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Concepts in Action: US$3.4 Billion Is an Incentive
TRANSFER PRICING ● 801
3. The transfer price should help top management evaluate the performance of individual subunits.
4. If top management favours a high degree of decentralization, transfer prices should preserve a high degree of subunit autonomy in decision making. That is, a subunit manager
seeking to maximize the operating income of the subunit should have the freedom to
transact with other subunits of the company (on the basis of transfer prices) or to transact with external parties.
Transfer Pricing in Practice
An illustration of transfer pricing can be seen in the case of Northern Petroleum of Calgary,
Alberta, which operates two divisions (the transportation and refining divisions) as profit
centres. The transportation division manages the operation of a pipeline that transports
crude oil from the Calgary area to Sarnia, Ontario, where the refining division processes crude
oil into gasoline. (For simplicity, assume that gasoline is the only saleable product the refinery makes and that it takes two barrels of crude oil to yield one barrel of gasoline.)
Variable costs in each division are variable with respect to a single cost driver: barrels
of crude oil transported by the transportation division, and barrels of gasoline produced
by the refining division. The fixed cost per unit is based on the budgeted annual fixed
costs and practical capacity of crude oil that can be transported by the transportation
division, and the budgeted fixed costs and practical capacity of gasoline that can be produced by the refining division.
◆ The production division can sell crude oil to outside parties in the Calgary area at $72
◆ The transportation division “buys” crude oil from the production division, transports
it to Sarnia, and then “sells” it to the refining division. The pipeline from Calgary to
Sarnia has the capacity to carry 40,000 barrels of crude oil per day.
◆ The refining division has been using its total practical capacity, operating at 30,000
barrels of crude oil a day, using oil delivered by both the transportation division (an
average of 10,000 barrels per day) and other external suppliers who also deliver to
the Sarnia refinery (an average of 20,000 barrels per day, at $85 per barrel).
◆ The refining division sells the gasoline it produces at $190 per barrel.
Exhibit 21-1 summarizes Northern Petroleum’s variable and fixed costs per barrel of
crude oil in the transportation division and variable and fixed costs per barrel of gasoline
in the refining division, the external market prices of buying crude oil, and the external market price of selling gasoline. What’s missing in the exhibit is the actual transfer
price from the transportation division to the refining division. This transfer price will vary
Operating Data for Northern Petroleum
Contact price per barrel of crude
oil supplied in Calgary
Variable cost per barrel of crude oil
Fixed cost per barrel of crude oil
Full cost per barrel of crude oil
Barrels of crude oil transferred
Market price per barrel of crude
oil supplied to Sarnia refinery
Variable cost per barrel of gasoline
Fixed cost per barrel of gasoline
Full cost per barrel of gasoline
Market price per barrel of
gasoline sold to external parties
802 ● CHAPTER 21 TRANSFER PRICING AND MULTINATIONAL MANAGEMENT CONTROL SYSTEMS
depending on the transfer-pricing method used. Transfer prices from the transportation
division to the refining division under each of the three methods are as follows:
1. Market-based transfer price of $85 per barrel of crude oil based on the competitive
market price in Calgary.
2. Cost-based transfer prices at, say, 105% of full cost, where full cost is the cost of the
crude oil purchased plus the transportation division’s own variable and fixed costs
(from Exhibit 21-1): 1.05 × ($72 + $1 + $3) = $79.80.
3. Hybrid transfer price of $82 per barrel of crude oil, which is between the market-based
and cost-based transfer prices and is established through agreement of management.
