Transfer Pricing Series (TP Series) – Part 1

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Transfer Pricing
Transfer Pricing

Introduction

 

“Transfer” a simple and daily usage word as defined by Oxford Learners Dictionary as “to move from one place to another; to move something/somebody from one place to another” is going to be a subject of series of write ups when it’s paired with another innocent and daily usage word, “Pricing” which is also defined by the same dictionary as “the act of deciding how much to charge for something” which have transmogrified into a monstrous phrase TRANSFER PRICING” (TP)

 

A beautiful and harmless phrase “Transfer Pricing” will be a subject of discussion in an effort to demystify it to the reading public in simple terms. I will achieve this purpose with series of articles targeting the application of TP in various studies including Management Accounting, Treasury Management, and Taxation with more emphasis on TP in Taxation. 

 

  • TP in Management Accounting    

 

In managerial accounting, the transfer price represents the price at which one subsidiary, or upstream division, of a company, sells goods and services to another subsidiary, or downstream division. Goods and services can include labour, manufacturing parts, components, and other supplies used in production, and general consulting services.

TP may impact managerial accounting areas like Division Performance, Managerial Incentives, and Investment Decisions. The transfer price affects the performance of both subsidiaries in opposite ways. 

TP affects managerial accounting in the determination of the costs and revenues among transacting divisions, by impacting the performance of each division and also influences division managers’ incentives to sell goods either internally or externally. If the transfer price is too low, the upstream division may refuse to sell its goods to the downstream division, potentially impairing the company’s profit-maximizing goal or synergy harnessing objectives.

 

Transfer prices can be determined under the Market-Based, Cost-Based, or Negotiated Methods. Under the market-based method, the transfer price is based on the observable market price for similar goods and services. Under the cost-based method, the transfer price is determined based on the production cost plus a markup if the upstream division wishes to earn a profit on internal sales. Whilst under the negotiated method, management of the subsidiaries involved agree on the transfer price after considering market forces and the overall objectives of the Group.

 

Arriving at a fair transfer price is not only beneficial to both subsidiaries but allows a company to reach profit maximization and the whole group to enjoy harnessing the synergies among its participants in the group.

 

  • TP in Treasury Management 

 

Fund Transfer Pricing (FTP) measures the contribution by each source of funding to the overall profitability in a financial institution. Funds that go toward lending products are charged to asset-generating businesses whereas funds generated by deposit and other funding products are credited to liability-generating businesses.

FTP is an important concept of how financial institutions determine the internal price when allocating funds across different business units. The Organisation for Economic Co-operation and Development (OECD) recommends that each financial institution should have its FTP policy governing the basis on which funds are transferred between different business units and treasury. In financial institutions adopting FTP, the treasury is responsible for liquidity management and the internal pricing of funds to its different business units. One can think of the treasury as a financial institution within the financial institution: it buys funds from the business units, managing the liability side of the financial institution, and sells funds to the divisions that invest in banking assets.

The two major objectives of FTP in financial institutions are motivating profitable actions and comparable financial performance evaluation among business units, and when properly utilized, transfer pricing systems allow comparable financial performance evaluation of net fund generators and net fund users. Without an FTP system, net fund users receive credit for interest income without being charged for the total amount of interest expense associated, while net fund generators are charged by interest expense without being credited with revenue of interest associated. 

FTP is a specific type of transfer pricing and is identified by the OECD as a treasury dealing. FTP measures the value of funds transferred through the treasury between business units within a financial institution. Internal exchanges that are measured by transfer prices result in revenue for the business unit furnishing (i.e., selling) the funds and costs for the business unit receiving (i.e., buying) the funds.

FTP is a way to value the margin contribution from each individual loan and deposit that a bank has on their books. The way each instrument is valued is by calculating a funds transfer charge on the asset side (loans) and funds transfer credit to the liability side (deposits). The funds’ transfer charges and credits are calculated based on the bank’s opportunity cost of borrowing at the time of origination. The value assigned to a deposit account would be equal to the difference between the cost of an equivalent term borrowing less the cost that is being paid on the instrument. 

The implementation of FTP gives way for management accountants to play a more significant role within the financial service industry under a performance evaluation focus. Financial institutions can use FTP to achieve the following objectives:

  1. Liquidity Management
  2. Balance Sheet Management
  3. Profitability Management 
  4. Product Pricing

There are three common approaches to transfer pricing the balance sheet, these are:

 

  1. Net funds transfer pricing. In a net funds approach, you net all assets and liabilities for each profit centre and ascribe a cost/credit to the shortage/excess of funding for the branch/unit. 

