Transfer Pricing Research Paper Starter

Transfer Pricing

(Research Starters)

Recent growth in international trade and global commerce is increasingly relevant to college students who desire to obtain maximum value from their course work in economics and accounting. Transfer pricing, as a topic spanning those two disciplines, describes a set of strategies through which firms attempt to send a portion of their profits offshore in order to minimize their income tax liabilities. Because those transactions occur between two firms related through common ownership, transfer pricing historically downplayed the influence of markets in price determination processes. More recently, however, tax regulations and authorities from around the globe are calling for broader perspectives in order to avoid corporate income tax evasion. Effective involvement in those processes requires a solid understanding of the essential differences and similarities between economics and accounting. The tax laws in many countries define five methods for determining and communicating a firm's transfer price to taxing authorities. Those methods generally involve primary comparisons between two unrelated firms and a secondary comparison of those results to related firms, which is the essence of the so-called arm length standard. The purpose of this essay is to illuminate standards, methods, and concepts that are relevant to transfer pricing and to demonstrate the importance and value of integrating economics and accounting perspectives. Individuals who gain a better understanding of transfer pricing may find themselves in high demand.

In an era expecting growth in international trade and relations, college students will find additional value from courses in economics and accounting. Professionals at facilitating decision making and planning, economists and accountants are becoming integral partners in helping multinational corporations in demonstrating regulatory compliance and developing pricing strategies. Transfer pricing is an interdisciplinary topic that challenges governmental tax authorities, corporate accountants, and market analysts equally. On the one hand, there is a need to describe how the prices of goods and services reflect cost functions, consumer demand, and market conditions. On the other hand, there lies a need to determine prices that maximize profits while using specific methods for minimizing tax burdens.

Transfer pricing, as a topic that traditionally downplays the forces of markets and consumer demand, represents a vast opportunity for closing a lingering gap between theory and practice. It also presents a dynamic tension between a group of professionals who seek to minimize corporate income tax burdens and another group whose aim is to prevent tax evasion. In their works related to taxation, accountants are encountering unprecedented challenges to apply sound economic analysis in their tax reduction methodologies and post-tax profit maximization efforts. Transfer pricing practices require interactions between the regulated and regulators. Furthermore, governmental tax authorities around the world are adjusting corporate tax returns and prompting timely explanations. In response, accounting service firms are helping their corporate clients by preparing reports that justify, document, and communicate how they determine prices for transactions between firms (which have relationships through common ownership) that operate in multiple countries.

Involvement in those processes requires a solid understanding of the essential differences and similarities between economics and accounting. Acknowledging the reality that persons learned and trained in one discipline often find it difficult to comprehend other disciplines, this essay tends to emphasize the economics perspective because of its reference in tax regulations that govern the treatment of international transactions. Consequently, several of the largest accounting firms in the world recognize those limitations and are adding economists to their staff. If recent job postings for transfer pricing specialists are any gauge, it appears that the demand for economists is much higher now than it was before the $3.4 billion settlement in September, 2006 between GlaxoSmithKline (GSK) and the Internal Revenue Service. Whether they agree or disagree on this verdict, many professionals are aware of the important and interrelated roles of maintaining data accuracy and assuring assumption reliability. In the pages ahead, the reader will find an exposition of varied aspects with regard to transfer pricing and the apparent need to depart from past inward- or domestic-focused practices.

Firm Profitability

In terms of long-standing traditions, a major task of corporate tax departments and accounting staff is to influence firm profitability. Taking a narrow view of that work, accounting is a profession that prepares governmental and financial reports, analyzes costs and revenues, and calculates post-profit tax liabilities. In short, income tax minimization represents a final step toward profit maximization. Therefore, it is reasonable for accountants to invest their time, talent, and energy adding legitimacy to their efforts to minimize the tax burdens of their employers and their clients. Likewise, it is reasonable for government revenue agents to scrutinize that work guarding against potential cases of tax evasion and/or system abuse.

Many tend to view economics in terms of its focus on pre-tax profit maximization conditions. Casting aside any debate regarding views on the inclusion of taxes as an economic cost, economists and some tax authorities expect to observe high levels of profits in industries and markets characterized by new entry, product innovation, and price leadership strategies. Any attempts by corporate tax departments and their accounting staff to understate those profits by transferring them via questionable, inappropriate, and/or undocumented methods of pricing will certainly raise suspicions and garner attention from taxing authorities especially those who understand the broader perspective. As something to which we return later in this essay, it is important for students, practitioners, and clients to focus their attention on a few concepts central to economics including, but not limited to, opportunity costs, economic profits, and market structures.

