Corporates the world over are expanding their wings in an

effort to gain a share of the global pie. There is talk of the

world fast turning into a global village with economies
increasingly becoming inter-connected. But with cross-
border trade comes a whole new set of problems. Transfer
pricing is one of them.
When a company opens a branch in another country, gets
its products manufactured there and then imports it, there
is a question mark over what price should the parent pay
for buying the product from the subsidiary. This price till
now has been subject to the parent’s discretion and has
been used by many corporates the world over to control
the tax outgo to their Government. In effect, the price at
which goods are transferred from one arm of the company
to another is known as transfer pricing.
The question arises that how the transfer price can be
used as a mechanism to evade tax, especially between
countries that have a treaty against double taxation. To
explain this let’s take an example. Suppose there is an
MNC shoe corporation with a subsidiary in India. The
Indian subsidiary manufactures shoes at a cost price of Rs
50 per unit and supplies it to the MNC. The MNC sells the
same shoes in its own country at Rs 200. To be fair, the
transfer price, which the Indian subsidiary should get, is
cost plus a reasonable rate of return (i.e. Rs 50 plus). This
is where the MNC company calls the shots.
In India, the corporate tax on profits is at 35%. Suppose
for the MNC country the rate of tax is 45%.
Case 1.

The MNC decides that Rs 100 is the correct transfer price.

Then the scenario looks like this:
Transfer Price at Rs 100
Indian subsidiary MNC Grand Total
Cost price 50 100
Selling price 100 200
Profit 50 100 150
Tax 17.5 45 62.5
Net Profit 32.5 55 87.5

The transfer price becomes the cost price for the MNC
and thus it earns a profit of Rs 100 per unit. Post tax, its
profit is whittled down to Rs 55. Overall, the total profit
after tax earned by the MNC (including the subsidiary’s
profit) is Rs 87.5 per unit.
Case 2.

The MNC decides that Rs 150 is the correct transfer price.

Then the scenario looks like this:
Transfer Price at Rs 150
Indian subsidiary MNC Grand Total
Cost price 50 150
Selling price 150 200
Profit 100 50 150
Tax 35 22.5 57.5
Net Profit 65 27.5 92.5
The MNC’s profits post tax in its own country comes down
to Rs 27.5. But overall the profit surges to Rs 92.5 per
unit.
Case 3.

The MNC decides that Rs 200 is the correct transfer price.

In such a case, the MNC earns zero profits in its own
country, but its subsidiary pays a 35% tax on its profit of
Rs 150 and thus overall net profit surges to Rs 97.5.
Transfer Price at Rs 200
Indian subsidiary MNC Grand Total
Cost price 50 200
Selling price 200 200
Profit 150 0 150
Tax 52.5 0 52.5
Net Profit 97.5 0 97.5

Case 4.

The MNC decides that Rs 300 is the correct transfer price.

In this case, the MNC earns a loss of Rs 100 per unit of
shoe sold in the home country. Meanwhile, its subsidiary
earns Rs 162.5 as profit, after paying Rs 87.5 as tax. But
the clever MNC gets a tax write off at home worth Rs 45
m.
Transfer Price at Rs 300
Indian subsidiary MNC Grand Total
Cost price 50 300
 Selling price 300 200
Profit 250 -100 150
Tax 87.5 -45 42.5
Net Profit 162.5 0 192.5

