Transfer Pricing (TP)

P. GURU PRASAD
FACULTY
INC GUNTUR
Evaluating Management Control Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary
The concept of Transfer Pricing

A transfer price is the internal price

charged by a selling department,
division, or subsidiary of a company for a
raw material, component, or finished
good or service which is supplied to a
buying department, division , or
subsidiary of the same company.
Transfer Prices

 The concept of transfer pricing is

fundamentally aimed at simulating
external market conditions within the
organization so that the managers of
individual business units are motivated
to perform well
Purpose of Transfer Pricing

Multinational companies use transfer

pricing to minimize their worldwide
taxes, duties, and tariffs.
Transfers at Cost

 About half of the major companies in the

world transfer items at cost.
Transfer Pricing
 Many organizations set up business units that
cater to the needs of other business units
within their own fold. For example, one
business unit may manufacture components
that are used by another business unit to
assemble the final product.
 Here , there is a transfer of goods from the first
business to the second and the concept of
transfer pricing comes into play.
Transfer Pricing
 Decentralization is one of the approaches that
many large organizations use to attain
operational effectiveness. However , the main
challenges in operating in a decentralized
manner lie in designing responsibility
structures and formulating appropriate policies
and methods to determine the performance of
the responsibility centers.
 The technique of transfer pricing plays an
important role in the smooth functioning of
responsibility structures in such an
organization
Objectives of TP policy
 Goal congruence:- the divisional
manager in maximizing the profits of his
division, should not engage in decision-
making that fails to optimize the
organization’s performance.
 Performance appraisal :-it should aid in
reliable and objective assessment of the
value added activities by profit centers
toward the organization as a whole.
Objectives of TP policy

 Divisional autonomy:- each divisional

manger should be free to satisfy the
requirements of his profit center from
internal or external sources. There
should be no interference in the process
by other divisions like buying centers
and selling centers.
General Appliance Corporation case study

 The GAC was an integrated manufacturer of all

types of home appliances. The company had a
decentralized , divisional organization consisting
of four product divisions , four manufacturing
divisions, and six staff offices.
 Each division and staff office was headed by a
vice president. The staff offices had functional
authority over their counterparts in the divisions,
but they had no direct line authority over the
divisional general managers.
General Appliance Corporation case study

 The product division designed, engineered,

assembled , and sold various home appliances.
They manufactured very few components parts,
rather , they assembled the appliances from
parts purchased either from the manufacturing
divisions or from outside vendors.
 The manufacturing divisions made
approximately 75 percent of their sales to the
product divisions. Parts made by the
manufacturing divisions were generally designed
by the product divisions, the manufacturing
divisions merely produced the parts to
specification provided to them
General Appliance Corporation case study

 The divisions were expected to deal with one

another as though they were in dependent
companies. Parts were to be transferred at
prices arrived at by negotiation between the
divisions. These prices generally were based on
the actual prices paid to outside suppliers for the
same or comparable parts.
 These outside prices were adjusted to reflect
differences in design of the outside part from
that of the inside part. In general, the divisions
established prices by negotiation among
themselves, but if the divisions could not agree
on a price, they could submit the dispute to the
finance staff for arbitration
Arm's length transaction

 Definition
A transaction between two related or
affiliated parties that is conducted as if
they were unrelated, so that there is no
question of a conflict of interest. Or
sometimes, a transaction between two
otherwise unrelated or affiliated parties.
Organizational chart Board of Directors
Of
GAC
president

Finance Engineering Manufacturing Industrial Purchasing Marketing

staff staff staff Relations staff staff staff

Group vice president Group vice president

Manufacturing divisions Product divisions

Chrome Laundry
Electric Electric
Product Equipment
Motor Stove
division division
division division
Gear Miscellaneous
And Stamping Refrigerating Appliance
Transmission division division division
division
Minimize Tax Liability
 For organizations operating in many countries,
internal transfer pricing can be a determinant
of where profits are to be declared and taxes
paid. The fact that different countries have
different tax and exchange rates has to be
taken into consideration case of transactions
with sister concerns that supply intermediary
products.
 Ideally the transfer pricing policy should
enable multinational corporations to minimize
tax liability
TP objective in International Business

