The influence of Value Based Management on Transfer Pricing

1
The influence of Value Based Management on
Transfer Pricing

• Prof. Dr. Michael von Wuntsch

2

• I. Transfer Pricing

3
Definition

• A considerable proportion of the world trade
  occurs within MNCs
• Separate units are responsible of their own
  profits they also have to calculate their own
  Return on Invested Capital
• Transfer Price the price set for transactions
  within the divisions of a MNC

4

• If we have a decentralized organization and we
  take two divisions
• Division 1 produces an intermediate good
• Division 2 transforms it into a final good and
  sells it in the market

Intermediate good
Division 1
Division 2
TRANSFER PRICE
Revenue
Expense
5
Legal Background

• The most important legal institutions that
  provide a legal background to Transfer Pricing
  are the OECD and the IRS
• They are both devoted to the arms length
  principle

6
Legal Background

• Arms length principle
• the prices set on transactions between related
  parties should be determined as if those parties
  were independent
• the principle is easily applicable when
  comparable tansactions can be found on the market
• However, there are transactions for which a term
  of comparison can not be found on the market

7
Transfer Pricing Methods

• According to the OECD Guidelines there are two
  types of methods
• Traditional Transaction Methods
• they analyse the transactions and based on this
  analysis the TP is determined
• they are the most direct way of determining TP
• Transactional Profit Methods
• They are based on the analysis of the profits
  that associated companies earn from a controlled
  transaction

8
Traditional Transaction Methods

• The Comparable Uncontrolled Price Method (CUP)
• TP for controlled transactions TP for
  comparable uncontrolled transactions
• The Resale Price Method
• TP selling price - the gross margin that would
  be charged by unrelated firms in the same
  circumstances
• The Cost Plus Method
• TP standard cost of production of the related
  seller cost mark-up that unrelated sellers
  would charge

9
Transactional Profit Methods

• Profit Split Method
• Determine the overall profit from a controlled
  transaction and then split this profit between
  the two parties according to each partys
  contribution
• Transactional Net Margin Method
• According to this method the net profit margin
  that related enterprises could earn should be
  comparable with that of unrelated enterprises

10
Transfer Pricing controversy

• By manipulating Transfer Prices MNCs can avoid
  taxes, tariffs on imported goods or avoid foreign
  exchange restrictions

11
CUP

• Average price per ton (and product)
  576
• Price differences can result from volume of
• sales quality transportation competition
• intangible assets involved.
• Adjustments
  32
• Duties
  28
• Total
  60
• Transfer Price
  516

12
Resale Price Method

• Net sales of reseller (with 15 commission)
  4,000
  
• Arms length commission 15 600
• Reseller gives warranty for products
• after sale and conducts sales promotion.
• Promotional costs
  10
• Warranty costs
  22
• Total Adjustments
  32
• Adjusted sales commission
  632
• Transfer Price
  3,368

13
Cost Price Method

• Direct costs
  1,000
  
• Indirect costs (50)
  500
• Total costs
  1,500
• Profi margin (10)
  150
• Transfer Price
  1,650
• Price based on indirect costs 30
  1,300

14

• II. Value Based Management

15
Definition

• VBM is an approach to management whereby the
  companys overall aspirations, analytical
  techniques, and management processes are aligned
  to help the company maximize its value by
  focusing management decision making on the key
  drivers of shareholder value
• VBM is based on two elements
• the value creation objective
• the management processes and systems

16
The Value Creation Objective

• Shareholders are interested in increasing the
  value of their shares
• their interests should be represented by having
  as a goal for the company to maximize shareholder
  value

17
Management processes

• Represent the processes developed by managers in
  order to bring the value creation objective in
  the day to day activities of the corporation
• There are four main management processes that are
  important for VBM
• strategy
• performance targets
• action plans and budgets
• performance measurement and incentive systems

18
Discounted Cash Flow Method

• valuation method widely used in the context of
  VBM
• Value of a business the present value of all the
  cash flows that the business is expected to bring
  in the future and that are estimated over an
  unlimited period of time
• The DCF method is preffered to other methods
  because it creates an objective picture

19
Calculating the Value

• There are two main variables to be calculated
• The future expected cash flows
• The discount rate to be used

Value Where CFi the cash flow
forecasted for an unlimited time period, from 1
to n r the discount rate used to translate
future cash into its present value
20
The Continuing Value

• After determining the length of the forecast for
  the rest of the period a CV can be calculated