Exhibit 21-2 presents divisional operating incomes per 100 barrels of crude oil purchased under each transfer-pricing method. Transfer prices create income for the selling
Exhibit 21-2 Division Operating Income of Northern Petroleum for 100 Barrels of Crude Oil Under Alternative
Production and Sales Data
Barrels of crude transferred 5
Barrels of gasoline sold 5
Internal Transfers at
Internal Transfers at
at Market Price of
105% of Full Cost 5
Negotiated Price of
Revenue: 100 3 $85; $79.80; $83
$72 3 100 barrels of crude oil
Division variable costs
$1 3 100 barrels of crude oil
Division fixed costs
$3 3 100 barrels of crude oil
Total division costs
18 Division operating income
19 Operating margin
21 Refining Division
22 Revenues: $190 3 50
Transferred-in costs: 100 3 $85; $79.80; $83
Division variable costs
$8 3 50 barrels of gasoline
Division fixed costs
$6 3 50 barrels of gasoline
Total division costs
30 Division operating income
31 Operating margin
32 Total operating income for Northern Petroleum
TRANSFER PRICING ● 803
division and corresponding costs for the buying division that cancel out when division
results are consolidated for the company as a whole. Northern Petroleum’s total operating income from purchasing, transporting, and refining the 100 barrels of crude oil and
selling the 50 barrels of gasoline is the same, $1,200, regardless of the internal transfer
The operating income of the transportation division is $520 more (= $900 – $380) if
transfer prices are based on market prices rather than on 105% of full cost. The operating
income of the refining division is $520 more (= $820 – $300) if transfer prices are based
on 105% of full cost rather than market prices. If the transportation division’s sole criterion were to maximize its own division operating income, it would favour transfer prices
at market prices. In contrast, the refining division would prefer transfer prices at 105% of
full cost to maximize its own division operating income. The negotiated transfer price of
$82 is between the 105% of full cost and market-based transfer prices. It splits the $1,200
of operating income between the divisions, and could arise as a result of negotiations
between the transportation and refining division managers.
It’s not surprising that subunit managers, especially those whose compensation or
promotion directly depends on subunit operating income, take considerable interest in
setting transfer prices. To reduce the excessive focus of subunit managers on their own
subunits, many companies compensate subunit managers on the basis of both subunit and
companywide operating incomes.
Interprovincial Transfers and Taxes
Top management at Northern Petroleum transferred intermediate goods interprovincially.
The corporate tax rates in Alberta are the lowest in Canada, whereas Ontario has the
highest provincial corporate tax rates in the country. From the company’s perspective, the
split of taxable income between the provinces would make a difference in both operating
cash flow and net income. It would also make a difference to the taxes collected by each
The operating margin if the market price is used will be 10.59% for the transportation division in Alberta and 3.16% for the refining division in Ontario. This would be
the best after-tax choice for Northern Petroleum. The second-best choice would be at the
negotiated transfer price, which will leave 8.43% of the operating income in Alberta and
transfer 5.26% to Ontario. The least preferred choice from the company’s perspective is
to use full cost because that leaves only 4.76% of operating income in the provincial jurisdiction with the lowest tax rates (Alberta) and transfers 8.63% to the provincial jurisdiction with the highest tax rates in Canada (Ontario).
Fortunately, the first choice from the company’s perspective also ranks first in the
transfer price hierarchy of the OECD. The national and provincial governments prefer
transfer prices at the market price because it is assured this transfer price is an arm’slength price. In this situation there is no need for Northern Petroleum to approach either
tax authority to obtain an advance transfer price arrangement (APA). APAs are a substitute for dispute resolution wherein the company and the tax authority can cooperate to
prospectively agree on a transfer price method.3
APAs are exceptionally important to sustain good corporate governance. In disputes
between the tax authorities and corporations, fines alone can reach billions. This excludes
legal expenses and opportunity costs of diverting resources to dispute resolution. Most
MNCs will approach the tax authorities in all countries (or provinces) where relatedparty transfers of intermediate goods will occur. Most tax authorities, including CRA,
will negotiate a tax method acceptable to them for some specified future time period.
Companies voluntarily undertake APAs, but the agreement is legally binding.
The APA process is costly; however, complex, high-dollar-value related-party transactions should be negotiated in advance because it is exactly these transactions that tax
authorities will most likely audit. The opportunity cost of a CRA transfer price audit is
M. Przysuski, “Advance Pricing Arrangements (APAs) in Canada,” Corporate Business Taxation Monthly, 6.2 (2004): 11–16.
804 ● CHAPTER 21 TRANSFER PRICING AND MULTINATIONAL MANAGEMENT CONTROL SYSTEMS
very high, especially if the company has failed internally to produce ongoing documentation. All related-party transfers are reportable in the corporate tax return. The maximum
late-filing penalty is $10,000 and the maximum failure to file penalty is $12,000 for
each infraction. Legislation authorizes provinces to levy the same penalties domestically.4
When companies fail to provide acceptable documentation, a 10% penalty can be added
to any transfer-pricing adjustment. The penalty is applied only if the transfer-pricing
adjustment exceeds 10% of the gross revenue prior to any transfer-pricing adjustments
or $5 million.5
Market-Based Transfer Prices
▶ LO 3
Assess the market-based
transfer price method.
