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Discuss the issues relating to Transfer Pricing techniques engaged by Multinational Enterprises specifically as it relates...

Discuss the issues relating to Transfer Pricing techniques engaged by Multinational Enterprises specifically as it relates to how the MNE's report on its profit in a particular Jurisdiction. Use examples to illustrate your answers

You are required to

(1) Give a useful definition on What is Transfer Pricing
(2) Is there a management element to Transfer Pricing
(3) always ensure you speak to What parties are involved in Transfer Pricing
(4) more specifically you must comment where possible on what relevance taxation has on Transfer Pricing

Solutions

Expert Solution

The first challenge is to implement a successful process to determine and manage transfer pricing. In fact, creating a reporting structure among divisions that can measure the allocation of company resources in detail is one of the most critical factors for success. This helps for future planning as well. To start, a corporation needs to decide how it will determine the actual transfer prices for particular goods and services.

There are five basic methods for establishing transfer prices outlined in the OECD guidelines:

1. The Comparable Uncontrolled Price, or CUP, Method, is the most common method and preferred in most cases by the OECD. The CUP Method compares the price of goods or services in an intercompany transaction to the price changed between independent parties. It’s important that goods and services are assessed under comparable conditions to get an accurate price that tax authorities will accept.

2. Cost-Plus-Percent Method is an approach favored by some manufacturers and is popular with the aerospace industry. It’s a transaction method that compares gross profit to costs of sales. The division supplying goods or services determines the cost of the transaction, then adds a markup for profit on the goods or services delivered. The markup should be equal to what a third party would earn for transactions in a comparable situation, including similar risks and market conditions.

3. The Resale Price Method looks at the gross margin, or the difference between the price at which a product or service is purchased and the price at which it is sold to a third party. While similar to the Cost-Plus-Percent Method, the Resale Price Method only counts the margin (minus associated costs such as customs duty) as the transfer price. For this reason, it is most appropriate for distributors and resellers, as opposed to manufacturers.

4. Transaction Net Margin Method, or TNMM,recently emerged as a favored model for many multinationals because transfer pricing is based on net profit as opposed to comparable external market pricing. The CUP, Cost-Plus-Percentage and Resale Price Methods are all based on the actual cost of comparable goods or services for external transactions. TNMM instead compares net profit margin earned in a controlled intercompany transaction to the net profit margin earned by a similar transaction with a third party. It can also look at the net margin earned by a third party on a comparable transaction with another third party.

5. The Profit-Split Method, like TNMM, is based on profit, not comparable market price. For this method, transfer pricing is determined by assessing how the profit arising from a particular transaction would have been divided between the independent businesses involved in the transaction. This is based on the relative contribution of each associated business party to the transaction as established by the functional profile, and as available, external market data.

With a methodology (or a mix of methodologies) in place, the corporation can determine a strategy to collect, analyze and report transfer pricing data. This requires a review of the ERP systems, enterprise data warehouse architecture and, most importantly, the right corporate performance management platform to execute transfer pricing across multiple subsidiaries and ERP systems While much of the actual transaction data resides in and comes from the ERP systems, a robust CPM platform is critical to collecting, processing and reporting this information. For example, whichever method a company selects, there must be a profit elimination step as part of the consolidation process to remove the effects of such sales from the consolidated financial statements. The elimination should occur in the same period that the sale occurs. Of course, this includes all intercompany sales and costs of sales recorded by the transfer partner affiliates.

Assume Company P, an MNC headquartered in the U.S., sells semi-finished widgets to its Canadian subsidiary, S. S further processes the widgets, and sells the final product to Canadian retail customers. A functional analysis determines that S's processing activities are minimal, and that it primarily functions as a distributor. While the widgets are sold under a brand, the brand is not widely recognized. P holds patents on the widget processing machines the Canadian subsidiary uses, and is responsible for strategic decisions.
S's cost of goods sold (COGS) amount is also the revenue earned by P on the transaction. This amount covers P's COGS and operating expenses required to process and ship the materials, plus profit to P in the form of a markup on P's total costs. Assume S earns revenue sufficient to realize an operating margin of 6 percent.

Regardless of how the MNC performs on a consolidated basis, the IRS will want to understand the pricing between P and S, the returns earned by each party, and how these returns compare to that of third parties engaged in similar transactions. The Regulations offer several ways to determine which methods and data can be used to determine arm's length pricing. In this example, we assume it is appropriate to determine a benchmark range of operating margins based on publicly available financial data for third-party companies that are comparable to S.

While this example is straightforward, in practice, transfer pricing issues can be complex. The ownership and use of intangible property is often a complicating factor; in the above example, if S's machinery used patented technology that was invented by S's engineers, or if the widgets were sold in Canada under a valuable brand owned by P, it would be necessary to understand whether appropriate returns were being paid for the ownership and use of intangible property.

If S developed the technology and know-how to process widgets, S may potentially merit returns higher than a routine distributor. If S sells products under brands owned by P, a separate licensing arrangement for Canadian use of the U.S. owned brand name may be required


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