T
CV
1 2 3 4 5 6 7
8 n8
From T on, we calculate the Continuing Value
21
Taxation and VBM

• An effective tax management can have a positive
  impact on shareholder value
• VBM all decisions should be taken taking
  into consideration the goal of maximizing
  shareholder value
• Taxation influences decisions managers take in a
  VBM environment

22

• III. The influence of Transfer Pricing on the
  Value of a business

23
Example Scenario A
Parent (Country A) Affiliate (Country B) Overall
Sales CGS Profit before tax Tax Country A Country B After tax profit 300,000 (200,000) 100,000 (60,000) 40,000 200,000 (100,000) 100,000 (20,000) 80,000 120,000
WACC 10
Value FCF/WACC 400,000 800,000 1,200,000

• Country A
• Tax rate 60
• Selling price300,000
• Country B
• Tax rate 20
• Production Cost 100,000
• TP 200,000
• WACC10

24
Example Scenario B
Parent (Country A) Affiliate (Country B) Overall
Sales CGS Profit before tax Tax Country A Country B After tax profit 300,000 (250,000) 50,000 (30,000) 20,000 250,000 (100,000) 150,000 (30,000) 120,000 140,000
WACC 10
Value FCF/WACC 200,000 1,200,000 1,400,000

• Country A
• Tax rate 60
• Selling price300,000
• Country B
• Tax rate 20
• Production Cost 100,000
• TP 250,000
• WACC10

25
Income shifting

• 84 of the developing countries felt that the
  foreign affiliates operating in their countries
  used income shifting to avoid tax liability
  (UNCTAD Survey)
• A significant percentage of the examinations of
  transfer pricing transactions end with an
  adjustment (Ernst Young)
• In a survey conducted by Ernst and Young in 2005,
  53 of the interviewed companies were found to
  set aside a provision for transfer pricing risk
  in their financial statements

26
Conclusion

• TP can be used as a tool to shift profits between
  countries
• TP policies also influence the value of a company
• The goal of governments and tax authorities is to
  minimize their losses and fight tax avoidance
• According to a survey of Ernst Young, a
  majority of companies strongly believe that
  transfer pricing will present challenges in the
  future

27

• Transfer Price Documentation in Germany and
  the U.S.
• Trying to avoid Double Taxation

28

• Goals of documentation

• Goals of Tax Administrations (IRS)
• Checking correct profit per firm (in a group)
• Protecting tax revenues

• Goals of Companies
• Guaranteeing tax planning strategy of firm
• Avoiding financial risks

29
Documentation Requirements in Germany
Independent expert must be able to understand
and evaluate the case conditions and the price
determination.
30
Documentation Requirements in the
U.S.

• Taxpayer must proof that chosen transfer prices
• are reasonable
• reflect trust in comparability

31
Price Adjustments Double
Taxation
Germany U.S.
Legal Source of adjustments Legal source of adjustments
Hidden Profit Distribution (Verdeckte Gewinnausschüttung) Sec. 482 IRC
Hidden Contributions (Verdeckte Einlage)
3. 1 Abs. 1 AStG
National Provisions of Respective States on
Profit Adjustments can be applied according to
Art. 9 sect. 1 DTC Germany -
U.S.
32
Documentation Double
Taxation
Germany U.S.
Price and Profit Adjustments do not conflict with Price Documentation Price and Profit Adjustments do not conflict with Price Documentation

• But, a proper and acceptable documentation is of
  advantage for the firm because
• a refutable presumption of higher prices and
  income is
• not possible anymore,
• a reasonable price spread can not lead to price
  
• adjustments against the tax payer anymore.

33
Documentation of transfer prices can avoid double taxation Documentation of transfer prices can avoid double taxation
Germany U.S.
No, but documentation is less risky. The probability of adjustments is lower. Risk Management No



34

Penalties
Germany U.S.
Penalties are connected to false or unsufficient documentation Penalties are connected to Adjustments of Transfer Prices

• Documentation of transfer prices can avoid
• penalties !

35
Institutional Response to TP
Value Management Shareholder Value Value Management Shareholder Value Institutional Response to Transfer Pricing tax incentives
Strong pressure towards convergence Liberal Market Economies Dominated by viewpoint of industrialized countries Goal Avoiding decreases in tax revenues
Strong pressure towards convergence Coordinated Market Economies Developing countries have own interests to defend Goal restrictions on profit repatriation and equal tax contribution of foreign and domestic firms