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Control With Fairness In Transfer Pricing

September 25, 2023
Bill Kimball

Documentation requirements are quite specific, and generally require a best method analysis and detailed support for the pricing and methodology used for testing such pricing. To qualify, the documentation must reasonably support the prices used in computing tax. U.S. rules require that the IRS may not adjust prices found to be within the arm’s length range. Where prices charged are outside that range, prices may be adjusted by the IRS unilaterally to the midpoint of the range. The burden of proof that a transfer pricing adjustment by the IRS is incorrect is on the taxpayer unless the IRS adjustment is shown to be arbitrary and capricious. However, the courts have generally required that both taxpayers and the IRS to demonstrate their facts where agreement is not reached.

Competitive organizations usually decentralize decision-making responsibility to the business unit level. The second dimension is diversification, that is, the extent to which the company is engaged in different businesses.

full cost transfer pricing

Such services may include back-room operations (e.g., accounting and data processing services for groups not engaged in providing such services to clients), product testing, or a variety of such non-integral services. This method is not permitted for manufacturing, reselling, and certain other services that typically are integral to a business. It is common for enterprises to perform services for themselves that support their primary business. Examples include accounting, legal, and computer services for those enterprises not engaged in the business of providing such services. Transfer pricing rules recognize that it may be inappropriate for a component of an enterprise performing such services for another component to earn a profit on such services. Testing of prices charged in such case may be referred to a cost of services or services cost method. Application of this method may be limited under the rules of certain countries, and is required in some countries e.g.

A common complaint is that these estimates are purposefully conservative so that the selling unit can show positive variances. The primary mechanism of control in cooperative organizations is the organizational structure. These interviews left no doubt that the key to the transfer pricing problem is strategy. Transfer pricing schemes are a means of generating information and control for implementing corporate, business unit, and product strategy. It is not always possible to satisfy both the control and the fairness objectives through the transfer pricing scheme alone. By using these costs as a target, businesses can determine whether they are meeting their goals as outlined.

Commensurate With Income Standard

In another high-stakes case, the IRS alleges that Facebook Inc. transferred $6.5 billion of intangible assets to Ireland in 2010, thereby cutting its tax bill significantly. If the IRS wins the case, Facebook may be required to pay up to $9 billion in addition to interest and penalties. A few prominent cases continue to be a matter of contention between tax authorities and the companies involved. These prices are monitored closely, and they must be reported in the company’s financial statements for auditors and regulators.

full cost transfer pricing

Significant deviation among points in the range may indicate lack of reliability of data. They report to group general managers and so are one layer removed from the president. “Full-Cost Pricing” is one of the principles of sustainability described in your text.

The tiers vary in documentation content and include the master file, the local file, and the country-by-country report. The draft also requires companies involved with related-party service transactions, cost sharing agreements or thin capitalization to submit a so-called “Special File.” The rules on services expand cost-plus, providing an additional option to mitigate these data problems. Charges to related parties for services not in the primary business of either the tested party or the related party group are rebuttably presumed to be arm’s length if priced at cost plus zero .

How The Cost Plus Transfer Pricing Method Works

Because the production, marketing, and sales of Coca-Cola Co. are concentrated in various overseas markets, the company continues to defend its $3.3 billion transfer pricing of a royalty agreement. The company transferred IP value to subsidiaries in Africa, Europe, and South America between 2007 and 2009. The IRS and Coca-Cola continue to battle through litigation and the case has yet to be resolved. However, let’s say that Division A is in a higher tax country than Division B. The overall company can save on taxes by making Division A less profitable and Division B more profitable. By making Division A charge lower prices and pass those savings on to Division B, boosting its profits through a lower COGS, Division B will be taxed at a lower rate. In other words, Division A’s decision not to charge market pricing to Division B allows the overall company to evade taxes.

  • There may be tax advantages obtained for the group if one member charges another member for services, even where the member bearing the charge derives no benefit.
  • Perceptions of unfairness go far beyond mere financial compensation to include pride, concern with others in the unit, and personal values about what is just.
  • We also reference original research from other reputable publishers where appropriate.
  • The findings of this study have implications for managerial practice by providing insights into supply chain design and showing that firms should consider the competition between channels when making decisions about transfer pricing methods.

The structures of collaborative organizations are more complicated and messier than the clean multidivisional form of the competitive organization or the clean functional form of the cooperative organization. In competitive organizations, the business units must compete with each other; in cooperative organizations they must cooperate with each other. An example of the latter is a highly vertically integrated chemical company, organized on a functional basis, where all the units are cost centers except for a single sales force that acts as a revenue center. Unit heads think that the no-policy default is the fairest situation because top management does not interfere with their autonomy—which is consistent with exercising control through results.

