Chapter 19 – Strategic Performance Measurement: Investment Centers
19–76
19–53 (continued)
3. If the use of a negotiated transfer price was instituted by Ajax
Consolidated, which also permitted the divisions to buy and sell on the
open market, the price range for toldine that would be acceptable to both
divisions would be determined as follows.
The Mining Division would prefer to sell to the Metals Division for the
same price it can obtain on the outside market, $90 per unit. However,
Mining would be willing to sell the toldine for $85 per unit as the $5
variable selling cost would be avoided.
The Metals Division would prefer to continue paying the bargain price of
$66 per unit. However, if Mining does not sell to Metals, Metals would be
the company as a whole.
4. A negotiated transfer price is the most likely to elicit desirable
management behavior as it will:
• Encourage the management of the Mining Division to be more
• Provide a more realistic measure of divisional performance.
Chapter 19 – Strategic Performance Measurement: Investment Centers
19–77
19–54 Transfer pricing; International Taxation; Ethics (30 minutes)
1. Because the tax rates are the same, there will be no effect on Target’s
total tax burden from the change in transfer price.
2. Now that the tax rates are different, Target has an opportunity to use
transfer pricing to manage its overall tax burden. The increase in the
transfer price so that sales go from $200,000 to $240,000 would save
Target $8,000 in taxes:
Taxes before the change in price:
Taxes after the change in price:
Profits to retail unit = $300,000 – $240,000 = $60,000
Profits to Manufacturing unit = $240,000 – $100,000 = $140,000
3. Most tax lawyers and accountants would call this good business and see
no ethical issue. Others would argue that “artificial” changes in prices as
described in this situation are unfair to the countries involved which
depend on tax revenues to support the public services that these
companies use. On balance, it is most likely that tax treaties and tax
policies and procedures within the major trading countries have limited
which most large trading countries belong.
Chapter 19 – Strategic Performance Measurement: Investment Centers
19–78
19-55 Transfer Pricing—International Example (45-50 Minutes)
1. Combined (i.e., world-wide) after-tax income per unit:
Country A
Country B
Subsidiary
Parent
Consolidated
Revenue/Unit =
$200.00
$300.00
$300.00
Cost/Unit =
$100.00
$200.00
$100.00
Op. Income/Unit =
$100.00
$100.00
$200.00
Income Tax/Unit =
$20.00
$60.00
$80.00
After-tax Income
$120.00
2. Revised selling price, subsidiary to parent company = $280.00:
Country B
Parent
Consolidated
Revenue/Unit =
$300.00
$300.00
Cost/Unit =
$280.00
$100.00
Op. Income/Unit =
$20.00
$200.00
Income Tax/Unit =
$12.00
$48.00
After-tax Income
$152.00
3. In this situation (i.e., where the income tax rate is the same in Country A
as it is in Country B), then the transfer price has no impact on the total
amount of tax paid by the entity (as a whole) on the sale of each unit.
The converse of this is also true: it is the existence of differential income
tax rates across countries that provides management with some
Chapter 19 – Strategic Performance Measurement: Investment Centers
19–79
19-55 (Continued)
4. Laws limiting the kind of tax-planning opportunities alluded to above in
(3) differ across countries. The laws in some countries prohibit such
practice altogether, while other countries provide at least some
possibility for reducing income taxes through transfer-pricing decision.
Section 482 of the Internal Revenue Code (IRC) addresses the issue of
setting international transfer prices by companies subject to the U.S.
income tax. For both tangible and intangible property transfers, Section
482 requires that the transfer price be set at an amount equal to the
similar, unrelated transactions.
We note here that in addition to income tax considerations, the transfer
price in an international setting has a cash-flow effect through its impact
on the level of import duties and tariffs. These items are imposed by a
country on goods being imported into that country. The amount imposed
transfer prices on cash flows) are relevant in the U.S. as well,
specifically, for interstate transfers of goods and services.
