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Transfer pricing by multinational marketers: Risky business
Transfer Pricing by Multinational Marketers: Risky Business John P, Fraedrich and Connie Rae Bateman
T
ransfer pricing decisions are made every day in multinational corporations. When a department within an MNC transfers its tangible or intangible output to another department or a subsidiary, it regards this transfer as a sale. The price that is placed on such products, services, and know-how is generally regarded as the transfer price, or TP. MNCs regularly use TP policies as strategic tools to increase subsidiary profits when the subsidiary is in a foreign country with a lower tax rate. The subsidiary, in turn, creates value that can yield more profits in the country of entry and minimize effective tax rates. Depending upon foreign country tax rates, the parent will choose either a low or high TP. When the tax rate is low relative to the United States, American-owned, foreign-based subsidiaries should buy low and sell high, accruing the majority of the profits in the low tax rate country. This cuts the effective tax rate to the parent. When the foreign tax rate is high, the goal is to buy high and sell low (that is, at a minimum profit), accruing the majority of the profits in the low tax rate country. Depending on country-ofentry tax rates relative to the home country and the level of unrelated competition, the TP strategy will affect the risk of an audit. Past practice has set the TP arbitrarily by using a method of cost-plus and a “percentage for contingencies,” which has not always been considered carefully. TP policies can sometimes reflect market and competitive dynamics (those set by default or in line with competition), cost and profit objectives (using a 1-P that promotes efficiency of the seller), or resource allocation decisions (extra human resources needed on the value-added end of production). Setting a TP usualiy occurs within a legislative vacuum, which can cause inefficiencies. The “Basic Arm’s Length Standard” (BALS) criterion championed by the U.S. has now been accepted worldwide as the preferred standard by Transfer
Pricing by Multinational
Marketers:
Risky Business
which transfer prices should be set. To determine the BALS, the tax authority looks to comparable selling prices set by independent buyers and sellers in similar selling environments. This price level then becomes the “benchmark” by which the BALS is set. MNC managers must gain as fLll1an understanding as possible of the complex legal foundations of transfer pricing as well as its effects on their business. In this review the MNC manager is shown how each of the basic TP strategies derived from the BALS affects sales, audit risks, government-assessed penalties, and position in the marketplace. TRANSFER
PRICING TODAY
n the past several years, corporate actions have caused U.S. authorities to strengthen their focus on transfer price issues. The policies and procedures implemented by U.S. authorities have resulted in a loss of taxpayer incentives to multiple profits and an increase in the penalties for manipulating profits. Moreover, U.S. officials have become more effective in the development and processing of TP cases and have established a Competent Authority (CA) to resolve disputes. Any manager unaware of these recent events is at an extreme disadvantage. In making the transfer pricing decision, managers must consider both tax and non-tax related criteria. If all relevant criteria are not assessed properly, the MNC will suffer losses that go unnoticed; and if respective tax authorities disagree as to the appropriate calculation of the TIJ, double taxation can occur. This happens when the same income is taxed in the jurisdiction of the transferor (seller) and also in the jurisdiction of the transferee (buyer). Once a decision is
I
17
made, the TP policy should be formally defined, clearly communicated to all countries of interest, be based on the BALS. and show no currency or profit manipulation. In reality, the TP system is often illegally used for tax evasion purposes, short-changing the U.S. government billions of dollars annually. And the problem is not only with foreign controlled corporations, but with U.S.-controlled companies and their overseas operations as well.Any MNC that illegally uses TP policies to reduce its overrtll tax rate effectively puts itself at risk of a TP audit. Section 482 of the IRS Code sets broad rules for evaluating the BALS characteristic of a TP. If the TP is set outside the boundaries of the BALS, the IRS or foreign tax authority may conduct a TP audit and allocate or reallocate profits, deductions, or other income items to determine the true taxable income. Many countries are aggressively dealing with MNCs that use TP as a strategic tool to minimize tax liabilities. In addition, an MNC can be ordered by the tax authority to pay any due taxes and assessed penalties. As a consequence, it can experience negative press and lose consumer and supplier confidence. If the MNC decides that a tax authority’s decision is unjust, it can appeal the decision and request a Competent Authority (CA) to render a judgment. Ultimately the case can be brought before the Tax Court. LJpon hearing the positions in the case, the court in some cases has ruled against the 1% audit findings. For example, in 19X1 and 1982, the IRS increased Bausch & Lomb, Inc. consolidated taxable recorded income by allocating income from B&L Ireland to its U.S. parent. In this case the IRS had recalculated the BALS price using a method not previously used by B&L. The tax court agreed with B&L’s position and ruled that the IKS recalculation \vas an “unreasonable” adjustment. thus supporting B&L‘s claim that the adjustment was too liberal. New regulations and additional litigation involving the use or transfer of intangible assets covered by Section 482 are anticipated. Thus, compliance lvill become a bigger challenge for the MNC. The IRS‘s new focus on TP issues, the broadening scope of cases heard by the Tax Court. and market-based effects all call for a reevaluation by MNC taxpayers as to what their TP methods will be and how they w311defend their position in an audit.