Manage exchange rate fluctuations

Handle competitive pressures
Reduce the impact of taxes and
tariffs
Movement of funds between
countries
Manage Exchange Rate Fluctuations

 MNCs can reduce exchange rate risks by

transfer pricing, when the currency of a
country depreciates, the purchasing power of
that currency declines. Therefore
organizations based in that country may have
to pay more for imports.
 On the contrary, if the currency appreciates,
the revenues from exports will fall for
organizations based in that country. But
MNCs can depend on their subsidiaries for
imports and exports and use transfer prices to
manage exchange rate fluctuations.
Handle Competitive Pressures
 The subsidiaries of an organization operating
in different countries can use transfer pricing
to lower prices to match local completion. For
example, garment manufactures in Europe
depend mainly on china, Japan , and India for
silk .
 Therefore, if an organization has subsidiaries
in these countries, it may mange to get silk at
a lower cost by transfer pricing. Thus , it will be
able to reduce the price of the finished product
to match or undercut local competition
Reduce the Impact of Taxes and Tariffs

 Many MNCs make use of transfer pricing to

reduce their total tax liability,. Organizations try
to maximize profits in countries where
corporate taxes are lower, thus reducing the
tax liability of the organizations a whole.
 For example, the exporting business unit can
quote a lower selling price. This will result in
lower tariffs for the importing business unit,
since most duties are levied on the value of
goods imported.
Movement of Funds between Countries

 The MNCs may prefer to invest its funds in

one country rather than another. Transfer
pricing provides an indirect way of shifting
funds into or out of a particular country.
 While trying to achieve these objectives
specific to international business, disputes
may arise between the multinational
corporations and the tax authorities in different
countries
Factors Influencing TP
 The conditions necessary for the development
of a proper mechanism of TP are
 Role definition
 External advisers
 Competent mangers
 Equity,
 Information on the prevailing market prices
 And proper investment
Methods of Calculating TP

 Market based pricing method

 Cost based pricing method
 Negotiated pricing method
 Resale price method
 Alternative methods
Transfer Pricing Methods (1)
When choosing the best transfer pricing method, the
available methods should be considered in the
following order:

1. Comparable Uncontrolled Price (CUP);

2. Resale Price or Cost Plus (C+);

3. Profit Split or Transactional Net Margin (TNM).

24
Market-Based Transfer Prices

If there is a competitive market for the product

or service being transferred internally, using
the market price as a transfer price will
generally lead to the desired goal
congruence and managerial effort.
Market-Based Transfer Prices

 The major drawback to market-based

prices is that market prices are not
always available for items transferred
internally.
Market Based Pricing Method
 An organization X in India that sells textile fiber
to its subsidiary organization Y in Bangladesh.
If the rate charged by X in India is the same as
the current market price – as if the transaction
is taking place between two unrelated
organizations – then the method of estimating
transfer pricing is know as market based
pricing method or the comparable uncontrolled
price (CUP)- Ranbaxy and Cipla follow the cup
method
Transfers at Cost

What are some examples?

Full cost plus a profit markup
Variable costs
Standard costs
Actual costs
Full cost
Cost Based Pricing Method

 Indianorganization X sells textile fiber to

its subsidiary Y in Bangladesh and the
rate charged by X is the total cost of
manufacturing the fiber plus some
margin or mark-up percentage, then this
method of estimating the transfer price is
known as cost-based transfer pricing
Negotiated Transfer Prices

 Companies heavily
committed to segment
autonomy often allow
managers to negotiate
transfer prices.
Negotiated Pricing Method

 The buying and selling divisions

negotiate a mutually acceptable transfer
price. Since each division is responsible
for its own performance, this will
encourage cost minimization and
encourage the parties to seek a transfer
price that yields them an appropriate
return.
Resale Price Method
 The resale price method is similar to the
cost based pricing method. In this
method, the transfer price is determined
by calculating back from the transition
taking place at the next level of the
supply chain, by deducting a suitable
mark-up from the price at which the
internal buyer sells the item to an
unrelated third party.
Alternative Methods