Transferring products or services at market prices generally leads to optimal decisions
when three conditions are satisfied: (1) the intermediate market is perfectly competitive,
(2) interdependencies of subunits are minimal, and (3) there are no additional costs or
benefits to the corporation as a whole in using the market instead of transacting internally.
A perfectly competitive market exists when there is a homogeneous product with equivalent buying and selling prices and no individual buyers or sellers can affect those prices by
their own actions. By using market-based transfer prices in perfectly competitive markets,
a company can meet the criteria of goal-congruence, management effort, optimal subunit
performance, and (if desired) subunit autonomy.
Reconsider the Northern Petroleum example, assuming that there is a perfectly competitive market for crude oil in the Calgary area and that the market price is $85 per barrel. As a result, the transportation division can sell and the refining division can buy as
much crude oil as each wants at $85 per barrel. Northern, however, would like its managers to buy or sell crude oil internally. Think about the decisions that Northern’s division
managers would make if each had the option to sell or buy crude oil externally.
If the transfer price between Northern’s transportation and refining divisions is set
below $85, the manager of the transportation division will be motivated to sell all production to outside buyers at $85 per barrel. If the transfer price is set above $85, the manager
of the refining division will be motivated to purchase all its crude oil requirements from
outside suppliers. A current market value transfer price of $85 could motivate both the
transportation and refining division to buy and sell internally.
In perfectly competitive markets, the minimum price the selling division is willing
to accept from the buying division is the market price, because the selling division can
always sell its output in the external market at that price. The maximum price the buying
division is willing to pay to the selling division is the market price, because the buying
division can always buy its input in the external market at that price.
When supply outstrips demand, market prices may drop well below their historical average. If the drop in prices is expected to be temporary, these low market prices are sometimes called distress prices. Deciding whether a current market price is a distress price is
often difficult. The market prices of several agricultural commodities, such as wheat and
oats, have stayed for many years at what observers initially believed were temporary distress levels.
Which transfer-pricing method should be used for judging performance if distress
prices prevail? Some companies use the distress prices themselves, but others use long-run
average prices, or “normal” market prices. In the short run, the manager of the supplier
division should meet the distress price as long as it exceeds the incremental costs of supplying the product or service; if not, the supplying division should stop producing, and the
buying division should buy the product or service from an outside supplier. These actions
would increase overall companywide operating income. If the long-run average market
M. Przysuski, S. Lalapet, and H. Swaneveld, “Transfer Pricing Filing in Canada,” Corporate Business Taxation Monthly, 6.7
S. J. Smith and P. L. Kelley, “It’s an Art, Not a Science,” camagazine, 138.8 (2005): 44–46.
COST-BASED AND NEGOTIATED TRANSFER PRICES ● 805
price is used, forcing the manager to buy internally at a price above the current market
price will hurt the buying division’s short-run performance and understate its profitability.
If, however, prices remain low in the long run, the manager of the supplying division must
decide whether to dispose of some manufacturing facilities or shut down and have the
buying division purchase the product from outside.
Cost-Based and Negotiated Transfer Prices
Cost-based transfer prices are helpful when market prices are unavailable, inappropriate,
or too costly to obtain. For example, the product may be specialized or unique, price lists
may not be widely available, or the internal product may be different from the products
available externally in terms of quality and service.
In practice, many companies use transfer prices based on full costs. These prices, however, can
lead to suboptimal decisions. Assume that Northern Petroleum makes internal transfers at
105% of full cost. The Sarnia refining division purchases crude oil from a local Sarnia supplier,
who delivers the crude oil to the refinery; the freight-on-board (FOB) cost is $85 per barrel.
To reduce crude oil costs, the refining division has located an independent producer in Calgary
who is willing to sell crude oil at $79 per barrel, delivered to Northern’s pipeline in Calgary.