Transfer Price Vs Standard Cost: An Overview

The sense of fairness in collaborative organizations is based on a rational trust the unit managers have in top management. The rational component signifies the impartial spectator standards of fairness appropriate for competitive organizations. The trust component signifies the shared-fate standards of fairness appropriate for cooperative organizations. Mixed-mode bargaining processes between business units are a consequence of their simultaneously competitive and cooperative relationships. Due to the emphasis on systems for measuring quantitative results, business units have an incentive to win at the expense of others. Structural interdependence, however, acts as an incentive for each business unit to be concerned with the performance of the other as it affects total corporate results. The management processes shaping corporate-business unit relationships are iterative in nature.

The transfer pricing policy for these organizations follows from the structure and systems. Internal transfers are mandated for both buying and selling units and the transfer price is full cost. In collaborative organizations, it is impossible to find a transfer pricing policy that will satisfy top management’s needs for control and be perceived as fair by the units involved. Indeed, achieving fairness between units would reduce the utility of transfer prices as a mechanism for generating information and control.

Under an APA, the taxpayer and one or more governments agree on the methodology used to test prices. APAs are generally based on transfer pricing documentation prepared by the taxpayer and presented to the government. Multilateral agreements require negotiations between the governments, conducted through their designated competent authority groups. The agreements are generally for some period of years, and may have retroactive effect. Rules controlling how and when a taxpayer or tax authority may commence APA proceedings vary by jurisdiction.

full cost transfer pricing

Although no simple solution to the transfer pricing problem exists, it can be effectively managed. The ability to do so rests on recognizing that the nature of the transfer pricing problem varies according to a company’s (group’s, unit’s, or product’s) location on the MAP and the direction in which management wishes to move. Effective management of transfer pricing requires policies and organizational characteristics that are consistent with strategy. Appropriate processes are essential for achieving the desired objectives of fairness and control. The selling unit’s product comes in several grades and in several degrees of finish. The largest internal user buys the product in a degree of finish less than for that sold on the outside, which makes finding comparable market prices impossible. The oligopolistic nature of the market for the intermediate good and the extent of vertical integration in the industry also make it difficult to determine a fair market price and an appropriate volume discount, if any.


Transfer prices are closely monitored and must be reported on financial statements. Chip Stapleton is a Series 7 and Series 66 license holder, CFA Level 1 exam holder, and currently holds a Life, Accident, and Health License in Indiana. He has 8 years experience in finance, from financial planning and wealth management to corporate finance and FP&A. Gross cost plus, which is essentially how much the company should mark up the cost of the finished goods it produces when selling to their German partner. Note that while Canada and the United States are OECD members, each has adopted its own comprehensive regulations that differ in some material respects from the OECD guidelines. A second threshold based on the relative magnitude of the adjustment may also applyl.

The latest adopter is Cyprus which issued a ruling in 2017 for financial arrangements. Robert G. Eccles is a visiting professor of management practice at Saïd Business School, Oxford University, and a senior adviser to the Boston Consulting Group. Transfer price is the price at which related parties transact with each other, such as during the trade of supplies or labor between departments. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Standard costs are the average or anticipated costs of producing an item under normal circumstances.

Cost Sharing

In this article, we will discuss cost-based transfer pricing, how you can calculate it and compare it with other pricing methods. Even when managers mostly agree about what fair standard costs and variance allocations are, the standard full-cost method still causes problems. The selling unit does not receive a profit on internal transfers, resulting in lower profit margins and return on investment percentages. Even though top management does not attach much meaning to unit comparisons of net profit and ROI, some selling unit managers may feel that some of “their” profits are showing up in the performance measures of buying units. The mandating of transfers is a direct consequence of the vertical integration strategy whereby the large capital investments involved make any other approach impractical. Cooperative organizations measure performance of the total product flow across units, not of units as stand-alone profit centers.

The Cost Plus Transfer Pricing Method With Examples

The criteria for reliably applying the CUP method are often impossible to satisfy for licenses and other transactions involving unique intangible property, requiring use of valuation methods based on profit projections. If the company sets the cost transfer with the variable approach, they will set the pricing at $700. When companies move from the competitive to the collaborative area it may be because they want to increase vertical integration and emphasize internal cooperation and the total product flow. Absorption accounting is a method of accounting where all the costs of manufacturing, are allocated to the produced units. Price skimming is a pricing strategy in which a marketer sets a relatively high initial price for a product or service at first, then lowers the price over time.