Global transfer pricing: a practical guide for managers.

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.

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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 be market price and the lowest transfer price would be differential cost. Depending on the options available to the buyer and seller, some other transfer price might be chosen between these two extremes. Economic rules work best in a domestic business environment where both buyer and seller divisions are taxed at the same corporate rate, because the tax rates do not affect the outcome.

While the economic principles work well for domestic transfer pricing, they differ substantially from international rules. Each country legislates and enforces its own transfer pricing laws. A multinational company (MNC) with foreign divisions must then comply with tax laws for each country in which one of its divisions is domiciled. Every transaction between company sub-units is subject to audit by two sets of tax authorities. Tax compliance places a heavy burden on MNCs and takes precedence over economic rules.

Global Transfer Pricing--How It Works

It is widely accepted that companies seek to maximize profits. A multinational company can help achieve this goal by shifting profits from high-tax to low-tax jurisdictions. For example, take Hungary, with a corporate tax rate of 16%, and France, with a tax rate of 35%. An MNC with divisions in these two locales will benefit by shifting more profit toward Hungary and less to France. Each division is controlled by corporate headquarters, which can set a transfer price to benefit the entity as a whole. Figure 1 offers an illustration of how this works.

In Case 1, the Hungary division transfers goods to the France division and charges a sales price of $1,000. (1) Hungary division's revenue becomes France division's cost of goods sold. Using the respective country tax rates, net income for the Hungary division is $420 and for the France division is $260.

Case 2 shows how these results differ if the Hungary division sells the same goods to the France division for $600 instead of $1,000. Now the France division's cost of goods sold is only $600. As a result, the Hungary division's net income falls to $84 and the France division's net income increases to $520. Total company net income falls from $680 to $604--solely due to the change in transfer price and its impact on division taxes.

Case 3 shows the effects when tax authorities unilaterally impose a transfer price adjustment. Assume the Hungary division first used a $600 transfer price, as in Case 2. Now Hungary's tax authorities disallow the $600 price, claiming it does not represent arm's length. The Hungary division is forced to use a $1,000 transfer price. Further, assume that the France division is unable to adjust the $600 purchase price it first reported. Without adherence to any convention between the two countries, the result is double taxation because the government on the other end of the transaction does not provide a correlative adjustment (Gujarathi, 2007). Total company net income falls from $604 (Case 2) to $540 (Case 3).

This is the type of situation that an MNC might face when its transfer prices fail to meet country regulations. Despite the fact that the arm's length standard is universally accepted as the basis for transfer pricing, calculations can vary from country to country. An MNC can gamble in selecting a transfer price that maximizes its corporate profit. However, the outcome can be disastrous if the gamble fails and tax authorities force a less favorable price. Even if the division in the other country can make a correlative adjustment, tax authorities can still impose significant frees and penalties.

Tax Implications of Transfer Pricing

The trend worldwide is for countries to strengthen their efforts to collect tax revenues from transfer pricing. The idea is that an arm's length price will result in a more equitable distribution of profits between the buying and selling divisions. As a result, each host country will collect its fair share of taxes. Impetus for the use of arm's length pricing comes from section 482 of the Internal Revenue Code in the U.S. and from the Organization for Economic Co-Operation and Development in Europe (OECD, 2001). OECD rules are most commonly used throughout the world (Miesel, Higinbotham, and Yi, 2002). Although there are minor differences, the two sets of rules are essentially the same.

A firm can mitigate tax conflicts by entering into advance pricing agreements. These are binding contracts between the firm and a country's tax authority that define beforehand how the firm will compute its transfer price and the type of arms-length results expected. As a consequence, a firm controls the risk of having authorities impose transfer price adjustments at a later date. It does not, however, eliminate risk, since the firm can be challenged on the way it implements the agreed-upon method for calculation.

A firm can also enter into bilateral or multilateral agreements that depend on having transfer pricing terms accepted by two or more countries. As new countries enact transfer pricing regulations, such agreements are growing in use. Of particular significance is the first bilateral agreement between the U.S. and China, announced by the IRS in 2007, over Wal-Mart Stores' pricing policies. Despite the obvious appeal of advance pricing agreements, they are expensive in terms of time and money. Therefore, each firm must evaluate its own circumstances to determine whether they are worthwhile.