 

  1. Pool-based transfer pricing. In a pool-based approach, you create funding pools such as short-, medium-, and long-term, assigning each product or portfolio to one of the pools. The funds transfer pricing rate assigned to the pool then determines the transfer rate and margin for every account in the pool. 

 

  1. Matched-term transfer pricing. Also called matched maturity, this is the most widely accepted approach to transfer pricing. In a matched-term approach, you transfer price at the individual instrument level based on its characteristics, such as origination date, term, options, and expected cash flows. It requires a funding desk function to centralize how instruments are priced and rated, with oversight from Treasury.

Incorporating an FTP framework at banks can radically change the understanding of the make-up of Net Interest Margin (NIM) and how the bank’s activities have contributed to economic profitability. Too often, management focus and incentive plans for commercial lenders are not properly aligned with the institution’s processes for measuring economic contribution.  By using an appropriate FTP framework, a bank can devise an incentive plan that rewards loan officers for the incremental NII revenue they generate after transfer pricing.  Extending this approach to add economic capital to determine a Risk-Adjusted Return On Capital(RAROC) takes into consideration not only the volume and spread, but the underlying risk when calculating contribution and the associated incentive compensation plan.  

Treasury Management and FTP discussion will require a dedicated series to be fully exhausted.   

  • TP in Taxation 

 

Just as TP is applied in other disciplines, in taxation, TP has become one of the most important concepts which has gain popularity and prominence in tax practice. Most stakeholders in taxation including Taxpayers, Tax Practitioners, Developmental Agencies, Civil Society Organisations, and Tax Administrators follow the application of TP with keen interest.

According to Wikipedia, in taxation and accounting, transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control”. Multinational Enterprises (MNEs) use TP as a method of allocating profits among its various subsidiaries within the organization. Because of the potential for cross-border controlled transactions to distort taxable income, tax authorities in many countries can adjust intragroup transfer prices that differ from what would have been charged by unrelated enterprises dealing at arm’s length (the arm’s-length principle-ALP). 

 

MNEs are most concerned with the prices they trade between and among themselves across the various jurisdictions they have footprints. Some MNEs use TP as a tax planning tool to reduce their tax exposure in certain jurisdiction where tax rates are high. This tax avoidance mechanism is being frown upon by tax authorities since such practices reduces the tax base of their jurisdiction and effectively affecting their tax revenues. When an organisation is able to perform reliable TP documentation, it gets several tax reliefs which helps the organisation to claim tax benefits in different tax jurisdictions.   

 

As taxpayers try to use TP as a tax avoidance tool, tax administrators on the other hand ensures that the application of TP by MNEs do not result to loss of revenue to them. These opposing interest in TP has led to several tax disputes and legal tussles which most of the time ends up being more bitter to MNEs who tries to use TP to avoid taxes by paying huge taxes, interest, and penalties. 

 

Some Specific Transactions Under TP in Taxation are: 

  1. Sale of accomplished goods;
  2. The sale or buy of machinery and fixed assets;
  3. Purchase of raw ingredients and raw materials;
  4. Buy or sale of Intangible Properties (IPs);
  5. Return of expenses paid/received;
  6. Support services;
  7. Corporate Guarantee fees;
  8. Software Development service;
  9. IT services;
  10. Technical Service fees;
  11. Management and Royalty fees;
  12. Loan received or paid;
  13. Any other transaction having an impact on the profit, income, losses, or assets of enterprises.

 

  • Conclusion

 

Considering the relevance of transfer pricing mechanism, it must not be forgotten that TP is a complicated process because unlike market price which is determined by the forces of demand and supply of the product, TP is not determined by such forces only, instead, a number of variables come into play while deciding the transfer price. Further, such pricing mechanism has the potential of creating rift and animosity between the departments because the supply department may feel that it is foregoing the profit which it could have easily made in the open market and Tax Administrators also fears of been short-changed on their tax revenues. Therefore, it is recommended to seek assistance from Professional Tax Practitioners when devising the transfer price to avoid erring on the side of the law with its biting consequences. 

 

This series of articles is my contribution to tax literacy in Ghana as a professional tax practitioner in the discharge of my duties as a GHANAIAN CITIZEN who seeks the success of Ghana. The subsequent series of articles will look at TP in taxation from professional tax practitioner’s lenses as part of efforts in deepening tax literacy in Ghana. The next edition will be the history of TP and TP in Ghana.   

 

Ibrahim Asare (CA, MCITG, BCom, HND)  

ibasare@gmail.com; 0244 423 960

(The author is a Chartered Tax Practitioner- a Member of ICAG and a Member of the Chartered Institute of Taxation Ghana).

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