Given Northern’s organization structure, the transportation division could purchase
the 20,000 barrels of crude oil in Calgary, transport it to Sarnia, and then sell it to the
refining division. The pipeline has excess capacity and can ship the 20,000 barrels at its
variable costs of $1 per barrel. Will Northern Petroleum incur lower costs by purchasing
crude oil from the independent producer in Calgary or by purchasing crude oil from the
Sarnia supplier? Will the refining division show lower crude oil purchasing costs by using
oil from the Calgary producer or by using its current Sarnia supplier?
The following analysis shows that operating income of Northern Petroleum as a
whole would be maximized by purchasing oil from the independent Calgary producer.
The analysis compares the incremental costs in all divisions under the two alternatives:
◆ Alternative 1: Buy 20,000 barrels from the Sarnia supplier at $85 per barrel.
Total costs to Northern Petroleum = 20,000 × $85 = $1,700,000
◆ Alternative 2: Buy 20,000 barrels in Calgary at $79 per barrel and transport it to
Sarnia at $1 per barrel variable costs or $80 per barrel.
Total costs to Northern Petroleum = 20,000 × $80 = $1,600,000
There is a reduction in total costs to Northern Petroleum of $100,000 by using the
independent producer in Calgary ($1,700,000 – $1,600,000).
In turn, suppose the transportation division’s transfer price to the refining division is
105% of full cost. The refining division will see its reported division costs increase if the
crude oil is purchased from the independent producer in Calgary:
Purchase price Unit variable cost
Unit fixed cost
= 1.05 * ° from Calgary + of transportation + of transportation Â
= 1.05 ì ($79 + $1 + $3) = 1.05 × $83 = $87.15 per barrel
◆ Alternative 1: Buy 20,000 barrels from the Sarnia supplier at $85 per barrel.
Total costs to refining division = 20,000 × $85 = $1,700,000 (constant)
◆ Alternative 2: Buy 20,000 barrels from the transportation division of Northern
Petroleum that are purchased from the independent producer in Calgary.
Total costs to refining division = 20,000 × $87.15 = $1,743,000
As a profit centre, the refining division can maximize its short-run division operating
income by purchasing from the Sarnia supplier ($1,700,000 versus $1,743,000).
▶ LO 4
Apply relevant costs and tax
considerations to evaluate the
selection of cost-based and
negotiated transfer prices.
806 ● CHAPTER 21 TRANSFER PRICING AND MULTINATIONAL MANAGEMENT CONTROL SYSTEMS
The refining division looks at each barrel that it obtains from the transportation division as a variable cost of $87.15 per barrel; if 10 barrels are transferred, it costs the refining division $871.50; if 100 barrels are transferred, it costs $8,715. In fact, the variable
cost per barrel is $80 ($79 to purchase the oil in Calgary plus $1 to transport it to Sarnia).
The remaining $7.15 (= $87.15 – $80) per barrel is the transportation division’s fixed
cost and markup. The full cost plus a markup transfer-pricing method causes the refining
division to regard the fixed cost (and the 5% markup) of the transportation division as a
variable cost and leads to goal incongruence.
A transfer price between the minimum and maximum transfer prices of $80 and
$85 respectively will promote goal congruence—both divisions will increase their own
reported division operating income by purchasing crude oil from the independent producer in Calgary. In particular, a transfer price based on the full costs of $83 without a
markup will achieve goal congruence. The transportation division will show no operating
income and will be evaluated as a cost centre. Surveys indicate that managers prefer to
use full-cost transfer pricing because it yields relevant costs for long-run decisions and
because it facilitates pricing on the basis of full product costs.
Variable Cost Bases
Transferring 20,000 barrels of crude oil from the transportation division to the refining
division at the variable cost of $80 per barrel achieves goal congruence, as shown in the
preceding section. The refining division would buy from the transportation division because
the transportation division’s variable cost (which is also the relevant incremental cost for
Northern Petroleum as a whole) is less than the $85 price charged by outside suppliers.
At the $80 per barrel transfer price, the transportation division would record an operating loss and the refining division would show large profits because it would be charged
only for the variable costs of the transportation division. One approach to addressing
this problem is to have the refining division make a lump-sum transfer payment to cover
fixed costs and generate some operating income for the transportation division while the
transportation division continues to make transfers at variable cost. The fixed payment is
the price the refining division pays for using the capacity of the transportation division.
The income earned by each division can then be used to evaluate the performance of each
division and its manager.
