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International Transfer Pricing

International Transfer Pricing

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International Transfer Pricing

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  1. International Transfer Pricing

  2. Transfer Pricing- the determination of the price at which transactions between related parties will be carried out.

  3. Types of Intercompany Transactions and their Associated Price • Sale of tangible property Sale Price • Use of tangible property rental payment • Use of intangibles royalties, license fees • Intercompany services Mgt fee, service charge • Intercompany Loans Interest rate

  4. Objectives of Transfer Pricing • Performance Evaluation • Cost minimization These objectives might be incongruent

  5. Transfer Pricing Methods • Cost-Priced Transfer price • Market-based Transfer Price • Negotiated Price

  6. Cost-Based Transfer Pricing • Advantages • Simple to do • Disadvantages • Which measure of cost to use?? • Can transfer pricing inefficiencies to other units

  7. Market Based Transfer Pricing • Advantages • Eliminate the risk of inefficiencies being transferred. • Ensure divisional autonomy • Disadvantage • Depends on existence of competitive markets

  8. Negotiated Prices • Advantages • Freedom to bargain is preserved • Divisional autonomy • Disadvantages • External markets required • Can take a long time • Sub-optimization issues • Rewards negotiation skill as opposed to actual productivity

  9. Most companies: • Use either cost-based or market-based transfer pricing. • Many use a mix of both

  10. Chan and Lo’s Study (2004): • Cost-based methods are preferred when: • Income tax rate differences matter • Import duty is being minimized • Foreign exchange rules exist • Expropriation risks exist • Market-based methods are preferred when: • Local partners matter • Local government relations matter

  11. 7 Most Important Environmental Variables (USA) • Overall Profit to the company • Restrictions on repatriation of profit/dividends • The competitive position of foreign subs • Performance evaluation of foreign subs • Custom Duties • Import restrictions • The need for adequate cash flow in foreign subs

  12. 7 Most Important Environmental Variables (Japan) • Overall corporate profit • The competitive position of foreign subs • Devaluation/revaluation in countries with foreign operations. • Restrictions on repatriation of profits/dividends • Performance Evaluation of foreign subs • The interests of local partners in foreign subs • The need to maintain adequate cash flow in foreign subs

  13. Cost Minimization Objectives and Related Transfer Prices ObjectiveTransfer Pricing Rule • Minimize income Tax • Transfer to lower tax rate country Low price • Transfer to Higher tax rate country High price • Minimize withholding tax • Upstream transfer Low price • Downstream transfer High price • Minimize import duties Low price • Protect foreign cash flows from currency devaluation High price • Avoid repatriation High price • Improve competitive position Low Price

  14. Government Reactions • OECD Transfer Pricing Guidelines- 1979, 1984, 1994 • Section 482 of the IRC • Based on OECD guidelines • IRS may audit transfer prices between companies controlled by the same taxpayer. • Burden of proof on taxpayer • Inbound and outbound transactions • General rule: “arm’s length prices”. • Treasury regs provide specific guidance on “arms length” prices

  15. Government Reactions • Treasury Regs Section 1.482 • Best method rule- which method provides the most reliable measure of an arm’s length price • Depends on (a) degree of comparability between intercompany transaction and comparable uncontrolled transactions, and (b) quality of data and assumptions used in analysis. • Separate guidelines for transfers of tangible property, intangible property, intercompany loans, and intercompany services.

  16. TrReg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices • Comparable Uncontrolled Price Method • Generally considered the best method when it can be used. • Parent sells to Sub in Country X • Parent also sells to uncontrolled customer in the same country • Arm’s Length Price = price charged the uncontrolled customer

  17. TrReg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices • Resale Price Method- • Parent Sells to Sub in Country X • Sub sells to customers in country X • Sub’s competitors sell the same product at 25% markup as % of sales • Arm’s length price = Sub’s selling price to customers less 25% • To use this method, final selling price and appropriate gross profit % must be known.

  18. TrReg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices • Cost Plus Method- • Parent Sells to Sub in Country X • Parent’s competitors sell same product to customers in County X at 50% markup to cost. • Arms Length Price = Parent’s cost plus 50% • Most appropriate method when there are no uncontrolled sales to compare to and the buyer does more than just distribute goods.

  19. TrReg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices • Comparable Profits Method- • Parent sells to Sub in Country X • Sub sells to Customers in Country X • Parent’s competitiors sell similar product and earn a 15% margin. • Arms Length price = price that allows Parent (or sub) to earn 15% operating profit margin.

  20. TrReg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices • Profit Split Method- • Parent Sells to Sub in Country X • Sub sells to Customers in Country X • Total profit = Sub sales price less Parent’s cost • Total profit is split based on profit earned by each party in an uncontrolled transaction. • Method assumes buyer and seller are really one economic unit.

  21. TrReg Section 1.482: Transfers of Tangible Property: Determination of Arm’s Length Prices • Residual Profit Split Method- • Used when parties possess intangibles that allow them to earn excessive profits, compared to uncontrolled transactions. • Total Profit is split in 2 steps: • Allocate market return to parent and sub for their routine contributions to the relevant business activity. • Allocate residual profit to Parent and Sub on the basis of relative value of intangibles that each contributes to the activity.

  22. Ernst and Young Study (07-08) reports: • Comparable Uncontrolled Price is most popular (32%) • Cost plus is second (29%) • Resale price is third (17%) • Comparable profits is fourth (11%)

  23. Intangible Property • Three identified methods allowed: • Comparable uncontrolled • Comparable profits • Profit split

  24. Correlative Adjustments • If the IRS adjusts a transfer price, there is no guarantee the foreign government will concur.

  25. Penalties • 20% (40%) or the understatement!!

  26. Advance Pricing Agreements • TPM agreed upon between company and tax authority. • If there is an agreement, IRS agrees to make No TP adjustments • Length negotiation typical…..avg 22 months. • 60% of APAs are from foreign Parents with US subs.