To understand the extent of the challenge involved in developing a TP strategy, managers must recognize that no one strategy is appropriate for all transactions or markets. MNCs face the challenge of balancing differences in foreign tax systems, exchange controls, and competition with the need to allocate economic, human, and financial resources. Can Compliance with Government Regulation Be That Difficult?
A corporation’s TP objective is to price intercompany sales as close as possible to the standard set by the BALS. When the TP approximates the price that would have been charged between an independent seller and buyer, the BALS is met. Failure of the arm’s length method to correctly attribute income to the taxing jurisdiction, however, is a major problem in U.S. tax policy. The IRS alleges that foreign companies overcharge their American subsidiaries and have avoided paying up to $8 billion in taxes annually. Regulations across countries can be fundamentally different, adding to TP difficulties. For example, the same good or service transferred between parent and subsidiaries is often priced at different transfer levels using different methods. Each country’s tax authority can identify different TP methods, and any deviation from the preferred one increases the risk of an audit. As a result, countries have accepted the BALS as the international standard for assessing TP. In countries where there is unrelated conpetition, tax authorities may have difficulty determining a benchmark, which helps the MNC in justifying its TP level. In countries \\here the level of unrelated competition is reasonable, the tax authority is usually able to identify a more concrete benchmark. For example, Germany and the 1J.K. have both intensified their scrutiny of MNC transfer prices. When problems occur in Germany. firms rely on the IT.K.-German Income Tax Treaty, which contains voluntav arbitration mechanisms available when competent authorities cannot agree. The LJ.K. government uses MNC objectives to determine TP policy as xvell. Japan is also aggressively scrutinizing TPs by including in its tax code a general taxation of foreign corporations. a capital gains tax. specific TP rules. and an anti-tax avoidance provision. The Republic of Korea’s Office of National Tax Administration (ONTA) has enlarged its scope of TP reporting requirements as well. For example, Kee and Jeong (1991) found that (a) the tmnsactions subject to transfer pricing rules are the sale and purchase of inventory assets. the provision of services. and the lease of assets and loans: and (b) the BALS price can be set by either the corn paral~leiuncontrolled price method, the resale
price method, the cost-plus method, or functional analysis (which looks at each party’s contribution to income production). ONTA authorities have begun to recalculate income and secure information regarding TPs between a L7.S. parent and Korean subsidiaries. In intercompany transactions over the U.S.Canadian border, the governing bodies have relatively similar substantive laws, but increasingly dissimilar compliance and reporting rules The method for determining a BALS price is company-specific to some degree, so there is a push by tax authorities for advance pricing agreements (APAs). Canadian oil import parent firms have kept subsidiary TPs at significantly less than an arm’s length price (below market) and priced transport costs above market. The effect has been to reduce the taxable income attributable to property in Canada and reduce the overall effective tax rate (Canadian tax rates are higher than those in the IJnited States). Other Canadian corporations have attempted to sidestep U.S. TP regulations by restructuring value-added operations in the LJ.S. and shifting more of their taxable income to the U.S., which can be illegal in the determination of a TP strategy. The European Union (EU) is also primed for TP issues. The EU market has had an excess supply of certain products, so price competition has increased. EU fiscal policy response has been to protect parents that have subsidiaries within or between EU states from double taxation. MNCs are encouraged to reach an a priori agreement with authorities on how direct taxes will be handled. In addition, ELI policy calls for the establishment of TP adjustment arbitration procedures and provisions. There is a worldwide move toward more TP regulations. the effects of which are many. The LJ.S. is stepping up its scrutiny not only of LJ.S.controlled companies but of foreign-controlled ones as well, including foreign manufacturers that operate in the U.S. through subsidiaries. The brunt of these effects will be felt by the foreign firms and their governments as they wrestle with double taxation, LJ.S.-assessed penalties, and other TP issues. s L Businesses can take active steps to avoid risking exposure to a transfer pricing audit and any subsequent penalties. One suggestion is to follow the requirements set by the IRS in information reporting. record retention. agency designation, monetary penalties, and determining rules. An APA or an established and acceptable cost-sharing arrangement can also forestall or minimize audit controversies. If an audit does occur, an organization has several options: an administrative or judicial forum, a cooperative versus adversarial approach. or settlement strategies.
TRANSFER
PRICING
METHODS
o assess whether your current TP meets BALS criterion, your company can calcuT late a BALS price using one of three methods identified by Section 482 of the IRS Code: comparable/uncontrollable price, resale price, or cost-plus. These are based on the separate entity theory, which compares a given TP to a comparable price on the open market. Many companies prefer the comparable/uncontrollable price method and apply it first. The resale price method is preferred next, followed by cost-plus. Each method will be described below. The IRS allows the MNC discretion in choosing which TP method it will use, but it will closely evaluate whichever method is chosen. If the MNC opts to use another method, the burden of proof falls on the corporation to show that the BALS has been met. Or it may contact the IRS and form an APA with it that defines an acceptable TP calculation method before implementation. When this occurs, the APA frees the MNC from any TP audit for the time period specified in the contract, usually three to four years.
