How managerial transfer pricing can help create economic value

26 Octombrie 2011

ERNST & YOUNG S.R.L.

 

What is transfer pricing?

Transfer pricing is the function of determining, applying and maintaining transfer prices and supporting systems, methods and techniques. Transfer prices — prices for products, services, rights and fi nancial instruments transferred between group companies — impact the revenues, costs, assets and liabilities of group entities trading between each other. Therefore, transfer prices actually or potentially infl uence the motivation of group entities to cooperate, the transparency of performance measurement, the relevance of performance evaluation, the effectiveness of decision-making and the fi scal defensibility of intercompany charges.

“Optimal transfer prices” enhance cooperation between group entities and the realization of potential synergies. They provide incentives for continuously improving performance and making decisions that create economic value. The administrative burden caused by them is minimal. And they meet fiscal and other legal criteria.

When the term “managerial transfer pricing” is used, it is to underscore that optimal transfer prices are the goal and not just transfer prices that only serve one purpose. Unfortunately, there are still many multinational companies (MNCs) that treat transfer pricing as a legal compliance exercise and miss the benefits of using it as a management tool for enhancing economic value creation.

This article aims to show the relevance of transfer pricing as a management tool for MNCs and to lay out six key principles for managerial transfer pricing. The article is based on parts of the author’s dissertation.⁽¹⁾

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• ⁽¹⁾ Steens (2008).

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Why management should pay attention to transfer pricing

The fi rst reason why management of MNCs should pay attention to transfer pricing is the risk that strict fiscal and other legal transfer pricing requirements could narrow management attention to (predominantly) safeguarding compliance and distract management from (also) using transfer pricing as a tool of management control.⁽²⁾ Cools (2002) even found that the increased transfer pricing regulations hinder the optimal use of transfer pricing as an instrument of management control and result in a reduction of the controllability and entrepreneurship of the managers in the profit centers of an MNC.⁽³⁾ Also, more recently, the increasing burden of complying with fiscal regulations⁽⁴⁾ and its consequences for management control effectiveness⁽⁵⁾ have been observed.

Cools and Emmanuel (2007) point out possible impacts of fiscal regulations and the resulting burden on management control systems. One effect could be a “greater centralization with internal and external tax experts and internal auditors being involved in systems governing sub-unit relationships and trade. […] Uniform, consistently applied fiscal compliant transfer prices are likely to result with little scope for exceptions to accommodate market changes in different parts of the world.” Furthermore, they assert that the use of the same transfer prices for fiscal purposes (meeting the arm’s length criterion) and target setting could result in “limited scope for sub-unit management control over financial results. It is possible that managers who attempt to decrease costs and increase sales volume may produce results that trigger tax authority’s interest. […] The fundamental diffi culty concerns the extent to which managerial judgment and commercial realities can play a part in tax-compliant management control systems (MCS). The bleak outcome of this assessment suggests that the MCS ossifi es.”⁽⁶⁾

 

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• ⁽²⁾ See Cools (2002, 2003), Steens (2008), and Wong, Nassiripour, Mirand Healey (2011).
• ⁽³⁾ Cools (2002, 2003).
• ⁽⁴⁾ Cools and Emmanuel (2007) and Ernst & Young (2007) report observations regarding the increasing burden of complying with fiscal regulations.
• ⁽⁵⁾ Management control effectiveness is defi ned as the extent to which the management control system results in managerial behavior (shown by decisions and actions) that is consistent with achieving the firm-wide objectives.
• ⁽⁶⁾ Cools and Emmanuel (2007), p. 583.

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The challenge is how to motivate and enable management to elevate their transfer pricing policy beyond compliance. If they are to begin to design and shape policy as a management control instrument that enhances economic value creation then this will require the value of transfer pricing as a management control instrument to be substantiated and understood by management and recognized by tax authorities.⁽⁷⁾ At the same time, management is in a much better position, given the legal constraints, if it can get as close as possible to optimal transfer prices.

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• ⁽⁷⁾ A similar conclusion is drawn by Cools and Emmanuel (2007). They assert that (p. 584): “A more sanguine view may emphasize that some tax authorities recognize the need for judgment. This enlightened perspective must be juxtaposed with the highest-commondenominator effect. It does, however, highlight the importance of the relationship between the individual multinational enterprise and the tax authority.”

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