Please remember, these are just a few hypothetical simple

situations. In reality, these dealings are much more
complex with conglomerates having more than 50
subsidiaries in just as many countries. Transfer pricing
became a subject of much debate in the western countries
as government’s felt that corporates are down paying their
fair share of tax. As a result, these countries spearheaded
awareness regarding transfer pricing.
To find out a reasonable price for products and
technologies transferred, leading accountancy and legal
firms propagate ‘arm’s length’ methodologies. Arm’s
length, as the term indicates, means keeping a neutral
balance between inter-corporate arms. The idea is that
companies should treat each subsidiary as a separate
entity and deal with them on purely commercial terms, as
they would have if they transacted with any other market
player.
Arm’s length methodologies are of two types.
1. Transactional Methods – Where focus is on the
product or the technology to ascertain the correct
transfer price.
2. Profit Methods – Where profitability is the
cornerstone for analyzing the correct transfer price.
Transaction methods can be further divided into two broad
sub-groups.
A. Comparable uncontrolled price : In this method, the
focus is on ascertaining the correct price of the
property or service. This maybe done by finding out
the price of such services or products prevailing in
that market. However, it is difficult to implement
because it requires similarity of products and also of
markets.
B. Resale price method : Here the accountants look at
ascertaining the resale price of the product or service
under question. The focus is on the margins earned.
However, this method is only useful for subsidiaries
that add little value. For example, this method is
useful when the subsidiary is just a manufacturing
base for the parent and thus adds little economic
value to the product or service. However, where a
technology transfer is involved, the resale price is
subjective.
Profit method has been further sub-divided into two sub-
groups.
A. Profit split method : In this method, the
conglomerates entire profits are consolidated and
then this profit is split between various subsidiaries
depending on their perceived contribution to profits.
But this method is also not without its share of
criticism. For one, some experts argue that the
 allocation of profits to subsidiaries is subjective and
hence, open to manipulation.
B. Net margin method : As the name suggests, this
method focuses on ascertaining the appropriate net
margins for the transactions. The net margin earned
is benchmarked to a relative base like sales or assets
employed.
While going through each of these methods, it becomes
clear that all these methods are not definitive methods for
ascertaining transfer prices. Being a complex subject,
more fine-tuning is needed to finally get a definitive
benchmark method for calculating the transfer price.
As business between countries is likely to only increase in
future, transfer-pricing issues would be subject of even
more scrutiny not only by government’s and legal bodies,
but also the companies’ respective shareholders. But
there is a lot of ground still to be done in this area.

{‘Transfer pricing’, a financial accounting

device used by multinational corporations
(MNCs) to rake huge financial benefits, has
long been a major problem facing host
countries. Kavaljit Singh discusses this
phenomenon in the wake of the recent
disclosure of resort to this practice by the
pharmaceutical giant, Glaxo Smith Kline. }
The large-scale tax avoidance practices resorted to
by multinational corporations (MNCs) came to
public notice recently when the giant drug MNC,
Glaxo Smith Kline, agreed to pay the US
government $3.4 billion to settle a long-running
dispute over the tax dealings between the UK
parent company and its American subsidiary. This
was the largest settlement of a tax dispute in the
US. The investigations carried out by the Internal
Revenue Services (IRS) found that the American
subsidiary of Glaxo Smith Kline overpaid its UK
parent company for drug supplies, mainly its
block-buster drug.Zantac, during the period 1989-
2005. These over payments were meant to reduce
the company’s profit in the US and thereby its tax
bill. The IRS charged Europe’s largest drug
company with engaging in manipulative ‘transfer
pricing’.

Transfer pricing relates to the price charged by one

associate of a corporation to another associate of
the same corporation. When one subsidiary of a
corporation in one country sells goods, services or
know-how to another subsidiary in an other
country, the price charged for these goods or
services is called the transfer price. All kinds of
transactions within corporations are subject to
transfer pricing including those involving raw
material, finished products and payments such as
management fees, intellectual property royalties,
loans, interest on loans, payments for technical
assistance and know how and other transactions.
The rules on transfer pricing require MNCs to
conduct business between their affiliates and
subsidiaries on an ‘arm’s length’ basis, which
means that any transaction between two entities of
the same MNC should be priced as if the
transaction was conducted between two unrelated
parties.
Manipulating the accounts
Transfer pricing, a very controversial and complex
issue, requires closure scrutiny not only by the
critics of MNCs but also by the tax authorities in
the developing world. Transfer pricing is a strategy
frequently used by MNCs to obtain huge profits
through illegal means. The transfer price could be
purely arbitrary or fictitious, therefore different
from the price that unrelated firms would have had
to pay. By manipulating a few entries in the
account books, MNCs are able to reap obscene
profits with no actual change in the physical
capital. For instance, a Korean firm manufacturers
an MP3 player for $100, but its US subsidiary buys
it for $199, and then sells it for $200. By doing
this, the firm’s bottom line does not change but
the taxable profit in the US is drastically reduced.
At a 30% tax rate, the firm’s tax liability in the US
would be just 30 cents instead of $30.
MNCs derive several benefits from transfer pricing.
Since each country has different tax rates, they
can increase their profits with the help of transfer
pricing. By lowering prices in countries where tax
rates are high and raising them in countries with a
lower tax rate. MNCs can reduce their overall tax
burden, thereby boosting their overall profits. That
is why one often finds that corporations located in
high-tax countries hardly pay any corporate taxes.

