TRANSFER
PRICING
- A transfer price is the price one department or division charges for a product or service supplied i.e. transferred to another department or division of the same organization.
- It is a price at which the goods or services are internally transferred from one division to another within an organization.
- The goods which are transferred in this way are called the intermediate product. The transfer may be made either for further processing or for sale by the transferee unit.
- The transfer price creates revenue for the transferor department and on the other hand incurs purchase costs for the transferee department accordingly affecting each department’s operating income.
In decentralized
organizations where the divisional managers have autonomy to take various
decisions and are responsible for the profitability of the division, decisions
regarding transfer pricing help to achieve goal congruence, to maintain
divisional autonomy and to evaluate the performance of the division.
In divisional organizations, the output of one department may
form the input for another department. For the purpose of preparing management
accounts for the two departments, which reflects the work performed by both
divisions, a transfer pricing system is required.
When Needed
A transfer pricing policy is needed when:
i.
An organization has been decentralized into divisions; and
ii.
Inter divisional trading of goods or services occur.
Transfers between divisions
must be recorded in monetary terms as revenue for supplying divisions and costs
for receiving divisions.
Transfer pricing is more
than just a bookkeeping exercise.
It can have a large effect on the behaviour of divisional managers.
Objectives of transfer pricing
i)
Maintains divisional autonomy by allowing divisional
managers to set their own transfer prices and by allowing other divisions to
decide whether or not to trade at the prices quoted, the autonomy of individual
divisions is encouraged.
ii)
To motivate divisional managers if their remuneration
is based on the division’s profits.
iii)
To provide a reliable base for decision making and to
ensure that optimal decisions are made.
iv)
To allow performance evaluation of divisional managers
and gauge divisional performance.
v)
Tax minimization. Where a business has operations in
various countries, it may be beneficial to set transfer prices such that the
bulk of profits are reported in divisions where the host country has low
corporation tax rates.
Transfer pricing
systems are mainly designed for the following reasons:
i)
to provide information that motivates divisional
managers to make sound economic decisions
ii)
To provide information that is useful in evaluating the
managerial and economic performance of the divisions.
iii)
To ensure that divisional autonomy is not undermined.
iv)
To intentionally move profits between divisions for
financial performance measurements of the division.
TRANSFER PRICING: PURPOSES
Transfer pricing can contribute directly to the process of
departmental performance measurement and indirectly to the measurement of
product performance.
A transfer price is a value attached to the output of a department
in order to measure the value of its trade with other departments inside the organization. The transfer price of the supplying division
is charged to the receiving division.
Transfer prices do not affect overall organizational profit results but
do affect the profits reported by divisions.
The following example illustrates this point.
Example 1
Mwangi Inc. Plc. sells a single product at £5 per unit. The product is manufactured by passing raw
materials through two departments, A and B, at costs of £1.50 and £2.50
respectively. A transfer price of £2 has
been established to measure the profit achieved by department A.
Department A:
Transfer price
per unit £2.00
Cost per unit £1.50
Profit £0.50
Department B:
Selling price per
unit £5.00
Transfer price £2.00
Other costs £2.50 £4.50
Profit £0.50
Mwangi Inc.
Selling price per
unit £5.00
Cost per unit:
Department A £1.50
Department B £2.50 £4.00
Profit £1.00
The total cost of the product is £4 per unit providing a profit to
the company of £1 per unit. Department A
has costs, or inputs, of £1.50 per unit and a transfer price of £2 per unit as
a measure of output value. It thus shows
a profit of £0.50 per unit. Department B
has input costs of £2.50 per unit, plus a transfer price of £2 per unit, and an
output value of £5. Department B also
shows a profit of £0.50 per unit, therefore, the profit of both departments
together is £1 per unit (£0.50 plus £0.50).
The organization’s profit of £1 per unit is unaffected by the transfer
price because the output value attached to department A's production becomes an
input value for department B.
If a transfer price of £1.50 per unit is used in this situation,
department A appears to show £nil as a profit.
The costs to department B are £1.50 plus £2.50, giving a £1 profit per
unit for a selling price of £5 per unit.
This transfer price ensures that department A's costs are transferred to
department B but does not offer a profit motivation to department A's
manager. Department A is unlikely to
take action to improve performance if all credit for such effort is shown under
department B's results. Different
transfer prices allocate profit in different ways between divisions and it
should be clear that:
1. Transfer pricing
shares profits between divisions but does not, on its own, affect total
profits;
2. Transfer pricing
can motivate managers to take actions to improve profits for their divisions
and for the organization as a whole. The
transfer price should allow the opportunity for effort to be translated into a
positive measurement of performance.