Prorating the Difference Between Minimum and
Maximum Transfer Prices
An alternative cost-based approach is for Northern Petroleum to choose a transfer price
that splits the $5 difference between the maximum transfer price the refining division is
willing to pay and the minimum transfer price the transportation division wants on some
equitable basis. Suppose Northern Petroleum allocates the $5 difference on the basis of the
budgeted variable costs incurred by the transportation division and the refining division
for a given quantity of crude oil. Using the data in Exhibit 21-2, the variable costs are as
Transportation division’s variable costs to
transport 100 barrels of crude oil ($1 × 100)
Refining division’s variable costs to refine 100 barrels of
crude oil and produce 50 barrels of gasoline ($8 × 50)
Total variable costs
The transportation division gets to keep $100/$500 × $5 = $1, and the refining division gets to keep $400/$500 × $5 = $4 of the $5 difference. That is, the transfer price
between the transportation division and the refining division would be $81 per barrel of
crude oil ($79 purchase cost + $1 variable costs + $1 that the transportation division
gets to keep). Essentially, this approach is a budgeted variable cost plus transfer price; the
“plus” indicates the setting of a transfer price above variable costs.
COST-BASED AND NEGOTIATED TRANSFER PRICES ● 807
To decide on the $1 and $4 allocation of the $5 contribution to total corporate operating income per barrel, the divisions must share information about their variable costs. In
effect, each division does not operate (at least for this transaction) in a totally decentralized manner. Because most organizations are hybrids of centralization and decentralization anyway, this approach deserves serious consideration when transfers are significant.
Note, however, that each division has an incentive to overstate its variable costs to receive
a more favourable transfer price.
Negotiated Transfer Prices and MNC Issues
Negotiated transfer prices arise as the outcome of a bargaining process between selling
and buying divisions. Consider again the choice of a transfer price between the transportation and refining divisions of Northern Petroleum. The transportation division has
excess capacity that it can use to transport oil from Calgary to Sarnia. The transportation division will be willing to “sell” oil to the refining division only if the transfer price
equals or exceeds $80 per barrel of crude oil (its variable costs). The refining division
will be willing to “buy” crude oil from the transportation division only if the cost equals
or is below $85 per barrel (the price at which the refining division can buy crude oil in
Given the transportation division’s unused capacity, Northern Petroleum as a whole
maximizes operating income if the refining division purchases from the transportation
division rather than from the Sarnia market (incremental costs of $80 per barrel versus
incremental costs of $85 per barrel). Both divisions would be interested in transacting
with each other if the transfer price is set between $80 and $85. For example, a transfer
price of $83 per barrel will increase the transportation division’s operating income by
$83 − $80 = $3 per barrel. It will increase the refining division’s operating income by
$85 − $83 = $2 per barrel because refining can now “buy” the oil for $83 inside rather
than for $85 outside.
The key question is where between $80 and $85 the transfer price will be. The answer
depends on the bargaining strengths of the two divisions. The transportation division has
more information about the price less incremental marketing costs of supplying crude
oil to outside refineries, while the refining division has more information about its other
available sources of oil. Negotiations become particularly sensitive if Northern evaluates
each division’s performance on the basis of divisional operating income.
The price negotiated by the two divisions will, in general, have no specific relationship to either costs or market price. But cost and price information are often useful starting points in the negotiation process. Exhibit 21-3 compares the three methods of transfer
pricing discussed. The full-cost-based transfer price is the most used and negotiated prices
are the least frequently used transfer-pricing method worldwide.
There is seldom a single transfer price that simultaneously meets the criteria of promoting goal congruence, motivating management effort, evaluating subunit performance, and
preserving subunit autonomy. As a result, some companies choose dual pricing, using two
separate transfer-pricing methods to price each transfer from one subunit to another. An
example of dual pricing arises when the selling division receives a full-cost based price and
the buying division pays the market price for the internally transferred products.
Assume Northern Petroleum purchases crude oil in Calgary at $79 per barrel. One
way of recording the journal entry for the transfer between the transportation division
and the refining division is as follows:
1. Debit the refining division (the buying division) with the market-based transfer price
of $85 per barrel of crude oil.
2. Credit the transportation division (the selling division) with the 105%-of-full-cost
transfer price of $87.15 per barrel of crude oil.