Comparable/Uncontrollable
Price Method
The comparable/uncontrollable price method most accurately approximates an arm’s length price and has been used in most Section 482 pricing cases. It forces the parent to compare the TP of its controlled subsidiary to the selling price charged by an independent seller to an independent buyer for similar goods. Comparing actual profits of one company to the profitability of a number of unrelated companies with similar activities establishes a comparable profit interval. Comparable sales occur when physical property and circumstances of the controlled sales are almost identical to those of uncontrolled sales. Use of this method is thought to best focus on ovemll operating profits as they relate to similarly situated firms rather than on similar trdnsactions involving unrelated firms. If comparisons are not possible, then sales of other resellers in the same market could be used. This allows management to evaluate international subsidiaries as it would any other distributor.
Resale Price Method The resale price, or market, method places the transferor in direct competition with outside sup-
pliers. It is the strategy used most often for setting a TP for international transfers. In this scenario the BALS TP is determined by subtracting the gross margin percentage used by comparable independent buyers from the final third-party sales price. It is typically used when the valueadded by the subsidiary is not substantial. Cost-Plus Method
The cost-plus method is computed by adding the gross profit markup (on a percentage basis) earned by comparable companies performing similar functions to the production costs of the controlled manufacturer or seller. (An amount equal to cost times an appropriate gross profit percentage is the gross profit percentage, expressed as a percent of cost. earned by the seller or another party on the uncontrolled sales, to cover some or all of the fixed costs.) An arm’s length price is considered the best approximation of the price that would he charged if companies involved in the sales transactions did not have common ownership. Other Methods
TRY) common TP methods used 1,~ MNCs hut not recommended by Section 482 are the no-charge method and the cost method. Neither considers a reference to comparal+ sellers or buyers, and I>oth usually violate RALS criteria, thus jeopardizing the MNC’s TP status. When reference to conipalal~le/uncontrolled prices is not availal,le or not considered. the Tax Court applies the unitary entity theory to the MNC’s international pricing structure. A relative profit-split strategy is cornmonly wised to assess the appropriateness of the TP. The assumption is that overall profits should be shared in proportion to relative assets employed, functions performed. and risks assumed. Tax courts have not revealed the exact rationale used in splitting profits. so MKCs are responsible for documenting assets. functions. and risk information to justify the TP level to an auditor. Transfer pricing methods vary in their effects on pricing flexibility, efficiency, and profital>ility. The no-charge method gives the least incenti\re to the parent to control efficiency and allows the greatest amount of pricing tlexil,ility and profitability markup at the subsidiary le\rel. On the other hand, the comparal~lei~lncontrollecl method gives the most incenti\,e to control efficiency 1Xit allows the least amount of pricing flexibility and the least profit markup at the subsidiary level. The ability to respond to changes in elasticity of demand in the marketplace will depend on the percentage of markup to the ultimate consumer. If the markup is high. the company is more flexible in meeting ;I price the market bill bear-
which is of particular concern when demand is volatile. There is a direct and critical relationship between the TP strategy chosen and the final percentage markup. At one end, when a no-charge TP is chosen between parent and subsidiary, the subsidiary’s cost of goods sold is minimal and the percentage markup is maximized relative to other TP strategies. At the other extreme, when a market-based TP is chosen between parent and subsidiary. the latter’s cost of goods sold is maximized and the percentage markup is minimized relative to other TP strategies. The more intense the competition, the increased likelihood of an elastic demand in the consumer market. The more elastic the demand in the marketplace, the more sensitive consumers will be to the ol>jective price of the product. When price sensitivity is enhanced by intense competition, the parent and subsidiary should try to establish a TP policy that will result in the lowest product cost structure. By keeping the cost structure low, the MNC has more flexibility in setting competitive prices while maintaining acceptable profit margins. It must be emphasized that minimizing effective tax rates is not without risk. A primary danger is a TP audit resulting in assessed penalties. As the MNC departs from the BALS and the criterion used to define it by the tax authority, the risk of a penalty increases. No-charge and cost methods are not HALS-based. so, again, the risk of penalty is sul>st:mtially higher for these methods. TRANSFER PRICING STRATEGIES: THE LIGHT AT THE END OF THE TUNNEL
R
esearch shows that many MNC managers are not aware of the significant penalties of a TP audit. They often make their TP decisions very informally, without legally acc~irate TP decision guidelines. The Figure presents a prescriptive decision-making model designed to help a manager determine whether the TP policies in place are set at a level that protects the MNC from the risk of an intensive TP audit and its substantial penalties. The I1.S. Tax Authority. including the Tax Court, have set la\vs and precedents for transfer pricing. It is firmly established that risk exposure to a TP audit depends on the ans\vers to five key questions: 1. L)o comparable/ uncontrolled transactions exist? 2. Where is the most value added? Parent, subsidiary. or shared between the t\vo? 3. Are combined profits of parent and subsidiary shared in proportion to contributions? of. Does the MNC’s TP meet the benchmark set I,y the tax authority? 5. Are the MNC’s information reporting requirements aHe to justify the TP cased?