·
Transfer pricing is similar to cost apportionment and allocation
in that values of one department are passed to another. For cost apportionment and allocation systems,
costs of one department are passed to another with the objective of
accumulating costs for product cost information purposes. Under transfer pricing arrangements, values
of one department are also passed to another.
Output measures of activities are used to charge departmental costs and
allowable profits to other departments.
The information produced can be used to accumulate product costs. Where transfer prices are cost based and make
no allowance for profits, the results would differ from apportionment and
allocation systems only with regard to the basis for transferring costs between
departments.
·
Where performance measurement is linked to rewards such as
promotion or salary, the method of transfer price can have a direct impact on
the motivation of the divisional manager.
For example, a divisional manager appraised on a profit centre basis
will be in a position of advantage where high transfer prices are established
for the particular division. The effect
of motivating managers to improve profits may lead to bargaining for transfer
pricing methods which provide the highest transfer prices for their particular
divisions. In a transfer pricing
situation, as in a number of accounting situations, there will inevitably be
winners and losers. The challenge to the
accountant is to devise a transfer pricing methodology which ensures that the
winners are those who will benefit the organization most in the long term.
·
Some multinational companies are in a position to use transfer
pricing to reduce total taxation costs.
This can be achieved by establishing transfer prices towards the higher
end of the spectrum of allowable values in countries with low taxation. This would tend to lead to high profits in
countries with low taxation and lower profits in countries with higher
taxation. Governments in some countries
take steps from time to time to regulate the operation of transfer pricing
systems for this reason.
TRANSFER PRICING METHODS
Transfer
pricing methods are concerned with the alternative means by which a transfer
price can be set and its impact on organizations gauged. Emmanuel and Otley bring together a number of
views of transfer pricing methods in practice.
Essentially, they report that there are three categories of transfer
price: cost based, market based and negotiated.
Within the surveys reported, in terms of very rough approximations,
about 20% of companies used negotiated prices; about 30% of companies used
market values and about half used cost based prices. For each category, a good degree of
discretion existed to develop alternative bases at a detailed level. For market based prices, for instance,
competitors' prices, list prices, most recent bid and values adjusted by a
discount provided alternative bases. The
description which follows does not go to such a level of detail but
concentrates on four main approaches: absorption cost bases, variable cost
bases, market value bases and negotiated value bases.
1. Cost-based transfer pricing
This method can be used when
either the market price is not available or it is inappropriate to consider.
-
The costs used in cost-based transfer prices can be
actual costs or budgeted costs.
-
Sometime, the cost-based transfer price includes a
mark-up or profit margin that represents a return on departmental or divisional
investment.
-
Under this methods, either variable or marginal cost or
full costs of the intermediate products are the widely- used bases for transfer
pricing.
a) Marginal / variable cost.
Under this
method, transfer price is the variable production cost for the product. This cost includes all the direct costs of
producing the product as well as the variable indirect production costs.
Example:
Roy Plc has two
divisions, East and West. East division
manufactures an intermediate product, Alfa which can be used by west division
in manufacture of product Beta. East
division can sell Alfa internally as well as in the external market. East division provided the following
information
Material cost
(per unit) $62.50
Labor per unit $43.75
Variable
overheads per unit $18.75
Total fixed cost $125,000
Budgeted
production 5000 units
Calculate the
transfer price to be charged to west division on marginal cost.
Solution:
As the transfer
price is determined on the basis of marginal cost, all direct costs of
manufacturing Alfa and indirect variable costs are considered. Therefore, transfer price to be charged to
west division will be:
$
Material 62.50
Labour 43.75
Variable
overheads 18.75
Transfer price
per unit 125
Advantages
i)
it facilitates decision making by not considering fixed
costs in the transfer price
ii)
It is used when there is idle production capacity in
the selling division.
Disadvantages
i)
Provides poor information for evaluating the
performance of either the supplying or receiving divisions.
ii)
Marginal costs may not be constant over the entire
range of output because step increases in fixed cost may occur.
iii)
It is only used in the short-terms and not long term.
b) Full cost transfer price
Under this
method, the full cost (both variable and fixed) is taken as a basis for the
transfer price.
The cost of
production plus the costs of other business functions such as research and
development, design, marketing, distribution etc allocated to the product are
included in the full cost.