A cursory review of regulations on transfer pricing makes it apparent that tax accountants, their clients, and other parties stand to benefit from learning more about the price determination processes whether those analyses include or exclude market orientations. Because the regulations contain numerous references to marketplace dimensions, the apparent gap between accounting and economics is quite perplexing given the fact that most students in business programs receive ample exposure to those disciplines early in their studies. Perhaps those studies need to place greater emphasis on transfer pricing mechanisms and on international tax regulations. With some digression at this juncture, that need is real especially in light of the fact that China and other developing nations will become major economic forces in the future.

Transfer Pricing

Returning attention to the central topic here, the field of transfer pricing seems to remain in its infancy although publications on the topic first appeared in academic journals several decades ago. Without tracing the historical roots and development of transfer pricing in this essay, readers can begin to gain a deeper appreciation of this time-honored and current topic by pondering the content and relevance of a clear and concise definition. Using the words from Pearce (1992), transfer pricing is: "The system of setting prices for transactions among subsidiaries of a multinational corporation, where the prices are not subject to market determination. The prices are often deliberately chosen to minimize tax or tariff burdens on the corporation on a world scale, e.g. costs may be overstated in subsidiaries in a country with a high profits tax so that profits can be shifted to a subsidiary in lower tax country" (p. 433).

Readers of this essay will find departure from that fine definition with respect to its dismissal of market influences on transfer price. Furthermore, the applicable regulations call for its inclusion in transfer price determinations and analyses. Moreover, a portion of this essay devotes itself to the division between market and non-market influences.


In the context of international trade and global commerce, tax strategy is largely a function of the geographic locations of the seller and the buyer which also happen to be affiliates by virtue of common ownership. Furthermore, firms that charge their subsidiaries a high (low) price suggests they are booking a higher (lower) taxable income on the sales end of a transaction and a lower (higher) taxable income on the purchase end of a transaction. Those bookings are controlled transactions because one party is under the control of the other party. More precisely, the seller is often the parent firm and the buyer its subsidiary. Moreover, the price of an item in a transaction between two related firms, in contrast to two unrelated firms, may reflect professional creativity more so than market forces.

According to Amram, "transfer pricing is merely an art describing the internal accounting costs assigned to an exchange of goods, services, or intangibles between commonly controlled foreign and domestic entities." Consider the following hypothetical case presented by Amram. Let's say that domestic parent company USCO, which is located in United States, owns foreign subsidiary CaymanCo, which is located in the Cayman Islands. The former entity produces laptop computers at a cost of $50.00 per unit and sells them to the latter entity for $100.00 per unit. CaymanCo incurs an additional $400.00 in costs per computer bringing the total unit cost to $500.00. CaymanCo distributes those laptops to third-parties elsewhere around the globe who pay $1,000.00 for each new laptop. In sum, CaymanCo realizes a taxable income of $500.00 for each computer it sold and USCO realizes $50.00. The hypothetical corporate income tax rate, furthermore, in the US is 35 percent whereas it is zero in the Cayman Islands. In accordance with Generally Accepted Accounting Principles, USCO and CaymanCo prepare and file consolidated financial statements for a governing agency. In addition, they prepare and file an annual report with their shareholders. On the one hand, the actual post-tax profit on each computer amounts to $482.50. This is the result of subtracting USCO's income tax of $17.50, which is thirty-five percent of the initial $50.00 transfer pricing profit, from CaymanCo's $500.00 profit per computer. On the other hand, the potential post-tax profit on each computer sold amounts to $500.00 per computer, which would produce $175.00 (35 percent of $500.00) per computer in tax revenue for the United States given the absence of a transfer pricing arrangement.

At issue is whether the shifting of income offshore is legitimate or artificial in nature. In order to ensure legitimacy, the Organization for Economic Cooperation and Development (OECD) in conjunction with various professions established a set of methods for determining transfer prices. The specific choice of methods for pricing international transactions will likely affect the allocation of total profit among units within a multinational company. Application of a single method or an inappropriate method without ample justification may give the appearance of being tax evasive whether accidental or otherwise. The challenge is to devise, use, and document the most appropriate methods of transfer pricing thereby proactively avoiding an unfortunate appearance and the associative complexities of reactively untangling an adjustment by a district director at the Internal Revenue Service or another tax authority elsewhere.

Those price determination methods will receive some coverage later in this essay. Meanwhile, this essay directs the attention of readers to a set of economic concepts most applicable to transfer pricing and price determination processes. In doing so, the next section begins without references to market forces and it then concludes with some direct references.


Opportunity Cost

Undergraduate business students discover some key differences between accounting profit and normal or economic profit and between accounting costs and economic costs. In general, accountants tend to ignore or downplay the opportunity cost approach advanced in economics. Opportunity cost,...

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