Insufficient TP information reporting leaves the MNC at maximum risk for significant penalties, plus money and time spent on Tax Court appeals, stockholder loss of confidence, supplier and customer skepticism, loss of sales or profitability, and negative publicity. Tax authorities worldwide are forecasting a dramatic increase in the number of audits and the number and size of the penalties as they “crack down” on TP violations.
As the prescriptive model shows, the answers to these questions put corporations at critical junctures. For example, if a TP audit occurs, the first question the tax authority asks is, “Do comparable/uncontrollat,le transactions exist?” If they do, the separate entity theory is applied (that is, the subsidiary is treated as a separate and unique company) and the BALS must be met. Before a reasonable BALS can be calculated, the tax authority must determine if the bulk of the value added is at the parent or subsidiary level. To set what it determines is a “fair” TP benchmark for the BALS, the tax authority has a different “preferred” calculation method, depending on where the most value is added. For example, if the most value added is at the IJS. parent level and the subsidiary is in a lower tax country, the preferred method is the resale method. This ensures that the parent will not be selling to the subsidiary at below or near cost with the result of higher subsidiary profits, and ultimately lower effective tax rates for the MNC as a whole. If the MNC’s TP policies in place meet the benchmark calculated by the IRS, the audit is concluded with no penalty. If the benchmark is not met, the MNC’s TP records must meet tax authority information reporting requirements for the TP to be justified.
Figure A Decision
Making Model for Assessing
I
n the United States, many problems have arisen when a multinational corporation translates Section 482 of the IRS Code into practice because of the perceived ambiguous and vague regulations. Most cases between the IRS and the MNC result in a Tax Court settlement, sometimes after several appeals. Menssen (1988) suggests that a contract price schedule be set for subsidiaries to formalize the TP after (1) projected market prices have been approved by the corporate controller, (2) projected profitability has been established, (3) marketplace constraints on selling/profitability have been assessed, and (4) a legal benchmark for the TP has been met. Guidelines suggested by the IRS for multinationals are as follows:
Risk of TP Strategy Do comparable/uncontrollrd
transactions exist?
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I
Separateentity theory
Unitary entity theory applied by tax authority
applied by tax authority
I I
I I
I
Where is most value added? I
I Parent
Profit-solit rationale is emnloved I Subsidiary
Shared
I
I method preferred by tax authority -
Resale
I
Comparablei uncontrolled method preferred by tax authority
I
Cost-plus method preferred I,y tax authority
TP benchmark set
Does
MNC‘s TP meet
the
benchmark set by t;ix authority?
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+
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Transfer Pricing by Multinationd
Are MNC’s information reporting requirements able to justify the TP used?
Marketers:
Risky Business
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1. File with the tax authority. 2. Plan ahead by having justifiable information reporting requirements and APAs. 3. Leave a paper trail. 4. He consistent. and use comparahle/‘uncontrolled price or cost-plus pricing. MNCs must realize that home country tax authorities are not the only threat. Controversies ofkn arise because the tax authority in the host county suspects misuse of transfer pricing. When MDjCs review or document TP xmngernents with sulxidiaries in host countries, tax controversies
o\wseas are minimized. protection against U.S. tax penalties is created. and doulde Lixation is avoided. In adclition. the “justified information reporting requirement” criterion can he met. MNCs can optx~tionalize these guidelines hy forming 211‘1’ teum coniprised of departniental product managers. general mmagers, managenient accountants. and sales/marketing managers who are in a position to assess the txoad range of opportunity costs xncl risks of various TP strategies. Team decisions should reflect corporate objectives and coorcliixite activities of all depxmerits. Mcimlwrs should consult full), \vith delxtrtments on TP, and attention sl~ould lx pxid to its effects on measuring managenicnt effectiveness. lixely does a single TP srtxregy meet all needs. This is why an MNC’s o\~~dl objecrhx3 may be best served I,)- ;I numlxr of legal Tl% ;IS defined in all countries of operation. Multin:ition:ils M-ill continue to facv the challenges of aligning tax regul;ltions \vith their business ol+xctives. Further research by mxugers and researchers should look into he ‘1’1’decision lvithin the MTCC itself. examining such internal effcxcts :is fin:inc%il performance nitxibures, niotiv3tion incentives for m:uiagement. ;incl incongruence of go:ds ktmwn functional xreas. The external effects-sales, relati1.c sales. :hility to coimpt~li~ivc$~ price. :il,ility to react to :I highlv price-sensiti\,c nlarket-are also key we:~s for r&exch. 1’1’ concerns, after all. w,ill not go :ILL~). or diminish in the future: the). \\,ill continue to go\\. in stature and compleuit)~. fl References
John P. Fraedrich is an associate professor of marketing at Southern Illinois University in Carbondale, Illinois. Connie Rae Bateman is an assistant professor of marketing at the University of North Dakota in Grand Forks, North Dakota.
