Corporates the world over are expanding their wings in an effort to gain a share of the global pie. There is talk of the world fast turning into a global village with economies increasingly becoming inter-connected. But with cross-border trade comes a whole new set of problems. Transfer pricing is one of them.

When a company opens a branch in another country, gets its products manufactured there and then imports it, there is a question mark over what price should the parent pay for buying the product from the subsidiary. This price till now has been subject to the parent’s discretion and has been used by many corporates the world over to control the tax outgo to their Government. In effect, the price at which goods are transferred from one arm of the company to another is known as transfer pricing.

The question arises that how the transfer price can be used as a mechanism to evade tax, especially between countries that have a treaty against double taxation. To explain this let’s take an example. Suppose there is an MNC shoe corporation with a subsidiary in India. The Indian subsidiary manufactures shoes at a cost price of Rs 50 per unit and supplies it to the MNC. The MNC sells the same shoes in its own country at Rs 200. To be fair, the transfer price, which the Indian subsidiary should get, is cost plus a reasonable rate of return (i.e. Rs 50 plus). This is where the MNC company calls the shots.

In India, the corporate tax on profits is at 35%. Suppose for the MNC country the rate of tax is 45%.

Case 1.

The MNC decides that Rs 100 is the correct transfer price. Then the scenario looks like this:

Transfer Price at Rs 100Indian subsidiary MNC Grand TotalCost price 50 100  Selling price 100 200  Profit 50 100 150Tax 17.5 45 62.5Net Profit 32.5 55 87.5

The transfer price becomes the cost price for the MNC and thus it earns a profit of Rs 100 per unit. Post tax, its profit is whittled down to Rs 55. Overall, the total profit after tax earned by the MNC (including the subsidiary’s profit) is Rs 87.5 per unit.

Case 2.

The MNC decides that Rs 150 is the correct transfer price. Then the scenario looks like this:

Transfer Price at Rs 150Indian subsidiary MNC Grand TotalCost price 50 150  Selling price 150 200  Profit 100 50 150Tax 35 22.5 57.5Net Profit 65 27.5 92.5

The MNC’s profits post tax in its own country comes down to Rs 27.5. But overall the profit surges to Rs 92.5 per unit.

Case 3. 

The MNC decides that Rs 200 is the correct transfer price. In such a case, the MNC earns zero profits in its own country, but its subsidiary pays a 35% tax on its profit of Rs 150 and thus overall net profit surges to Rs 97.5.

Transfer Price at Rs 200Indian subsidiary MNC Grand TotalCost price 50 200  Selling price 200 200  Profit 150 0 150Tax 52.5 0 52.5Net Profit 97.5 0 97.5

Case 4.

The MNC decides that Rs 300 is the correct transfer price. In this case, the MNC earns a loss of Rs 100 per unit of shoe sold in the home country. Meanwhile, its subsidiary earns Rs 162.5 as profit, after paying Rs 87.5 as tax. But the clever MNC gets a tax write off at home worth Rs 45 m.

Transfer Price at Rs 300Indian subsidiary MNC Grand Total

Cost price 50 300  

Selling price 300 200  Profit 250 -100 150Tax 87.5 -45 42.5Net Profit 162.5 0 192.5

Please remember, these are just a few hypothetical simple situations. In reality, these dealings are much more complex with conglomerates having more than 50 subsidiaries in just as many countries. Transfer pricing became a subject of much debate in the western countries as government’s felt that corporates are down paying their fair share of tax. As a result, these countries spearheaded awareness regarding transfer pricing.

To find out a reasonable price for products and technologies transferred, leading accountancy and legal firms propagate ‘arm’s length’ methodologies. Arm’s length, as the term indicates, means keeping a neutral balance between inter-corporate arms. The idea is that companies should treat each subsidiary as a separate entity and deal with them on purely commercial terms, as they would have if they transacted with any other market player.

Arm’s length methodologies are of two types.

1. Transactional Methods – Where focus is on the product or the technology to ascertain the correct transfer price.

2. Profit Methods – Where profitability is the cornerstone for analyzing the correct transfer price.

Transaction methods can be further divided into two broad sub-groups.