Methods for Finding Arm's Length Price

U.S. Internal Revenue Code Section 482 identifies five methods for determining an arm's length price. At first glance, the tax methods seem to bear little resemblance to the three economics-based methods (market price, cost, negotiation) normally discussed in textbooks (Maher, Stickney, and Weil, 2006; Zimmerman, 2006). In fact, there is similarity in that all five tax law methods attempt to estimate market price.

The following is a brief description of the five tax methods for tangible goods (Misey, 1999; Miesel, Higinbothan and Yi, 2003; Dean, Feucht, and Smith, 2008). Throughout this discussion, a controlled company refers to a multi-division MNC, while an uncontrolled company refers to a free-standing firm that operates independently in the marketplace. Keep in mind the goal: the controlled company must estimate what the market would have charged for goods transferred from one of its divisions to another. Figure 2 offers a numerical example for each of the five transfer pricing methods. For each method, the transfer price turns out to be $100.

* Comparable uncontrolled price. With this method, the controlled company's interdivisional transfer price is derived from prices charged by an uncontrolled third-party supplier. In other words, the task is to determine how goods would be priced in an independent market transaction. This works best for commodity-type items. The method, commonly referred to as CUP, is used by 32% of companies, the highest percentage reported (Ernst and Young, 2007).

* Cost plus. The controlled company looks to the gross profit percentage earned by comparable uncontrolled companies performing similar functions. It uses this percentage to add a gross profit amount to production cost, thereby determining the transfer price it can charge for an inter-divisional sale. Cost plus is used mainly in manufacturing. It is the second most popular method with a 29% usage rate (Ernst and Young, 2007).

* Resale price. This method is similar to cost plus but is based on price rather than markups. It is used in wholesaling as opposed to manufacturing. A controlled company uses a gross profit percentage comparable to independent distributors performing similar functions. It then deducts gross profit from its retail price to estimate a wholesale-level transfer price.

* Comparable profits. Here the controlled company looks to the profitability of outside independent companies to determine a comparable profit for its subsidiary division. The division then works backwards to determine the transfer price for a transaction. This method differs from the previous two in that it is based on company profits assigned to its divisions rather than on the price of any one individual transaction.

* Profit split. As the name suggests, the controlled company allocates profits from interdivisional transactions to the units involved in proportion to the relative contribution of each. The controlled company looks to outside independent companies to determine comparable profits for division contributions. A common means for dividing company-wide profit is based on each division's use of capital, its risks, and costs at different stages of the value chain. Transfer prices are then based on costs plus allocated profits.

These calculations are not the end of the story, however. We need to discuss how comparability between circumstances surrounding controlled and uncontrolled transactions affects the determination of a transfer price.

Issues of Comparability

The controlled firm has a great deal of flexibility in selecting a method and determining a transfer price. The IRS regulations include a "best method rule," which allows the firm to make the choice--as long as the method selected produces the most reliable results. In reality, the method itself is of secondary importance. More important, the controlled company must demonstrate that the price chosen is comparable to one used by uncontrolled firms in independent market transactions. In other words, does the transfer price approximate what would be charged in the market? The IRS requires that the transfer price fall within the middle 50% range of transactions to which it is being compared.

Several factors are used to determine comparability. To the extent that a chosen method results in circumstances different from those faced by the controlled firm, a price adjustment will be needed. The firm must look at the following factors to ensure their comparability (Styron, 2007):

* Functional analysis--examines what the product does within the firm's operations. Does it do essentially the same thing as the product to which it is being compared in the marketplace? Both should be performing equivalent organizational activities, such as fabrication, extraction, assembly, transportation, or research and development. Insight on comparability might also be gained by examining surrounding issues, such as production cost, volume, insurance, testing cost, advertising intensity, and scale of operations. Small differences require adjustments to the transfer price. Major differences may require selection of other products for comparison or use of a different transfer price method.

* Contractual terms-looks at issues, like length of commitment and warranty terms, upon which the controlled buyer and seller have agreed. The contract is then compared with an independent arrangement offered by an uncontrolled firm in the market. Perhaps the controlled firm's contract is six months but the contract of the uncontrolled firm requires a one-year minimum commitment. This difference would call for a price adjustment by the controlled firm.

* Risk--is concerned with the distribution of market and financial risk within the controlled company. For example, the parent company of the controlled MNC might sell to a foreign subsidiary acting as an overseas distributor. Assume the parent provides financial backing for this venture. The foreign subsidiary is then compared to an uncontrolled local independent retailer. An adjustment would be needed to the transfer price of goods if the local independent retailer accepted the risk for financing, whereas the controlled company did not. Its financing was provided by the parent.

