Transfer Pricing, Research Paper Example

Transfer price is the price that a division of a company like production or sales charges another division of the same company, a subsidiary or company located internally or externally, for the product it will move from upstream to the downstream location, according to Caplan (2012).

In the meantime, Price Waterhouse Coopers (2007) define the same concept as a multi disciplinary practice that involves close cooperation between subject matter experts on issues tax law and accounting and economic analysis.

Three purposes are served when transfer pricing transactions takes place, according Caplan (20120, and these are (a) products are transferred between profit centers or investment centers within a firm that is decentralized because necessary to calculate divisional profits, which in turn affects divisional performance evaluations, (b) in cases where divisional managers decide to buy or sell internally or externally, the transfer price policy is what determines whether the incentive design by the managers aligns with the overall company strategy, and (c) in cases where multinational firms transfer international borders, transfer prices become relevant with respect to the computation of income taxes and relevant international trade as well as regulatory issues (Caplan 2012).

In accounting terms, when transfers takes place they are recorded as journal entries, with no actual cash exchanges occurring, but the transfer prices are treated as expenses by the downstream recipient entities, while the upstream centers will treat them as revenues, according to Caplan (2012).

According to Caplan (2012), transfer process can be established using three basic methodologies, namely a market based transfer, a negotiated and a cost base approach, and in the case of pursuing any of these options, there accompanying advantages and disadvantages.

Cost based approach, according to Caplan (2012), involve pricing mechanism using the actual cost, full cost or variable cost along with the attached markup while the external price is used by firms once a competitive and stable structure exist and is available for use.

A negotiated transfer price will often be achieved when divisional with knowledge of their profit and cost structure for specific goods and interest, negotiate with and arrive at mutually agreeable price with external, and in some cases with internal parties. Cost savings are often realized from external transactions, when compare to internal transfers, and issues of credit checks, Caplan (2012) asserts was one way this can be by upstream partners for their downstream associates, who in the process will can also be spared the cost application of inspection procedures.

Caplan (2012) went further to demonstrate that market base transfers, with respect to prices for commodities, can become distorted by the fluctuations of prices on the market, while negotiated transfer pricing provides the advantage of replicating a free market in which managers may sell and buy from each other in fashions that simulates arm’s length transactions. However, there are no guarantees that these transactions will always achieve the desired outcomes and serve the interest of companies and shareholders at the same time (Caplan, 2012).

The European Union Transfer Pricing Landscape

The region consist of a coexistence of 25 different direct taxation regimes and this is often seen by experts as widely contributing to the problems policy makers have been having as they strive to develop efficient and competitive a single European market according to Price Waterhouse Coopers (2007), by trying to reduce income tax compliance, and to alleviate double taxation within the region.

As part of the effort the European Union (EU) Joint Transfer Pricing Forum (JTPF), has in place a code of conduct calling for better adherence to the EU arbitration convention for assisting taxpayers in avoiding double taxation on their intra-group trade, and the standardization of EU transfer pricing documentation across member states, according to Price Waterhouse Coopers (2007).

Despite these efforts, according to Price Waterhouse Coopers (2007), member states still differ widely in terms of approaches to transfer documentation and enforcement. Fourteen of the sixteen countries had chosen to enact some form of transfer pricing legislation, but Ireland and Switzerland to date were still non-compliant.

In terms of tax enforcement enactment, according to Price Waterhouse Coopers (2007), Belgium, Denmark, Italy, the Netherlands, Sweden, Germany, Greece and the UK were most active, enforcing the transfer pricing rules, despite the fact that varying levels of enforcement existed among the countries making up the union.

In particular Ireland has been posing a special problem for the OECD, in that it was yet to introduce legislation based transfer pricing, due to the favorably tax opportunities the country had been offering to multinationals operating within, and the impact the Foreign Direct Investment was having on national GDP other economic indicators (Price Waterhouse Coopers, 2007).

It has been widely believed that one of the key successes to Ireland attracting Foreign Direct Investment (FDI), according to Price Waterhouse Coopers (2008), was its taxation pol.icy, which has empowered it to seek more broad based transfer pricing legislations.

