
• Some are based on divisional profits
• Effectiveness of these is influenced by the fairness of
transfer prices
• Effectiveness of these affects the satisfaction of managers
TRANSFER PRICING
• (1) Performance evaluation systems - example
Alpha Company (a manufacturer) and Beta Company (a
retailer) are both subsidiaries of Parent Company, located in the
United States. Alpha produces DVD players at a cost of $100
each and sells them both to Beta and to unrelated customers.
Beta purchases DVD players from Alpha and from unrelated
suppliers and sells them for $160 each. The total gross profit
earned by both producer and retailer is $60 per DVD player.
Assuming that a transfer price of $130.00 per unit is agreed on
by the managers of Alpha and Beta, the impact on income for
Alpha Company, Beta Company, and Parent Company (after
eliminating the inter company transaction) is as follows:
TRANSFER PRICING
TRANSFER PRICING
• Now assume that Alpha Company is located in Taiwan
and Beta Company is located in the United States.
Taiwan tax rate is 25 percent, U.S. income tax rate of 35
percent, Parent Company would like as much of the
$60.00 gross profit to be earned by Alpha as possible.
Rather than allowing the two managers to negotiate a
price based on external market values, assume that
Parent Company intervenes and establishes a
“discretionary” transfer price of $150.00 per unit.
 The impact of the intercompany transaction on income
for the three companies is as follows:
TRANSFER PRICING
TRANSFER PRICING
(2) Cost minimization
• Profit maximization and, by extension, cost minimization
are important corporate objectives
• Manipulating transfer prices between countries is one
way for multinational enterprises to achieve cost
minimization
– This is referred to as discretionary transfer pricing
• The most common approach is to minimize costs by
shifting profits to lower tax rate jurisdictions
TRANSFER PRICING
(2) Cost minimization – Example

• Padre Inc., a U.S. company, has two subsidiaries, Hijo
and Hija. Hijo is located in Chile and Hija in the U.S. The
tax rate is 17 percent in Chile and 35 percent in the U.S.
Hijo transfers 100 units of cosa to Hija at a negotiated
transfer price of $10 per unit. The cost per unit is $5 for
Hijo, and Hija sells the units in the U.S. at $15 per unit.
Padre intervenes to set the transfer price at $13 per unit.
TRANSFER PRICING
Cost minimization – Example

• Divisional profits under the negotiated transfer
price:
Hijo Hija Padre

Sales $1,000 $1,500 $1,500
Cost of goods sold 500 1,000 500
Gross profit $ 500 $ 500 $1,000
Income tax effect 85 175 260
After-tax profit $ 415 $ 325 $ 740
TRANSFER PRICING

• Divisional profits under the discretionary transfer
price:
Hijo Hija Padre

Sales $1,300 $1,500 $1,500
Cost of goods sold 500 1,300 500
Gross profit $ 800 $ 200 $1,000
Income tax effect 136 70 206
After-tax profit $ 664 $ 130 $ 794
TRANSFER PRICING
• Corporate profits under the discretionary transfer price
are $54 greater relative to the negotiated price
– This results from shifting $300 of pre-tax profits from
the U.S. to Chile
• The overall tax rate decreases from 26 to 20.6 percent
• The performance evaluation objective is better served by
the negotiated transfer price
• The cost minimization objective is better served by the
discretionary price
TRANSFER PRICING
Other cost minimization objectives
• Avoidance of Withholding taxes on dividend
• Minimization of import duties(Tariffs)
• Circumvent Profit Repatriation Restrictions
• Increase cash flows out of a devaluing currency
• Enhance the competitive position of a foreign operation
TRANSFER PRICING
• Cost Minimization Objectives and Transfer Pricing
Interaction of Transfer Pricing Method and
Objectives
1. Cost-based methods of determining transfer prices are
preferred when the following variables are important:
• Differences in income tax rates.
• Minimization of import duties.
• Foreign exchange controls and risks.
• Restrictions on profit repatriation.
• Risk of expropriation and nationalization
2. Market-based methods of determining transfer prices are
preferred when the following variables are important:
• Interests of local partners.
• Good relationship with local government.
GOVERNMENT REACTIONS
• Governments are aware of risk that multinationals will use

transfer pricing to avoid paying income and other taxes
• Most governments publish guidelines regarding
acceptable transfer pricing
• The Organization for Economic Cooperation and
Development (OECD) developed transfer pricing
guidelines in 1979 that have been supplemented or
amended several times since then.
Worldwide Enforcement
• There are a number of documented cases of companies,

both U.S. and foreign, deemed to have underpaid taxes in
the U.S.
• Some of these cases reflect obvious attempts by companies
to evade U.S. taxes by manipulating transfer prices
• In one case, a U.S. subsidiary sold bulldozers to its foreign
parent for $551 each
• From 1998-2005, over 60 percent of U.S. and foreign
multinationals paid no U.S. income tax
• There is a worldwide trend toward strengthening transfer
pricing rules
End of Chapter 9

Chapter 9. International Transfer Pricing

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Chapter 9. International Transfer Pricing

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CHAPTER 9:

1. Describe the importance of transfer pricing in achieving

• Business enterprises often are organized by division.

TRANSFER PRICING METHODS

1. Cost-based transfer price: The transfer price is based

Management accounting theory suggests that different

(2) Cost minimization – Example

Cost minimization – Example

Hijo Hija Padre

Cost minimization – Example

Hijo Hija Padre

• Governments are aware of risk that multinationals will use

• There are a number of documented cases of companies,

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