* Economic conditions--looks at differences surrounding the controlled firm's transaction and the uncontrolled transaction to which it is compared. This might include such things as differences in geographic location, market size, or market share. To the extent differences occur, price adjustments would be needed.

* Property or services--focuses on any material differences in the goods being compared. If the controlled company product is similar to one sold in the independent market, but differs in some substantive way, an adjustment is needed. For example, assume a controlled company transfers fabric to its foreign subsidiary. The fabric is compared to another that is similar in texture, design, and durability, but differs significantly in thread count. The transfer price would be adjusted for the difference.

An Illustration: Determining the Value of a Generic Drug 

Assume that a multinational company has a division in Austria making nonbranded generic pharmaceutical drugs. This case involves the sale by the Austrian division of a hypertension drug to another corporate division located in the United States. Profits for each division will be taxed at the maximum regulated corporate rate in the host country, 25% in Austria and 35% in the U.S. Under tax terminology, this is called a controlled transaction since both the seller and buyer are part of the same corporate entity. In other words, the price for the sale can be set by MNC headquarters independently of the market. Now the firm must choose an arm's length sales price that will satisfy two tax authorities--the U.S. and Austria. The top part of Figure 3 shows a diagram of the flow of goods.

First, we need to know more about the activities of each division. The Austrian division sells the same prescription drug to other divisions in Austria, as well as to other European countries. The U.S. division will purchase the goods and act as an independent agent. However, conditions and sales prices differ due to the prevalence in Europe of universal health care and regulated drug prices. The U.S. division will purchase, warehouse, advertise, and distribute the product to pharmaceutical retailers, such as Walgreens and Wal-Mart. It is a well-established division but has not previously carried this line of pharmaceuticals. To attract retailers, it plans to undertake an intensive marketing campaign and initially to offer lower prices. The U.S. division is taking on more risk than other distributors who are already well established in the generic hypertension drug wholesale market.

Since the U.S. division is acting as an independent distributor, corporate headquarters advises the buyer and seller to use the resale price method to estimate an arm's length transfer price. This method is especially useful when the products being sold are tangible and are identical to comparables sold in the independent market. Further, it is assumed that independent distributors in the U.S. market perform similar functions and earn similar gross profit margins. All these conditions seem to apply. Upon analysis, it is determined that unrelated companies earn on average a gross margin of 30% on similar transactions.

Calculation of the transfer price is shown in the lower part of Figure 3. A similar transaction by established distributors would carry a price of $1,000 and generate an average gross profit of 30%, thus yielding a gross profit amount of $300. If the circumstances faced by the U.S. subsidiary were comparable to independent distributors, it could use a transfer price of $700. This amount represents a wholesale price that yields an identical gross profit.

However, circumstances faced by the controlled firm, the U.S. subsidiary, differ from those of uncontrolled companies. Most important, it is new to the generic hypertension drug market. Thus, the U.S. subsidiary must examine factors of comparability that differ and make price adjustments for each. Three specific factors causing a lack of comparability are identified:

1. Risk. The U.S. subsidiary faces higher risk due to its status as a new market entrant,

2. Contractual terms. Unlike competitors, the U.S. subsidiary will not require its customers to make a long-term purchase commitment, and

3. Economic conditions. The U.S. subsidiary will undertake an intensive advertising campaign to sell its goods.

An economic analysis is performed to estimate how much each of these factors will affect the transfer price. Figure 3 shows price adjustments in percentage and dollar terms. The total amount, $91, is deducted from the $700 wholesale price without adjustments. As a result, the transfer price charged the U.S. division by the Austrian division is $609. Since the transfer price was reduced due to adjustments, the Austrian division will earn less profit on this transaction. The reduced price lowers overall corporate profit since more profit is shifted to the U.S. division, which incurs a higher tax rate.

Transfer Pricing for Intangible Assets

Transfer pricing for intangible assets presents special challenges. This category of assets, also called intellectual property, includes a host of seemingly unrelated items. The IRS and OECD guidelines specifically identify patents, formulas, copyrights, trademarks, brand names, licenses, contracts, systems (like software), to name a few. Just as with tangible property, international tax law requires that controlled firms establish an arm's length transfer price when one of its divisions makes use of intangibles owned by another division of the firm. However, measuring arm's length value for intangibles is more difficult than doing so for tangible products, whose cost of production and market value is more clearly determinable (Myring and Bloom, 2007).