A.Comparable uncontrolled price : In this method, the focus is on ascertaining the correct price of the property or service. This maybe done by finding out the price of such services or products prevailing in that market. However, it is difficult to implement because it requires similarity of products and also of markets. 

B.Resale price method : Here the accountants look at ascertaining the resale price of the product or service under question. The focus is on the margins earned. However, this method is only useful for subsidiaries that add little value. For example, this method is useful when the subsidiary is just a manufacturing base for the parent and thus adds little economic value to the product or service. However, where a technology transfer is involved, the resale price is subjective.

Profit method has been further sub-divided into two sub-groups.

A.Profit split method : In this method, the conglomerates entire profits are consolidated and then this profit is split between various subsidiaries depending on their perceived contribution to profits. But this method is also not without its share of criticism. For one, some experts argue that the

allocation of profits to subsidiaries is subjective and hence, open to manipulation.

B.Net margin method : As the name suggests, this method focuses on ascertaining the appropriate net margins for the transactions. The net margin earned is benchmarked to a relative base like sales or assets employed.

While going through each of these methods, it becomes clear that all these methods are not definitive methods for ascertaining transfer prices. Being a complex subject, more fine-tuning is needed to finally get a definitive benchmark method for calculating the transfer price.

As business between countries is likely to only increase in future, transfer-pricing issues would be subject of even more scrutiny not only by government’s and legal bodies, but also the companies’ respective shareholders. But there is a lot of ground still to be done in this area.

{‘Transfer pricing’, a financial accounting device used by multinational corporations (MNCs) to rake huge financial benefits, has long been a major problem facing host countries. Kavaljit Singh discusses this phenomenon in the wake of the recent disclosure of resort to this practice by the pharmaceutical giant, Glaxo Smith Kline. }The large-scale tax avoidance practices resorted to by multinational corporations (MNCs) came to

public notice recently when the giant drug MNC, Glaxo Smith Kline, agreed to pay the US government $3.4 billion to settle a long-running dispute over the tax dealings between the UK parent company and its American subsidiary. This was the largest settlement of a tax dispute in the US. The investigations carried out by the Internal Revenue Services (IRS) found that the American subsidiary of Glaxo Smith Kline overpaid its UK parent company for drug supplies, mainly its block-buster drug.Zantac, during the period 1989-2005. These over payments were meant to reduce the company’s profit in the US and thereby its tax bill. The IRS charged Europe’s largest drug company with engaging in manipulative ‘transfer pricing’.

Transfer pricing relates to the price charged by one associate of a corporation to another associate of the same corporation. When one subsidiary of a corporation in one country sells goods, services or know-how to another subsidiary in an other country, the price charged for these goods or services is called the transfer price. All kinds of transactions within corporations are subject to transfer pricing including those involving raw material, finished products and payments such as management fees, intellectual property royalties, loans, interest on loans, payments for technical assistance and know how and other transactions. The rules on transfer pricing require MNCs to

conduct business between their affiliates and subsidiaries on an ‘arm’s length’ basis, which means that any transaction between two entities of the same MNC should be priced as if the transaction was conducted between two unrelated parties.Manipulating the accountsTransfer pricing, a very controversial and complex issue, requires closure scrutiny not only by the critics of MNCs but also by the tax authorities in the developing world. Transfer pricing is a strategy frequently used by MNCs to obtain huge profits through illegal means. The transfer price could be purely arbitrary or fictitious, therefore different from the price that unrelated firms would have had to pay. By manipulating a few entries in the account books, MNCs are able to reap obscene profits with no actual change in the physical capital. For instance, a Korean firm manufacturers an MP3 player for $100, but its US subsidiary buys it for $199, and then sells it for $200. By doing this, the firm’s bottom line does not change but the taxable profit in the US is drastically reduced. At a 30% tax rate, the firm’s tax liability in the US would be just 30 cents instead of $30.

MNCs derive several benefits from transfer pricing. Since each country has different tax rates, they can increase their profits with the help of transfer pricing. By lowering prices in countries where tax

rates are high and raising them in countries with a lower tax rate. MNCs can reduce their overall tax burden, thereby boosting their overall profits. That is why one often finds that corporations located in high-tax countries hardly pay any corporate taxes.

