Cost Accounting (14th Edition)

792 CHAPTER 22 MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING, AND MULTINATIONAL CONSIDERATIONS
also payroll taxes, customs duties, tariffs, sales taxes, value-added taxes, environmentrelated
taxes, and other government levies. Our aim here is to highlight tax factors, and in
particular income taxes, as important considerations in determining transfer prices.
Transfer Pricing for Tax Minimization
Consider the Horizon Petroleum data in Exhibit 22-2 (p. 783). Assume that the transportation
division based in Mexico pays Mexican income taxes at 30% of operating
income and that the refining division based in the United States pays income taxes at
20% of 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 income reported in Mexico, where income is taxed
at a higher rate than in the United States.
Operating Income for 100 Barrels of Crude Oil
Transportation
Division
(Mexico)
(1)
Refining
Division
(United
States)
(2)
Income Tax on 100 Barrels of Crude Oil
Transportation
Division
(Mexico)
(4) 0.30 : (1)
Refining
Division
(United States)
(5) 0.20 : (2)
Transfer-Pricing
Method
Total
(3) (1) (2)
Market price $900 $300 $1,200 $270 $ 60 $330
105% of full costs 380 820 1,200 114 164 278
Hybrid price 600 600 1,200 180 120 300
Total
(6) (4) (5)
Income tax considerations raise additional issues. Tax issues may conflict with other objectives
of 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 to evaluate the economic profitability of the transportation
division. But it is costly from the perspective of income taxes. To minimize income
taxes, Horizon would favor using 105% of full cost for tax reporting. Tax laws in the United
States and Mexico, however, constrain this option. In particular, the Mexican tax authorities,
aware of Horizon’s incentives to minimize income taxes by reducing the income reported in
Mexico, would challenge any attempts to shift income to the refining division through an
unreasonably low transfer price (see also Concepts in Action, p. 793).
Section 482 of the U.S. Internal Revenue Code governs taxation of multinational
transfer pricing. 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-plusbased,
where the plus represents margins on comparable transactions. 7
If the market for crude oil in Houston is perfectly competitive, Horizon would be
required to calculate 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 ($85 - $2) per barrel, the selling price net of marketing and distribution costs.
Under the U.S. Internal Revenue Code, Horizon could obtain advanced approval of the
transfer-pricing arrangements from the tax authorities, called an advanced pricing agreement
(APA). The APA is a binding agreement for a specified number of years. The goal of the APA
program is to avoid costly transfer-pricing disputes between taxpayers and tax authorities. In
2007, there were 81 APAs executed, of which 54 were bilateral agreements with other tax
treaty countries. Included in this was the completion of the first bilateral APA between the
United States and China, involving Wal-Mart Stores.
The current global recession has pushed governments around the world to impose
tighter trading rules and more aggressively pursue tax revenues. The number of countries
7 J. Styron, “Transfer Pricing and Tax Planning: Opportunities for US Corporations Operating Abroad,” CPA Journal Online
(November 2007); R. Feinschreiber (Ed.), Transfer Pricing Handbook, 3rd ed. (New York: John Wiley & Sons, 2002).