INTERNATIONAL TRANSFER PRICING

Transfer Pricing- the determination of the price at which transactions between related parties will be carried out.

Types of Intercompany Transactions and their Associated Price

Sale of tangible property Sale Price

Use of tangible property rental payment

Use of intangibles royalties, license fees

Intercompany services Mgt fee, service charge

Intercompany Loans Interest rate

Objectives of Transfer Pricing Performance Evaluation Cost minimization

These objectives might be incongruent

Transfer Pricing Methods

Cost-Priced Transfer price Market-based Transfer Price Negotiated Price

Cost-Based Transfer Pricing Advantages

Simple to do Disadvantages

Which measure of cost to use?? Can transfer pricing inefficiencies to

other units

Market Based Transfer Pricing

Advantages Eliminate the risk of inefficiencies being

transferred. Ensure divisional autonomy

Disadvantage Depends on existence of competitive

markets

Negotiated Prices

Advantages Freedom to bargain is preserved Divisional autonomy

Disadvantages External markets required Can take a long time Sub-optimization issues Rewards negotiation skill as opposed to

actual productivity

Most companies:

Use either cost-based or market-based transfer pricing.

Many use a mix of both

Chan and Lo’s Study (2004): Cost-based methods are preferred

when: Income tax rate differences matter Import duty is being minimized Foreign exchange rules exist Expropriation risks exist

Market-based methods are preferred when: Local partners matter Local government relations matter

7 Most Important Environmental Variables (USA)

Overall Profit to the company Restrictions on repatriation of

profit/dividends The competitive position of foreign subs Performance evaluation of foreign subs Custom Duties Import restrictions The need for adequate cash flow in

foreign subs

7 Most Important Environmental Variables (Japan)

Overall corporate profit The competitive position of foreign subs Devaluation/revaluation in countries with

foreign operations. Restrictions on repatriation of

profits/dividends Performance Evaluation of foreign subs The interests of local partners in

foreign subs The need to maintain adequate cash flow in

foreign subs

Cost Minimization Objectives and Related Transfer Prices

Objective Transfer Pricing Rule Minimize income Tax

Transfer to lower tax rate country Low price Transfer to Higher tax rate country High price

Minimize withholding tax Upstream transfer Low price Downstream transfer High price

Minimize import duties Low price Protect foreign cash flows from currency devaluation High price Avoid repatriation High price Improve competitive position Low Price

Government Reactions

OECD Transfer Pricing Guidelines- 1979, 1984, 1994

Section 482 of the IRC Based on OECD guidelines IRS may audit transfer prices between

companies controlled by the same taxpayer. Burden of proof on taxpayer Inbound and outbound transactions General rule: “arm’s length prices”. Treasury regs provide specific guidance on

“arms length” prices

Government Reactions

Treasury Regs Section 1.482 Best method rule- which method

provides the most reliable measure of an arm’s length price Depends on (a) degree of comparability

between intercompany transaction and comparable uncontrolled transactions, and (b) quality of data and assumptions used in analysis.

Separate guidelines for transfers of tangible property, intangible property, intercompany loans, and intercompany services.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices

Comparable Uncontrolled Price Method Generally considered the best method

when it can be used. Parent sells to Sub in Country X Parent also sells to uncontrolled

customer in the same country Arm’s Length Price = price charged the

uncontrolled customer

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices

Resale Price Method- Parent Sells to Sub in Country X Sub sells to customers in country X Sub’s competitors sell the same product

at 25% markup as % of sales Arm’s length price = Sub’s selling price

to customers less 25% To use this method, final selling price

and appropriate gross profit % must be known.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices

Cost Plus Method- Parent Sells to Sub in Country X Parent’s competitors sell same product

to customers in County X at 50% markup to cost.

Arms Length Price = Parent’s cost plus 50%

Most appropriate method when there are no uncontrolled sales to compare to and the buyer does more than just distribute goods.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices

Comparable Profits Method- Parent sells to Sub in Country X Sub sells to Customers in Country X Parent’s competitiors sell similar product

and earn a 15% margin. Arms Length price = price that allows

Parent (or sub) to earn 15% operating profit margin.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices

Profit Split Method- Parent Sells to Sub in Country X Sub sells to Customers in Country X Total profit = Sub sales price less

Parent’s cost Total profit is split based on profit earned

by each party in an uncontrolled transaction.

Method assumes buyer and seller are really one economic unit.

Tr Reg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices

Residual Profit Split Method- Used when parties possess intangibles

that allow them to earn excessive profits, compared to uncontrolled transactions.

Total Profit is split in 2 steps: Allocate market return to parent and sub

for their routine contributions to the relevant business activity.

Allocate residual profit to Parent and Sub on the basis of relative value of intangibles that each contributes to the activity.

Ernst and Young Study (07-08) reports:

Comparable Uncontrolled Price is most popular (32%)

Cost plus is second (29%) Resale price is third (17%) Comparable profits is fourth (11%)

Intangible Property

Three identified methods allowed: Comparable uncontrolled Comparable profits Profit split

Correlative Adjustments

If the IRS adjusts a transfer price, there is no guarantee the foreign government will concur.

Penalties

20% (40%) or the understatement!!

Advance Pricing Agreements TPM agreed upon between company

and tax authority. If there is an agreement, IRS agrees

to make No TP adjustments Length negotiation typical…..avg 22

months. 60% of APAs are from foreign Parents

with US subs.