A study conducted by Simon J Pak of Pennsylvania State University and John S.Zdanowiczn of Florida State University found that US corporations used manipualtive pricing schemes to avoid over $53 billion in taxes in 2001. Based on US import and export data, the authors found several examples of abnormally priced transactions such as tooth-brushes imported from the UK into the US at a price of $5,655 each, flashlight imported from Japan for $5,000 each, cotton dish towels imported from Pakistan for $153 each, briefs and panties imported from Hungary for $739 a dozen, car seats exported to Belgium for $1.66 each, and missile and rocket launchers exported to Israel for just $52 each.With the removal of restrictions on capital flows, manipulative transfer pricing has increased manifoldWith the removal of restrictions on capital flows, manipulative transfer pricing has increased manifold. According to the United Nations Conference on Trade and Development (UNCTAD)’s World Investment Report 1996, one-third of world trade is basically intra-firm trade. Because of

mergers and acquisitions, intra-firm trade, in both number and value terms, has increased considerably in recent years. Given that there are over 77,000 parent MNCs with over 770,000 foreign affiliates, the number of transactions taking place within these entitles is unimaginable. Hence, it becomes extremely difficult for tax authorities to monitor and control each and every transaction taking place within a particular MNC. The rapid expansion of Internet-based trading (e-commerce) has further complicated the task of national tax authorities.

Not only do MNCs reap higher profits by manipulating transfer pricing: there is also a substantial loss of tax revenue to countries, particularly developing ones, that rely more on corporate income tax to finance their development programmes. Besides, governments are already under pressume to lower taxes as a means of attracting investment or retaining a corporation’s operations in their country. This leads to a heavier tax burden on ordinary citizens for financing social and developmental programmes. Although several instances of fictitious transfer pricing have come to public notice in recent years, there are no reliable estimates of the loss of tax revenue globally. The Indian tax authorities are expecting to garner an additional US$111 million each year from MNCs

with the help of new regulations on transfer pricing introduced in 2001.

In addition, fictitious transfer pricing creates a substantial loss of foreign exchange and engenders economic distortions through fictious entries of profits and losses. In countries where there are government regulations preventing companies from setting product retail prices above a certain percentage of prices of imported goods or the cost of production, MNCs can inflate import costs from their subsidiaries and then charge higher retail prices. Additionally, MNCs can use over priced imports or underpriced exports to circumvent governmental ceilings on profit repatriation, thereby causing a drain of foreign exchange. For instance, if a parent MNC has a profitable subsidiary in a country where the parent does not wish to reinvest the profits, it can remit them by overpricing imports into that country. During the 1970s, investigations revealed that average overpricing by parent firms on imports by their Latin American subsidiaries in the pharmaceutical industry was as high as 155%, while imports of dyestuff raw materials by MNC affiliates in India were overpriced in the range of 124 to 147%.

Given the magnitude of manipulative transfer pricing, the Organisation for Economic Co-operation and Development (OECD) has issued

detailed guidelines. Transfer pricing regulations are extremely stringent in developed countries such as the US, the UK and Australia. In the US, for instance, regulations related to transfer pricing cover almost 300 pages, which dents the myth that the US espouses ‘free market’ policies.However, developing countries are lagging behind in enacting regulations to check the abuse of transfer pricing. India framed regulations related to transfer pricing as late as 2001. However, in many countries including Bangladesh, Pakistan and Nepal, tax authorities have yet to enact regulations curbing the abuse of transfer pricing mechanisms. Such abuse could be drastically curbed if there is enhanced international coordination among national tax authorities.

TRANSFER PRICING METHODSTo assess whether your current TP meets BALS criterion, your company can calculate a BALS price using one of three methods identified by Section 482 of the IRS Code: comparable/uncontrollable price, resale price, or cost-plus. These are based on the separate entity theory, which compares a given TP to a comparable price on the open market. Many companies prefer the comparable/uncontrollable price method and apply it first. The resale price method is preferred next, followed by cost-plus. Each method will be described below.

