Transfer pricing How MNC's use it

Chinmay Patil (1443) Shivraj Pawar (1447)

A transfer price is the price one sub-unit charges for a product or servicesupplied to another sub-unit of the same organization.

Alternate Definitions :

Anthony & Govindrajan – “It’s the value placed on a transfer of goods and services in transactions in which at least one of the two parties involved is a profit center. ”

General Definition :- “It is the amount used in accounting or any transfer of goods and services between two responsibility centers in an organization. ”

Definition :

Objectives: It should provide each Business Unit with relevant information so that Trade-off between

company cost and revenue,

Decision that improve business unit profit will improve company profit so It should induce Goal Congruence decision,

Measure the economic performance of business unit

Simple to understand, easy to administer

There are four approaches to transfer pricing:

A. Market-Based : Market price refers to a price in an intermediate market between independent buyers and sellers. When there is a competitive external market for the transferred product, market prices work well as transfer prices. Market-based prices are based on opportunity costs concepts.

B. Cost-Based : When external markets do not exist or are not available to the company or when information about external market prices is not readily available, companies may decide to use some forms of cost-based transfer pricing system. Cost-based transfer prices may be in different forms such as variable cost, actual full cost, full cost plus profit margin, standard full cost.

C. Negotiated : Negotiated prices are generally preferred as a middle solution between market prices and cost- based prices. Negotiation strategies may be similar to those employed when trading with outside markets. If both divisions are free to deal either with each other or in the external market, the negotiated price will likely be close to the external market price. If all of a selling division’s output can not be sold in the external market (that is, a portion must be sold to the buying division), the negoti ated price will likely be less than the market price and the total margin will be shared by the divisions.

D. Administered : Selling division sells the transferred goods at a (i) market or negotiated market price or (ii) cost plus some profit margin. But the transfer price for the buying division is a cost-based amount (preferably the variable costs of the selling division). The difference in transfer prices for the two divisions could be accounted for by special centralised account. This system would preserve cost data for subsequent buyer departments, and would encourage internal transfers by providing a profit on such transfers for the selling divisions.

Describes aspects of intercompany pricing arrangements between related business entities and commonly applies to intercompany transfer of tangible property, intangible property services and finance transfers.

Intercompany transactions are rapidly increasing to leverage the advantages of Transfer pricing.

Objective’s of TP in views of MNCs :

1.Competitiveness in the international marketplace,

2.Reduction of taxes and tariffs,

3.Management of cash flows,

4. Minimization of foreign exchange risks

5.Avoidance of conflicts with home and host Governments over tax issues and repatriation of profits,

6.Internal Concerns – goal congruence or subsidiary manager motivation.

The Parent The Parent CorporationCorporation

SubsidiarySubsidiaryBB

Latin AmericaLatin America

SubsidiarySubsidiary

AANorth AmericaNorth America

Subsidiary Subsidiary

CCAfricaAfrica

$$$$$$ $$$$$$

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

Tax on profits & not on gross income

Unlike individuals who are taxed on gross income, corporations are generally taxed only on their profits. Thus to minimize taxes, corporations try to find creative ways to lower their paper profits in high-tax countries, and shift those profits to low-tax countries.

A multinational company establishes a legal entity in a low-tax country. Then, the company can assign the rights to its intangible assets to the newly formed entity. Now, the company in a high-tax country must pay royalties for using the intangible assets to the company in the low-tax country.

This is very difficult to assess, since intangible assets can be very difficult to value. In effect, the company now has a free hand to set an arbitrarily high royalty rate. The company in the high-tax country now can achieve arbitrarily higher expenses and lower paper profits due to the royalty payment. The income from the royalty payment goes to the company in the low-tax country. In this way, profits are effectively shifted to low-tax countries

Intangible Assets

How much should it pay in royalties?

The Double Irish

Arm’s Length

The Dutch Sandwich

Unlimited liability company

Deferred Indefinitely

The double Irish arrangement is a tax avoidance strategy that some multinationalcorporations use to lower their corporate tax liability. The strategy uses payments between

related entities in a corporate structure to shift income from a higher-tax country to a lower-tax country. It relies on the fact that Irish tax law does not include US transfer pricing rules.

Specifically, Ireland has territorial taxation, and hence does not levy taxes on income booked in subsidiaries of Irish companies that are outside the state.

The double Irish tax structure was pioneered in the late 1980s by companies such as Apple Inc In 2010 Ireland passed a law intended to counter such arrangements, though existing arrangements were exempt and lawyers have said that this change will cause no significant problems for multinational firms.

Income shifting commonly begins when companies like Google sell or license the foreign rights to intellectual property developed in the U.S. to a subsidiary in a low-tax country. That means foreign profits based on the technology get attributed to the offshore unit, not the parent.

Under U.S. tax rules, subsidiaries must pay “arm’s length” prices for the rights -- or the amount an unrelated company would.

Because the payments contribute to taxable income, the parent company has an incentive to set them as low as possible. Cutting the foreign subsidiary’s expenses effectively shifts profits overseas.

Ireland does not levy withholding tax on certain receipts from European Union member States.Revenues from sales of the products shipped by the second Irish company (the second in the double Irish) are first booked by a shell company in the Netherlands, taking advantage of

generous tax laws there. Overcoming the Irish tax system, the remaining profits are transferred directly to Cayman Islands or Bermuda.

This part of the scheme is referred to as the "Dutch Sandwich".

Under Irish rules, ULC are not required to disclose such financial information as income statements or balance sheets.

Sticking an unlimited company in the group structure has become more common in Ireland, largely to prevent disclosure.

Multinational companies don’t have to pay U.S. income taxes on overseas profits until they transfer them back home. But in reality, companies just leave their profits in overseas tax havens, deferring taxes indefinitely. Not only that, Transfer pricing allows companies to move profits from the U.S. to offshore havens

so they’re counted as overseas earnings.

Some 83 percent of top 100 publicly traded companies had tax-haven units in 2009, according to the GAO. General Electric, Google, Pfizer, and many other companies use this technique. The

federal government loses an estimated (PDF) $100 billion a year through offshore tax abuses