Intangible assets, by their very nature, tend to be unique. Exchanges of similar assets may not be available in the market. Moreover, questions can arise about whether an asset exists at all. That is, does the intangible item in question contribute to the revenue generated by a separate foreign unit of the firm? For example, an American firm may have created a recognizable trade name through its widespread advertising campaign in the U.S. If a division is set up in Thailand to distribute company products in Southeast Asia, does the trade name create value in this new location? If so, are there comparable third-party licensing agreements for use of similar assets? The firm will need to gather such information to satisfy arm's length pricing requirements under tax law. These pricing agreements typically take the form of royalty payments.

* Methods for finding arm's length price. Methods used for determining the arm's length price of intangible assets are similar to those described earlier for tangible assets. However, there are a few notable exceptions:

1. The comparable uncontrolled transaction (CUT) method is the analog of the CUP method for tangible assets. Both methods are similar in that transfer price is determined by looking to direct comparables in the marketplace. Whereas CUP looks at prices of products between unrelated parties, CUT looks at transactions. These transactions should occur in the same industry and have the same profit potential (DeSouza, 1997). This is by far the most popular method, with 54% of firms citing its use (Ernst and Young, 2007). We provide a detailed illustration of the CUT method in the next section.

2. Earlier we discussed five methods for use with tangible assets, but only three are given for intangibles: CUT, comparable profits, and profit split. Two tangible product methods are not specifically included for determining the arm's length value of intangibles: cost plus and resale price.

3. Besides the methods identified under tax law, companies are allowed to use other "unspecified methods" in determining arm's length value. While these methods can also be used with tangible products, they are far more popular with intangibles. Surveys have put their use at 22% to 25% for intangibles, but only 6% of firms cite their use for tangible products (Ernst and Young, 2007; Borkowski, 2001). Intangibles increase the possibility of conflict between taxing jurisdictions, therefore leading companies to use other innovative ways to value transactions.

4. Comparability is just as important an issue with intangible assets as with tangible.

Recall that the item transferred must be like the one it is compared with in the marketplace. The comparison should include factors such as function, contract terms, risk, and the like. Here again, intangibles can create more problems in establishing their comparability because they are often unique.

* An illustration: determining the value of brand. (2) This case involves a large multinational company headquartered in Europe. The parent company acquired a well-recognized U.S. firm as a subsidiary. The U.S. affiliate will now sell the European parent's products in the U.S. while making use of the parent's trademarks and brand name. A transfer price is needed to determine an arm's length royalty rate to be used with an intra-company licensing agreement. The question is how to place a value on the European brand being used by the U.S. affiliate.

A consulting firm was engaged to establish the transfer price. The project required the identification of comparable transactions. The CUT method was determined to be the best method. These were the critical steps in that process:

1. Identify transactions that involved trademarks similar to that of the European parent.

2. Establish criteria to narrow the choice. For example, the transaction must involve trademarks used in the U.S. and Europe. The license agreements must cover products for similar customers. The license agreements must cover multiple years and must be exclusive for a given product in a given country.

3. Use the criteria to identify a licensing agreement with comparable terms and conditions. These were comparable uncontrolled transactions (hence, the CUT method).

4. Benchmark the comparable uncontrolled transactions against the terms and conditions in use with the European parent and U.S. subsidiary. The goal is to determine significant differences in comparability, which would give rise to price adjustments.

The consulting firm found a range of royalty rates for licensing agreements covering similar trademarks and brand names. The rates varied from a low of 0.5% of net sales to a high of 3.0%. However, there were identifiable differences between controlled transactions and comparable uncontrolled transactions. The U.S. subsidiary and its customers had only recently been exposed to the European brand. Consequently, the royalty rate chosen was only 1.0%. This was at low end of comparable independent transactions.

Further, the U.S. subsidiary would incur additional marketing costs to promote the European brand to its customers. These added costs would need to be taken into consideration in setting the transfer price. It was determined that a downward royalty rate adjustment of 0.25% was needed for this difference. As a result, the firm adopted a transfer price equal to 0.75% of subsidiary sales revenue.