The IRS allows the MNC discretion in choosing which TP method it will use, but it will closely evaluate whichever method is chosen. If the MNC opts to use another method, the burden of proof falls on the corporation to show that the BALS has been met. Or it may contact the IRS and form an APA with it that defines an acceptable TP calculation method before implementation. When this occurs, the APA frees the MNC from any TP audit for the time period specified in the contract, usually three to four years.Comparable/Uncontrollable Price MethodThe comparable/uncontrollable price method most accurately approximates an arm's length price and has been used in most Section 482 pricing cases. It forces the parent to compare the TP of its controlled subsidiary to the selling price charged by an independent seller to an independent buyer for similar goods. Comparing actual profits of one company to the profitability of a number of unrelated companies with similar activities establishes a comparable profit interval. Comparable sales occur when physical property and circumstances of the controlled sales are almost identical to those of uncontrolled sales.Use of this method is thought to best focus on overall operating profits as they relate to similarly situated firms rather than on similar transactions involving unrelated firms. If comparisons are not possible, then sales of other resellers in the same market could be used. This allows management to evaluate international subsidiaries as it would any other distributor.Resale Price Method

The resale price, or market, method places the transferor in direct competition with outside suppliers. It is the strategy used most often for setting a TP for international transfers. In this scenario the BALS TP is determined by subtracting the gross margin percentage used by comparable independent buyers from the final third-party sales price. It is typically used when the value-added by the subsidiary is not substantial.Cost-Plus MethodThe cost-plus method is computed by adding the gross profit markup (on a percentage basis) earned by comparable companies performing similar functions to the production costs of the controlled manufacturer or seller. (An amount equal to cost times an appropriate gross profit percentage is the gross profit percentage, expressed as a percent of cost, earned by the seller or another party on the uncontrolled sales, to cover some or all of the fixed costs.) An arm's length price is considered the best approximation of the price that would be charged if companies involved in the sales transactions did not have common ownership.Other MethodsTwo common TP methods used by MNCs but not recommended by Section 482 are the no-charge method and the cost method. Neither considers a reference to comparable sellers or buyers, and both usually violate BALS criteria, thus jeopardizing the MNC's TP status. When reference to comparable/uncontrolled prices is not available or not considered, the Tax Court applies the unitary entity theory to the MNC's international pricing

structure. A relative profit-split strategy is commonly used to assess the appropriateness of the TP. The assumption is that overall profits should be shared in proportion to relative assets employed, functions performed, and risks assumed. Tax courts have not revealed the exact rationale used in splitting profits, so MNCs are responsible for documenting assets, functions, and risk information to justify the TP level to an auditor.Transfer pricing methods vary in their effects on pricing flexibility, efficiency, and profitability. The no-charge method gives the least incentive to the parent to control efficiency and allows the greatest amount of pricing flexibility and profitability markup at the subsidiary level. On the other hand, the comparable/uncontrolled method gives the most incentive to control efficiency but allows the least amount of pricing flexibility and the least profit markup at the subsidiary level.The ability to respond to changes in elasticity of demand in the marketplace will depend on the percentage of markup to the ultimate consumer. If the markup is high, the company is more flexible in meeting a price the market will bear-- which is of particular concern when demand is volatile.There is a direct and critical relationship between the TP strategy chosen and the final percentage markup. At one end, when a no-charge TP is chosen between parent and subsidiary, the subsidiary's cost of goods sold is minimal and the percentage markup is maximized relative to other TP strategies. At the other extreme, when a market-based TP is chosen between parent and subsidiary, the

latter's cost of goods sold is maximized and the percentage markup is minimized relative to other TP strategies. The more intense the competition, the increased likelihood of an elastic demand in the consumer market. The more elastic the demand in the marketplace, the more sensitive consumers will be to the objective price of the product. When price sensitivity is enhanced by intense competition, the parent and subsidiary should try to establish a TP policy that will result in the lowest product cost structure. By keeping the cost structure low, the MNC has more flexibility in setting competitive prices while maintaining acceptable profit margins.It must be emphasized that minimizing effective tax rates is not without risk. A primary danger is a TP audit resulting in assessed penalties. As the MNC departs from the BALS and the criterion used to define it by the tax authority, the risk of a penalty increases. No-charge and cost methods are not BALS-based, so, again, the risk of penalty is substantially higher for these methods.