T
ransfer pricing decisions are made every day in multinational corporations. When a department within an MNC transfers its tangible or intangible output to another department or a subsidiary, it regards this transfer as a sale. The price that is placed on such products, services, and know-how is generally regarded as the transfer price, or TP. MNCs regularly use TP policies as strategic tools to increase subsidiary profits when the subsidiary is in a foreign country with a lower tax rate. The subsidiary, in turn, creates value that can yield more profits in the country of entry and minimize effective tax rates. Depending upon foreign country tax rates, the parent will choose either a low or high TP. When the tax rate is low relative to the United States, American-owned, foreign-based subsidiaries should buy low and sell high, accruing the majority of the profits in the low tax rate country. This cuts the effective tax rate to the parent. When the foreign tax rate is high, the goal is to buy high and sell low (that is, at a minimum profit), accruing the majority of the profits in the low tax rate country. Depending on country-ofentry tax rates relative to the home country and the level of unrelated competition, the TP strategy will affect the risk of an audit. Past practice has set the TP arbitrarily by using a method of cost-plus and a “percentage for contingencies,” which has not always been considered carefully. TP policies can sometimes reflect market and competitive dynamics (those set by default or in line with competition), cost and profit objectives (using a 1-P that promotes efficiency of the seller), or resource allocation decisions (extra human resources needed on the value-added end of production). Setting a TP usualiy occurs within a legislative vacuum, which can cause inefficiencies. The “Basic Arm’s Length Standard” (BALS) criterion championed by the U.S. has now been accepted worldwide as the preferred standard by Transfer
Pricing by Multinational
Marketers:
Risky Business
which transfer prices should be set. To determine the BALS, the tax authority looks to comparable selling prices set by independent buyers and sellers in similar selling environments. This price level then becomes the “benchmark” by which the BALS is set. MNC managers must gain as fLll1an understanding as possible of the complex legal foundations of transfer pricing as well as its effects on their business. In this review the MNC manager is shown how each of the basic TP strategies derived from the BALS affects sales, audit risks, government-assessed penalties, and position in the marketplace. TRANSFER
PRICING TODAY
n the past several years, corporate actions have caused U.S. authorities to strengthen their focus on transfer price issues. The policies and procedures implemented by U.S. authorities have resulted in a loss of taxpayer incentives to multiple profits and an increase in the penalties for manipulating profits. Moreover, U.S. officials have become more effective in the development and processing of TP cases and have established a Competent Authority (CA) to resolve disputes. Any manager unaware of these recent events is at an extreme disadvantage. In making the transfer pricing decision, managers must consider both tax and non-tax related criteria. If all relevant criteria are not assessed properly, the MNC will suffer losses that go unnoticed; and if respective tax authorities disagree as to the appropriate calculation of the TIJ, double taxation can occur. This happens when the same income is taxed in the jurisdiction of the transferor (seller) and also in the jurisdiction of the transferee (buyer). Once a decision is
I
17
made, the TP policy should be formally defined, clearly communicated to all countries of interest, be based on the BALS. and show no currency or profit manipulation. In reality, the TP system is often illegally used for tax evasion purposes, short-changing the U.S. government billions of dollars annually. And the problem is not only with foreign controlled corporations, but with U.S.-controlled companies and their overseas operations as well.Any MNC that illegally uses TP policies to reduce its overrtll tax rate effectively puts itself at risk of a TP audit. Section 482 of the IRS Code sets broad rules for evaluating the BALS characteristic of a TP. If the TP is set outside the boundaries of the BALS, the IRS or foreign tax authority may conduct a TP audit and allocate or reallocate profits, deductions, or other income items to determine the true taxable income. Many countries are aggressively dealing with MNCs that use TP as a strategic tool to minimize tax liabilities. In addition, an MNC can be ordered by the tax authority to pay any due taxes and assessed penalties. As a consequence, it can experience negative press and lose consumer and supplier confidence. If the MNC decides that a tax authority’s decision is unjust, it can appeal the decision and request a Competent Authority (CA) to render a judgment. Ultimately the case can be brought before the Tax Court. LJpon hearing the positions in the case, the court in some cases has ruled against the 1% audit findings. For example, in 19X1 and 1982, the IRS increased Bausch & Lomb, Inc. consolidated taxable recorded income by allocating income from B&L Ireland to its U.S. parent. In this case the IRS had recalculated the BALS price using a method not previously used by B&L. The tax court agreed with B&L’s position and ruled that the IKS recalculation \vas an “unreasonable” adjustment. thus supporting B&L‘s claim that the adjustment was too liberal. New regulations and additional litigation involving the use or transfer of intangible assets covered by Section 482 are anticipated. Thus, compliance lvill become a bigger challenge for the MNC. The IRS‘s new focus on TP issues, the broadening scope of cases heard by the Tax Court. and market-based effects all call for a reevaluation by MNC taxpayers as to what their TP methods will be and how they w311defend their position in an audit.
