transfer pricing Flashcards

Question

what are the disadvantages of negotiated TPs?

Answer 1

- time consuming - lack of agreement - central mgment may be needed, and if TP is based on this it would negate objective of giving autonomy. however, central mgrs might act simply as arbitrators or mediators to reach acceptable conclusion. - unequal bias - not based on sound economic or business reasoning - could lead to sub-optimal decisions.

Answer 2

intro - cost plus fixed fee OR cost plus profit share growth - price related to closest substitute maturity - price based on identical products only during maturity are you likely to find substitutes, at intro there may be no alternative to cost basis that can actually be used.

Answer 3

standard cost - using actual or cost + doesn’t motivate the suppling division to act in group interests. either not encouraged to be efficient and control costs, or encouraged to push up actual cost as it increases markup too. std costs least subject to scrutiny when set once a year and receiving div has change to challenge. if used, selling div has incentive to control actual costs below std to increase their own profits.

Answer 4

TP takes place in many different types of orgs and can have profound effect on beh. e.g., garage carries out number of different activities that are linked to activities of another section - selling new cards, old cards, servicing cars sold, general repairs, providing financing. TP is used to transfer used car accepted in part payment for new car between the new car sales and used car sales divisions. TP will also have to be established for cost of servicing and repairing these for sales between servicing and used car sales divisions. these prices will have implications for profitability of different sections and on actions of employees when making sales deals. if perf measurement and assessment is to be fair, TPs need to be set carefully.

Answer 5

if vertically integrated org concentrates profits at stage of production where least competition, competitors may be attracted to enter. on other hand, competitors operating at other stages may be disadvantaged by low profits they’re taking and may not be able achieve good return if only operating in limited area of value chain. US oil companies and Japanese trading and manufacturing companies have been seen to do this (Neghandhi, 87)

Answer 6

often TP systems can reward mgrs for poor performance or inefficiency. this is much more likely in cost based systems. thinking back to oil companies, suppose plant manager in charge of refining overspends by 200m on variable costs. will reduce total profit by 200m, but sub-unit profits affected differently depending on TP method. margin attached to cost passes some inefficiencies on to next division. of cost based, only market cost leaves whole 200m loss with responsible division. in principle, depending on figures/TP arrangements, an increase in costs may even increase a dept’s profits under cost +. there’s also no incentive to control costs, but can be mitigated with std TP costs that apply for given time period.

Answer 7

one problem artificially created by TP is where TP is apparently higher than external mkt price. would appear rational for buying div to go external, but can often be wrong. TP made up of different cost components and artificial accounting figures. mkt price may only be temporarily depressed by abnormal mkt conditions or part of deliberate pricing strategy. e.g., if its cost+markup and the TP is higher than mkt, the actual cost to the company for manufacturing may be lower than the cost of buying in it’s just an artificial markup. also if selling div think they can sell externally for more than they can transfer, there are other costs involved like invoicing and delivery. there’s also the issue that the buying div would then have to buy on the open mkt and all advantage of vertical integration gone.

Answer 8

if all methods are used and reported upon, org will have broader view of fin perf of divisions. would even avoid incorrect diagnosis of divisional problems. despite common sense of this, very few use this because: expensive - however computerised accounting makes this less valid it was felt to be too complicated for mgrs. want to come up with precise and objective figure. giving mgrs a whole range of figures undermined this perception of scientific accuracy and objectivity. was felt that mgrs would simply cherry pick between different outcomes and emphasise the one that made them look best.

Answer 9

improvements in costing resulting from operation of activity based costing can also be used to help alleviate TP problem. resources consumed by activities incurred in producing intermediate product can be identified and costed to not confuse short and long term costs. ABC based on underlying cost structure of product. changes in prod levels, methods and capacity levels will result in changes in TP in manner than reflects the actual changes. however, doesn’t reflect value of product just resources used. to measure profitability of individual units, product’s profit needs to be attributed to activities required inproduction. ABM also includes analysing activities in terms of value they create in overall product. this value-added analysis of individual activities allows profit element to be attributed throughout the production process. ABC allows integration of market and cost based measures, reflecting complexity and interdependence of org reality. clear advantages but not widely used.