SYNOPSIS FORMAT

Title of the project

Literature review

Objective of the study

Research methodology

Scope

Findings and conclusions

references

 MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES

 By Dennis Caplan

 PART 5: PLANNING TOOLS AND

PERFORMANCE MEASURES FOR PROJECTS AND DIVISIONS

 CHAPTER 23:  TRANSFER PRICING 

 

Ferrari:           Shall we draw up the papers, or is our handshake good enough? Rick:               It’s certainly not good enough. But since I’m in a hurry, it’ll have to do. Ferrari:           Ah, to get out of Casablanca and go to America! You’re a lucky man. Rick:               Oh, by the way, my agreement with Sam’s always been that he gets 25% of the profits. That still goes. Ferrari:           Hmmm. I happen to know that he gets 10%. But he’s worth 25%. Rick:               Don’t forget, you owe Rick’s a hundred cartons of American cigarettes. Ferrari:           I shall remember to pay it … to myself.

 From Casablanca, 1942

  Chapter Contents:

-         Definition and Overview-         Transfer Pricing Options-         Market-based Transfer Prices-         Cost-based Transfer Prices-         Negotiated Transfer Prices-         Survey of Practice-         External Reporting-         Dual Transfer Pricing-         Transfer Pricing and Multinational Income Taxes

-         Other Regulatory Issues  Definition and Overview:A transfer price is what one part of a company charges another part of the same company for goods or services. In the excerpt from Casablanca, Rick apparently loaned Ferrari 100 cartons of cigarettes for which he was never repaid. Now that Ferrari owns both the Blue Parrot and Rick’s Café, he jokes about the fact that what was previously a debt that he owed to Rick, is now a “debt” from one nightclub that he owns to another nightclub that he owns. If Ferrari continues to transfer cartons of cigarettes between the two clubs, he might wish to establish a “transfer price” for cigarettes, but knowing Ferrari, he won’t bother. We will restrict attention to transfers that involve a tangible product, and we will refer to the two corporate entities engaged in the transfer as divisions. Hence, the transfer price is the price that the “selling” division charges the “buying” division for the product. Because objects that float usually flow downstream, the selling division is called the upstream division and the buying division is called the downstream division.  Transferred product can be classified along two criteria. The first criterion is whether there is a readily-available external market price for the product. The second criterion is whether the downstream division will sell the product “as is,” or whether the transferred product becomes an input in the downstream division’s own production process. When the transferred product becomes an input in the downstream division’s production

process, it is referred to as an intermediate product. The following table provides examples. 

An external marketprice is available

No external marketprice is available

 The downstream division will sell

“as is”:

The West Coast Division of a supermarket chain transfers oranges to the Northwest Division, for retail sale. 

A pharmaceutical company transfers a drug that is under patent protection, from its manufacturing division to its marketing division.

 The downstream division will use the transferred product in its own

production process:

An oil company transfers crude oil from the drilling division to the refinery, to be used in the production of gasoline. 

The Parts Division of an appliance manufacturer transfers mechanical components to one of its assembly divisions.

  Transfer pricing serves the following purposes. 

1.      When product is transferred between profit centers or investment centers within a decentralized firm, transfer prices are necessary to calculate divisional profits, which then affect divisional performance evaluation.

 2.      When divisional managers have the authority to decide

whether to buy or sell internally or on the external market, the transfer price can determine whether managers’ incentives align with the incentives of the overall company and its owners. The objective is to achieve goal

congruence, in which divisional managers will want to transfer product when doing so maximizes consolidated corporate profits, and at least one manager will refuse the transfer when transferring product is not the profit-maximizing strategy for the company.

 3.      When multinational firms transfer product across

international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues.

