Home | Business News | Browse by Publication | S | SAM Advanced Management Journal

Global transfer pricing: a practical guide for managers.

Article Excerpt
A firm with operations in more than one country must be cautious when setting transfer prices for goods or services sold between divisions. Methods traditionally used to set prices between divisions in a single country may not be acceptable for international tax purposes. This paper describes the basic arms-length standard used by most countries and the difficulties that arise when applying this standard. Numeric examples show approved ways to calculate transfer prices and explain how application differs between tangible goods and intellectual property. General managers should benefit from the guidelines offered for selecting and implementing a transfer pricing policy.

**********

Transfer prices are the amounts charged for goods and services exchanged between divisions of the same company. For companies operating solely within U.S. borders, there is wide latitude on the price one division might charge another. However, for companies with divisions outside the U.S., strict international tax laws regulate the amounts charged for goods and services that cross borders. Managers working globally must understand how the laws apply or risk significant fines, penalties, and lost profits.

In the past, these issues were relatively unimportant to all but large multinational companies operating in three countries: Australia, South Africa, and the U.S. As recently as 1995, only these three countries had transfer pricing tax regimes in place. By 2007, this list had expanded to 38 countries and others are expected to join soon. Why has this list grown so dramatically? Host countries see the control of transfer pricing as a way to generate tax revenues. As world trade increases, each jurisdiction wants to get its fair share of the international tax pie. Tax regulations apply equally to large multinational firms and the growing number of small companies with operations overseas. No longer are super-sized multinationals the main ones affected.

The universally accepted approach for setting a transfer price is referred to as the "arms-length standard." Deloitte Tax LLP (2007), an international consulting firm, defines this as "the price at which two unrelated parties agree to execute a transaction." Despite the fact that countries worldwide use the arms-length standard to set transfer prices, they enact rules that can lead to different interpretations of what the price should be. Companies are stuck with compliance burdens on each side of the transaction. Meeting the rules of one country does not guarantee that the other's requirements will be met.

The recent tax case of GlaxoSmithKline, the pharmaceuticals giant, offers an example of the difficulty firms can face (Matthews and Whalen, 2006). Glaxo agreed to settle for $3.4 billion in back taxes in 2005 after it fought with the U.S. Internal Revenue Service for nearly two decades. The IRS claimed that Glaxo paid its U.K division too much for drugs sold in the U.S., thereby reducing the amount of U.S. affiliate profit subject to U.S. tax. The core issue was determining an acceptable transfer price for the source of Glaxo's U.S. value creation. Glaxo claimed that R&D in Britain was the main source of value, whereas the IRS argued successfully that the value was the result of marketing efforts in the U.S. Calculating values for R&D and marketing was crucial to resolving the case.

This paper reviews the complexities of international transfer pricing and offers guidelines for compliance. We identify two major types of transactions, intra-company sales of products and intra-company licensing of intangible property. We review methods used to estimate arms-length values and adjustments needed for noncomparable circumstances. We offer short case studies to illustrate these ideas and show practical applications. This article differs from most others on this topic in that it is written for the general manager and does not assume any previous understanding of transfer pricing or income tax regulations.

Economic Rules

Before we examine the complexities of international transfer pricing, it is useful to review what most managers have been taught about transfer pricing. The textbook approach to transfer pricing is based on economic rules (Hirshleifer, 1956). In a decentralized company, each division manager will buy or sell from another company sub-unit only when doing so increases the manager's division profits more than going outside the firm. Because a manager's compensation is based on division profit, each manager is interested in maximizing that profit. Deciding on the best choice for action depends on the transfer price that the seller division is willing to offer and the buyer division is willing to accept. The question of price comes down to the seller's use of existing capacity. Consider these two situations:

* Seller is at capacity. If the seller division is at capacity, it will have to give up outside sales at the going market price to transfer goods internally to another company division. The seller would require the buyer division to pay full market price. Nonetheless, the buyer division has the option to buy outside the firm if it can find a comparable product at a lower price.

* Seller is under capacity. If the seller is not using all its available capacity, it will add to profit by selling above the differential cost to produce the good. The minimum transfer price it would charge is its differential cost, which would result in a breakeven situation. On the other hand, the maximum price the buyer would pay is its next best price outside the firm.

The economic rules suggest that the highest transfer price would...

View this article FREE - Now for a Limited Time, try Goliath Business News
Free for 3 Days!