A study conducted by Simon J Pak of Pennsylvania

State University and John S.Zdanowiczn of Florida
State University found that US corporations used
manipualtive pricing schemes to avoid over $53
billion in taxes in 2001. Based on US import and
export data, the authors found several examples of
abnormally priced transactions such as tooth-
brushes imported from the UK into the US at a
price of $5,655 each, flashlight imported from
Japan for $5,000 each, cotton dish towels imported
from Pakistan for $153 each, briefs and panties
imported from Hungary for $739 a dozen, car
seats exported to Belgium for $1.66 each, and
missile and rocket launchers exported to Israel for
just $52 each.
With the removal of restrictions on capital
flows, manipulative transfer pricing has
increased manifold
With the removal of restrictions on capital flows,
manipulative transfer pricing has increased
manifold. According to the United Nations
Conference on Trade and Development (UNCTAD)’s
World Investment Report 1996, one-third of world
trade is basically intra-firm trade. Because of
mergers and acquisitions, intra-firm trade, in both
number and value terms, has increased
considerably in recent years. Given that there are
over 77,000 parent MNCs with over 770,000
foreign affiliates, the number of transactions taking
place within these entitles is unimaginable. Hence,
it becomes extremely difficult for tax authorities to
monitor and control each and every transaction
taking place within a particular MNC. The rapid
expansion of Internet-based trading (e-commerce)
has further complicated the task of national tax
authorities.

Not only do MNCs reap higher profits by

manipulating transfer pricing: there is also a
substantial loss of tax revenue to countries,
particularly developing ones, that rely more on
corporate income tax to finance their development
programmes. Besides, governments are already
under pressume to lower taxes as a means of
attracting investment or retaining a corporation’s
operations in their country. This leads to a heavier
tax burden on ordinary citizens for financing social
and developmental programmes. Although several
instances of fictitious transfer pricing have come to
public notice in recent years, there are no reliable
estimates of the loss of tax revenue globally. The
Indian tax authorities are expecting to garner an
additional US$111 million each year from MNCs
with the help of new regulations on transfer pricing
introduced in 2001.

In addition, fictitious transfer pricing creates a

substantial loss of foreign exchange and engenders
economic distortions through fictious entries of
profits and losses. In countries where there are
government regulations preventing companies
from setting product retail prices above a certain
percentage of prices of imported goods or the cost
of production, MNCs can inflate import costs from
their subsidiaries and then charge higher retail
prices. Additionally, MNCs can use over priced
imports or underpriced exports to circumvent
governmental ceilings on profit repatriation,
thereby causing a drain of foreign exchange. For
instance, if a parent MNC has a profitable
subsidiary in a country where the parent does not
wish to reinvest the profits, it can remit them by
overpricing imports into that country. During the
1970s, investigations revealed that average
overpricing by parent firms on imports by their
Latin American subsidiaries in the pharmaceutical
industry was as high as 155%, while imports of
dyestuff raw materials by MNC affiliates in India
were overpriced in the range of 124 to 147%.

Given the magnitude of manipulative transfer

pricing, the Organisation for Economic Co-
operation and Development (OECD) has issued
detailed guidelines. Transfer pricing regulations are
extremely stringent in developed countries such as
the US, the UK and Australia. In the US, for
instance, regulations related to transfer pricing
cover almost 300 pages, which dents the myth
that the US espouses ‘free market’ policies.
However, developing countries are lagging behind
in enacting regulations to check the abuse of
transfer pricing. India framed regulations related
to transfer pricing as late as 2001. However, in
many countries including Bangladesh, Pakistan and
Nepal, tax authorities have yet to enact regulations
curbing the abuse of transfer pricing mechanisms.
Such abuse could be drastically curbed if there is
enhanced international coordination among
national tax authorities.