 The transfer generates journal entries on the books of both divisions, but usually no money changes hands. The transfer price becomes an expense for the downstream division and revenue for the upstream division. Following is a representative example of journal entries to record the transfer of product: Upstream Division:(1)        Intercompany Accounts Receivable                   $9,000                        Revenue from Intercompany Sale                                  $9,000 (2)        Cost of Goods Sold – Intercompany Sales        $8,000                        Finished Goods Inventory                                             $8,000 

(To record the transfer of 500 cases of Clear Mountain Spring Water, at $18 per case, to the Florida marketing division, and to remove the

500 cases from finished goods inventory at the production cost of $16 per case.)

 Downstream Division:(1)        Finished Goods Inventory                                 $9,000                        Intercompany Accounts Payable                                   $9,000 

(To record the receipt of 500 cases of Clear Mountain Spring Water, at $18 per case, from the bottling division in Nebraska)

  Transfer Pricing Options:There are three general methods for establishing transfer prices. 

1. Market-based transfer price: In the presence of competitive and stable external markets for the transferred product, many firms use the external market price as the transfer price.

 2. Cost-based transfer price: The transfer price is based on

the production cost of the upstream division. A cost-based transfer price requires that the following criteria be specified:

a. Actual cost or budgeted (standard) cost.b. Full cost or variable cost.c. The amount of markup, if any, to allow the upstream

division to earn a profit on the transferred product. 

3. Negotiated transfer price: Senior management does not specify the transfer price. Rather, divisional managers negotiate a mutually-agreeable price.

 Each of these three transfer pricing methods has advantages and disadvantages.  Market-based Transfer Prices:Microeconomic theory shows that when divisional managers strive to maximize divisional profits, a market-based transfer price aligns their incentives with owners’ incentives of maximizing overall corporate profits. The transfer will occur when it is in the best interests of shareholders, and the transfer will be refused by at least one divisional manager when shareholders would prefer for the transfer not to occur. The upstream division is generally indifferent between receiving the market price from an external customer and receiving the same price from an internal customer. Consequently, the determining factor is whether the downstream division is willing to pay the market price. If the downstream division is willing to do so, the implication is that the downstream division can generate incremental profits for the company by purchasing the product from the upstream division and either reselling it or using the product in its own production process. On the other hand, if the downstream division is unwilling to pay the market price, the implication is that corporate profits are maximized when the upstream division sells the product on the external market, even if this leaves the downstream division idle. Sometimes, there are cost savings on internal transfers compared with external sales. These savings might arise, for example, because the upstream

division can avoid a customer credit check and collection efforts, and the downstream division might avoid inspection procedures in the receiving department. Market-based transfer pricing continues to align managerial incentives with corporate goals, even in the presence of these cost savings, if appropriate adjustments are made to the transfer price (i.e., the market-based transfer price should be reduced by these cost savings).  However, many intermediate products do not have readily-available market prices. Examples are shown in the table above: a pharmaceutical company with a drug under patent protection (an effective monopoly); and an appliance company that makes component parts in the Parts Division and transfers those parts to its assembly divisions. Obviously, if there is no market price, a market-based transfer price cannot be used. A disadvantage of a market-based transfer price is that the prices for some commodities can fluctuate widely and quickly. Companies sometimes attempt to protect divisional managers from these large unpredictable price changes.  Cost-based Transfer Prices:Cost-based transfer prices can also align managerial incentives with corporate goals, if various factors are properly considered, including the outside market opportunities for both divisions, and possible capacity constraints of the upstream division. First consider the case in which the upstream division sells the intermediate product to external customers as well as to the

downstream division. In this situation, capacity constraints are crucial. If the upstream division has excess capacity, a cost-based transfer price using the variable cost of production will align incentives, because the upstream division is indifferent about the transfer, and the downstream division will fully incorporate the company’s incremental cost of making the intermediate product in its production and marketing decisions. However, senior management might want to allow the upstream division to mark up the transfer price a little above variable cost, to provide that division positive incentives to engage in the transfer. If the upstream division has a capacity constraint, transfers to the downstream division displace external sales. In this case, in order to align incentives, the opportunity cost of these lost sales must be passed on to the downstream division, which is accomplished by setting the transfer price equal to the upstream division’s external market sales price. Next consider the case in which there is no external market for the upstream division. If the upstream division is to be treated as a profit center, it must be allowed the opportunity to recover its full cost of production plus a reasonable profit. If the downstream division is charged the full cost of production, incentives are aligned because the downstream division will refuse the transfer under only two circumstances: 

- First, if the downstream division can source the intermediate product for a lower cost elsewhere; 

- Second, if the downstream division cannot generate a reasonable profit on the sale of the final product when it pays the upstream division’s full cost of production for the intermediate product.

