Fin management materials / P4AFM-Session16_j08

SESSION 16 – INTERNATIONAL OPERATIONS

7.4Other transfer pricing methods

¾Market price – suitable if an external market exists and the supplying division is at full capacity. However, the market price might need to be adjusted downwards if internal sales incur lower costs than external sales e.g. due to lower delivery costs.

¾Cost plus - the supplying division charges cost plus a mark-up. However the mark up is arbitrary and the resulting transfer price may not be optimal for decision making.

¾Two-part transfer prices - the supplying division charges the receiving division a fixed charge per period and a variable cost per unit. May not be optimal for decision making.

¾Negotiated transfer prices - bargaining between divisional managers. May lead to conflict.

¾Dual pricing - one price is used for crediting the supplying division and another (usually lower) price used for debiting the receiving division. Allows both divisions to record profits – improves motivation.

7.5Tax planning

¾In a large number of multinational organisations the issues relating to taxation take precedence over other transfer pricing issues and significant amounts of management time are spent attempting to determine the transfer prices that will minimise tax paid on a global basis.

¾Transfer prices should be set in a way that minimises the taxation payable by the organisation as a whole - it is in the company's best interest to transfer profits to the division which is located in the lowest taxation country.

¾Management should be aware of the fact that anti-avoidance legislation may exist to prevent companies using transfer pricing policies to divert profits to subsidiaries/divisions based abroad.

Multinationals may use two transfer pricing systems:

One for use in internal decision making (based upon marginal cost + opportunity cost)

another for tax purposes

¾Import duties/tariffs – it is desirable that transfer prices be kept as low as possible in order to minimise the payment of duty in countries that impose import tariffs based on the “value” of incoming goods. Governments are aware of such practices and may invoke similar policies to that of anti-avoidance legislation.

¾Repatriation of funds – some developing countries place restrictions on the payment of dividends to a foreign parent, or imposes high withholding taxes on dividends. In this situation transfer pricing may be alternative method of remitting profits back to the parent.

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SESSION 16 – INTERNATIONAL OPERATIONS

Example 1

Supplying division A manufactures components in a country whose tax regime is 12% and transfers to receiving division B suffering a tax rate of 40%.

Required:

(a)State whether the transfer price should be maximised or minimised

(b)State any other factors which should be taken into account

Solution

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SESSION 16 – INTERNATIONAL OPERATIONS

Key points

The risk of exporting is not confined to exchange rate risk but includes more fundamental risks such as loss of goods in transit. However for each risk there is a method of management or at least evaluation before entering a particular market.

A key risk when exporting, as with domestic sales, is of bad debts. Carefully structuring the deal can minimize this risk e.g. requesting a letter of credit from the overseas customer’s bank.

The firm may move from exporting to establishing operations overseas. This brings in a whole range of issues about how to structure the investment, how to finance it, how to evaluate projects overseas and how to repatriate the profits.

FOCUS

You should now be able to:

¾discuss the risks of exporting and how they can be reduced by careful choice of payment method;

¾discuss the functions of international treasury management;

¾describe the various forms of overseas expansion and methods of financing;

¾undertake detailed appraisal of an international capital investment project;

¾discuss transfer pricing issues for multinationals.

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SESSION 16 – INTERNATIONAL OPERATIONS

EXAMPLE SOLUTION

Solution 1 — International aspects of transfer pricing

(a)It is in the company’s best interest to maximise the transfer price and hence the profits of the supplying division where tax rates are much lower. This simultaneously lowers the profits of the receiving division where tax rates are higher.

(b)Some taxation authorities are aware of these policies and may attempt to impose additional tax. OECD guidance on arms length transactions recommends a price based on one that would have been negotiated between unrelated parties.

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