How Multinationals Use Transfer Pricing to Minimize Their Income Taxes

Learning Objective 9 Incorporate income tax considerations in multinational transfer pricing

• set transfer prices to minimize tax payments to the extent permitted by tax authorities

Transfer pricing is an important accounting priority for managers around the world. A 2010 Ernst & Young survey of multinational enterprises in 25 countries found that 74% of parent firms and 76% of subsidiary respondents believed that transfer pricing was “absolutely critical” or “very important” to their organizations. The reason is that parent companies can save large sums of money in income taxes depending on the transfer-pricing methods they use. As noted in the vignette at the start of this chapter, firms such as Apple place their intellectual property in locations with low tax rates (e.g., Ireland). They then charge a high royalty fee to the units that generate sales revenue in higher tax areas (e.g., the United Kingdom), thereby minimizing or even eliminating the profits in those regions. Facebook, IBM, and Microsoft have used similar transfer-pricing practices, with names like “Double Irish” and “Dutch Sandwich.” Such profit-shifting arrangements are estimated to save companies billions of dollars annually.^*

Consider the Horizon Petroleum data in Exhibit 23-2 (page 896). Assume that the transportation division based in Mexico pays a Mexican tax rate of 30% on its operating income and that the refining division based in the United States pays a U.S. income tax rate of 20% on its operating income. Horizon Petroleum would minimize its total income tax payments with the 105%-of-full-cost transfer-pricing method, as shown in the following table, because this method minimizes the income reported in Mexico, where income is taxed at a higher rate than in the United States.

Minimizing a firm’s income taxes can sometimes conflict with the other objectives the firm’s top managers hope to achieve via transfer pricing. Suppose the market for crude oil in Houston is perfectly competitive. In this case, the market-based transfer price achieves goal congruence, provides incentives for management effort, and helps Horizon evaluate the economic profitability of the transportation division. But this transfer price is costly from the perspective of income taxes. For tax reporting purposes, Horizon would favor using 105% of the full cost as the transfer price. But the tax laws in the United States and Mexico constrain this option. Mexico’s tax authorities would challenge any attempt by Horizon to shift income to the refining division through an unreasonably low transfer price (see also Concepts in Action: IRS Accuses Medtronic of Unfair Tax Deal).

Section 482 of the U.S. Internal Revenue Code governs how multinationals can set transfer prices for tax purposes. Section 482 requires that transfer prices between a company and its foreign division or subsidiary, for both tangible and intangible property, equal the price that would be charged by an unrelated third party in a comparable transaction. Regulations related to Section 482 recognize that transfer prices can be market-based or cost-plus-based, where the plus represents margins on comparable transactions.^*

Consequently, if the market for crude oil in Houston is perfectly competitive, Horizon would be required to calculate its taxes using the market price of $85 for transfers from the transportation division to the refining division. Horizon might successfully argue that the transfer price should be set below the market price because the transportation division incurs no marketing and distribution costs when selling crude oil to the refining division. For example, if marketing and distribution costs equal $2 per barrel, Horizon could set the transfer price at $83 $(\mathrm{\$}85-\mathrm{\$}2)$ per barrel, the selling price net of marketing and distribution costs.

Transfer pricing has long been an important issue for tax directors and government authorities. It is now firmly on the agenda of world leaders, who have been driven by a search for tax revenues, as well as media scrutiny on transfer pricing, to impose tighter rules. Countries such as Canada, Greece, India, and Turkey have focused on intellectual-property values, the costs of back-office functions, and losses of any type. Countries rich in minerals and natural resources, including Australia, Chile, and Indonesia, have introduced new tax policies and transfer-pricing guidelines aimed at increasing the local tax base, especially in the area of outbound commodities. There is also coordinated action by governments, best illustrated by the Organisation for Economic Co-operation and Development’s (OECD’s) project on base erosion and profit shifting, which produced a 15-point action plan in October 2015. Today, over 130 countries and jurisdictions are collaborating on the implementation of these measures to tackle tax avoidance, improve the coherence of international tax rules and ensure a more transparent tax environment.

In the United States, the IRS has made a substantial investment in transfer-pricing resources. In 2011, the IRS named its first director of transfer pricing and subsequently raised inquiries or disputes with a variety of technology firms, including Amazon, Adobe, Juniper Networks, and Yahoo. In July 2016, the IRS delivered a “notice of deficiency” to Facebook for $3 billion to $5 billion, plus interest and penalties, following an audit of the value at which Facebook transferred its intellectual property to its Irish entity.

The tariffs and customs duties governments levy on imports of products into a country also affect the transfer-pricing practices of multinationals. The issues here are similar to income tax considerations. Companies are motivated to lower the transfer prices of products they are exporting into a country to reduce the tariffs and customs duties charged on those products. The restrictions some countries place on dividend- or income-related payments to parties outside their national borders also affect how firms set their transfer prices. By increasing the prices of goods or services transferred into divisions in these countries, companies can increase the cash paid out of these countries without violating dividend- or income-related restrictions.

Transfer Prices Designed for Multiple Objectives

At times, one transfer price will not satisfy all of a firm’s objectives, such as minimizing its income taxes, achieving goal congruence, and motivating managers’ effort. As a result, a company may choose to keep one set of accounting records for tax reporting and a second set for internal management reporting. Of course, it is costly to maintain two sets of books. Some companies, such as CNH Industrial, a world leader in the agricultural and construction equipment business, have opposed doing so based on the principle that statutory and internal reporting systems must reflect the same information. However, a survey by the AnswerThink Consulting Group of large companies (more than $2 billion in revenues) found that 77% of companies considered to follow “best practices” used separate reporting systems to track internal pricing information, compared with about 25% of companies outside that group.

Microsoft, for example, believes in “delinking” transfer prices and employs an internal measurement system (Microsoft Accounting Principles) that uses a separate set of company-designed rules and accounts.^* A key aspect of management control at Microsoft is holding product and division managers accountable for the profitability of products and establishing appropriate sales and marketing spending levels for every product line. To set these sales and spending levels, the firm creates a profitability statement for every product in each region and allocates research and development and administrative costs across sales divisions in ways that aren’t necessarily the most tax efficient.

Even if a company does not have separate reporting systems, a firm can still informally adjust its transfer prices to satisfy the tradeoff between minimizing its taxes and incentivizing its managers. Consider a multinational firm that makes semiconductor products that it sells through its sales organization in a higher-tax country. To minimize the firm’s taxes, the parent company sets a high transfer price, thereby lowering the operating income of the foreign sales organization. It would be inappropriate to penalize the country sales manager for this low income because the sales organization has no say in determining the transfer price. As an alternative, the company can evaluate the sales manager on the direct contribution (revenues minus marketing costs) incurred in the country. That is, the transfer price incurred to acquire the semiconductor products is omitted for performance-evaluation purposes. Of course, this is not a perfect solution. By ignoring the cost of acquiring the products, the sales manager has an incentive to overspend on local marketing relative to what would be optimal from the firm’s perspective. If the dysfunctional effects are suitably large, corporate managers must then step in, evaluate the situation, and dictate specific operational decisions and goals for the manager. More generally, when a firm adopts a tax-compliant transfer-pricing policy, it needs nonfinancial performance indicators (such as production yields, number of on-time deliveries, or customer-response times) at lower management levels in order to better evaluate and reward performance.^*