The operations in the external market therefore was forcing Ireland to adopt transfer pricing strategies that will help to advance the countries’ economic stability and growth, as well as its less reliance on the OECD for any other forms of developmental assistance.

Price Waterhouse Coopers (2007), closed their case on the attempts by the EU to standardize aspects of tax policy across group member states, including policies related to transfer pricing, by pointing to the broad based spectrum the MNE’s operating in Europe faces, in terms if transfer pricing of different regimes and the need for taxpayers as to become aware of therefore great diversity within these similar geographical boundaries to develop strategically powerful and rewarding transfer pricing models .

The Use of Profit Based Pricing Methods

According to Przysuski and Lalapet (2005), the use of profit based pricing methods has been driven mainly by the lack of adequate transactional data to apply to any of the preferred transfer pricing methods. The authors informs that the availability of comparable data was not the concern, because profit based methods can be acquired from publicly available data, but the best possible options are those with the highest degree of functional comparability being treated with the highest level of imperativeness, in terms of developing s systematic approach.

Critically, according to Przysuski and Lalapet (2005), will be the economic integrity of the comparable data screening process, and the choice of profit indicators used to derive arms’ length range of profits, against which related parties are compared.

Acceptable Pricing Methods

In order to determine acceptable transfer pricing methods are in place in many transactions, according to Eden and Smith (2001), the 1994 Section 482 Regulations, set in the United States has to be utilized, as this was the established using the best method rule, which include heavy contemporaneous documentation, and imposed controversial accuracy related penalties for large transfer price misevaluations.

The success of the model and its effectiveness has led countries like the OECD (1995), Argentina, Brazil, Chile, and China adopting it at different levels and this has facilitated widespread growth of the arm’s length standard as the international norm for cross border transactions (Eden and Smith, 2001).

According to Eden and Smith (2001), there are several key contributors as to how to best apply the model, but sine price fixing is both an issue of facts and circumstances, the critical step one should take is to determine which method is ideal for world situations, and then timely apply that method.

The Berry Ratio

Originating in the late 1960’s, when Princeton Professor Charles Berry was consulted by the IRS and the Justice Department to assist in evaluating the economic circumstances as they relate to a dispute between the IRS and E.I. DuPont de Nemours Company of Wilmington, Delaware (Przysuski and Lalapet, 2005), the Berry Ratio was about to come to the fore and become a critical determining factor in solving transfer pricing disputes, especially as it relates to cross border activities.

DuPont brought the case against to court when it filed papers in the Supreme Court to recover assessments by the IRS, during the tax years 1959 and 1960. The fact of the case was that DuPont had established a new wholly owned subsidiary in Switzerland to act as a super distributor in Europe on its behalf. DISA, as the company was eventually called, performed marketing and advertising on behalf of DuPont (USA), and establish its presence in Europe, according to Przysuski and Lalapet (2005).

Accordingly, DuPont USA performed transfer pricing with its subsidiary by allowing it to perform distribution functions, which include purchasing products for resale to other affiliates in Europe, according to Przysuski and Lalapet (2005). DISA was charged 20 % on the selling price of all products from DuPont, and it was on this issue that that the IRS objected, stating that it was too high, and issued a Deficiency report for the 1959 and 1960 financial period.

Professor Berry was enlisted to determine whether DuPont had transacted arm’s length with its subsidiary DISA, and had acted as an independent party. The case of DISA was made exceptional due to the number of transactions it had performed on behalf of DuPont. According to Przysuski and Lalapet (2005), the subsidiary was conducting marketing, consulting, advertising, logistic activities, and taking shipments directly and as such, had to be characterized as marketing, research, consultant, advertiser and distributor for DuPont.

Berry had to take all the activities of DISA individually, as a function and use third party market, research, management, and advertisers to evaluate the company’s gross profit to operating expenses to the ratio total income to the total cost of all service provisions.