A petroleum company has three divisions:

the crude oil division, the refinery division,
and the sales division. The crude oil
division extracts the crude oil and sells it
to the refinery division, which refines the
crude through a process of fractional
distillation. The output of the refinery is
then sold in the market by the sale
division.
Alternative Methods
 In this situation, the sales division may
underestimate the costs incurred during
extraction and processing. So it might sell the
final product at a price that is not high enough
to recover fixed costs. Due to this the sales
division may earn revenues but the company
as a whole may incur losses. In order to
prevent these kinds of problems, such
companies adopt some other methods of
calculating transfer price like two step method,
profit sharing and two sets of process methods
Alternative Methods

 Two step pricing:- fixed cost component and

variable cost component. In a transaction of
goods between two divisions, the cost of
production for the selling division is Rs. X per
unit and the fixed cost per month is Rs. Y and
the margin decided is Rs. Z per month. If “n”
units of these goods are sold, then the transfer
price for the month will be (nX+Y+Z). Or if the
margin is included with the variable component,
say Rs. A per unit, then the transfer price will be
(nX+nA+Y).
Alternative Methods
 Profit sharing or split method:- all the
business units share the operating profit.
 Two sets of pricing:- revenue is
credited to the manufacturing unit at the
market sales price while the buying unit
is charged for the total standard costs.
The difference between the outside
sales price and the standard cost is
charged to the parent firm’s account
Variable-Cost Pricing

In situations where idle capacity exists,

variable cost would generally be the
better basis for transfer pricing and
would lead to the optimum decision
for the firm as a whole.
Variable-Cost Pricing

 When market prices cannot be used,

versions of “cost-plus-a-profit” are often
used as a fair substitute.
Transfer Pricing Methods (2)
Type of Transaction Possible method
Manufacturing of goods CUP, C+, Profit split

Sale of goods CUP, Resale price,

Profit split, TNM
Provision of services CUP, C+, TNM

Financing (loans, deposits, CUP, Profit split, TNM

guarantees)
Transfer of intangibles CUP, C+
(technology, brand, know –how)

39
Implementing the TP

 Articulation and communication of the

transfer pricing strategy
 Documentation of the TP process and
inter-organization agreements
 Involvement of multi-disciplinary team
 Negotiation and conflict resolution
Potential Misuse of TP

 TP is a very important issue from the

point of view of management control.
The firms can misuse TP to minimize
their tax liabilities, as well as to project a
wrong image about their financial health
and thus mislead the stakeholders.
The Indian Perspective
 Liberalization of the Indian economy has
led to a phenomenal growth in the
industrial and services sector. Due to
the availability of cheap skilled labor,
India has become a favorite destination
for labor-intensive service industries like
BPO and software. This has resulted in
increased cross border related party
transactions between India and other
nations.
TP Tax Guidelines

 This has made transfer pricing very important

from the taxation point of view. The Indian
government has introduced detailed transfer
pricing regulations with effect from April ,2001, to
reduce tax avoidance by organizations operating
in India.
 The regulations have largely been designed
along the lines of the Transfer Pricing Guidelines
issued by the Organization for Economic
Cooperation and Development (OECD).
The GlaxoSmithKline TP Dispute

 The US Internal Revenue Service (IRS)

demanded back taxes from GSK, a large UK-
based drug manufacturer, for misusing transfer
pricing to minimize its tax liabilities to the US
government.
 The US affiliate of the company charge with
overpaying for product supplies during the
period 1989 to 2000 and in subsequent year,
while at the same time charging lower rates for
the marketing services that it supplied, thus
understating GSK’s income subjected to Us
taxation during the period.
The GlaxoSmithKline TP Dispute

 The IRS wanted the pharmaceutical Giant to pay

taxes, penalties and interest.
 The dispute was to go to trail in February 2007.
according to experts, the IRS’s decision to take
GSK to court was a manifestation of the new
thinking in transfer pricing regulations proposed
by the IRS in September 2003.
 GSK decided to settle the issue to avoid future
fund outflow toward legal proceedings. On
September 11, 2006, GSK announced that it
was settling the dispute by paying $3.1 billion to
the IRS.
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