TRANSFER PRICING METHODS

To assess whether your current TP meets BALS criterion,
your company can calculate 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 overall
operating profits as they relate to similarly situated firms
rather than on similar transactions 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 suppliers. 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 value-added 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 be
charged if companies involved in the sales transactions
did not have common ownership.
Other Methods
Two common TP methods used by MNCs but not
recommended by Section 482 are the no-charge method
and the cost method. Neither considers a reference to
comparable sellers or buyers, and both usually violate
BALS criteria, thus jeopardizing the MNC's TP status.
When reference to comparable/uncontrolled prices is not
available or not considered, the Tax Court applies the
unitary entity theory to the MNC's international pricing
structure. A relative profit-split strategy is commonly
used 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
MNCs 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 profitability. The no-charge
method gives the least incentive to the parent to control
efficiency and allows the greatest amount of pricing
flexibility and profitability markup at the subsidiary level.
On the other hand, the comparable/uncontrolled method
gives the most incentive to control efficiency but 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 a price the
market will 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 objective
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 BALS-based, so, again, the risk of
penalty is substantially higher for these methods.

SYNOPSIS FORMAT
• Title of the project
• Literature review
• Objective of the study
• Research methodology
• Scope
• Findings and conclusions
• references

MANAGEMENT ACCOUNTING:
CONCEPTS AND TECHNIQUES
 By Dennis Caplan

PART 5: PLANNING TOOLS AND

PERFORMANCE MEASURES FOR
PROJECTS AND DIVISIONS
CHAPTER 23: TRANSFER PRICING

Ferrari: Shall we draw up the papers, or is our

handshake good enough?

Rick: It’s certainly not good enough. But since

I’m in a hurry, it’ll have to do.

Ferrari: Ah, to get out of Casablanca and go

to America! You’re a lucky man.

Rick: Oh, by the way, my agreement with Sam’s

always been that he gets 25% of the profits. That still
goes.

Ferrari: Hmmm. I happen to know that he gets

10%. But he’s worth 25%.

Rick: Don’t forget, you owe Rick’s a hundred

cartons of American cigarettes.

Ferrari: I shall remember to pay it … to myself.

From Casablanca, 1942

Chapter Contents:
- Definition and Overview
- Transfer Pricing Options
- Market-based Transfer Prices
- Cost-based Transfer Prices
- Negotiated Transfer Prices
- Survey of Practice
- External Reporting
- Dual Transfer Pricing
- Transfer Pricing and Multinational Income Taxes
- Other Regulatory Issues

Definition and Overview:

A transfer price is what one part of a company charges another
part of the same company for goods or services. In the excerpt
from Casablanca, Rick apparently loaned Ferrari 100 cartons of
cigarettes for which he was never repaid. Now that Ferrari owns
both the Blue Parrot and Rick’s Café, he jokes about the fact
that what was previously a debt that he owed to Rick, is now a
“debt” from one nightclub that he owns to another nightclub that
he owns. If Ferrari continues to transfer cartons of cigarettes
between the two clubs, he might wish to establish a “transfer
price” for cigarettes, but knowing Ferrari, he won’t bother.

We will restrict attention to transfers that involve a tangible

product, and we will refer to the two corporate entities engaged
in the transfer as divisions. Hence, the transfer price is the price
that the “selling” division charges the “buying” division for the
product. Because objects that float usually flow downstream, the
 selling division is called the upstream division and the buying
division is called the downstream division.

Transferred product can be classified along two criteria. The

first criterion is whether there is a readily-available external
market price for the product. The second criterion is whether the
downstream division will sell the product “as is,” or whether the
transferred product becomes an input in the downstream
division’s own production process. When the transferred product
becomes an input in the downstream division’s production
process, it is referred to as an intermediate product. The
following table provides examples.

An external market No external marke

price is available
The West Coast Division of
downstream division will sell a supermarket chain
“as is”: transfers oranges to the
Northwest Division, for
retail sale.
price is available
A pharmaceutical compa
transfers a drug that is un
patent protection, from it
manufacturing division to
marketing division.

An oil company transfers The Parts Division of an

downstream division will use crude oil from the drilling appliance manufacturer
ransferred product in its own division to the refinery, to transfers mechanical
production process: be used in the production of components to one of its
gasoline. assembly divisions.

Transfer pricing serves the following purposes.

 1. When product is transferred between profit centers or
investment centers within a decentralized firm, transfer
prices are necessary to calculate divisional profits, which
then affect divisional performance evaluation.

2. When divisional managers have the authority to decide

whether to buy or sell internally or on the external market,
the transfer price can determine whether managers’
incentives align with the incentives of the overall company
and its owners. The objective is to achieve goal
congruence, in which divisional managers will want to
transfer product when doing so maximizes consolidated
corporate profits, and at least one manager will refuse the
transfer when transferring product is not the profit-
maximizing strategy for the company.

