Management Accounting Techniques - Essay Example

TRANSFER PRICING By Number of words (2485) Introduction Transfer pricing is fast becoming the most discussed issue in the wake of globalisation. Transfer pricing is the restructuring of the international transfer prices within the multi-corporate enterprises or business, especially in the evaluation of intangible or tangible assets of business entities within the same multi-corporate organisation (Organisation for Economic Co-Operation and Development, 2012). Transfer pricing is an internationally accepted term that is used in the determination and adjustment of price for a transaction that has taken place between two parties i.e. affiliated companies that are situated in two different countries. With the rise in the intra-group cross-border transactions in the current globalisation era, transfer pricing is quickly emerging as one of the key considered tax issues that are facing multinational enterprises (MNE’s). The ability of MNE’s to manipulate prices in related party transactions; thereby, allocation of the profits from jurisdictions with high tax to those with low or favourable jurisdictions is an issue of serious consideration for tax authorities worldwide (OECD, 2012). Transfer pricing was until the recent years a subject of interest only for tax administrators and subject specialists. However, the recent development in economies around the world has ensured that a good number of the groups in society such as multinational employees, businessmen, banks and among others have realised the vitality of transfer pricing in the wake of the globalisation (Holtzman & Nagel, 2014). Today, approximately 70% of the cross-border trade is taking place within the MNE’s. The transfer pricing is the price that can be charged for the intercompany transactions within a group. It relates to both the trade operations and the intra-firm transactions such as dividend remittances transfer of technology, technical fees payments, and royalties. Transfer pricing is majorly about the shifting of the profits from one business entity to a related business through the charging of the transfer prices, such as those prices that do not conform well to the arm’s length standards (Abdallah, 2004). Transfer Pricing and the Growth of the World Trade Over the last two centuries, the world has experienced two globalisation booms and one bust. The global trade has recorded a remarkable increase prior to the World War I as well as the decades following the World War II. Economic globalisation is widely seen as one of the most dominant aspects that shaped the post-war world. The increase in the production activities accelerated at a significant rate after the Second World War, as developed countries began to invest heavily in the rebuilding their economies. Many historians indeed attribute the foundation of the global economy to an era immediately following the Second World War. Over the last three decades, the volume of the cross-border economic transfers has increased rapidly. This is particularly motivated by developments in communications and technology, national markets’ liberalisation and free trade agreements that have eliminated significant constraints on the operations of the foreign companies and eased cross-border trade (Kroppen, Dawid & Schmidtke, 2012). Additionally, increased growth in the world trade is largely attributed to the desire of companies to expand globally by taking advantage of cheaper labour and growing demand in developing countries. This has a result has increased transfer prices through increased number of MNE’s. The enhanced scope of trade around the world has led to an increased number of goods produced in the world (Konrad & Schön, 2012). The various economies have, therefore, tried to invest globally, rather than depending wholly on their economy. More than 60 countries have adopted the transfer pricing rules that are largely based on the “arm’s length principle” that establishes the transfer prices that is based on the analysis of the pricing in comparable transactions among the unrelated parties dealing at the arm’s length (Konrad & Schön, 2012). The Arm’s Length Standard The failure by governments across the globe in ensuring that the fiscal policies are in line with the growing border trade by the MNE’s is a vital issue that has contributed to the increased significance of the transfer pricing (Kroppen, Dawid & Schmidtke, 2012). Traditionally, most governments have some previously had some forms of the transfer pricing legislations, however, currently many nations have started to formulate comprehensive rules in this regards. The arm’s length principle is the transfer pricing principle determined by the Organisation for Economic Co-Operation and Development (OECD) MS as the international TP standard for the tax purposes (OECD, 2012). The principle is used both by the taxpayers and the tax administrators within the MNE groups. The main purpose for the arm’s length principle is to find the transactions between the independent enterprises called the “comparable uncontrollable transactions” and the determination if they differ from the controlled transactions that are found between the associated enterprises (Sahay, 2014). Even though the tax authorities and the taxpayers are faced with the challenges by using the arm’s length principle, the principle provides the income levels that are adequate enough for the satisfaction of the tax administrators (Kroppen, Dawid & Schmidtke, 2012). Additionally, the principle provides a fair estimate value of the transactions that are usually transferred between the associated enterprises as to uphold the open market. Failure to use the arm’s length principle will lead to the risk of the double taxations increase (Kroppen, Dawid & Schmidtke, 2012). Transfer Pricing Techniques 1. Traditional Transaction Methods The traditional transaction method of the transfer pricing is one of the most direct means of establishing whether the conditions of the transactions between the associated corporations are set in accordance with the arm’s length principle. However, the drawback of these methods is that in situations where there is lack of the information or insufficient information, it’s hard to apply the method (Sikka & Willmott, 2010). a) Comparable Uncontrolled Price (CUP) The Comparable Uncontrolled Price method is a method that is based on the market price of the comparable goods. The market based prices include both the internal and external comparison of the transactions to ensure the setting of the arm’s length principle is set in accordance with CUP (Rossing, Cools & Rohde, 2014). The comparison can be done either with the price used for the similar or the same product that is transferred between two independent corporations, an external comparison. Or the price of the similar or same product that is usually transferred the independent corporation and the dependent one in the case of the internal comparison. Examples of these features include; terms of the contract, the differences in the quantity and quality and the terms of payment (Sikka & Willmott, 2010). The Income Tax Rules 1962 (Rules) describes the CUP under the r 10B(1)(a) as the price that is paid or charged for the property transferred or the services provided in the comparable uncontrolled transaction or the number of such transactions that is identified (Rossing, Cools & Rohde, 2014). The adjusted price that is arrived at is usually adjusted to be an arm’s length price in respect to the property that is transferred or the services that is provided in the international transaction. Advantages and Disadvantages of CUP This method is one of the most direct methods used in the ascertaining of an arm’s length price of the controlled transaction owing to the fact that it’s the “open market” price of the tested business transactions between the related parties (Sikka & Willmott, 2010). The method is mostly preferred in scenarios where it meets the stringent comparability criteria. In such scenarios, then it’s prudent to use CUP over the other methods owing to the fact that the results derived will be most accurate. However, in practice, the CUP method is rejected because it’s hard to match one or more of the comparability criteria such as similar markets, position and volumes in supply chains. This therefore makes CUPs most preferable only in the transactions involving products traded on commodity-type markets (Joey, 2007). b) Resale Price Method (RPM) The determination of the market based price in accordance to the RPM is the indirect method of determining the transfer pricing. The RPM evaluates the transfer price through the comparison of the profit margin in the controlled transaction with the gross profit margin in the independent transactions (Boos, 2003). When the product acquired from the associated corporation is sold to the independent buyer, the resale price that is used to sell the product(s) to the independent buyer is found based on this method. In order to get the transfer price using the RPM, the resale price that is given to the independent buyer is reduced usually with the suitable before-tax profit. Just like the CUP, the RPM method can also be applied by way of an external RPM or Internal RPM. The RPM is most preferred method for the marketing operations (Garrison, Noreen & Eric. 2010). It’s most appropriate in situations where the reseller doesn’t add substantially to the value of the product or the service. However, the RPM method is regarded as the most difficult method to use in arriving at the arm’s length price whereby before the resale, the goods can be further processed into a complex product leading to the loss of the identity. For instance, in situations whereby the components are usually joined together into the finished or the semi-finished goods. One of the demerits of the RPM is that it’s hard to properly identify whether the comparable business employ or do not employ valuable marketing intangibles in their business activities (Boos, 2003). c) Cost plus Method (CPM) This method usually builds on the cost of the service or the product. Just the RPM, the CPM is also the indirect method that is used for the setting of the transfer price in accordance with the arm’s length principle (Udoayang, Akpanuko & Asuquo, 2009). The method is based usually on the seller’s cost of the production or acquiring of the service or product in addition to the costs for each link in the MNE, plus the “cost plus mark-up” that is based on the market (Pfeiffer, Schiller & Wagner, 2011). The seller’s original cost of the product or the service include the costs for the acquisition of the semi-finished products and the production costs of the finished service or products, plus the mark-up for the reasonable profit. The CPM is the most useful method especially where the semi-finished goods are sold between the associated corporations and when there is concern for the service provision from the controlled transaction (Garrison, Noreen & Eric. 2010). However, the method has one downside in that the regulations and the ways of the account for the costs is not constant among countries. This can cause severity in the determination of the relevant data of the costs. When using the CPM it’s important to use the cost calculations that are based on the averages. The limitation of the method is that it’s only the costs of the supplier of the goods that is considered and this can raise allocation problems of some of the costs between the purchasers and the suppliers (Garrison, Noreen & Eric. 2010). 