Could being tax compliant on transfer-pricing actually be bad for business?

International transfer pricing, that is, the setting of a price for internal transactions within a multinational group, is irretrievably linked to international tax law. In seeking equity across borders, tax law imposes the arm’s length principle as the yardstick to judge the fairness and correctness of the transfer pricing system, in line with the OECD Transfer Pricing Guidelines.

In broad terms, the tax authorities take a separate entity approach when assessing a Multinational Entity (MNE)’s adherence to the arm’s length principle. This principle implies that MNEs need to be prepared to demonstrate that inter-company prices are in line with what would have been charged had the two companies not been connected. Research has shown that the potential penalties, the risk of encountering economic double taxation, and the significant financial and reputation consequences in case of non-compliance, motivate MNEs to give high priority to transfer pricing tax compliance.

As a result, these regulatory constraints have meant that the majority of MNEs opt for a single set of transfer prices (also called one set of books) for both tax compliance and management control purposes. But is this approach actually in the best interest of business, or could tax compliance actually lead to poor management decisions?
Recent research examines the impact of tax-compliant transfer pricing on responsibility accounting by conducting an in-depth case study of one MNE. By limiting the field of study to a single MNE, the complexity and effects of the transfer pricing system could be analysed in greater depth.

The Tax-Compliant Transfer Pricing Policy

The MNE under scrutiny faced different transfer pricing regulations in the various countries in which it operated. The Internal Revenue Service (IRS) in the US had created the most stringent and detailed jurisdiction, accompanied by numerous transfer pricing audits and heavy penalties for non-compliance. The European and Asian countries in which the MNE operated had also expended efforts to implement the OECD transfer pricing Guidelines. However, these countries showed significant differences in the training levels of their tax officials and the intensity with which transfer pricing audits were undertaken. The MNE’s Corporate Tax department responded to the tax compliance pressures in the various countries by adopting a single, comprehensive transfer pricing policy. This policy, it was felt, would not only guarantee tax compliance, but would also ease the administrative burden on the company and avoid confusion on the managers’ part.
While different transfer pricing methods were required at different stages in the value chain, the MNE applied these methods in a uniform way for all similar transactions, independently of the countries involved in the transfer. By using this uniform policy, the company wanted to demonstrate that it did not leave any room for tax manipulation. Since purely negotiated transfer prices were not allowed for tax compliance reasons, the transfer pricing policy was imposed upon all sections of the business by divisional management. The MNE stressed its use of a single set of books, both for tax compliance and for management control.

The actual transfer pricing method used was the cost-plus method in manufacturingand the resale-minus method in sales. Since the number of production steps undertaken in a particular plant varied, the MNE calculated and used a cost-plus price for every step in the manufacturing process, whether the next activity took place in the same plant or not. The transfer price between operational units was therefore the sum of the prices for all steps already undertaken. Budgeted rather than actual costs were used in calculating the transfer price to prevent manufacturing inefficiencies from being passed on to other parts of the value chain, with a detailed tax adjustment being made at the end of the fiscal year.
The centrally dictated transfer prices influenced the results of the various business units and departments within the MNE, which needed to work together in order to steer the products through the value chain. From the moment the products were sent from the product bank to an assembly and test facility, the production transfer price became a cost for the business line, along with a charge for the assembly and test activities, the sales efforts, and the use of particular services. As a result, the transfer pricing policy now played a central role in performance measurement and evaluation of operations.

The Effect on Staff and Operations

Originally, the various plants and business units within the MNE had not necessarily been established as profit centres, that is, if a plant was providing a component or service to other areas of the business at a competitive price, it was not required to make a profit in its own right. However, once the transfer pricing policy was applied across the board, managerial preference was to assess each area of the business against that transfer price as a measure of performance. For example, the plants were evaluated based on their achievement of assembly and test cost targets measured as indices. At the end of the year their cost reduction performance was compared to the budgeted, benchmarked costs used in the transfer pricing model.

On the face of it, this method was easy for managers to understand, with one business unit manager describing the process thus: “Once the plant is built and the technological base installed, we just use the transfer pricing models to calculate the prices. The better the plant is managed, the more the costs can decrease, and the transfer prices will then decrease, too. And I am in favor of low transfer prices because they imply that the underlying costs are low.”

However, the logical conclusion of this policy, given that next year’s transfer prices will be set based upon the efficiencies achieved now, is that assembly and test transfer prices had to be reduced continuously in order for those business unit managers to consistently deliver.

Initially, this meant there was a discrepancy between the figures required for tax compliance, where all units were considered profit centres, and those used for management control purposes, where units were evaluated on a cost centre basis, costs being something within the control of each unit. However, higher-level management became convinced that the elimination of the mixed treatment and the further reduction of complexity would allow them to do a better job in steering subunit managers. Since the profit mark-ups were allocated for tax compliance anyway, divisional management perceived it as a small step to move towards real profit centers, which had adverse effects on both the business units and the staff whose performance was linked to the new ‘profit centres’.

Negotiating on centrally calculated transfer prices was banned within the MNE, as negotiating transfer prices did not provide a sufficient and valid proof of arm’s length transaction. However, the research found that all interviewees who became subject to a full profit centre treatment as a result of the transfer pricing policy complained that they felt the inability to negotiate transfer prices was incompatible with their responsibility to behave as autonomous profit centres:

"It cuts up the organisation into too many separate departments, each one trying to make as much profit as possible. This could lead to a situation where the plants realise a profit while the business units do not sell anything and incur losses. It creates a lot of friction in the organisation… I am only a producer, I don’t “own” the products. I do not feel like a real entrepreneur." (Plant Manager)

"I am against these internal discussions of lowering and raising transfer prices as they are a waste of time. It does not make sense to have a profit model for the manufacturing plants." (Plant Manager)

This highlighted the issue of matching the decision rights and responsibilities of the subunits managers with the performance measurement and reward system- the managers felt unfairly treated because they were held accountable for elements outside their span of control.

Bad for Business?

 These undesirable demotivational effects caused by the effect of tax compliance on transfer prices has thrown a different light on the importance attached to the role of inter- and intra-firm negotiations on transfer pricing. Clearly managers experiencedthe reduction in their sense of autonomy as psychologically disagreeable but the lack of negotiation power was sometimes even economically harmful to the MNE as a whole.

One manager explained how he had felt discouraged from entering the Chinese market with one type of semiconductor, since the manufacturing transfer prices induced too high a price for the region. Having been allowed to negotiate, he would have been able to reduce his cost, and enter the Chinese market generating a reasonable financial result, and the MNE could have benefitted from a first mover advantage.

Overall, managers within the MNE experienced the loss of autonomy consequential to the blanket transfer pricing policy with uniform profit margins and mark-ups as demotivating, and this simplistic approach was also found to be hindering economically sound decision making. While the simplification was welcomed from an administrative point of view, it could lead to suboptimal decision making. MNEs need to make sure they can properly assess the administrative burden of employing separate tax and managerial transfer prices against the true cost of fixed and immutable prices restricting business.

Related Article

Slagmulder R. Cools M. "Tax-compliant Transfer Pricing and Responsibility Accounting". Winner JMAR Best Paper Award (2010).  

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