In the final analysis, after using all the third party computation and analyses, the ration of gross profit to operating expenses was later named the Berry Ration in his honor. The conclusion as a result of Professor Berry work, was that regardless of whether one consider the markup realized by a third party management consulting and research marketing firm, advertising agencies or independent distributors, the DISA Berry Ratio for its services was significantly above what could be classified as arm’s length business transactions

The Application of the Berry’s Ratio in Transfer Pricing Analysis

This ratio according to Przysuski and Lalapath (2005) should be conceived as a variant of cost plus methods. It represents a return on company’s value added functions and assumes generally that all these functions have been captured in its operation.

In trying to explain the application of the concept, Przysuski and Lalapath (2005) argued that the connecting the gross profit margin earned by the distributor as analogous to a firm’s total cost available to a distributor, and the operating expense incurred to a distributor products as also analogous, in the process of determining the ratio of the markup on operating expenses that was afforded to the distributor.

Berry’s ratio, it was decided can be used to analyze operating data and then determine whether the markup earned by distributors are at arm’s length as well as sustainable at the same time.

Base on evaluations of distributors, the remarks made by Przysuski and Lalapet (2005) that given the ratio that the gross profit in the numerator and the operating expense in the denominator, a profitable distribution would no doubt show a greater Berry ratio than one or 100 %. It could be argued that results showing ratio calculations that are less than 1 or 100% are indications of the presence of excessive operating expenses, and these should be curtailed in the long run, to prevent possible negative returns on investment

Conclusively Przysuski and Lalapet (2005), has emphasized that no distributor with Berry ratio of less than 1 is involved in a sustainable operation. This ration can be used by service providers on the basis that the markup earned can be used as the basis of cost provision and by subtracting 1 from the ratio, the ratio of operating profit and operating expenses is generated.

Formula

Berry’s Ratio – 1 = GP/OE-1

= GP- OE/OE= OP/OE

The use of the ratio OP/OE and the formula developed by according to Przysuski and Lalapet (2005) will be helpful to distributors and service providers, as long as they remain with the time demarcation categories and are classified appropriately

The Importance of Transfer Pricing

One of the most important taxation issues facing multinationals in the 1990’s , according to Ernst and Young (1999), was transfer pricing. While multinationals normally set their transfer prices based on production cost and marketing prices, surveys showed that nearly two-thirds of these transactions were often based on cost.

According to Eden and Smith (2001), there are good reasons why multinationals establish transfer prices for infirm goods, business, services and other intangibles, and one of the reason was the fact that many foreign affiliate operate profit centers for their managers, and this enable them to be rewarded for the amount of profits their respective subsidiaries are able to generate from transfer pricing transactions.

Transfer pricing also serve as dual motivation for managers as well as the multinationals they manage , in that they have to pay cooperate income taxes on their domestic and foreign income sources, and this necessitate the use of transfer process to for all cross border trade flows..

In addition, intra-firms engaging in the importation of parts, components, and finished goods, according to Eden and Smith (2001), are often required to meet NAFTA rules of origin and requirements.

Shifting profits across borders

Secrecy, complex organizational structures, tax havens and profit hungry firms are what constitute the key ingredients in the tax avoidance industry, according to Premm Sikka (2009), and they all come together under the subject of transfer pricing. Due to globalization Sikka (2009), continued, a company can design a microchip in country A, manufacture it country B, conduct tests for it in country C, hold patients in country D, and assign marketing rights to a specific subsidiary in country E.

By means of these structures, according to Sikka (20090, huge corporations can exercise large discretions when allocating cost to each country as well as to shift profits through internal trade, and to compound the problem, approximately 60 % of the world trade is made up of transfers internal to multinational corporations, there is a lack of proper policing, and as such entities have unlimited opportunities to easily shift profits across borders without detection.

Tax cuts, according to Sikka (2009), requires arm’s length practices by companies, but the notion of cost changes often and are hard to find, and with the dominance of multinationals of this kind of market, the competitiveness of other companies are often non-existent.

Ernest and Young reporting on transfer pricing, according to Sikka (2009), infer that successfully managing businesses and tax issues related to transfer pricing entails much more than documentation compliance, as practically every multinational is affected by the tax burden associated with transfer pricing.

What is needed according to Sikka (2009) is a multi-disciplinary strategy involving pricing strategies, effective tax solutions and controversy management approach that enables best ft objectives to be established in the process. This would no doubt help to reduce the abuse encountered in a country like China for example.