To understand the extent of the challenge involved in developing a TP strategy, managers must recognize that no one strategy is appropriate for all transactions or markets. MNCs face the challenge of balancing differences in foreign tax systems, exchange controls, and competition with the need to allocate economic, human, and financial resources. Can Compliance with Government Regulation Be That Difficult?
A corporation’s TP objective is to price intercompany sales as close as possible to the standard set by the BALS. When the TP approximates the price that would have been charged between an independent seller and buyer, the BALS is met. Failure of the arm’s length method to correctly attribute income to the taxing jurisdiction, however, is a major problem in U.S. tax policy. The IRS alleges that foreign companies overcharge their American subsidiaries and have avoided paying up to $8 billion in taxes annually. Regulations across countries can be fundamentally different, adding to TP difficulties. For example, the same good or service transferred between parent and subsidiaries is often priced at different transfer levels using different methods. Each country’s tax authority can identify different TP methods, and any deviation from the preferred one increases the risk of an audit. As a result, countries have accepted the BALS as the international standard for assessing TP. In countries where there is unrelated conpetition, tax authorities may have difficulty determining a benchmark, which helps the MNC in justifying its TP level. In countries \\here the level of unrelated competition is reasonable, the tax authority is usually able to identify a more concrete benchmark. For example, Germany and the 1J.K. have both intensified their scrutiny of MNC transfer prices. When problems occur in Germany. firms rely on the IT.K.-German Income Tax Treaty, which contains voluntav arbitration mechanisms available when competent authorities cannot agree. The LJ.K. government uses MNC objectives to determine TP policy as xvell. Japan is also aggressively scrutinizing TPs by including in its tax code a general taxation of foreign corporations. a capital gains tax. specific TP rules. and an anti-tax avoidance provision. The Republic of Korea’s Office of National Tax Administration (ONTA) has enlarged its scope of TP reporting requirements as well. For example, Kee and Jeong (1991) found that (a) the tmnsactions subject to transfer pricing rules are the sale and purchase of inventory assets. the provision of services. and the lease of assets and loans: and (b) the BALS price can be set by either the corn paral~leiuncontrolled price method, the resale
price method, the cost-plus method, or functional analysis (which looks at each party’s contribution to income production). ONTA authorities have begun to recalculate income and secure information regarding TPs between a L7.S. parent and Korean subsidiaries. In intercompany transactions over the U.S.Canadian border, the governing bodies have relatively similar substantive laws, but increasingly dissimilar compliance and reporting rules The method for determining a BALS price is company-specific to some degree, so there is a push by tax authorities for advance pricing agreements (APAs). Canadian oil import parent firms have kept subsidiary TPs at significantly less than an arm’s length price (below market) and priced transport costs above market. The effect has been to reduce the taxable income attributable to property in Canada and reduce the overall effective tax rate (Canadian tax rates are higher than those in the IJnited States). Other Canadian corporations have attempted to sidestep U.S. TP regulations by restructuring value-added operations in the LJ.S. and shifting more of their taxable income to the U.S., which can be illegal in the determination of a TP strategy. The European Union (EU) is also primed for TP issues. The EU market has had an excess supply of certain products, so price competition has increased. EU fiscal policy response has been to protect parents that have subsidiaries within or between EU states from double taxation. MNCs are encouraged to reach an a priori agreement with authorities on how direct taxes will be handled. In addition, ELI policy calls for the establishment of TP adjustment arbitration procedures and provisions. There is a worldwide move toward more TP regulations. the effects of which are many. The LJ.S. is stepping up its scrutiny not only of LJ.S.controlled companies but of foreign-controlled ones as well, including foreign manufacturers that operate in the U.S. through subsidiaries. The brunt of these effects will be felt by the foreign firms and their governments as they wrestle with double taxation, LJ.S.-assessed penalties, and other TP issues. s L Businesses can take active steps to avoid risking exposure to a transfer pricing audit and any subsequent penalties. One suggestion is to follow the requirements set by the IRS in information reporting. record retention. agency designation, monetary penalties, and determining rules. An APA or an established and acceptable cost-sharing arrangement can also forestall or minimize audit controversies. If an audit does occur, an organization has several options: an administrative or judicial forum, a cooperative versus adversarial approach. or settlement strategies.
TRANSFER
PRICING
METHODS
o assess whether your current TP meets BALS criterion, your company can calcuT late a BALS price using one of three methods identified by Section 482 of the IRS Code: comparable/uncontrollable price, resale price, or cost-plus. These are based on the separate entity theory, which compares a given TP to a comparable price on the open market. Many companies prefer the comparable/uncontrollable price method and apply it first. The resale price method is preferred next, followed by cost-plus. Each method will be described below. The IRS allows the MNC discretion in choosing which TP method it will use, but it will closely evaluate whichever method is chosen. If the MNC opts to use another method, the burden of proof falls on the corporation to show that the BALS has been met. Or it may contact the IRS and form an APA with it that defines an acceptable TP calculation method before implementation. When this occurs, the APA frees the MNC from any TP audit for the time period specified in the contract, usually three to four years.
