Strategic Management Accounting Group 5

111571 – Kamau, Susan Njoki

112078 – Mutemi, Titus
112068 – Lwanga Josephine
112016 – Kayinja, Patience Babirye
112503 – Patel, Shreya Naresh
113436 – Ngugi, Lydia Wambui
110955 – Njoroge. Hellen
112069 – Telles, Christopher Derek
1 WHAT IS TRANSFER
PRICING?
⬢ Transfer pricing is an accounting and taxation practice that allows for
pricing transactions internally within businesses and between
subsidiaries that operate under common control or ownership. The
transfer pricing practice extends to cross-border transactions as well as
domestic ones.

⬢ A transfer price is used to determine the cost to charge another division,

subsidiary, or holding company for services rendered. Typically, transfer
prices are reflective of the going market price for that good or service.
Transfer pricing can also be applied to intellectual property such as
research, patents, and royalties.

⬢ Multinational corporations (MNC) are legally allowed to use the transfer

pricing method for allocating earnings among their various subsidiary
and affiliate companies that are part of the parent organization. However,
companies at times can also use (or misuse) this practice by altering their
taxable income, thus reducing their overall taxes.
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2 METHODS OF TRANSFER
PRICING
1. Comparable Uncontrolled Price Method
This method is applied in transactions of goods and services with prices of which are
comparable. Using this method, the price applied within the company or between a company
and its subsidiary is compared with:
• the price of a comparable transaction carried out between the company and any other party
not related to the company (the internal price)
• the price of a comparable transaction carried out between two parties unrelated to the
company (external price)
• an aggregated publicly available information on comparable transactions entered into
between unrelated parties (aggregated information on external prices)

2. Resale Price Method

This method is applied to the related-party transactions related to the acquisition of resale
goods if the reseller sells the goods to an unrelated person (a person outside the company and
the company’s subsidiary). Using this method, the resale price margin earned by the reseller in
a transaction carried out between related parties is compared with:
• The profit earned by the reseller on the goods purchased and sold in comparable
uncontrolled transactions (internal comparable transactions)
• or using the resale price margin earned by unrelated parties in uncontrolled transactions
(external comparable transactions)
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3. Cost-Plus Method
This method is applied to the transactions of the seller/manufacturer of goods or provider of
services if the goods are sold, or services provided to a related party. Using the method, the cost
mark-up applied by the seller in the related-party transactions is compared with:
• The cost mark-up applied by the seller in a comparable uncontrolled transaction (internal
comparable transactions)
• The cost mark-up applied by unrelated parties in comparable uncontrolled transactions
(external comparable transactions)

4. Transactional Net Margin Method

This method can be used in place of the resale price method or the cost-plus method. This
happens when the resale price margin or the direct and indirect cost mark-up of the controlled
transaction of unrelated parties has not yielded a sufficiently credible result, which can be
justified with the factors affecting the price (value) of the transaction. Using this method, the
net margin indicator earned by the taxpayer in the controlled transaction is compared:
• with the net margin indicator earned by itself in a comparable uncontrolled transaction
(internal comparable transactions); or
• with the net margin indicator earned by unrelated parties in controlled transactions
(external comparable transactions)

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5. Profit Split Method
This method is applied to mutually dependent transactions if comparable
transactions between unrelated parties may not be identified. It is also applied in
transactions in which several related parties are involved.

Using this method, the overall profit earned by related parties in mutual
transactions is allocated according to the contribution of each party to the
transaction in the creation of value using an economically justified basis. This is
only for those parties involved in the transaction.

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3 EXAMPLES OF HOW TO
USE TRANSFER PRICING
Example 1:
A division of a company is capable of making two products X and Y. They can sell both
products as follows:
X Y
External Selling Price (USD) 100 130
Variable Costs (USD) 80 100
Contribution Per Unit (USD) 20 30
Labour Hours Per Unit 5 10

The company has limited labour hours available, and the other division requires product Y.
What is the minimum transfer price that should be charged by the division to achieve goal
congruence? Solution:

Contribution per hour from X = 20/5 = $4

Contribution per hour from Y = 30/10 = $3

Minimum transfer price = $100 + (10 hours * $4) = $140

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Example 2:
Epsilon has two divisions, P and Q. Division P makes a component which it can only sell to
Division Q. Current information for division P is as follows:
Marginal Cost Per Unit $240
Transfer Price of the Components $396
Total production and sales per year (Units) 4000
Specified Fixed Costs of Division P $24,000

Alpha Co has offered to sell the component to division Q for $350 per unit. I f division Q
accepts this offer; division P will be closed. If Division Q accepts Alpha Co’s offer what will be
the impact on the profits per year for the group as a whole? Solution:

Extra costs if buy from Alpha: 4,000 * (350 - 240) = $440,000

Saving if closing division P = $24,000

Net impact on profits: 440,000 – 24,000

Decrease by $416,000

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 WHAT SHOULD MNCs
4 CONSIDER WHEN USING
TRANSFER PRICES?
1. Appropriately assess your level of transfer pricing risk
Many factors can affect the level of a company’s transfer pricing risk, and it is critical to gain a
clear understanding of where your transfer pricing risk lies in order to mobilize the appropriate
resources to mitigate such risk. Some factors to consider may include: (a) transaction size (b)
nature of the transactions (c) tax attributes of the taxpayer (d) impacted jurisdictions

2. Transfer pricing policy tax-efficiency

While transfer pricing rules can be complex and can impose many documentation
requirements, they present significant opportunities for taxpayers to minimize their tax burden.
In many cases, an economic study will unearth opportunities to adjust transfer pricing practices
in a way that reduces a company's overall global tax burden. Without a thorough analysis, these
opportunities may be lost.

3. Appropriate support for the policy

Taxpayers should ensure they have an appropriate level of documentation to justify their
intercompany pricing. For example, this support may be in the form of a full transfer pricing
study, a benchmarking analysis, or an analysis of certain similar transactions that the taxpayer
enters into with third parties.

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4. Appropriate intercompany agreements
It is very important to memorialize the terms and conditions of various related-party
transactions through formal intercompany agreements in order to mitigate the risk that the tax
authorities will re-characterize the underlying transactions. This is particularly important in
relation to intercompany financing arrangements and licensing of intangible property, as well as
services transactions.

5. Implementing policy in line with your documentation and intercompany agreements

Having a transfer pricing study and intercompany agreements in place is only the starting point.
If a taxpayer's facts are not consistent with the taxpayer's transfer pricing documentation, the
documentation will provide no protection in an audit. Appropriately implementing and ensuring
the accuracy of the facts presented in your study are critical.

6. Considering the impact on other direct and indirect taxes

Not only does transfer pricing impact the income tax position of the taxpayer and the
associated related parties, but it can also impact customs and import duties, withholding taxes
and value-added taxes. Thus, any transfer pricing planning must consider both direct and
indirect obligations of the taxpayer.

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 COMPANIES THAT HAVE
5 USED TRANSFER PRICING
FOR TAX EVASION
1. Apple
Their operations in Europe and Apple sales, internationally signed advance
pricing agreements which allow allocation of taxes to various Irish branches.
The agreements lowered the effective tax rates of these two companies in
Ireland. The agreement included a cost sharing agreement and tax
agreements.

2. Google
They used a tax loop known as a double Irish Dutch sandwich structure to
shield the majority of its international profits from taxation. The involves
transferring revenue from one Irish subsidiary to a Dutch company with no
employees, and then on to a Bermuda-mailbox owned by another company
registered in Ireland. It allowed google to delay paying US taxes and to pay
for lower taxes overseas.

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3. Starbucks
Starbucks UK has over the years given contradictory reports to their
investors and the taxman. Investors are told the company makes profit in a
financial year while a loss is reported in their taxes, they do this to avoid tax
payment in the UK. This is the best performing subsidiary as stated by
Starbucks US yet in some years, it reports no profits and paid no income tax.
A report given by UK CFO stated that at least six percent of their sales come
from payment of royalty fee of their intellectual property which reduces their
tax payments.

4. Coca-Cola
They used transfer pricing as a result of its intercompany license agreements.
It based its transfer price on a settlement and an IRS audit. They are however
claimed to be transferring prices through incorrect transfer prices.

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