One last point is worth noting. The adjustment in this illustration resulted in a decrease to the transfer price. This is similar to the adjustment in the generic drug illustration in Exhibit 3. Each adjustment depends on the circumstances of the case at hand. Because there is some flexibility in determining a transfer price acceptable to tax authorities, an MNC can use adjustments to legitimately shift profit from a high-tax to a low-tax jurisdiction.

What Should a Manager Do?

As business becomes increasingly global, managers need to be aware of the complexities of international transfer pricing. MNCs can take a number of actions to minimize the risks associated with intra-company transfers.

First, every MNC should have a detailed, documented transfer pricing policy that guides manager actions. Corporations with extensive international transfers often have a committee to monitor the firm's policy and its proper implementation. The policy must ensure that transactions are priced using an arm's length standard, even when there is great difficulty in achieving such assurance. It is helpful to establish a policy planning process involving a variety of individuals with knowledge of the operations of the firm and its divisions. They can participate in setting initial transfer pricing policies and in identifying any implementation problems.

Second, a firm should modify its transfer pricing policy when changes to its business environment affect the factors used in establishing the arm's length price. For example, changes in market conditions could affect a firm's costs, its competitors' costs and prices, or any number of other factors critical to establishing the transfer price. So, too, will modifications in a firm's internal operations, regardless of whether they arise from division activities, market concentrations, or organizational structure. Such changes will necessitate a review of the firm's transfer pricing policies. If the policy is modified in any way, there should be clear and complete documentation of the reasons for change and the details of implementation.

As a related matter, managers should take great care in tweaking operations as a way to justify more favorable transfer prices. Minimizing the corporate tax liability might make such changes seem worthwhile in the short term. Other factors, like pricing or production strategy, must be considered before deciding whether this is in the firm's best interest. Even if a firm decides to modify its operations, a change in tax rates can nullify the outcome.

Third, a firm should consider an advance pricing agreement. The benefits to the firm can be substantial, since it is likely that tax disputes will be kept to a minimum. On the other hand, the documentation requirements can be extensive, and reaching such an agreement can take a significant amount of time and investment. The circumstances facing each firm will determine whether benefits of an agreement outweigh the costs. Firms that conduct many cross-border transactions with uncertain arms-length prices, as with intellectual property, are apt to find advanced pricing agreements worthwhile. A firm may have no choice: some countries require an advance pricing agreement for the transfer of certain intangibles.

Finally, managers of firms that make international transfers of goods and services should familiarize themselves with the regulations of the countries involved. One of the best resources is the OECD. It offers valuable publications and organizes widely attended conferences designed to resolve current transfer pricing issues. Because this is an issue for the company as a whole, top management must become fluent in the ongoing language and concerns of international transfer pricing. If they fail to do so, the costs and penalties to the firm can be significant.

REFERENCES

Anson, W., and Ahya, C. (2004, October). How to make transfer pricing work for IP and intangible assets. International Tax Review, 14-16.

Borkowski, S .C. (2001). Transfer pricing of intangible property: Harmony and discord across five countries. The International Journal of Accounting, 36, 349-374.

Dean, M., F.J. Feucht, and Smith, L.M. (2008, January/February). International transfer pricing issues and strategies for the global firm. Internal Auditing, 12-19.

Deloitte Tax LLP (2007). At arm's length. New York: Deloitte Development LLC.

DeSouza, G. (1997). Royalty methods for intellectual property. Business Economics, 32, 46-53.

Ernst & Young (2007). 2007-2008 global transfer pricing survey. New York: Ernst & Young.

Gujarathi, M.R. (2007). Teaching notes--GlaxoSmithKline, Plc.: International transfer pricing and taxation. Issues in Accounting Education, 22, 147-156.

Hirshleifer, J. (1956). On the economics of transfer pricing. Journal of Business, 29, 172-184.

Maher, M.W., C.P. Stickney, and R.L. Weil (2006). Managerial accounting (9th ed.) Mason, Ohio: Thomson/Southwestern.

Matthews, R.G., and Whalen, J. (2006, September 12). Glaxo to settle tax dispute with IRS over U.S. unit for $3.4 billion. Wall Street Journal, A3.

Miesel, V.H.H., Higinbotham, H., and Yi, C.W. (2002). International transfer pricing: Practical solutions for intercompany pricing. The International Tax Journal, 28, 1-22.

Miesel, V.H.H., Higinbotham, H., and Yi, C.W. (2003). International transfer pricing: Practical solutions for intercompany pricing--part II.--The International Tax Journal, 29, 1-40.