Answer 10

1. goal congruence - within divisionalised company, div mgrs will have responsibility for / will be judged on performance. system in general and TP policy in particular should ensure that what is good for an individual div is good for company as a whole. 2. perf measurement - TP system should result in report of div profits that’s reasonable measure of managerial performance 3. maintain div autonomy 4. minimise global tax liability 5. record movement of goods and services - in practice, important function 6. fair allocation of profits between divs

Answer 11

equitable distribution of profit between divisions neutral - no sub-optimal behaviour induced simple and transparent, in order to be cost effective

Answer 12

1. where there is a competitive market for intermediate product if perfect, all suppliers sell all output at prevailing market price. no restrictions on demand at that price and no single dominating supplier. provided selling above MC, the only limitation on selling div’s profitability from external sales is the output capacity of the division. this makes the optimum transfer price = market price ± small adjustment, which could be selling costs avoided. in a perfect market can see that the only transfer price for divs to trade is mkt, because selling div will go external if it’s equal to or more than mkt and buying will go external unless equal to or less than. if there are sales costs to be considered, cost savings can be reflected in an adjustment and both divs share the benefit. this will create a range of acceptable TPs 2. where selling div has selling capacity may arise where there is intermediate mkt and also sells internally but there’s a limit on external sales and there’s spare capacity. the opp cost is therefore 0, so would be a cost based price (MC). buying div unlikely to purchase for lower than MC elsewhere but unlikely to be fair to supplying div when appraising directors’ performance. the solutions to this are 2 part tariff, cost plus and dual pricing. 3. where there are production constraints and selling div has no surplus capacity. can’t satisfy external demand and therefore internal sales have contribution losses. optimum transfer price = MC + shadow price. shadow price = opp cost of lost contribution from other product or extra contribution that would’ve been earned if resource was available. this ensures optimal decision making, if TP is less than buying div’s max transfer occurs and if more than buying div’s max then the contribution selling div gets from selling externally exceeds and benefits.

Answer 13

scenario in which there is no capacity constraint in selling div in this case, manufacturing is to the advantage of the org as a whole. however, it is the manager of the buying div that will decide if end products are made, deciding based only on profits in the buying div (not selling). In this case, the marginal cost is the opportunity cost as there are no forgone sales/additional opp costs to actually consider. scenario in which selling div operates at full capacity, meaning transfers to other div are foregone sales here, the opp cost is the MC + contribution foregone, so the transfer price is higher under opp cost system than MC system. a system based on MC might introduce the wrong result as it doesn’t consider foregone sales. only a system based on opp cost guides the mgr right in both scenarios

Answer 14

underlying assumptions of competitive markets: unlimited demand for selling and availability for buying divs, without affecting price. economic solution is based on inadequate and partial understanding of the problem. internal economies in internal trading include lower selling, packaging, delivery costs, no risk of bad debts and no credit costs. there are non-financial advantages too: more control over quality and delivery times, product confidentiality and secret design/processes, using org resources more efficiently and avoidance of plant closures. the market price should be adjusted to take account of these savings. should have a discount against external mkt price, as it’s unwise to include prices that are not actually incurred in the pricing of the transfer.

Answer 15

imperfect intermediate market = selling div unable to sell all its output externally at same market price. can happen if it’s a dominant influence in market, and monopoly conditions apply. if divisions are limited in ability to trade with external market for some reason, market price has little significance. may be possible to establish a demand curve, although this is difficult in practice. if for confidentiality, divs are restricted in operations then they’re not foregoing any value or lost sales; in such cases the market price is largely irrelevant for their decision making.

Answer 16

sometimes, market for intermediate mkt doesn’t exist - who would buy a specific car door? few situations with true competitive mkt for intermediate products. also, where an external supplier quotes a low price to break into a market this cannot be used. if market prices exist that allow optimal resource allocation and managerial evaluations to be made, would be little reason for divisions to remain part of same org. they could function more effectively as independent companies. notion of independent divisions ignores the fact that there are synergistic benefits arising from being in one org.

Answer 17

micro-economic theory suggests that optimal prod level and therefore transfer price is where price = MC. however, it’s vague on meaning of marginal costs and suggests capacity can be altered constantly without incurring additional costs (incorrect). these ignored costs can be factory building, production machinery, supervisory costs to name a few. approach of short term VC + opp cost has been rejected despite being seen as best practice, because seen that production related problems are long term, not short, and should reflect long term costs.

Answer 18

seems to be most popular approach, based usually on traditional costing system. full cost = variable, fixed AND apportioned. serious problems can arise if arbitrary apportionment methods used. main method is estimate total cost of dept and / expected production level.

Answer 19

varying TP based on changes in activity level mixes up short term and long term costs, obscuring underlying cost structure from org decision makers and fails to siggest how cost savings can emerge. also creates set of perverse incentives where inefficiencies get passed on schemes not actual costing systems but recovery systems that make no attempt to reflect underlying cost behaviour.

Answer 20

this approach can often cause serious dysfunctional problems, resulting from significant difference between internal tfer and external market price. buying divs have incentive to go external.

