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Chapter 9

International Transfer Pricing

Timothy Doupnik | Mark Finn Giorgio Gotti

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill
 Learning Objectives 1

• Describe the importance of transfer pricing in achieving

goal congruence in decentralized organizations.
• Explain how the objectives of performance evaluation and
cost minimization can conflict in determining international
transfer prices.
• Show how discretionary transfer pricing can be used to
achieve specific cost minimization objectives.
• Describe governments’ reaction to the use of discretionary
transfer pricing by multinational companies.
• Discuss the transfer pricing methods used in sales of
tangible property.

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 Learning Objectives 2

• Explain how advance pricing agreements can be used to

create certainty in transfer pricing.
• Describe worldwide efforts to enforce transfer pricing
regulations.

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 Introduction 1

Transfer pricing: the determination of the price at which

transactions between related parties will be carried out
• Transfers between related parties are also referred to as
intercompany transactions.
Upstream transfers go from subsidiary to parent, while
downstream transfers are from parent to subsidiary
Transfers also occur between different subsidiaries of the
same parent
A significant proportion of international transactions are
intercompany transfers
• In 2020, they comprised 42.6% of U.S. total goods trade.

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 Introduction 2

Two factors that influence transfer price:

1. Headquarters’ objectives.
• Management control and performance evaluation.
• Minimization of one or more types of costs.
• Sometimes these objectives conflict.

2. Laws
• Governing the manner in which intercompany transactions
that cross borders may be priced.
• Countries have set up laws to make sure multinational
corporations (MNCs) don’t avoid paying their fair share of
taxes.

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 Introduction 3

2. Laws (continued)
• 78% of companies identified tax risk as the most critical
issue driving transfer pricing policies.
• 80% of companies claim to have experienced
government challenges to their transfer pricing policy.

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 Decentralization and Goal Congruence
Decentralized companies are organized by division and division
managers have significant authority
• Decomposes problems into smaller pieces.
• Permits local decision making, which provides more responsibility and
motivation for division managers.
• Agency-wide problems can occur since division managers make
decisions in their self-interest, which can differ from the best interests
of the company.
• An effective accounting system can alleviate this problem by providing
incentives to division managers to act in the interests of the organization.
• This is referred to as goal congruence

• These concepts are relevant to both multinational and purely domestic

companies.

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 Transfer Pricing Methods 1

Three commonly used methods:

1. Cost-based transfer price: the transfer price is based on
the cost to produce.

• Could include fixed costs and possibly a markup (a “cost-

plus” price).
• Potential problems:
• What cost to use (variable cost, standard cost, absorption cost,
etc ).
etera

• No incentive for selling division to manage costs.

• Standard costing can help address this problem.

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 Transfer Pricing Methods 2

2. Market-based transfer price: the transfer price is based on

the price that would be charged to unrelated parties, or it
is determined by reference to sales of similar products by
other companies.
• Avoids inefficiencies of one division impacting other divisions
• Helps ensure divisional autonomy.
• Must have an efficient market to get “good” market price.
• Unfinished or unique items may not have a market price.

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 Transfer Pricing Methods 3

3. Negotiated price: the transfer price is the result of

negotiation between “buyer” and “seller”.
• Preserves autonomy of divisions.
• Must have an external market.
• Can take a long time to get negotiated price.
• Agreed upon price may reduce overall production.

A 1990 survey found that 41% of Fortune 500 companies

used cost-based methods, 46% used market-based, and
13% used negotiation

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 Objectives of International Transfer Pricing

Two possible objectives:

1. Performance evaluation.
2. Cost minimization.
Performance evaluation:
• 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.

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 Cost Minimization
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 jurisdictions.
• Another approach is to avoid withholding taxes.
• Rather than have interest, dividends, and royalties from subsidiary,
have profit from the sale of products.
• High selling price from parent to subsidiary; low selling price from
subsidiary to parent.

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 Other Cost-Minimization Objectives
Minimize import duties through low import prices
Circumvent profit repatriation restrictions
• Some countries have limits on the amount a subsidiary can
transfer out of the country to a foreign parent.
• Reduces income of subsidiary and increases income of parent.

Protection of cash flow from currency devaluation

• High transfer price pulls currency away from weak currency.

Improvement of the foreign operation’s competitiveness

• Use low transfer price to reduce “cost” to foreign operation, thus
giving an advantage versus foreign local competitors.
Improve credit status of subsidiary by shifting income to subsidiary

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 Interaction of Transfer Pricing Method and
Objectives
1. Cost-based methods are preferred when the following 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 are preferred when the following

are important:
• Interests of local partners (N CI of subsidiary).
• Good relationship with local (foreign) government.