Comparable/Uncontrollable
Price Method
The comparable/uncontrollable price method most accurately approximates an arm’s length price and has been used in most Section 482 pricing cases. It forces the parent to compare the TP of its controlled subsidiary to the selling price charged by an independent seller to an independent buyer for similar goods. Comparing actual profits of one company to the profitability of a number of unrelated companies with similar activities establishes a comparable profit interval. Comparable sales occur when physical property and circumstances of the controlled sales are almost identical to those of uncontrolled sales. Use of this method is thought to best focus on ovemll operating profits as they relate to similarly situated firms rather than on similar trdnsactions involving unrelated firms. If comparisons are not possible, then sales of other resellers in the same market could be used. This allows management to evaluate international subsidiaries as it would any other distributor.
Resale Price Method The resale price, or market, method places the transferor in direct competition with outside sup-
pliers. It is the strategy used most often for setting a TP for international transfers. In this scenario the BALS TP is determined by subtracting the gross margin percentage used by comparable independent buyers from the final third-party sales price. It is typically used when the valueadded by the subsidiary is not substantial. Cost-Plus Method
The cost-plus method is computed by adding the gross profit markup (on a percentage basis) earned by comparable companies performing similar functions to the production costs of the controlled manufacturer or seller. (An amount equal to cost times an appropriate gross profit percentage is the gross profit percentage, expressed as a percent of cost. earned by the seller or another party on the uncontrolled sales, to cover some or all of the fixed costs.) An arm’s length price is considered the best approximation of the price that would he charged if companies involved in the sales transactions did not have common ownership. Other Methods
TRY) common TP methods used 1,~ MNCs hut not recommended by Section 482 are the no-charge method and the cost method. Neither considers a reference to comparal+ sellers or buyers, and I>oth usually violate RALS criteria, thus jeopardizing the MNC’s TP status. When reference to conipalal~le/uncontrolled prices is not availal,le or not considered. the Tax Court applies the unitary entity theory to the MNC’s international pricing structure. A relative profit-split strategy is cornmonly wised to assess the appropriateness of the TP. The assumption is that overall profits should be shared in proportion to relative assets employed, functions performed. and risks assumed. Tax courts have not revealed the exact rationale used in splitting profits. so MKCs are responsible for documenting assets. functions. and risk information to justify the TP level to an auditor. Transfer pricing methods vary in their effects on pricing flexibility, efficiency, and profital>ility. The no-charge method gives the least incenti\re to the parent to control efficiency and allows the greatest amount of pricing tlexil,ility and profitability markup at the subsidiary le\rel. On the other hand, the comparal~lei~lncontrollecl method gives the most incenti\,e to control efficiency 1Xit allows the least amount of pricing flexibility and the least profit markup at the subsidiary level. The ability to respond to changes in elasticity of demand in the marketplace will depend on the percentage of markup to the ultimate consumer. If the markup is high. the company is more flexible in meeting ;I price the market bill bear-
which is of particular concern when demand is volatile. There is a direct and critical relationship between the TP strategy chosen and the final percentage markup. At one end, when a no-charge TP is chosen between parent and subsidiary, the subsidiary’s cost of goods sold is minimal and the percentage markup is maximized relative to other TP strategies. At the other extreme, when a market-based TP is chosen between parent and subsidiary. the latter’s cost of goods sold is maximized and the percentage markup is minimized relative to other TP strategies. The more intense the competition, the increased likelihood of an elastic demand in the consumer market. The more elastic the demand in the marketplace, the more sensitive consumers will be to the ol>jective price of the product. When price sensitivity is enhanced by intense competition, the parent and subsidiary should try to establish a TP policy that will result in the lowest product cost structure. By keeping the cost structure low, the MNC has more flexibility in setting competitive prices while maintaining acceptable profit margins. It must be emphasized that minimizing effective tax rates is not without risk. A primary danger is a TP audit resulting in assessed penalties. As the MNC departs from the BALS and the criterion used to define it by the tax authority, the risk of a penalty increases. No-charge and cost methods are not HALS-based. so, again, the risk of penalty is sul>st:mtially higher for these methods. TRANSFER PRICING STRATEGIES: THE LIGHT AT THE END OF THE TUNNEL
R
esearch shows that many MNC managers are not aware of the significant penalties of a TP audit. They often make their TP decisions very informally, without legally acc~irate TP decision guidelines. The Figure presents a prescriptive decision-making model designed to help a manager determine whether the TP policies in place are set at a level that protects the MNC from the risk of an intensive TP audit and its substantial penalties. The I1.S. Tax Authority. including the Tax Court, have set la\vs and precedents for transfer pricing. It is firmly established that risk exposure to a TP audit depends on the ans\vers to five key questions: 1. L)o comparable/ uncontrolled transactions exist? 2. Where is the most value added? Parent, subsidiary. or shared between the t\vo? 3. Are combined profits of parent and subsidiary shared in proportion to contributions? of. Does the MNC’s TP meet the benchmark set I,y the tax authority? 5. Are the MNC’s information reporting requirements aHe to justify the TP cased?