3. When multinational firms transfer product across

international borders, transfer prices are relevant in the
calculation of income taxes, and are sometimes relevant in
connection with other international trade and regulatory
issues.

The transfer generates journal entries on the books of both

divisions, but usually no money changes hands. The transfer
price becomes an expense for the downstream division and
revenue for the upstream division. Following is a representative
example of journal entries to record the transfer of product:

Upstream Division:
(1) Intercompany Accounts Receivable $9,000
 Revenue from
Intercompany Sale $9,000

(2) Cost of Goods Sold – Intercompany Sales $8,000

Finished Goods
Inventory $8,000

(To record the transfer of 500 cases of Clear

Mountain Spring Water, at $18 per case, to
the Florida marketing division, and to remove the
500 cases from finished goods inventory at the
production cost of $16 per case.)

Downstream Division:
(1) Finished Goods Inventory $9,000
Intercompany Accounts
Payable $9,000

(To record the receipt of 500 cases of Clear

Mountain Spring Water, at $18 per case, from the
bottling division in Nebraska)

Transfer Pricing Options:

There are three general methods for establishing transfer prices.

1. Market-based transfer price: In the presence of

competitive and stable external markets for the transferred
product, many firms use the external market price as the
transfer price.
 2. Cost-based transfer price: The transfer price is based on
the production cost of the upstream division. A cost-based
transfer price requires that the following criteria be
specified:
a. Actual cost or budgeted (standard) cost.
b. Full cost or variable cost.
c. The amount of markup, if any, to allow the upstream
division to earn a profit on the transferred product.

3. Negotiated transfer price: Senior management does not

specify the transfer price. Rather, divisional managers
negotiate a mutually-agreeable price.

Each of these three transfer pricing methods has advantages and

disadvantages.

Market-based Transfer Prices:

Microeconomic theory shows that when divisional managers
strive to maximize divisional profits, a market-based transfer
price aligns their incentives with owners’ incentives of
maximizing overall corporate profits. The transfer will occur
when it is in the best interests of shareholders, and the transfer
will be refused by at least one divisional manager when
shareholders would prefer for the transfer not to occur. The
upstream division is generally indifferent between receiving the
market price from an external customer and receiving the same
price from an internal customer. Consequently, the determining
factor is whether the downstream division is willing to pay the
market price. If the downstream division is willing to do so, the
implication is that the downstream division can generate
incremental profits for the company by purchasing the product
from the upstream division and either reselling it or using the
product in its own production process. On the other hand, if the
downstream division is unwilling to pay the market price, the
implication is that corporate profits are maximized when the
upstream division sells the product on the external market, even
if this leaves the downstream division idle. Sometimes, there are
cost savings on internal transfers compared with external sales.
These savings might arise, for example, because the upstream
division can avoid a customer credit check and collection
efforts, and the downstream division might avoid inspection
procedures in the receiving department. Market-based transfer
pricing continues to align managerial incentives with corporate
goals, even in the presence of these cost savings, if appropriate
adjustments are made to the transfer price (i.e., the market-based
transfer price should be reduced by these cost savings).

However, many intermediate products do not have readily-

available market prices. Examples are shown in the table above:
a pharmaceutical company with a drug under patent protection
(an effective monopoly); and an appliance company that makes
component parts in the Parts Division and transfers those parts
to its assembly divisions. Obviously, if there is no market price,
a market-based transfer price cannot be used.

A disadvantage of a market-based transfer price is that the prices

for some commodities can fluctuate widely and quickly.
Companies sometimes attempt to protect divisional managers
from these large unpredictable price changes.
Cost-based Transfer Prices:
Cost-based transfer prices can also align managerial incentives
with corporate goals, if various factors are properly considered,
including the outside market opportunities for both divisions,
and possible capacity constraints of the upstream division.

First consider the case in which the upstream division sells the
intermediate product to external customers as well as to the
downstream division. In this situation, capacity constraints are
crucial. If the upstream division has excess capacity, a cost-
based transfer price using the variable cost of production will
align incentives, because the upstream division is indifferent
about the transfer, and the downstream division will fully
incorporate the company’s incremental cost of making the
intermediate product in its production and marketing decisions.
However, senior management might want to allow the upstream
division to mark up the transfer price a little above variable cost,
to provide that division positive incentives to engage in the
transfer.

