Management Accounting-Performance Evaluation: Grahame Steven Explains Why It's Tempting to Manipulate Transfer Prices When Moving Products between a Group's Subsidiaries in Different Nations

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DuPont was the first company to recognise the need for transfer pricing when, in the early 20th century, some of its divisions started generating by-products from their manufacturing processes that other divisions could use as raw materials to make their products. It realised that transferring such materials for free would be unfair, since the supplying division would be subsidising the receiving division, which had previously bought them from a third party. The company initially used cost to price these transfers, but the DuPont management team that took over General Motors used market prices when it implemented transfer pricing at GM after World War I. So it seems that the debate about the most appropriate basis for transfer prices dates back to the origins of the idea.

A key objective of transfer pricing is the fair assessment of performance. The accounts will be distorted where there are significant levels of intra-company trading if transfer pricing isn't used or if an inappropriate method is adopted. This can lead to incorrect investment decisions and demotivate managers if they think that their division is subsidising another. But, when the internal trade occurs between subsidiaries in different countries, the company can gain a financial advantage by using transfer prices that won't assess performance fairly.

Consider a multinational with two subsidiaries in different EU countries that both use the euro. The subsidiary in country A makes products that it sells in its home market and to the subsidiary in country B. The selling price charged to the subsidiary in B, 50 [euro], is based on market price adjusted for internal savings on marketing, admin and so on. The market price for these goods in A is 60 [euro].

Table 1 calculates the profit made by the subsidiary in A from its external and internal sales and by the subsidiary in B that resells products bought from the subsidiary in A. The key difference between the two nations is the rate of corporation tax they charge: A's rate is 25 per cent while B levies 35 per cent. This difference could influence the company to change the transfer price charged to the subsidiary in B, since it would be better to make higher profits in country A, where the corporation tax rate is ten percentage points lower. So the company would increase its after-tax profits by setting a higher price for the goods purchased by its subsidiary in B from its subsidiary in A. Table 2 shows the impact of charging 54 [euro] per unit. The cost of sales is increased by the same amount, so the combined gross profit is the same as in table A. Pre-tax profits are also unaffected, since operating expenses are unchanged. What changes is profit after tax, since the profits previously taxed at 35 per cent are now taxed at 25 per cent. The net effect is to increase after-tax profits by 160,000 [euro].

Tables 3 and 4 show how the company could increase its after-tax profits where the corporation tax situation is reversed--ie, where country A's rate is 35 per cent and B's is 25 per cent. This time its after-tax profits are increased by 160,000 [euro] when the selling price charged to the subsidiary is cut to 46 [euro].

Research has found that multinationals have indeed manipulated transfer prices in such ways, sacrificing the fair assessment of performance for financial gain. Our example shows the favourable impact of changing the unit transfer price by 4 [euro]. But why stop there? Why not change it by 5 [euro], 6 [euro] or more? The answer: government intervention. Governments need to raise money to fund public spending, so they don't take kindly to losing tax revenue. Each country will try to ensure that transfer prices used by multinationals do not disadvantage it. This can put multinationals at risk of double taxation, since national tax authorities will probably seek to maximise their revenues by establishing transfer prices that are most appropriate for them. …