2. Transactional Profits Methods The transactional method is divided into two categories; the transactional Net Margin Method (TNMM) and the Transactional Profit Split Method (PS). These methods differ from the traditional methods in that their analysis is not based on the particular comparable uncontrolled transactions (Sikka & Willmott, 2010). a) Transactional Net Margin Method (TNMM) The TNMM usually examines the net profit relative to the appropriate base such as the costs, sales and the assets that the taxpayer realises from the controlled transaction. This method compares the net profit margin that the tested pay earns in the controlled transactions relative to the same net profit margin that is earned by the tested party in the comparable uncontrolled transactions (Udoayang, Akpanuko & Asuquo, 2009). The TNMM is usually used to analyse the transfer pricing issues involving the tangible property, the intangible property or the services. However, the method is more typically applied in the case where one of the associated enterprises employs the intangible assets. The TNMM is usually applied to the related parties that are involved in the controlled transaction. The tested party should not own the valuable intangible property (Udoayang, Akpanuko & Asuquo, 2009). If there are differences in the features of those transactions being compared, the TNMM method can be used. This is due to the fact that the operating margin is not affected to such differences in the same degree as the price does. This is one of the advantages of TNMM. Another advantage that can be derived through the use of the TNMM is that it’s only necessary to analyse only one party (Udoayang, Akpanuko & Asuquo, 2009). b) Profit Split Method Since there are few countries that are conversant with the TNMM, most countries therefore prefer PSM as the last resort method for the determination of the transfer pricing. The PSM method is; however, not frequently used and it’s most preferable in situations where the risk of unrelieved taxation is very minimal (Kroppen, Dawid & Schmidtke, 2012). When applying PSM, the profit is generated by a transaction where there are two or more associated corporations co-operated. The downside of the PSM is that the method is majorly based on external market data that has less connection to joint transactions than other methods (Kroppen, Dawid & Schmidtke, 2012). The external market data is usually used to estimate the contributions of each corporation that is within the MNE have done to the total transaction profits. The advantage of the PSM is that since both parties are involved in the transactions that are being evaluated, there exist lesser risks that either of the corporations will have and therefore improbable and extreme profits result. Additionally, this method does not require the comparable transactions (Pfeiffer, Schiller & Wagner, 2011). Developments in the Transfer Pricing In an Era of Globalisation In the U.K, the earlier transfer pricing regulations were majorly covered under the sections 770 to the 773 of the Income and Corporation Taxes Act, 1988. Due to globalisation, transfer pricing is fast becoming more vital as well as a more complex issue for industrial products and services companies. As the MNE’s expand their global operations, they must, thus be able to develop defensible and robust multinational transfer pricing policies and structures (Leng & Parlar, 2012). The companies must deal with the growing number of the jurisdictions that have adopted rigorous transfer pricing policies. The MNE’s must also respond to the aggressive enforcements by the tax authorities by many states in order to prevent the perceived abuses by the taxpayers and the desire for increased revenues so as to reduce deficits. These developments are taking place both for in emerging and developed countries. Indeed, TP landscape throughout the globe is fast evolving as evidenced by the recent focus on base erosion and profit shifting (BEPS) by the OECD (Leng & Parlar, 2012). Conclusion As a result of various OECD initiatives and the present United Nations work, monitoring of the OECD developments in the coming years is fundamental, both in terms of how detailed the OECD guidance provisions are in relation to intangible projects and the reaction of the United Nations. The developments can have material impact on the ways that countries can carry transfer pricing, thus necessitating a close examination of future developments. Ultimately, it is evident there are different techniques of transfer pricing that MNEs can use in this era of globalisation. Bibliography Abdallah, W. M., 2004. Critical concerns in transfer pricing and practice. Westport, Conn, Praeger. Boos, M., 2003. International transfer pricing: the valuation of intangible assets. The Hague, Kluwer Law International. 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