Using Roy Plc:
If East division
decided to transfer Alfa at full cost, calculate the transfer price to be
charged to West division.
Under the full
cost method, both variable and fixed costs are considered for determining the
transfer price. Therefore full cost
transfer price will be as follows:
Material cost $62.50
Labor $43.75
Variable
overheads $18.75
Total variables cost 125.00
Add fixed cost $125,000 $25
5000 units
Total cost per unit 150
Example 2
A division has a
product costing £5 which is transferred within a group of companies. Calculate a transfer price for the division
for each of the following mutually exclusive divisional targets:
1. A
net profit margin of 10%
2. A
mark-up on cost of 10%
3. A
net assets turnover rate of 5 and an ROCE of 30%.
4. An output of
1,000,000 units, a capital employed of £2,000,000 and an ROCE of 20%
Solutions:
1. A net profit
margin of 10% is the same as a mark-up on cost of 10/90. The selling price
is 100/90. Using a cost of £5, the transfer price should
be:
£5 X 100/90 or £5/0.9, which is £5.56, a profit of £0.56
2. The transfer price would be £5.50
3. Using the relationship:
Return on capital employed = Net profit
Capital
employed
= Net profit X
Sales
Sales Capital employed
The figures for the
division would be:
30% = Net profit margin
X 5
Net profit margin = 6%
(30%/5)
Transfer price = £5.32
(£5/0.94)
This example illustrates a general
procedure applicable in other situations.
4. Each unit of output utilizes £2 of
capital employed (£2,000,000/1,000,000).
The required return is 20% profit per unit of £0.40. The required transfer price is therefore
£5.40.
The two major
drawbacks to the full cost approach concern its inability to motivate the
supplying division's manager to improve performance and the danger of making
incorrect decisions. Since all costs are
passed on, irrespective of economy or efficiency in the supplying division,
there is little incentive for managers of supplying divisions to cut costs or
to operate more efficiently. Once costs
are passed on, fixed costs of the supplying divisions are interpreted as
variable costs of the receiving division and it is therefore possible for
divisions to make short-term decisions which are sub optimal for the organization
as a whole. Consider a make or buy
decision for which divisional variable costs are £2, including £0.30 fixed cost
included in a transfer price, and the external supplier's costs are £1.90. The division would buy in the product,
despite the fact that the company's variable costs, at £1.70, are lower than
the buy-in price. The company would wish
the division to continue to make, but can only do so by centralization of the
decision rule, with a loss of autonomy at the divisional level.
In order to
ensure that inefficiencies are not passed on by suppliers, it has been
suggested that standard absorption costing can produce reliable results. Underutilization of plant capacity,
inefficiencies and lack of price control remain in the division in which they
occurred and are reported through the calculation of standard costing
variances. However, the problem of sub-optimization
would not be overcome by standard absorption costing transfer prices.
Advantages
i)
it is simple to understand and easy to implement
ii)
It takes into account the total production cost of the
product.
Disadvantages
i)
The inefficiencies in the producing department or
division will be passed onto the buying division.
ii)
The method does not provide a measure of divisional
performance.
iii)
The fixed costs are utilized and treated as if they are
variable costs.
iv)
The autonomy of the buying division is undermined since
it cannot establish the appropriate transfer price.
2) Cost plus based transfer price
} Under
this method, a mark-up is added to the total cost so as to ensure some profit
for the selling department or division.
} The
mark-up or profit margin represents a return on departmental/divisional
investment.
} This
method is welcomed by the transferor division as their profitability will
increase if they add up their margin to the production cost of the transferred
units.
} The
disadvantage with this method is that the inefficiency of the transferor
division is transferred to the transferee division. If the transferor division incurs more costs
as a result of inefficiency or working at low volume, the same costs is
transferred to the transferee division.
Example cont.
If East division
decided to transfer Alfa at a profit of 10% on the total cost, calculate the
transfer price to be charged to west division.
The East
division decided to use cost plus method for determining the transfer
price. Therefore the price will be
calculated as follows:
Material cost $ 62.50
Labour $
43.75
Variable over
heads $
18.75
Total variable
costs $125.00
Add fixed costs
(125,000) 25.00
5000
Total
cost 150.00
15
Add
10% mark up _____
Price per unit transfer 165
3) Negotiated transfer pricing
Negotiated price
is determined by a bargaining process between the selling unit and the buying
unit.
It is the price
agreed to by both selling as well as the buying unit. This approach is adopted
when some market imperfection exists for the intermediate product such as there
being different selling costs for the internal and external markets or there
being several market prices.
