Transfer Pricing

Transfer Pricing

Transfer Pricing

• A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization.

• Intermediate products are the products transferred between subunits of an organization.

Transfer Pricing

• Transfer pricing should help achieve a company’s strategies and goals.

– fit the organization’s structure

– promote goal congruence

– promote a sustained high level of

management effort

Transfer Pricing and E-commerce

• Intra-company transfer pricing: an enterprise provides goods or services through a branch situated in a different country, using an electronic communications network (Internet or Intranet): e-commerce, e-tailing;

• Inter-companies transfer pricing: two companies that are part of the same group (holding-subsidiary, subsidiary-subsidiary) and that are located in different jurisdictions enter into an e-commerce transaction directed to trade goods or services.

Transfer Pricing Trends and Focus

• Trends:• Increase of Audits in Europe’s large economies• Specific issues for emerging economies• Intangibles and cost sharing agreements (CCA)• Enforcement and Advance Pricing Agreements (APA)• Documentation and penalties

• Transfer Pricing Focus:• Restructuring of business models• Use of low tax jurisdictions• Low margin and loss making businesses• Outbound payments for royalties/service (intangibles)• Use of international comparables

Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices


• Transfer prices are based on market prices. When there is a perfectly competitive market for the goods and services that are bought and sold between divisions of an organization, the transfer price should be the market price.

• The transfer price may be slightly lower than the market price if the selling expenses are lower for interdivisional transfers, e.g. because there is no advertising cost for transfers between divisions.

• There is a problem for managers in that market prices may fluctuate.

• Transferring products or services at market prices generally leads to optimal discussion where three conditions are satisfied

The market for the intermediate products is perfectly competitive

Inter dependencies of sub units are minimal There are no additional cost or benefits to the

company as a whole from buying or selling in the external market , instead of transacting internally



• Advantages– Forces selling division to be competitive with

market conditions– Does not penalize buying division by charging

a price greater than it would have to pay on the market


• Disadvantages– May lead selling division to ignore negotiation

attempts from buying division and sell directly to outside customers

• Could cause an internal shortage of materials• Forces buying division to purchase materials from

the outside• Overall company profits may fall even though

selling division makes a profit

Cost-Based Pricing Methods

• Managers can develop a price based on the cost of producing the product or service– If prices do not cover costs, the company will

fail

• Two pricing methods based on cost– Gross margin pricing– Return on assets pricing

Cost-Based Pricing Methods (cont’d)The Energeez Company buys parts from outside vendors and assembles them into portable solar panels. In the previous period, the company produced 14,750 solar panels.

Total costs and unit costs incurred were as follows

No changes in unit costs are expected this period. Desired profit for the period is $110,625. The company uses assets in producing the panels and expects a 14% return on those assets

Gross Margin Pricing• Gross margin

– The difference between sales and the total production costs of those sales

• Gross margin pricing– Cost-based pricing approach

• Price is computed using a markup percentage based on a product’s total production costs

• Markup percentage – Designed to include all costs other than those used in

the computation of gross margin– Composed of selling, general, and administrative

expenses and the desired profit

Gross Margin Pricing (cont’d)

• This method can be easily applied– An accounting system often provides

management with production cost data

Return on Assets Pricing

• Based on earning a profit equal to a specified rate of return on assets employed in the operation– Focuses on a desired minimum rate of return on

assets

• Also called the balance sheet approach to pricing

Return on Assets Pricing (cont’d)

Negotiated Transfer Prices

Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.

• Where subunits of a firm are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties

• May or may not bear any resemblance to cost or market data

• Often used when market prices are volatile

• Represent the outcome of a bargaining process between the selling and buying subunits

Negotiated Transfer PricesAdvantages• Autonomy Decentralisation• Better information about costs and benefits • Most appropriate where there are market imperfections for

the intermediate product and when managers have equal bargaining power.

• To be effective, managers must understand how to use cost and revenue information.

Limitations:• Can lead to sub-optimal decisions• Time - consuming• Divisional profitability may be strongly influenced by the

bargaining skills and powers of the divisional managers.

Comparison of Transfer-Pricing Methods

Criteria Market-Based

Cost- Based Negotiated

Achieves Goal Congruence

Yes, when markets are competitive

Often, but not always

Yes

Useful for Evaluating

Subunit Performance


Difficult unless transfer price

exceeds full cost and even then is

somewhat arbitrary

Yes, but transfer prices are affected

by bargaining strengths of the

buying and selling divisions




Motivates Management

Effort

Yes Yes, when based on budgeted costs;

less incentive to control costs if

transfers are based on actual costs

Yes

Preserves Subunit Autonomy


No, because it is rule-based

Yes, because it is based on

negotiations between subunits




Other Factors No market may exist or

markets may be imperfect or

in distress

Useful for determining full cost of

products; easy to implement

Bargaining and negotiations take

time and may need to be reviewed

repeatedly as conditions

change

Transfer Pricing Strategy

Pricing of goods, services, and intangible property bought and sold by operating units or divisions of a company doing business with an affiliate in another jurisdiction.

Transfer Pricing Strategy

Four arrangements for pricing goods for intra-company transfer are as follows:

1. Sales at the local manufacturing cost plus a standard markup

2. Sales at the cost of the most efficient producer in the company plus a standard markup

3. Sales at negotiated prices4. Arm’s-length sales using the same prices as

quoted to independent customers

Benefits of Transfer Pricing Strategy

1. Lowering duty costs by shipping goods into high-tariff countries at minimal transfer prices so that duty base and duty are low

2. Reducing income taxes in high-tax countries by overpricing goods transferred to units in such countries; profits are eliminated and shifted to low-tax countries

3. Facilitating dividend repatriation when dividend repatriation is curtailed by government policy by inflating prices of goods transferred

Transfer Pricing Risks

• Economic Double Taxation– Competent Authority Process

• Income Adjustments• Penalties and Interest• Internal Defence Costs

– Management Time– Staff Attrition

• Advisor Defence Costs• Revenue Authority Information Sharing

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Documents

Transfer Pricing