Chapter 19 – Strategic Performance Measurement: Investment Centers
19–80
19–56 Transfer Pricing, International Considerations, and Strategy (60
Minutes)
1. Transfer prices represent the amount that one division (subunit) of an
organization charges another division (subunit) of the organization for
services and products transferred internally.
Transfer prices serve the following roles:
a) They provide price data (i.e., inputs) for evaluating the financial
performance of profit centers and investment centers. In the
absence of such price information regarding internal exchanges,
international sense, tariffs and import duties).
d) They motivate divisional managers to put forth significant effort.
Thus, the transfer priceshould motivate producing divisions to
produce efficiently; it should motivate the buyingdivision to acquire
and use internally purchased goods and services efficiently.
2. It is the existence of differential income tax rates across countries that
provides managers with some opportunities to increase after-tax cash
flows through setting of the transfer price. In general, companies have
incentives to shift income to countries (or states, for that matter) where
eliminated.
Chapter 19 – Strategic Performance Measurement: Investment Centers
19–81
19-56 (Continued-1)
Laws limiting the kind of tax-planning opportunities alluded to above in
differ across countries. The laws in some countries prohibit such
practice altogether, while other countries provide at least some
possibility for reducing income taxes through transfer pricing decision.
transaction. Regulations pertaining to §482 of the IRC indicate that
transfer prices for transfers between a U.S. parent firm and a foreign
subsidiary or division can also be market-based or cost-plus-based. In
the latter case, the markup over cost must approximate the margin on
similar, unrelated transactions.
We note here that in addition to income tax considerations, the transfer
price in an international setting has a cash-flow effect through its impact
on the level of import duties and tariffs. These items are imposed by a
country on goods being imported into that country. The amount imposed
is typically levied on the basis of the reported value of the imports. As in
the income tax case, the laws across countries differ with respect to the
ability of a company to manage its import duty and tariff expense via the
transfer-pricing mechanism.
The following sites provide students with information regarding
differential income-tax rates for countries across the world:
http://www.worldwide-tax.com/; http://www.dits.deloitte.com/;
http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf ;
and,
http://www.pwc.com/extweb/pwcpublications.nsf/docid/9B2B760325449
64C8525717E00606CBD.
19–82
19-56 (Continued-2)
As alluded to above, students should be made aware that many of the
same issues that arise in an international setting (regarding the effect of
3. Profit and Income Tax Expense: Transfer Price Alternative #1
Irish
U.S. Parent
Subsidiary
Company
Combined
Revenue/Unit =
$1,600
$2,000
$2,000
Cost/Unit:
Incremental Cost =
$100
$100
$1,200
Transfer Price =
$1,200
$1,600
Total Cost per Unit =
$1,300
$1,700
Operating Income/Unit =
$300
$300
$800
Income Tax/Unit =
$45
$105
$210
After-tax Income
$255
$195
$590
4. Profit and Income Tax Expense: Transfer Price Alternative #2
Irish
U.S. Parent
Subsidiary
Company
Combined
Revenue/Unit =
$1,800
$2,000
$2,000
Cost/Unit:
Incremental Cost =
$100
$100
$1,200
Transfer Price =
$1,100
$1,800
Total Cost per Unit =
$1,200
$1,900
Op. Income/Unit =
$600
$100
$800
Income Tax/Unit =
$90
$35
$155
After-tax Income
$510
$65
$645
Chapter 19 – Strategic Performance Measurement: Investment Centers
19–83
19-56 (Continued-4)
5. First and foremost, the transfer pricing method chosen must be legally
acceptable in each of the countries involved. Second, the impact of the
transfer pricing policy on tariffs and import duties needsto be considered
a) Are there any currency controls that the foreign government(s)
would be able to apply in order to prevent the type of tax planning
illustrated above in (3) and (4)?
b) Does the transfer price approximate an external “arm’s length”
market price?
c) Would it be worthwhile for to company to secure an “advanced
pricing agreement” (APA) with the foreign government(s) affected
transfer price determined on the basis of formula?