 If the downstream division can source the intermediate product for a lower cost elsewhere, to the extent the upstream division’s full cost of production reflects its future long-run average cost, the company should consider eliminating the upstream division. If the downstream division cannot generate a reasonable profit on the sale of the final product when it pays the upstream division’s full cost of production for the intermediate product, the optimal corporate decision might be to close the upstream division and stop production and sale of the final product. However, if either the upstream division or the downstream division manufactures and markets multiple products, the analysis becomes more complex. Also, if the downstream division can source the intermediate product from an external supplier for a price greater than the upstream division’s full cost, but less than full cost plus a reasonable profit margin for the upstream division, suboptimal decisions could result.   Negotiated Transfer Prices:Negotiated transfer pricing has the advantage of emulating a free market in which divisional managers buy and sell from each other in a manner that simulates arm’s-length transactions. However, there is no reason to assume that the outcome of these transfer price negotiations will serve the best interests of the company or shareholders. The transfer price could depend on which divisional manager is the better poker player, rather than

whether the transfer results in profit-maximizing production and sourcing decisions. Also, if divisional managers fail to reach an agreement on price, even though the transfer is in the best interests of the company, senior management might decide to impose a transfer price. However, senior management’s imposition of a transfer price defeats the motivation for using a negotiated transfer price in the first place.  Survey of Practice:Roger Tang (Management Accounting, February 1992) reports 1990 survey data on transfer pricing practices obtained from approximately 150 industrial companies in the Fortune 500. Most of these companies operate foreign subsidiaries and also use transfer pricing for domestic interdivisional transfers. For domestic transfers, approximately 46% of these companies use cost-based transfer pricing, 37% use market-based transfer pricing, and 17% use negotiated transfer pricing. For international transfers, approximately 46% use market-based transfer pricing, 41% use cost-based transfer pricing, and 13% use negotiated transfer pricing. Hence, market-based transfer pricing is more common for international transfers than for domestic transfers. Also, comparison to an earlier survey indicates that market-based transfer pricing is slightly more common in 1990 than it was in 1977.   Tang also finds that among companies that use cost-based transfer pricing for domestic and/or international transfers, approximately 90% use some measure of full cost, and only about 5% or 10% use some measure of variable cost. 

 External Reporting:For external reporting under Generally Accepted Accounting Principles, no matter what transfer price is used for calculating divisional profits, the effect should be reversed and intercompany profits eliminated when the financial results of the divisions are consolidated. Obviously, intercompany transfers are not arm’s-length transactions, and a company cannot generate profits or increase the reported cost of its inventory by transferring product from one division to another.  Dual Transfer Pricing:Under a dual transfer pricing scheme, the selling price received by the upstream division differs from the purchase price paid by the downstream division. Usually, the motivation for using dual transfer pricing is to allow the selling price to exceed the purchase price, resulting in a corporate-level subsidy that encourages the divisions to participate in the transfer. Although dual transfer pricing is rare in practice, a thorough understanding of dual transfer pricing illustrates some of the key bookkeeping and financial reporting implications of all transfer pricing schemes. In the following example, the Clear Mountain Spring Water Company changes from a negotiated transfer price of $18 per case (see the above example) to a dual transfer price in which the upstream division receives the local market price of $19 per case, and the downstream division pays $17 per case.

 Upstream Division:(1)        Intercompany Receivable/Payable                                 $9,500                        Revenue from Intercompany Sale                                              $9,500 (2)        Cost of Goods Sold – Intercompany Sales                    $8,000                        Finished Goods Inventory                                                         $8,000 

(To record the transfer of 500 cases of Clear Mountain Spring Water, at $19 per case, to the Florida marketing division, and to remove the 500 cases from finished goods inventory at the production cost of $16 per case.)