Answer 21

evaluation of divs depends on the TP method. despite costs/qtys/prices all being constant, the TP between divs gives different outcomes. difficulties arise signalling successful divs as problem divs, or vice versa. could lead to wasted mgment effort to uncover incorrect labels, problem divs allowed to continue uncorrected, and major errors in strategic decision making.

Answer 22

1/3 of UKs exports to Europe are intragroup transactions. in 80s, foreign owned assets in the USA tripled but the tax paid changed little, as more than half the companies involved reported no taxable income. multinational orgs have issues other than behavioural to consider when setting transfer prices. natural inclination to minimise tax, or payments to minority shareholders.

Answer 23

temptation to move profits to low tax countries, but also set up marketing subs in countries with low corporation tax rates and transfer products at low price. when products are sold to final customer, low rate paid on difference between prices. according to an EY survey in 95, more than 80% of multinational orgs view TP as a major international tax issue. tax authorities in most countries monitor TPs in attempt to control the situation and collect full tax due. double taxation treaties between countries mean companies pay tax on specific transactions in one country only. however, if org sets unrealistic price to minimise tax and authority spots this, they will pay tax in both. this additional payment can be millions and an effective deterrent, although does need to be offset against gains of tax avoidance.

Answer 24

Hoffman La Roche, importing pharma drugs at extremely high costs. uk authority accepted the prices, but monopolies commission argued that the unbranded chemicals could be obtained for much less. HLR argued: price was set on market, not just cost of unbranded chemicals and they had incurred R&D costs that they had to recover. they were fined $1.85m in 1960.

Answer 25

most countries now accept org for economic cooperation and development (OECD) 1995 guidelines. the 1995 guideline statement is the basis many nations use for developing their national tax laws. guidelines state that TPs should reflect economic circumstances where possible, so mkt prices. if there are none, cost plus should be used. tax authorities tend to refer to external auditor’s guidelines on cost of transfers, based on GAAP.

Answer 26

because GAAP was made for external reporting, not mgment decisions, permits huge variation in costing practices. this creates opportunities to set tax minimising methods when devising cost based TP. guidelines were produced with aim of standardising national approaches to TP as part of OECD’s charter to encourage freedom of world trade. they provide guidance on application of arm’s length principles. they state that TPs should be adjusted using arm’s length price, which would have been arrived at by two unrelated companies acting independently.

Answer 27

1. comparable uncontrolled prices most widely used, pricing of similar products so mkt price or approximation of one. method is known as CUPS and preferred where possible. as most international trade is carried out between related companies, meaningful comparisons can be hard to find. where CUP cannot be found or is inappropriate, use one of two gross margins. 2. resale price method involves review of gross margins in comparable transactions between uncontrolled orgs. method used for tfer of goods to distributors and marketing operations where goods are sold with little further processing. price paid for final product by independent party is used and from this suitable markup is deducted. 3. cost plus method second gross margin method - arm’s length gross margin established and applied to seller’s manufacturing cost.

Answer 28

in the past in the UK it was up to tax authorities, which left UK vulnerable to certain tax leakage. but now under self-assessment regulation onus is on taxpayer to provide correct information. failure to demonstrate reasonable attempt at an arm’s length price in tax return will give rise to penalty of 100% of any tax adjustment. other european countries are tightening regulations in response to USA/OECD’s moves. to safeguard the position, the taxpayer may enter into an APA (advanced pricing agreement) with relevant tax authorities. this is new and done in advance to avoid disputes and penalties. more than 60% of companies intend to/do do this.

Answer 29

During the 1970s, in particular, repatriation of funds from a subsidiary to the group's headquarters was not always easy. For example, the Andean Common Market Pact (1970) limited the amount of profit that could be repatriated to 14% of registered capital. Repatriation of funds was particularly important to the organisation if inflation was very high, as it was in South America in the 1970s. Funds remaining unused in the host country would rapidly lose value but if they could be repatriated immediately their value was saved. If dividends could not be repatriated, prices to subsidiaries could be increased so that the subsidiary's profits were smaller and funds were repatriated by the higher price paid for the goods. Research into foreign companies in South America at that time showed that pharmaceutical companies inflated transfer prices between 30% and 300%. Where import duty exists on goods imported into a country, it is obviously advantageous to keep the transfer price as low as possible in order to avoid high duty payments.

Answer 30

Transfer prices can also be used to reduce the amount of profit paid to minority shareholders by artificially depressing a subsidiary's profit. Tate and Lyle was another organisation to have problems in this area. In a similar way different profit-sharing schemes in different parts of the group can influence the way in which transfer prices are set.

Answer 31

low rate on tax on profits low WHT on dividends paid to foreign holding companies tax treaties with other countries no exchange controls a stable economy good comms with the rest of the world well developed legal framework that protects company rights

transfer pricing Flashcards

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