Concept of the Transfer Pricing - Zumwald - Case Study Example

Transfer Pricing Name Course Tutor Date Concept of the Transfer Pricing Transfer pricing is the system adopted by multinational corporations for pricing the goods and services traded with their affiliate or subsidiary firms abroad to effectively reduce taxes and to optimize profits (Clinton & Van der Merwe 2006). The benchmark for approval of such transfer pricing is the “Arms Length Price” which must characterize the price charged in equivalent transactions between independent parties, where value of goods is not subjective to the relationship or business interest between the parties in the transaction (Baistrocchi, 2004). The Transfer Pricing regulations of many countries are based on the Organization of Economic Cooperation and Development Guidelines on the subject. Income tax and Customs authorities are guided by contradictory approaches to valuation in view of the inconsistent interests involved in measuring tax incidence (Baistrocchi, 2004). Although the Income Tax principals may seek to stay away from diversion of profits to the exporting foreign country by assessing a very low transaction price on imports, the custom authorities mostly have a preference to determine a higher transfer price to boost customs revenue. It would, therefore be advantageous to have a harmonized system of approach to pricing of imported goods in cases that involve transfer pricing so that the same value is adopted for both purposes after necessary substantiation for authenticity. Transfer pricing concept contains considerable significance with the accent of international trade. Multinational corporations (MNCs) continue to devote more and more consideration to intra-firm trade that involves various national centers. By history, multinational corporations conducted their business deals through self-sufficient subsidiaries. Considering the idea of increasing inter linkages in overall manufacturing worldwide, outsourcing and marketing, the Multinational continue to look at opportunities and possibilities of maximizing their international profits (Autrey & Bova, 2012). The World Development Report pointed out that a third of the international trade takes stage within international production networks. In fact, the report points out that American exports and imports between their firms and their foreign affiliates account for approximately 40 per cent of the total trade. Similarly, 40 per cent of the trade between US and Europe is between parent firms and their affiliates, and in the case of Japan and Europe, it amounts to 55 per cent (IMF, 2003). The amendment of Income Tax Act in the Finance Act, 2001, meant to provide for appropriate provisions in sections 92 to 92 F to standardize Transfer Pricing. These new regulations demand that international transaction between affiliate enterprises must be at an arm's length price (Baistrocchi & Eduardo, 2004). By definition, International transaction is a transaction that takes place between more than one affiliate enterprises that has a share of the profits, losses, income and assets. Associated Enterprises according to the amendments covers those enterprises having direct/indirect involvement in the management, capital or control of one enterprise by another enterprise (Ernst & Young, 2010). The fundamental characteristic of decentralized divisions of large firms such Zumwald AG is the provision of responsibility centers such as cost, profit and investment centers. The assessment of general performance in these centers has its basis on various accounting numbers such as divisional profit on return on investment (ROI), and actual and standard cost (Baistrocchi, 2004). Therefore, a central role of the managing accounting system is to assess the transactions between the different responsibility divisions. Under the broad unit of cost allocation, alternative methods to charge individual divisions for the services offered by service departments (frequently cost centers) are a major decision. Transfer pricing plays an important role in evaluating the goods and services exchanged amongst different profit divisions of a decentralized firm (Clinton & Van der Merwe 2006). Therefore, the transfer price is the actual price that one division of a firm charges another division of the same firm for a product transferred amongst the divisions. Drawbacks and Advantages of Transfer Pricing When a given firm arrives at a decision to create branches of affiliate firms in a foreign country or even when it approves a desire to make its trade international, then such firm must act respectively within the multifarious and complex process that entail the concepts of transfer pricing (Clinton & Van der Merwe 2006). As stated earlier, transfer pricing refers to the prices put in place when exchanging/selling products between any firm’s departments, divisions, or even between a subsidiary firm and a company’s parent company. In this context, a parent company is a company that possesses a full control over another company or in most cases, other several companies, by owning a substantial amount of its total assets. On the other hand, a subsidiary company would be a company owned and controlled by another. When utilized in a very professional manner and correctly, one of the many advantages of transfer pricing is how the concept assists the company in managing its ratios such as profit and loss ratios in a more efficient way (Ernst & Young, 2010). However, one of the most profound disadvantages is that the company must look out for at all times is double taxation. Generally, firms have the option of choosing a method of transfer pricing. However, there are three common methods for companies to choose from when putting their transfer pricing in place and each of them have their own drawbacks and merits as well. The first option a firm may choose is the market-based transfer pricing method. This is an act of pricing which bases its principles on competitive and balanced foreign market concerned with transferred products similar to the transferring company’s products. By application of this method, the transfer takes place when it is in the best interests of the firm’s shareholders (Ernst & Young, 2010). Contrary to this, there are high chances of refusal of the transfer by at least one or even more of the divisional or departmental managers.  