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 Government Reactions
OECD guidelines
• Basic rule: transfers must be at “arm’s-length prices”.
• Need to document “arm’s-length” nature of price.

• OECD rules are only a model and don’t have any legal
force, but most developed countries use this model.
• OECD “Transfer Pricing Documentation and Country-by-
Country Reporting” (CbC) is a part of BEPS.
• 81 countries have adopted CbC, including the U.S., China,
Japan, and the European Union.

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 U.S. Transfer Pricing Rules
The IRS has the authority to audit international transfer prices and adjust
income (and, therefore, taxes)
The IRS requires “arm’s-length” prices for transfers
Must use “best-method rule”: the given circumstances provides the most
reliable measure of an “arm’s-length” price
• Two factors to get “best-method rule”.
1. The degree of comparability between the intercompany transaction and
any comparable uncontrolled transactions.
• Functions performed by the various parties in the transaction.
• Contractual terms that could affect the results.
• Risks that could affect the prices.
• Economic conditions that could affect the price or profit earned.
• Property or services transferred in the transactions.

2. The quality of the data and assumptions used in the analysis.

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 Sale of Tangible Property 1

• Requires the use of one of five methods:

1. Comparable uncontrolled price method.
• Generally considered the most reliable.
• Reference to sales of same or similar product to unrelated party.
• A sale between two unrelated parties can also be used.

2. Resale price method.

• Subtract appropriate gross profit from price at which controlled buyer resells the
tangible property.
• Generally used when buyer/seller is basically a distributor.
• Not appropriate if reseller adds substantial value to the goods ultimately sold.

3. Cost-plus Method.
• Most appropriate when there are no comparable uncontrolled sales, and the
related buyer adds value to the tangible asset.
• Add appropriate gross profit to the cost of producing the product.

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 Sale of Tangible Property 2

4. Comparable profits method.

• Similarly situated taxpayers will tend to earn similar returns over a
given period.
• One of the two parties in a related transaction is chosen for
examination.
• “Arm’s-length” price is determined by an objective measure of
profitability earned by uncontrolled taxpayers on uncontrolled sales.
• Look at the ratio of:
• Operating income to assets.
• Gross profit to operating expenses.
• Operating profit to sales.
• The Treasury Regulations allow:
• The ratio of operating profit to operating assets, and gross profit to
operating expenses.

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 Sale of Tangible Property 3

5. Profit split method: assumes that the buyer and seller are one
economic unit.
• Profit allocated based on relative contribution to earning profit
• Based on:
• Functions performed.
• Risks assumed.
• Resources employed.
• Two versions:
1. Comparable profit split method
• Operating profit earned by each division.

2. Residual profit split method.

• Two steps:

1. Market return.
2. Allocate profit attributable to intangibles.

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 Licenses of Intangible Property 1

Six categories of intangible property:

1. Patents, inventions, formulae, know-how, designs.
2. Copyrights and literary musical, or artistic compositions.
3. Trademarks, tradenames, brand names.
4. Franchises, licenses, or contracts.
5. Methods, programs, systems, procedures.
6. Other: any item that derives its value from its intellectual
content.

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 Licenses of Intangible Property 2

Four methods for determining the arm’s-length consideration:

1. Comparable uncontrolled transaction method.
• Refers to the amount it charges an unrelated party for use of the intangible.
2. Comparable profits method.
• Uses the ratio of operating profit to operating assets.
• Compares that ratio to uncontrolled competitors in the same industry.

3. Profit split method

• Uses the ratio of operating profit to operating assets.
• Compares that ratio to uncontrolled competitors in the same industry.

4. Profit split method

• If approved by the IRS.

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 Intercompany Loans
“Arm’s-length” rate of interest
• Factors to consider:
• The principal and duration of the loan.
• The security involved.
• The credit standing of the borrower.
• The prevailing interest rate for comparable loans.

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 Intercompany Services
“Arm’s-length” price
• If the services are incidental, then arm’s-length price is the
direct and indirect costs with no profit.
• If the service is an “integral part” of business function, then
profit must be included along with direct and indirect costs.
• No fee required if the service duplicates an activity.
performed by the related party itself.
• The IRS allows range for “arm’s-length” transactions.

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 Correlative Relief
When the “arm’s-length” price of one government differs from
the “arm’s-length” price of the other government, causing
double taxation of part of a related party transaction:
A. Governments agree on an “arm’s-length” price, or.
B. Competent authorities of the two countries are required to
attempt to come to a compromise.
• With tax treaty, a compromise is usually reached.
• Without a tax treaty, maybe not.