3. Debit a corporate cost account for the $2.15 (= $87.15 − $85) per barrel difference
between the two transfer prices.
808 ● CHAPTER 21 TRANSFER PRICING AND MULTINATIONAL MANAGEMENT CONTROL SYSTEMS
Comparison of Different Transfer-Pricing Methods
Useful for evaluating
Yes, when markets
Yes, when markets
Often, but not always
Yes, but transfer
prices are affected by
of the buying and
Yes, when markets
exceeds full cost and
even then is somewhat
Yes, when based on
budgeted costs; less
incentive to control
costs if transfers are
based on actual costs
No, because it is
Market may not
exist, or markets
may be imperfect
or in distress
determining full cost
of products and
services; easy to
Yes, because it is
based on negotiations
negotiations take time
and may need to be
as conditions change
The dual-pricing system promotes goal congruence because it makes the refining division no worse off if it purchases the crude oil from the transportation division rather than
from the external supplier at $85 per barrel. The transportation division receives a corporate subsidy. In dual pricing, the operating income for Northern Petroleum as a whole is
less than the sum of the operating incomes of the divisions.
Dual pricing is not widely used in practice even though it reduces the goal incongruence associated with a pure cost-based transfer-pricing method. One concern with dual
pricing is that it leads to problems in computing the taxable income of subunits located in
different tax jurisdictions.
A General Guideline for Transfer-Pricing Situations
There exists no pervasive rule for transfer pricing that leads toward optimal decisions for
the organization as a whole because the three criteria of goal congruence, management
effort, and subunit autonomy must all be considered simultaneously. The following general guideline, however, has proven to be a helpful first step in setting a minimum transfer
price in many specific situations:
Additional incremental or outlay costs per unit
Opportunity costs per unit
incurred up to the point of transfer
to the supplying division
The term incremental or outlay costs in this context represents the additional costs
that are directly associated with the production and transfer of the products or services.
Opportunity costs are defined here as the maximum contribution forgone by the supplying division if the products or services are transferred internally. For example, if the
supplying division is operating at capacity, the opportunity cost of transferring a unit
internally rather than selling it externally is equal to the market price minus variable costs.
We distinguish incremental costs from opportunity costs because the accounting system
typically records incremental costs but not opportunity costs. We illustrate the general
guidelines in some specific situations using data from the production and transportation
divisions of Northern Petroleum.
COST-BASED AND NEGOTIATED TRANSFER PRICES ● 809
1. A perfectly competitive market for the intermediate product exists, and the selling
division has no unused capacity. If the market for crude oil in Calgary is perfectly
competitive, the transportation division can sell all the crude oil it transports to the
external market at $85 per barrel, and it will have no unused capacity.
The transportation division’s incremental cost (as shown in Exhibit 21-1) is either
$73 per barrel (purchase cost of $72 per barrel plus variable transportation cost of
$1 per barrel) for oil purchased under the long-term contract or $80 per barrel (purchase cost of $79 plus variable transportation cost of $1) for oil purchased at current
market prices from the Calgary producer. The transportation division’s opportunity cost
per barrel of transferring the oil internally is the contribution margin per barrel forgone
by not selling the crude oil in the external market: $12 for oil purchased under the longterm contract (market price, $85, minus variable cost, $73) and $5 for oil purchased
from the Calgary producer (market price, $85, minus variable cost, $80). In either case,
price per barrel
cost per barrel
costs per barrel
= +73 + $12 = +85
= +80 + +5 = +85
Market-based transfer prices are ideal in perfectly competitive markets when
there is no idle capacity.
2. An intermediate market exists that is not perfectly competitive, and the selling division has unused capacity. In markets that are not perfectly competitive, capacity utilization can be increased only by decreasing prices. Unused capacity exists because
decreasing prices is often not worthwhile—it decreases operating income. If the transportation division has unused capacity, its opportunity cost of transferring the oil
internally is zero because the division does not forgo any external sales or contribution margin from internal transfers. In this case:
$73 per barrel for oil purchased under the
transfer price =
+ long@term contract or $80 per barrel for oil
cost per barrel
purchased from the Calgary producer
Any transfer price above incremental cost but below $85—the price at which the
refining division can buy crude oil in Sarnia—motivates the transportation division
to transport crude oil to the refining division and the refining division to buy crude
oil from the transportation division. In this situation, the company could either use a
cost-based transfer price or allow the two divisions to negotiate a transfer price
Consider the following situation: Suppose the refining division receives an order
to supply specially processed gasoline. The refining division will profit from this order
only if the transportation division can supply crude oil at a price not exceeding $82 per
barrel. Suppose the incremental cost to purchase and supply crude oil is $80 per barrel.