Nonetheless, one of the drawbacks of this method is that the prices for some products can experience many unpredictable changes in price. In such event, the prices can fluctuate extensively and very fast. A second method of transfer pricing that a firm would choose to transfer its pricing with is the cost-based transfer pricing. In this case, pricing is based on the total cost of production for certain products (Ernst & Young, 2010). Generally, this method demands the specified notation of any costs that include actual or budgeted, amount of added markups as well as full or variable cost including a markup to costs is because of summing a set amount to the cost of products. Usually, this added amount ends up charged to the buyer. The most possible disadvantage cost-based transfer pricing method is the high chances it presents buyers with the opportunity to source the needed product at a lower cost elsewhere. Finally, a negotiated transfer price is the third method that a firm would choose for its transfer pricing needs. This method best suits a situation where the divisional managers negotiate an equally agreeable price (Ernst & Young, 2010). The greatest advantages of this method is how it creates the concept where division managers buy and sell products from each other in a manner that triggers the arm's length transactions (OECD 2010). However, there is limited guarantee that the results of these negotiations on price between divisional managers serves the best interests of the firm and its shareholders. Therefore, the transfer price is not essentially dependent on profit-maximizing production and sourcing decisions. Instead, it majorly depends on whichever manager is better compare to the other. Generally, pricing transfer advantage that all firms look out for and try to administer on there is the establishment of high transfer prices for their products and transfer them to a unit mainly located in a jurisdiction with low tax rates (OECD 2010). This puts the firm at a good position to accumulate high revenue subjected to minimal tax rates and less revenue subjected to exaggerated tax rate. Nevertheless, when firms trade products in opposite direction (from a low-tax rate jurisdiction to a higher tax rate jurisdiction), it becomes wise to set the transfer price at a very low level as much as possible. Discussions (Question 2&3) Looking at the Zumwald AG case, Heidelberg applies a standard markup guiding principle for their customers, which is 33.3 percent from its total cost. Consequently, this makes the price of Display. As a new product in the market and the technology industry at large, it is wise to have strategies and plans in place for the product to have a stable customer base and have a better part of the market share. With this in mind, it is obvious that Display tech is willing to participate in the stiff market competition in price. Furthermore, the other face of the case is that Heidelberg still having appropriate power and influence, especially in bidding approach, it should be wise for the firm to apply the contribution margin concept, which should only be considered concerning relevant cost. In the Zumwald AG case, relevant cost would be € 50,000. With the objective price of €140,000, Heidelberg would benefit with €90,000 contribution margin. The context of the X-73 tech project seemed very precise and clear. The clarity of the context was that X-73 project wanted to acquire share in the competitive market of technology, and it could not compete if the price did not match with what customer were able and willing to pay. In the general opinion of the entire Zumwald AG and the dispute at hand, I would propose it better off if Heidelberg provides supply services to ISD. This is logical and in line with the consideration of the fact that both Heidelberg and ECD do not work in full capacity. In that case, Zumwald AG could get a total contribution margin of € 90,000 from Heidelberg as well as € 12,600 from ECD. This total contribution margin could amount to € 102,600 in total. However, it is necessary to forego this idea if ISD orders from Display tech. In a sense, for Zumwald’s entire business, getting it vertically incorporated would be a better idea since venturing a new market with the possibility of absorb most of the internal sourcing would benefit the entire firm. In addition, this act would bar Display tech as potential competitor to Zumwald in getting more shares in monitoring display market. Nonetheless, I don’t have a clear picture if by doing so; creation of goal equivalence between the 3 divisions would be achievable. To support this, the idea would go against the decentralization that is already in place. It should also be noted that that transfer pricing are just moving profits from one division to another one in the same firm (Clinton et al. 2006). The best advice I would offer to Mr. Fettinger is that he refrains from involving himself in the dispute. If all the managing directors of Heidelberg, Bogardus NV and Display Technology plc are ready to make crucial and rational decisions through rational arguments and considering the fact that Zumwald operates in a decentralized system, then Mr. Fettinger should allow the managing directors of each division to have their sovereignty and absolute freedom in matters of sourcing. Interestingly, the whole idea concerns just a small fraction of less than 5% of the total 3 division’s business. In the case where Fettinger intervenes in this dispute, then he would be ready to involve himself in many related disputes of all the 6 divisions in Zumwald AG. Additionally, if the X-73 project involved a more significant part of total Zumwald’s business, then Fettinger’s intervention would be appropriate. Conclusion and Recommendations In a large firm such Zumwald, it is not in order for central management to monitor and control division’s activities and actions. A general principle behind decentralized organization is that each division is an autonomous unit. Furthermore, each division’s management has the full freedom to take all crucial actions required for the division to achieve its goals. However, such a decentralized organization encounters some difficulties in assessing the overall performance of the divisional managers. Additionally, the central management of the firm needs to synchronize the activities of each division in order to maximize the organization's turnover (OECD 2010). In order to calculate the general performance of every division, it is paramount to develop a method for measuring every division’s total profit to the organization’s business. A common solution to this problem (problems of similar dispute to the X-73 project) is to set prices for transferable intermediate products from one division to another. Transfer prices are mainly used. Reference Autrey, R & Bova, F 2012, Gray Markets and Multinational Transfer Pricing, The Accounting Review, vol. 2, no. 1, p. 393-421. viewed from http://www.hbs.edu/research/pdf/09-098.pdf Baistrocchi, E 2004, The Arm's Length Standard in the 21st Century: A Proposal for both Developed and Developing Countries, Tax Notes International, Vol. 36, no. 3, p. 241-255. Clinton, B & Van der Merwe, A 2006, Management Accounting - Approaches, Techniques, and Management Processess, Cost Management (New York: Thomas Reuters RIA Group) (May/Jun). viewed from http://s93063416.onlinehome.us/iloveaccounting/614/2006-Clinton-and-van-der-Merwe.pdf Ernst & Young 2010, 2010 Global Transfer Pricing Global Survey, New York, Ernst & Young International Limited. IMF (International Monetary Fund) 2003, World Economic Outlook, Washington D.C., IMF. OECD 2010, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, (2010 Edition), Transfer Pricing Features of Selected Countries 2012. Viewed from http://www.anefac.org.mx/Docs/TrabajosInformacion/PreciosTransferencia/PDF/TRNSFR%20PRICNG%20OCDE.pdf Read More