This world’s largest market economic powerhouse went to the extent of offering tax incentives and other benefits to several large multinationals around the world several years ago, but today many of these same organizations, approximately 70 %, have reported that they are incurring significant operational losses, and transfer pricing seems very much part of the equation.

Reducing the Cost of Transfer Pricing through improving the availability of Informational Sources

Transfer pricing faces serious challenges going forward, according to Eden and Smith (2001), especially with respect to the high cost of the search for information, and the lack of a suitable springboard to create the awareness needed to achieve low cost service and other objectives

To this end Eden and Smith (2001), has provided a list of transfer pricing books that libraries internationally may have in their possession, as well a scholarly journals that will drastically help to reduce the paucity of information of the field, as well as to ensure traders are empowered to achieve and effect arm’s length transactions across borders and within firms.

A sample of the list reads,

1. Cooper Lybrand International (1993) Transfer Pricing Chicago: CCH Inc.
2. Eden, Lorraine (1998(, Taxing Multinationals: Transfer Price and Corporate Income Taxation in North America, Toronto, and University of Toronto Press.
3. Pagan, Jill , & Willkie, Scott(1999), Transfer Pricing Strategy in a Global Economy Paris OECD (1995 and1999 update)
4. Atkinson, Mark, Tyrell, David (1999). International Transfer Pricing The Financial Times Management Briefing Series London UK Financial Times (1999).
5. International Tax Review London Euromoney Publications PLCIO Times Annually 1989- Present Review
6. International Transfer Pricing Journal Amsterdam 1BFD Publications Bi-Monthly 1999- Present

This information supplied by Eden and Smith (2001), may make significant inroads in to a very districted market in terms of transfer pricing, based on details provided by Sikka (2009). According to Sikka (2009), government need to mobilize the public and public companies should be required to publish a table showing their sales, profits, purchases, liabilities, assets, taxes and the number of employees within their operations in each country.

Sikka (2009).argues that in cases where large profits are made with very small number of employees, or where there are large number of employees and very small profits, government under whose jurisdiction these activities falls under may infer that transfer pricing are taking place, and may be able to conduct the appropriate investigations to bring about penalties under the government regulatory agencies.

The public may be horrified when this current lack of information gets resolved according to Sikka (2009), in that currently some companies have priced flash bulbs at $329.90 each, pillows cases at $909.29 each, and a ton of sand at $ 1993.67, when the average world prices are quoted in some official and reputable sources like those referred to by Eden and Smith (2001), as 66 cents, 62 cents, and $11.29 respectively.

Sikka is of the belief that should the consuming public be provided with these kinds of information on the transfers pricing activities, they would be able to mount boycotts and protest demonstrations, which would no doubt expose these corrupt organizations and force them to change their actions, pay compensations to those injured financially and adopt more consumer-friendly business strategies.

Two significant development, should Sikka recommendations be accepted and implemented may occur, and they are, (a) the employees of organizations that are abusing the price transfer market and generating high profit margins for both managers and companies at the same time, may be significantly under-paying their employees, and these employees may in turn strike and force their employers to address the financial disparity grievances identified in each environment, and (b) a number of consumer protection driven organizations and others with similar interest like Eden and Smith (2001), may be galvanized to demand actions from organizations like the WTO, as well as to organize global boycotts of the products and services these multinationals market around the world.

CONCLUSIONS

Transfer pricing is a critical tool used to advance the financial stability, profit making capability, and cooperative image of multinational organizations as well as the managers who lead these organizations. The extensiveness of the practice has reached global proportions, to the extent that the Price Waterhouse Coopers (2007) described it as a multinational practice that involves the close cooperation of profit centers and other department like production, distribution and marketing.

Fortunately for transfer pricing, the concept and practice of arm’s length deals came into the development process very early and has been able to provide a moral standard that can be evaluated and subjected to court rulings, there be reasons to suspect serious miscalculations of markups and other unethical practices.