In this case, the transfer price that would benefit both divisions must be greater than
$80 but less than $82 (rather than $85).
3. No market exists for the intermediate product. This would occur, for example, in the
Northern Petroleum case if oil from the production well flows directly into the pipeline
and cannot be sold to outside parties.
Here, the opportunity cost of supplying crude oil internally is zero because the
inability to sell crude oil externally means no contribution margin is forgone. At the
transportation division of Northern Petroleum, the minimum transfer price under
the general guideline would be the incremental costs per barrel of either $73 or $80.
As in the previous case, any transfer price between the incremental cost and $85
will achieve goal congruence. Knowledge of the incremental cost per barrel of crude
oil would be helpful to the refining division for many decisions, such as short-run
810 ● CHAPTER 21 TRANSFER PRICING AND MULTINATIONAL MANAGEMENT CONTROL SYSTEMS
In transfer-pricing situations, opportunity cost is the profit the selling division forgoes by selling internally rather than externally. Assume the selling division has no idle
capacity for a particular product and can sell all it produces at $4 per unit. Incremental
cost is $1 per unit. If the selling division sells internally, the opportunity cost is $3 per
unit (= $4 revenue per unit – $1 incremental cost per unit). In contrast, if the selling
division has unused capacity with no alternative use, no profit is forgone by selling
internally (opportunity cost is $0).
Multi-National Corporation (MNC) Transfer
Pricing and Tax Considerations
▶ LO 5
Analyze income tax
considerations in multinational transfer pricing.
Now we will consider factors affecting transfer prices among corporate subunits in different
countries. Sales between corporate subunits are called sales between related parties, in contrast to external sales between a subunit and a nonrelated party termed arm’s-length transactions. The transfer prices have tax implications and therefore affect the government revenues
of each country involved. Tax factors include income taxes, payroll taxes, customs duties,
tariffs, sales taxes, value-added taxes, environment-related taxes, and other government levies. We focus on income tax factors as a key consideration in transfer-pricing decisions.
The Income Tax Act of Canada (section 247) sets out the laws regarding transfer pricing. The most recent rules were introduced in 1998 after legislative changes in the United
States and the publication of transfer price guidelines by the OECD. The CRA intends to
achieve harmonization with OECD and US laws to reduce the costs of tax compliance for
multinational corporations. The most important laws limit how companies set transfer
prices to one of five methods.
Transfer prices also have tax implications, particularly when products are transferred
across country borders. Setting transfer prices is almost always a matter of judgment. At
no time, however, should management accountants choose transfer prices that do not
adhere to the tax codes of different countries. The time and cost to resolve transfer-pricing
disputes can be very high.
Concepts in Action
India Calls Vodafone on Transfer-Pricing
The mobile phone market is India is lucrative, with companies from all over the world seeking to maintain growth by
gaining a foothold in a country where 250 million mobile phones are sold every year. The British company Vodafone
Group PLC is the second-largest mobile phone operator, measured by subscribers. In 2007, Vodafone entered the
Indian mobile phone market by acquiring Hutchison Whampoa’s mobile phone assets. Upon entering, Vodafone established a transfer-pricing mechanism between its Indian subsidiary and Vodafone Mauritius Limited. The Indian government claimed that Vodafone had undervalued assets as part of the transfer-pricing policy and as a result had avoided
$1.8 billion in taxes that should be due to the Indian government. As of 2014, the case remains unresolved and is being
argued before the Indian Supreme Court. Establishing the price one division in a company charges another division in
the same company for products and services is often controversial and governments often intervene to alter the company’s price charged, and thereby impact the taxes owed. In the case of India and Vodafone, the Indian government has
created a law that allows it to retroactively assess taxes on transfer-pricing schemes. These cases are often expensive
in terms of legal fees and time—such as the case of Microsoft and Denmark, where the dispute over taxes owed has
lasted more than a dozen years.