 Downstream Division:(1)        Finished Goods Inventory                                             $8,500                        Intercompany Receivable/Payable                                             $8,500 

(To record the receipt of 500 cases of Clear Mountain Spring Water at $17 per case, from the bottling division in Nebraska)

 Corporate Headquarters:(1)        Interco. Receivable/Payable – Florida                           $8,500

            Corporate Subsidy for Dual Transfer Price                    $1,000                        Interco. Receivable/Payable – Nebraska                                   $9,500 

(To record the transfer of 500 cases of Clear Mountain Spring Water from Nebraska to Florida, at a dual transfer price of $19/$17 per case.)

 Corporate Subsidy for Dual Transfer Price is an expense account at the corporate level. This account and the revenue account that records the intercompany sale affect the calculation of divisional profits for internal reporting and performance evaluation, but these accounts—as well as the intercompany receivable/payable accounts—are eliminated upon consolidation for external financial reporting. To the extent that the Florida Division has ending inventory, the cost of that inventory for external financial reporting will be the company’s cost of production of $16 per case. In other words, the transfer price has no effect on the cost of finished goods inventory.   Transfer Pricing and Multinational Income Taxes:When divisions transfer product across tax jurisdictions, transfer prices play a role in the calculation of the company’s income tax liability. In this situation, the company’s transfer pricing policy can become a tax planning tool. The United States has agreements with most other nations that determine how multinational companies are taxed. These agreements, called bilateral tax treaties, establish rules for apportioning

multinational corporate income among the nations in which the companies conduct business. These rules attempt to tax all multinational corporate income once and only once (excluding the double-taxation that occurs at the Federal and state levels). In other words, the tax treaties attempt to avoid the double-taxation that would occur if two nations taxed the same income. Since transfer prices represent revenue to the upstream division and an expense to the downstream division, the transfer price affects the calculation of divisional profits that represent taxable income in the nations where the divisions are based. For example, if a U.S.-based pharmaceutical company manufactures a drug in a factory that it operates in Ireland and transfers the drug to the U.S. for sale, a high transfer price increases divisional income to the Irish division of the company, and hence, increases the company’s tax liability in Ireland. At the same time, the high transfer price increases the cost of product to the U.S. marketing division, lowers U.S. income, and lowers U.S. taxes. The company’s incentives with regard to the transfer price depend on whether the marginal tax rate is higher in the U.S. or in Ireland. If the marginal tax rate is higher in the U.S., the company prefers a high transfer price, whereas if the marginal tax rate is higher in Ireland, the company prefers a low transfer price. The situation reverses if the drug is manufactured in theU.S. and sold in Ireland. The general rule is that the company wants to shift income from the high tax jurisdiction to the low tax jurisdiction. There are limits to the extent to which companies can shift income in this manner. When a market price is available for the goods transferred, the taxing authorities will usually impose the

market-based transfer price. When a market-based transfer price is not feasible, U.S. tax law specifies detailed and complicated rules that limit the extent to which companies can shift income out of the United States.   Other Regulatory Issues:Transfer pricing sometimes becomes relevant in the context of other regulatory issues, including international trade disputes. For example, when tariffs are based on the value of goods imported, the transfer price of goods shipped from a manufacturing division in one country to a marketing division in another country can form the basis for the tariff. As another example, in order to increase investment in their economies, developing nations sometimes restrict the extent to which multinational companies can repatriate profits. However, when product is transferred from manufacturing divisions located elsewhere into the developing nation for sale, the local marketing division can export funds to “pay” for the merchandise received. As a final example, when nations accuse foreign companies of “dumping” product onto their markets, transfer pricing is often involved. Dumping refers to selling product below cost, and it generally violates international trade laws. Foreign companies frequently transfer product from manufacturing divisions in their home countries to marketing affiliates elsewhere, so that the determination of whether the company has dumped product depends on comparing the transfer price charged to the marketing affiliate with the upstream division’s cost of production.