The advantage of
this method is that it motivates managers to take decisions.
Disadvantages
i)
May lead to sub – optimal decisions being made since
the agreed transfer price may depend on the negotiation skills and bargaining
power of the managers involved.
ii)
Measurement of divisional profitability can be dependent
on the negotiation skills of managers who may have unequal bargaining powers.
iii)
The price may lead to conflicts between division and
resolutions of such conflicts may require top management to mediate.
iv)
Such transfer prices are time consuming for the managers
involved.
Market – based transfer pricing
Market price is
the listed price of the product or of a similar product or the actual price at
which the product is sold in the external market.
Some adjustments
are made to the market price e.g. deducting the sales and promotion overheads
as saved by selling internally, in order to arrive at the transfer price.
This is a widely
accepted basis for transfer pricing because of its multiple advantages.
Advantage
i)
This method motivates managers in decision making.
ii)
Transfer pricing based on market price allows the
performance of the decisions to be evaluated realistically.
iii)
The transfer price can be calculates easily
iv)
The price is a close reflection of the market price of
the commodity and hence, this transfer price mechanism is favored by management
as well as tax authorities.
v)
This method maintains the autonomy of the divisions as
the transfer is treated as a sale from one division to another.
Disadvantages
i)
it is difficult to determine the market price for the
intermediate products
ii)
The transfer price depends on the subjective decision
of the divisional managers.
How transfer
prices can distort the performance assessment of divisions and decision made.
In order to make
performance evaluation of the department or divisions useful, the ‘selling’
division should be credited with the revenue for the products and services
transferred.
By the same
token the ‘buying’ division needs to be charges with the expenses of using the
goods or services supplied by the ‘selling’ division.
Where
inter-divisional transfers represent a large part of the total sales or
purchases of a division, transfer pricing is a very important issue.
Any small charge
in the transfer price of the product or service transferred can result in large
changes in profit for division concerned.
The performances
of divisional managers are often assessed according to the profits generated by
the division concerned.
Accordingly,
setting transfer price can become a sensitive issue between divisional
managers.
The level at
which the transfer price for a particular goods or service is set could lead
divisional managers to make decisions which are not in the interest of the
business as a whole.
International Transfer pricing
International transfer pricing refers to the
determination of prices to be charged between related persons and in particular
within a multinational enterprise for transactions between various group
members (sales of goods, the provision of services, transfer and use of patents
and know-how granting of loans etc.) As
these prices are not negotiated in a free open market they may deviate from
prices agreed upon by non-associated trading partners in comparable
transactions under the same circumstances.
The above leads
to a special interest on the part of tax authorities in intra-group
transactions especially in cross- border transactions. In many circumstances
the tax authorities would seek to adjust the prices adopted in these
transactions to arm’s length prices.
However, the intra-group trading partners themselves may find it
difficult to settle on satisfactory transfer prices, even if they are in many
cases no comparable transactions in the open market. In such circumstances
the tax authorities may seek to arrive
at the arm’s length price by using cost-based methods or methods based on the
price changed to the final customer – the ‘resale minus’ or resale price method
or any other which can produce an acceptable result.
Transfer pricing with third party
consequences
Transfer prices
are used not only for internal record keeping and performance evaluation
purposes.
There are
several settings where transfer prices have direct cash consequences for a
company. The most widely cited case is in interstate and international
transactions where transfer prices may affect tax liabilities, royalties or
other payments due to different government jurisdiction. Since tax rates differ
across states, or jurisdictions, companies have an incentive to establish a
transfer price which will increase the income in the lower tax jurisdiction and
decrease income in the higher tax jurisdiction.
Example:
Ker brook Shirt
Company owns a manufacturing plant in Kenya where its marginal tax rate is 60
per cent of net income. These shirts are imported by Zambia where the marginal tax rate
is 75 per cent of net income. For
simplicity assume that there are no currency controls and that tax regulations
concerning the definition of taxable income are the same between the two
countries.
During the
current year, the company incurred production costs equivalent to sh.2 million
in Kenya.
Costs incurred in Zambia
aside from the costs of the shirts amounted to an equivalent of sh.6 million.
Sales revenues in Zambia
were sh. 24 million. Similar goods imported by independent companies in Zambia
would have cost an equivalent of sh. 3 million.
However, Ker
brook Shirt Company points out that because of its special control over its
operations in Kenya and the special approach it uses to manufacture its goods,
the appropriate transfer price is sh. 10 million.