If the upstream division has a capacity constraint, transfers to

the downstream division displace external sales. In this case, in
order to align incentives, the opportunity cost of these lost sales
must be passed on to the downstream division, which is
accomplished by setting the transfer price equal to the upstream
division’s external market sales price.

Next consider the case in which there is no external market for

the upstream division. If the upstream division is to be treated as
a profit center, it must be allowed the opportunity to recover its
full cost of production plus a reasonable profit. If the
downstream division is charged the full cost of production,
incentives are aligned because the downstream division will
refuse the transfer under only two circumstances:

- First, if the downstream division can source the

intermediate product for a lower cost elsewhere;

- Second, if the downstream division cannot generate a

reasonable profit on the sale of the final product when it
pays the upstream division’s full cost of production for the
intermediate product.

If the downstream division can source the intermediate product

for a lower cost elsewhere, to the extent the upstream division’s
full cost of production reflects its future long-run average cost,
the company should consider eliminating the upstream division.
If the downstream division cannot generate a reasonable profit
on the sale of the final product when it pays the upstream
division’s full cost of production for the intermediate product,
the optimal corporate decision might be to close the upstream
division and stop production and sale of the final product.
However, if either the upstream division or the downstream
division manufactures and markets multiple products, the
analysis becomes more complex. Also, if the downstream
division can source the intermediate product from an external
supplier for a price greater than the upstream division’s full cost,
but less than full cost plus a reasonable profit margin for the
upstream division, suboptimal decisions could result.
Negotiated Transfer Prices:
Negotiated transfer pricing has the advantage of emulating a free
market in which divisional managers buy and sell from each
other in a manner that simulates arm’s-length transactions.
However, there is no reason to assume that the outcome of these
transfer price negotiations will serve the best interests of the
company or shareholders. The transfer price could depend on
which divisional manager is the better poker player, rather than
whether the transfer results in profit-maximizing production and
sourcing decisions. Also, if divisional managers fail to reach an
agreement on price, even though the transfer is in the best
interests of the company, senior management might decide to
impose a transfer price. However, senior management’s
imposition of a transfer price defeats the motivation for using a
negotiated transfer price in the first place.

Survey of Practice:
Roger Tang (Management Accounting, February 1992) reports
1990 survey data on transfer pricing practices obtained from
approximately 150 industrial companies in the Fortune 500.
Most of these companies operate foreign subsidiaries and also
use transfer pricing for domestic interdivisional transfers. For
domestic transfers, approximately 46% of these companies use
cost-based transfer pricing, 37% use market-based transfer
pricing, and 17% use negotiated transfer pricing. For
international transfers, approximately 46% use market-based
transfer pricing, 41% use cost-based transfer pricing, and 13%
use negotiated transfer pricing. Hence, market-based transfer
pricing is more common for international transfers than for
domestic transfers. Also, comparison to an earlier survey
indicates that market-based transfer pricing is slightly more
common in 1990 than it was in 1977.

Tang also finds that among companies that use cost-based

transfer pricing for domestic and/or international transfers,
approximately 90% use some measure of full cost, and only
about 5% or 10% use some measure of variable cost.

External Reporting:
For external reporting under Generally Accepted Accounting
Principles, no matter what transfer price is used for calculating
divisional profits, the effect should be reversed and
intercompany profits eliminated when the financial results of the
divisions are consolidated. Obviously, intercompany transfers
are not arm’s-length transactions, and a company cannot
generate profits or increase the reported cost of its inventory by
transferring product from one division to another.

Dual Transfer Pricing:

Under a dual transfer pricing scheme, the selling price received
by the upstream division differs from the purchase price paid by
the downstream division. Usually, the motivation for using dual
transfer pricing is to allow the selling price to exceed the
purchase price, resulting in a corporate-level subsidy that
encourages the divisions to participate in the transfer. Although
dual transfer pricing is rare in practice, a thorough understanding
of dual transfer pricing illustrates some of the key bookkeeping
and financial reporting implications of all transfer pricing
schemes.
In the following example, the Clear Mountain Spring Water
Company changes from a negotiated transfer price of $18 per
case (see the above example) to a dual transfer price in which
the upstream division receives the local market price of $19 per
case, and the downstream division pays $17 per case.
Upstream Division:
(1) Intercompany
Receivable/Payable $9,500
Revenue from
Intercompany Sale $9,500

(2) Cost of Goods Sold – Intercompany

Sales $8,000
Finished Goods
Inventory $8,000

(To record the transfer of 500 cases of Clear

Mountain Spring Water, at $19 per case, to
the Florida marketing division, and to remove the
500 cases from finished goods inventory at the
production cost of $16 per case.)