C. U.S. taxpayers can request assistance from the U.S.

Competent Authority, but it is slow and not often beneficial

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 Penalties
• The IRS can impose penalties for underpaying taxes due
to inappropriate transfer pricing.
• The penalty can be either 20 or 40%, depending on the
size of the inappropriate transfer price.

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 Contemporaneous Documentation
Taxpayers must have documentation that justifies the transfer pricing method they
selected
Documentation must include:
1. An overview of the taxpayer’s business.
2. A description of the taxpayer’s organizational structure.
3. Any documentation specifically required by the transfer pricing regulations.
4. A description of the selected pricing method and an explanation of why that
method was used.
5. A description of the other methods considered and why they were rejected.
6. A description of controlled transactions, including the terms of sale and any
data used to analyze those transactions.
7. A description of comparable uncontrolled transactions that were used and
how comparability was evaluated.
8. An explanation of the economic analysis and projections relied upon in
applying the selected transfer pricing method.
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 Reporting Requirements 1

Substantial reporting and record keeping of any U.S.

company that:
a. Has at least one foreign shareholder with a 25% interest in
the company, and.
b. Engages in transactions with that shareholder.
Such companies must file Form 5472 each year

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 Reporting Requirements 2

Country-by-Country Reporting
• Filed along with annual income tax return.
• Required if revenue is $850 million or more.

In Part 1 of Form 8975, must report for each foreign jurisdiction:

• Revenues from transactions with other members of the MNE
group.
• Profit/loss before income tax.
• Income taxes paid and accrued.
• Stated capital, retained earnings, net book value of intangible
assets.
• Number of employees.

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 Reporting Requirements 3

In Part 2 of Form 8975, must report:

• Tax jurisdiction.
• Main business activities of each constituent entity.

The IRS shares this information with tax authorities in other

jurisdictions

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 Advance Pricing Agreements 1

An agreement between the IRS and the company to apply an

agreed-on transfer pricing method to specified transactions
The IRS will attempt to negotiate the terms of the APA with
foreign taxing authorities, creating a bilateral APA
Five phases of the APA process:
1. Application.
2. Due diligence.
3. Analysis.
4. Discussion and agreement.
5. Drafting, review, and execution.

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 Advance Pricing Agreements 2

Information needed for the application:

1. An explanation of the proposed methodology.
2. A description of the company and its related party’s business operations.
3. An analysis of the company’s competitors.
4. Data on the industry showing prices and rates of return on comparable
transactions.

Can be used by foreign companies with U.S. operations

Advantage of APAs:
• Transfer price will not be challenged by the IRS.

Disadvantages of APAs:
• Time consuming to conduct process.
• Information disclosure.

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 Advance Pricing Agreements 3

Sales of tangible assets are most common with A P A s

• Comparable profit method is the most commonly applied.

Other countries that have adopted APAs:

• Canada.
• France.
• The United Kingdom.
• The Netherlands.
• Australia.
• Brazil.
• China
• Germany.
• Japan.
• Mexico.
• Several others.
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 Enforcement of Transfer Pricing
Regulations
U.S. enforcement has concentrated on foreign companies
with U.S. subsidiaries
• Due to high U.S. tax rates, there is an emphasis on shifting
income out of the U.S.
• Enforcement increases U.S. income, making foreign
income drop, so sometimes foreign government pays part
of the penalty imposed on a foreign company
• Example: Nissan, Toyota.

Domestic companies with foreign subsidiaries are not

exempt from enforcement

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 Worldwide Enforcement 1

Most countries have strengthened transfer pricing rules

• Documentation requirements.
• Increased penalties.

Cost of fighting versus potential savings.

Risk of taxing authorities scrutinizing transfer pricing includes:
• Increased tax liability.
• Potential double taxation.
• Penalties for underpayment of tax.
• Uncertainty with regard to the company’s worldwide tax burden.
• Problems in relationships with local tax authorities.

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 Worldwide Enforcement 2

According to a 2010 Ernst & Young survey:

• More than two-thirds of MNCs had experienced a transfer
pricing audit since 2006.
• One-fourth of audits resulted in adjustment by a tax authority.
• One-fifth of adjustments included penalties.
Transfers and industries at higher risk of audit:
• Imports, more so than exports.
• Royalties.
• Interest.
• Service fees.
• Pharmaceuticals are most at risk, since all three are involved.

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 Worldwide Enforcement 3

Red flags that can increase the chance of an audit:

• Low profits or constant losses.
• Price changes.
• Royalty rate changes.
• Poor relationship with tax authorities.
• Aggressive tax planning.

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