Misey, R. J. (1999). A primer on transfer pricing. Taxes, 77, 43-47.

Myring, M. J., and Bloom, R. (2007). International transfer pricing and intellectual property: The PrimeCo case. Issues in Accounting Education, 22,769-774.

Organization for Economic Co-Operation and Development (OECD) (2001). Transfer pricing guidelines for multinational enterprises and tax administration. Paris, France: OECD.

Styron, W. J. (2007). Transfer pricing and tax planning. The CPA Journal, 77, 40-46.

Zimmerrnan, J.L. (2006). Accounting for decision making and control (5th ed.) New York: McGraw-Hill Irwin.

Ralph Drtina, Rollins College 

Jane L. Reimers, Rollins College

(1) To simplify illustrations, we assume the MNC is headquartered in the U.S. and its transactions are in U.S. dollars.

(2) This illustration is adapted from an example provided by Anson and Ahya (2004), consultants to the companies in question.

Drawing on past work experiences with CPA firms, businesses of all sizes, nonprofits and government agencies, Dr. Drtina focuses on how managers can use accounting for decision making and control. He has co-authored a text on managerial accounting and published in a number of journals. Dr. Reimers' research is in the area of decision making using accounting information, and she has published in the top accounting journals. The 3rd edition of her financial accounting textbook is forthcoming.

Figure 1. Transfer Pricing Effects on Taxable Income

Case 1: Transfer price = $1,000.

                           Hungary     France
                            Seller     Buyer     Company
                           Division   Division    Total

Country income tax rate       16%        35%       NA

Sales price                 $1,000     $1,400    $1,400
Cost of good sold             $500     $1,000      $500
Taxable income                $500       $400      $900
Income tax @16% and 35%        $80       $140      $220
Net income                    $420       $260      $680

Case 2: Transfer price = $600.

                          Hungary     France
                           Seller     Buyer     Company
                          Division   Division    Total

Income tax rate              16%        35%       NA

Sales price                 $600     $1,400    $1,400
Cost of good sold           $500       $600      $500
Taxable income              $100       $800      $900
Income tax @16% and 35%      $16       $260      $296
Net income                   $84       $520      $604

Case 3: French authorities reduce buyer's price to $600.

                          Hungary     France
                           Seller     Buyer     Company
                          Division   Division    Total

Country income tax rate      16%        35%       NA

Sales price                $1,000     $1,400    $1,400
Cost of good sold            $500       $600      $500
Taxable income               $500       $800      $900
Income tax @16% and 35%       $80       $280      $360
Net income                   $420       $520      $540

Figure 2. Five Transfer Pricing Methods

1. Comparable
uncontrollable price
method (CUP)

Comparable uncontrolled
transaction                                              $100.0

Transfer price                                           $100.0

2. Cost plus method
                           Cost of production            $60.00
Comparables                X Gross profit %               66.7%
                           + Gross profit amount         $40.00
                           Transfer price               $100.00

3. Resale price method
                           Retail price to a            $150.00
                             3rd party buyer
Comparables                X Gross profit %               33.3%
                           - Gross profit amount        $(50.00)
                           Transfer Price               $100.00

4. Comparables
profits method             Capital employed             $300.00
                           X Rate of return measure         10%
Comparables                Operating profit              $30.00
                           + Production cost             $70.00
                           Transfer price               $100.00

5. Profit split method
                                             Seller        Buyer
                                           Division     Division

                           Production cost     $70.00     $50.00
Comparables                Allocated profit    $30.00     $10.00
                           Transfer price     $100.00         NA

                           Sales revenue      $100.00    $160.00
                           Cost to buyer                $(100.00)
                           Production cost    $(70.00)   $(50.00)
                           Division profit     $30.00     $10.00

Figure 3. A Resale Price Method Case Study

Manufacturer                    Wholesaler      Retailer

Austria Division [right arrow] US Division   [right arrow] 3rd Parties

Retail price to a 3rd party buyer           $1,000
X Gross profit %                             30.0%
- Gross profit amount                       $(300)
Comparable wholesale price
  without adjustments                         $700
Adjustments to comparable price:
1. Risk--new market entrant         6.0%     $(42)
2. Contractual terms--no long-
   term contract                    4.0%     $(28)
3. Economic conditions--intensive
   advertising                      3.0%     $(21)
Total dollar adjustment                      $(91)
   Transfer price                             $609