Sources: David Phelan, “The Indian mobile phone market: An alien world where seven-inch tablets are big sellers,” The Independent, July 22, 2013,
http://www.independent.co.uk/life-style/gadgets-and-tech/features/the-indian-mobile-phone-market-an-alien-world-where-seveninch-tablets-arebig-sellers-8726573.html, accessed May 31, 2014; “Government seeks to scrap 2 billion tax dispute talks with Vodafone,” The Economic Times,
http://economictimes.indiatimes.com/news/news-by-industry/telecom/government-seeks-to-scrap-2-billion-tax-dispute-talks-with-vodafone/articleshow/30293912.cms; Ashwin Mohan, “Income Tax department can move against Vodafone in transfer pricing dispute,” The Economic Times, February 12, 2014, http://articles.economictimes.indiatimes.com/2014-02-12/news/47270080_1_shell-india-mauritius-based-group-company-revenue-underpriced-shares, accessed May 31, 2014; Liat Clark, “Microsoft may owe Denmark £660 million in tax,” Wired News, March 13, 2005, http://www.
wired.co.uk/news/archive/2013-03/05/microsoft-danish-billion-dollar-tax-bill, accessed May 31, 2014.
MULTI-NATIONAL CORPORATION (MNC) TRANSFER PRICING AND TAX CONSIDERATIONS ● 811
Traditional transaction methods include the comparable uncontrolled price (CUP)
method, resale price method (RPM), and cost-plus method (CPM). The CUP is analogous
to the internal market-based price. The related-party transfer price reported by a corporation is compared to prices for similar transactions among arm’s-length (nonrelated)
parties and must fall within the middle two quartiles of this range of prices.
The RPM requires that a company calculate the arm’s-length resale price. Distributors
of finished goods typically use this method when the cost of distribution is low relative
to the value of the finished goods (that is, almost non-value-added). Again the CRA compares the estimated transfer price to a range of prices for similar arm’s-length transactions
and usually accepts transfer prices in the two mid-quartiles of this range.
The CPM highlights the effect of the transfer price on the pretax income of each subunit. This method permits corporations the greatest discretion and most readily justified
transfer price to the CRA because of the quality of information provided by management
accounting and control systems.
The transactional profit methods of setting a transfer price are the profit split method
(PSM) and transactional net margin method (TNMM). The PSM requires understanding the value added by the functions performed by each related party and the resulting
allocation of profit and loss to each subunit. The fifth method, TNMM, is based on the
return on assets (ROA) of the corporation as a whole and provides maximum discretion
for establishing a transfer price.
Consider the Northern Petroleum data in Exhibit 21-2. Assume that Northern operates a transportation division in Mexico that pays Mexican income taxes at 30% of operating income and that both the transportation and refining divisions based in Canada pay
income taxes at 20% of operating income. Northern Petroleum would minimize its total
income tax payments with the 105% of full costs transfer-pricing method, as shown in the
Operating Income for 100 Barrels of
Income Tax on 100 Barrels of
(3) = (1) + (2) (4) = 0.30 × (1) (5) = 0.20 × (2) (6) = (4) + (5)
105% of full costs
Tax considerations raise additional issues that may conflict with other objectives of
transfer pricing. Suppose that the market for crude oil in Calgary is perfectly competitive.
In this case, the market-based transfer price achieves goal congruence and provides effort
incentives. It also helps Northern to evaluate the economic profitability of the transportation division. But it is costly from an income tax standpoint.
Northern Petroleum would favour using 105% of full costs for tax reporting, but
tax laws in Canada and Mexico constrain this option. In particular, the Mexican tax
authorities are fully aware of Northern Petroleum’s incentives to minimize income taxes
by reducing the income reported in Mexico. They would challenge any attempts to shift
income to the refining division through a low transfer price.
The perfectly competitive market for crude oil in Mexico would probably force
Northern Petroleum to use the market price for transfers from the production division to
the transportation division. Northern Petroleum might successfully argue that the transfer price should be set below the market price because the production division incurs no
marketing and distribution costs when “selling” crude oil to the transportation division.
Northern Petroleum could obtain advance approval of the transfer-pricing arrangements
from the appropriate tax authorities.
To meet multiple transfer-pricing objectives, a company may choose to keep one set of
accounting records for tax reporting and a second set for internal management reporting.