Required:
What would Ker
brook Shirt Company’s total tax liability in both countries be if it used the
sh. 3 million transfer price?
What would the
liability be if it used the sh. 10 million transfer prices?
Solution:
The solution is
approached by determining the taxable income for each country under the
alternative transfer price
scenarios. The resulting taxable income
is multiplied by the tax rate in each country to obtain the tax liabilities
For the sh. 3 million transfer price, the tax
liability is computed as follows;
Kenya Zambia
(sh) (sh)
Sales revenues 3,000,000 24,000,000
Third party costs 2,000,000 6,000,000
Transferred goods costs - 3,000,000
Total costs 2,000,000 9,000,000
Taxable income 1,000,000 15,000,000
Tax rate 60% 75%
Tax liability 600,000 11,250,000
Total tax liability = sh 11,850,000
For the sh.10 million transfer
price;
Kenya
|
Zambia
|
|
(Sh).
|
(Sh).
|
|
Revenues
|
10,000,000
|
24,000,000
|
Third party
costs
|
2,000,000
|
6,000,000
|
Transferred
goods costs
|
-
|
10,000,000
|
Total Costs
|
2,000,000
|
16,000,000
|
Taxable income
|
8,000,000
|
8,000,000
|
Tax rate
|
60%
|
75%
|
Tax
liability
|
4,800,000
|
6,000,000
|
Total tax
liability = sh. 10,800,000
The tax
liability assuming a sh. 10 million transfer price is about 9% less than the
liability that would be incurred if the transfer price was sh. 3 million.
International
taxing authorities look closely at transfer prices when examining the tax
returns of companies engaged in related party transactions which cross jurisdictional
lines. Companies must therefore have adequate support for the use of the
transfer price which they have chosen for such a situation.
Another
situation where transfer pricing has direct economic consequences is where the
owner of one entity holds a different ownership percentage than he or she holds
in another entity. It is generally in the best interest of this person to
transfer income to the entity in which he or she holds the higher ownership in
percentage.
In situations
where transfer prices have direct economic consequences it is important to
develop transfer prices in a manner that will meet third party scrutiny since
tax authorities may investigate transfer prices which affect cross-border tax
liabilities. In addition, in situations where an individual acts on both sides
of a related party transaction, the possibility of litigation arises if
transfer prices are not reasonable.
In general,
transfer prices for goods and services between segments or companies located in
different countries should reflect that countries have different tax rates and
regulations. Due to these variances, companies have an incentive to transfer
most of their income to the subsidiary that has a tax advantage over others
within the corporate group. In addition
some countries restrict payment of income or dividends to parties outside their
national borders. In such cases, the company often increases the transfer
prices so they pay more funds out of these countries while appearing to follow
regulations.
International transfer pricing -
compliance and documentation
Transfer pricing
is a perennial issue, within the international tax community (Richard Casna,
Accounting and Business, February 1988, pp.30-31).
As
multinationals become more sophisticated in employing transfer pricing
techniques in their tax planning, the revenue authorities have increased their
scrutiny of arrangements, putting transfer pricing at the forefront of
international tax concerns.
It naturally
follows that if profits can be shifted from a high tax jurisdiction to one of
low tax through transfer pricing, the tax authorities will respond with rules
designed to curtail tax avoidance and ensure tax payer compliance.
Revenue
authorities around the globe have become more adept at countering the
“profit-shifting” aspects of transfer pricing practices and are strengthening
their statutory powers with ever more extensive and complex legislation and
regulations.
To strengthen
the tax authorities’ position, regulations typically introduce specific rules
to determine arms’ length prices and require that tax payers maintain very
extensive records documenting the methods used to determine their transfer
prices (which often necessitates the employment of teams of both in-house and
outside counsel, accountants and economists). Provision is made as well for the
imposition of very stringent penalties in cases of non-compliance.
To achieve these
ends, the statutes generally focus on guidelines set out by the OECD’s
Committee on Fiscal Affairs (the tax policy body of the OECD); first in its
1979 document “Transfer pricing and multinational Enterprises” and the 1995-1996
“Transfer pricing Guidelines for Multinational Enterprises and Tax
Administrations.” These guidelines generally stipulate the parameters of the
arm’s length pricing standard and the methodology to be followed in achieving
arm’s length prices.
The practitioner
as adviser to multinationals which faces the complexities of transfer pricing
legislative and regulatory controls has therefore to simply consider the statutes
in each country/state carefully, comply with the rules and maintain extensive
documentation.
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