Downstream Division:
(1) Finished Goods
Inventory $8,500
Intercompany
Receivable/Payable $8,500

(To record the receipt of 500 cases of Clear

Mountain Spring Water at $17 per case, from the
bottling division in Nebraska)

Corporate Headquarters:
(1) Interco. Receivable/Payable
– Florida $8,500
 Corporate Subsidy for Dual Transfer
Price $1,000
Interco. Receivable/Payable
– Nebraska $9,500

(To record the transfer of 500 cases of Clear

Mountain Spring
Water from Nebraska to Florida, at a dual
transfer price of $19/$17 per case.)

Corporate Subsidy for Dual Transfer Price is an expense account

at the corporate level. This account and the revenue account that
records the intercompany sale affect the calculation of divisional
profits for internal reporting and performance evaluation, but
these accounts—as well as the intercompany receivable/payable
accounts—are eliminated upon consolidation for external
financial reporting. To the extent that the Florida Division has
ending inventory, the cost of that inventory for external financial
reporting will be the company’s cost of production of $16 per
case. In other words, the transfer price has no effect on the cost
of finished goods inventory.

Transfer Pricing and Multinational Income Taxes:

When divisions transfer product across tax jurisdictions, transfer
prices play a role in the calculation of the company’s income tax
liability. In this situation, the company’s transfer pricing policy
can become a tax planning tool. The United States has
agreements with most other nations that determine how
multinational companies are taxed. These agreements,
called bilateral tax treaties, establish rules for apportioning
multinational corporate income among the nations in which the
companies conduct business. These rules attempt to tax all
multinational corporate income once and only once (excluding
the double-taxation that occurs at the Federal and state levels).
In other words, the tax treaties attempt to avoid the double-
taxation that would occur if two nations taxed the same income.
Since transfer prices represent revenue to the upstream division
and an expense to the downstream division, the transfer price
affects the calculation of divisional profits that represent taxable
income in the nations where the divisions are based.

For example, if a U.S.-based pharmaceutical company

manufactures a drug in a factory that it operates in Ireland and
transfers the drug to the U.S. for sale, a high transfer price
increases divisional income to the Irish division of the company,
and hence, increases the company’s tax liability in Ireland. At
the same time, the high transfer price increases the cost of
product to the U.S. marketing division, lowers U.S. income, and
lowers U.S. taxes. The company’s incentives with regard to the
transfer price depend on whether the marginal tax rate is higher
in the U.S. or in Ireland. If the marginal tax rate is higher in
the U.S., the company prefers a high transfer price, whereas if
the marginal tax rate is higher in Ireland, the company prefers a
low transfer price. The situation reverses if the drug is
manufactured in theU.S. and sold in Ireland. The general rule is
that the company wants to shift income from the high tax
jurisdiction to the low tax jurisdiction.

There are limits to the extent to which companies can shift

income in this manner. When a market price is available for the
goods transferred, the taxing authorities will usually impose the
market-based transfer price. When a market-based transfer price
is not feasible, U.S. tax law specifies detailed and complicated
rules that limit the extent to which companies can shift income
out of the United States.

Other Regulatory Issues:

Transfer pricing sometimes becomes relevant in the context of
other regulatory issues, including international trade disputes.
For example, when tariffs are based on the value of goods
imported, the transfer price of goods shipped from a
manufacturing division in one country to a marketing division in
another country can form the basis for the tariff. As another
example, in order to increase investment in their economies,
developing nations sometimes restrict the extent to which
multinational companies can repatriate profits. However, when
product is transferred from manufacturing divisions located
elsewhere into the developing nation for sale, the local
marketing division can export funds to “pay” for the
merchandise received. As a final example, when nations accuse
foreign companies of “dumping” product onto their markets,
transfer pricing is often involved. Dumping refers to selling
product below cost, and it generally violates international trade
laws. Foreign companies frequently transfer product from
manufacturing divisions in their home countries to marketing
affiliates elsewhere, so that the determination of whether the
company has dumped product depends on comparing the
transfer price charged to the marketing affiliate with the
upstream division’s cost of production.