Insufficient TP information reporting leaves the MNC at maximum risk for significant penalties, plus money and time spent on Tax Court appeals, stockholder loss of confidence, supplier and customer skepticism, loss of sales or profitability, and negative publicity. Tax authorities worldwide are forecasting a dramatic increase in the number of audits and the number and size of the penalties as they “crack down” on TP violations.
As the prescriptive model shows, the answers to these questions put corporations at critical junctures. For example, if a TP audit occurs, the first question the tax authority asks is, “Do comparable/uncontrollat,le transactions exist?” If they do, the separate entity theory is applied (that is, the subsidiary is treated as a separate and unique company) and the BALS must be met. Before a reasonable BALS can be calculated, the tax authority must determine if the bulk of the value added is at the parent or subsidiary level. To set what it determines is a “fair” TP benchmark for the BALS, the tax authority has a different “preferred” calculation method, depending on where the most value is added. For example, if the most value added is at the IJS. parent level and the subsidiary is in a lower tax country, the preferred method is the resale method. This ensures that the parent will not be selling to the subsidiary at below or near cost with the result of higher subsidiary profits, and ultimately lower effective tax rates for the MNC as a whole. If the MNC’s TP policies in place meet the benchmark calculated by the IRS, the audit is concluded with no penalty. If the benchmark is not met, the MNC’s TP records must meet tax authority information reporting requirements for the TP to be justified.
Figure A Decision
Making Model for Assessing
I
n the United States, many problems have arisen when a multinational corporation translates Section 482 of the IRS Code into practice because of the perceived ambiguous and vague regulations. Most cases between the IRS and the MNC result in a Tax Court settlement, sometimes after several appeals. Menssen (1988) suggests that a contract price schedule be set for subsidiaries to formalize the TP after (1) projected market prices have been approved by the corporate controller, (2) projected profitability has been established, (3) marketplace constraints on selling/profitability have been assessed, and (4) a legal benchmark for the TP has been met. Guidelines suggested by the IRS for multinationals are as follows:
Risk of TP Strategy Do comparable/uncontrollrd
transactions exist?
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Separateentity theory
Unitary entity theory applied by tax authority
applied by tax authority
I I
I I
I
Where is most value added? I
I Parent
Profit-solit rationale is emnloved I Subsidiary
Shared
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I method preferred by tax authority -
Resale
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Comparablei uncontrolled method preferred by tax authority
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Cost-plus method preferred I,y tax authority
TP benchmark set
Does
MNC‘s TP meet
the
benchmark set by t;ix authority?
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+
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Transfer Pricing by Multinationd
Are MNC’s information reporting requirements able to justify the TP used?
Marketers:
Risky Business
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21
1. File with the tax authority. 2. Plan ahead by having justifiable information reporting requirements and APAs. 3. Leave a paper trail. 4. He consistent. and use comparahle/‘uncontrolled price or cost-plus pricing. MNCs must realize that home country tax authorities are not the only threat. Controversies ofkn arise because the tax authority in the host county suspects misuse of transfer pricing. When MDjCs review or document TP xmngernents with sulxidiaries in host countries, tax controversies
o\wseas are minimized. protection against U.S. tax penalties is created. and doulde Lixation is avoided. In adclition. the “justified information reporting requirement” criterion can he met. MNCs can optx~tionalize these guidelines hy forming 211‘1’ teum coniprised of departniental product managers. general mmagers, managenient accountants. and sales/marketing managers who are in a position to assess the txoad range of opportunity costs xncl risks of various TP strategies. Team decisions should reflect corporate objectives and coorcliixite activities of all depxmerits. Mcimlwrs should consult full), \vith delxtrtments on TP, and attention sl~ould lx pxid to its effects on measuring managenicnt effectiveness. lixely does a single TP srtxregy meet all needs. This is why an MNC’s o\~~dl objecrhx3 may be best served I,)- ;I numlxr of legal Tl% ;IS defined in all countries of operation. Multin:ition:ils M-ill continue to facv the challenges of aligning tax regul;ltions \vith their business ol+xctives. Further research by mxugers and researchers should look into he ‘1’1’decision lvithin the MTCC itself. examining such internal effcxcts :is fin:inc%il performance nitxibures, niotiv3tion incentives for m:uiagement. ;incl incongruence of go:ds ktmwn functional xreas. The external effects-sales, relati1.c sales. :hility to coimpt~li~ivc$~ price. :il,ility to react to :I highlv price-sensiti\,c nlarket-are also key we:~s for r&exch. 1’1’ concerns, after all. w,ill not go :ILL~). or diminish in the future: the). \\,ill continue to go\\. in stature and compleuit)~. fl References
John P. Fraedrich is an associate professor of marketing at Southern Illinois University in Carbondale, Illinois. Connie Rae Bateman is an assistant professor of marketing at the University of North Dakota in Grand Forks, North Dakota.