Historically, DuPont showed how cross border trading can be maximized using the DISA subsidiary in several functional areas to generate maximum markups levels as well as to maintain its presence in Europe, while at the same time successfully challenge the US treasury on the accuracy of its calculations, when the Beer Ratio was brought in to untangle its webs of transactional activities.

Berry though the use of his ratio to assist in the handling of the DISA/DuPont CASE has securely claimed his place in history especially multinational organizations business practices involving cross border trading and other questionable practices, are carried out in attempts to evade tax payment. The use of his OE/OR ratio by experts in various governmental regulatory systems will serve to decide which way justice will be delivered base on the evidence collected from business transactions conducted in the periods under review.

Globally, as a result of the OECD adoption of the United States 1994 Section 482 Regulations one year later, significant development in relationships between countries, across borders, and intra-company in transfer pricing has been achieved. Additionally, with the imposition substantial fines for breaches, OECD countries like Ireland, despite attractiveness its tax incentives to multinationals and its desire for self autonomy, runs the risk of incurring substantial fines, which may affect its future capacity to enjoy the benefits of arm’s length transactions

However, a lack of information and the subsequent high cost of searches to find transfer pricing regulations, business practices, creditable sources and available offers, may have reduce the number of transactions in this area of operations, but the work of Eden and Smith has somewhat reduce this prevalence across the global marketing environment.

The continued rise of the use of transfer pricing in the USA and Europe, due to the profit motivation of multinationals and associated executives, as well as the availability of consistently high and reliable financial information, should be expected, even in countries that have not yet fully embraced the best practice standards of the USA as a country, because the benefits of arm’s length transactions will in the medium to long term force competitors to embraced the practice to avoid being relegated into obsolescence by other more progressive and profit orientated competitors.

Organizations with great interest in consumer protection needs to intervene in the transfer pricing abuse prevalent across the globe, especially when it comes to ensure prices are available uniformly, as a number of multinationals are too profit driven, secretive and strategically designed to ensure complexity, so that cross border transactions can take place almost impeded.

The global structure to handle transfers pricing based on the evidence found is not in placed, and without the accountability recommended by Sikka being implemented in the near future, despite the genuine profits made by many multinationals, the market will continue to favor the dominant players who seeks to find weak government and poor information systems to maximize profits.

Finally it could be argued that the reason a number of countries are hesitant to become a part of the OECD, may be due to the level of corruption and abuse that are brought into the practice of transfer prices by company CEO’S as well as these leaders on behalf of the company they lead. The OECD despite its penalties may not be effective to bring an end to the level of corruption that exist in the market, as it policies are not inclusive of informational distribution and management , which should play key roles in reducing the level of greed and corruption that exist.

Countries like Ireland and Switzerland may therefore seek other alternatives to ensure their respective economy develop in a sustainably manner.

Reference

Caplan, D. (2012). Management Accounting: Concepts and Techniques Oregon State University Retrieved from http://www.pwc.com/gx/en/tax/transfer-pricing/management-strategy/assets/tp_perspectives_europe.pdf on 05/16/12

Eden, J. L., & Smith, R.A., (2001). Not at arm’s length: A Guide to Transfer Pricing Resources A Journal of Business and Finance Librarianship Vol.6 Issue 4 Hawoth (2001)

Ernst and Young, (1999), Global Transfer Pricing Survey Washington DC Ernst and Young International Retrieved from www.ey.com/ on 05/17/12

Price Waterhouse Coopers (2007). Global Transfer Pricing Perspectives Tax & Legal Services Transfer Pricing Europe, autumn, 2007 Retrieved from: http://www.pwc.com/gx/en/tax/transfer-pricing/management-strategy/assets/tp_perspectives_europe.pdf

Przysuski, M., and Lalapet, S., (2005). A Comprehensive Look at the Berry Ratio in Transfer Pricing Reprinted from Tax Notes Int’l, November 21, 2005, p. 759 Retrieved from: http://saf.uwaterloo.ca/mtax/documents/PrzysuskiM_BerryRatioPaper.pdf on 05/16/12

Sikka, P. (2009). Tax Gap: Shifting Profits across Borders The Guardian www.guardian.co.uk/comments/free/2009/Feb/tax-avoidance-tax , 05/20/12