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International Transfer Pricing is the transaction made between related parties in different countries that are from the same multinational group. (“Transfer Pricing”, n.d.). Based on Worldwide Trade Partners LLC (n.d.), it stated that international transfer pricing includes 4 major types of transaction which are sales of goods, provision of services, sales of transfers of intangible and tangible assets, and intercompany financing.
In N’s case, Mr. Richardson, the finance executive has suggested two cost cutting methods which are to obtain tax saving by transferring operating cost and royalty charge of own brand products to Luxembourg operations. These two methods have fallen into the category of transfer pricing transaction as mentioned above by Worldwide Trade Partners LLC. In other words, it indicates that the cost cutting method proposed is international transfer pricing.
Upon approving the proposal, the pros and cons of transfer pricing should be taken into consideration by financial director. The Internal Revenue Service (IRS) considers transfer pricing enforcement a key revenue generating area. (Sanschagrin, 2014). Through the placement of profit in tax haven country, Luxembourg, N could incur a lower cost on tax. It is favorable to N even though the tax is charged in Country Z is at a higher rate, it overcharges by a reduced profit, thus it reduces N’s tax burden. Having more cash in hand, it allows N to engage more on reinvestment, especially in IT development, staff training, own brand for electrical goods, opening of convenience store as according to the updates from senior executives. Also, as the tax is reduced, it magnifies N’s retained earnings and shows a well-performed financial report as well as a favorable ratio reports. Such results could attract more investors and gather higher capital funds for N.
Secondly, international transfer pricing is operated by decentralizing the management of the company. (“Transfer Pricing”, n.d.). Such decentralized form of management allows N to evaluate the performance of its operation in Country Z and Luxembourg separately. By having their performance being evaluated others individually, it somehow encourage and motivate each department manager to do better. At the same time, the quality of decision making could be improved as local manager are more proximate to its local business environment as compared to centralized management.
Furthermore, transfer pricing allows multinational company to achieve sustainable tax efficient structure. (“What is Transfer pricing?”, n.d.). It allows N to layer its supply chain function with its tax planning via appropriate choice of transfer planning. Manager could make smart tax decisions on how and where to locate value factors and main functions within their supply chains planning by doing cost benefit analysis. Also, it helps manager in managing production, sales and pricing decisions as manager could be aware of the effect or value of an item to other division. (Heath, Huddart, & Slotta, 2009). Hence, transfer pricing is a constructive and useful method for manager to ensure optimal allocation of N’s resources.
Besides, Financial Director need not feel uneasy with this suggest as it is a absolute legal transaction as stated by Richard Murphy on the behalf of Tax Research LLP. (Murphy, 2007). Also, it is further supported by Tax Justice Network of USA, stated that transfer pricing action done by multinational company is completely legal. The one which is illegal is transfer mispricing, which involves the manipulation in the transfer of pricing. It is the trade between unrelated parties which is in other words, is called reinvoicing. (TJNUSA, n.d.) Hence, the suggestions that are proposed by Mr Richardson is not illegal and does not conflict with legislation of any nation. Yet, it is an effective method that helps in achieving the objective of cost cutting.
According to Drury (2012), guidelines and legislation by taxation authorities and OECD have introduced to ensure the integrity of transfer prices. However, Gillingham (2012) says that even though transfer pricing is guided by authorities, it is till open to abuse. Abusive transfer pricing could causes firm to be expose to reputation risk and tax penalties. According to Surtees (2012), who is the director of Norton Rose’s tax division, emphasized that SA Revenue Service has granted the power to adress transfer pricing which pricing is other than arms’ length price under Section 31. Other than that, significant tax adjustments and penalties have been imposed by many jurisdiction. (Song, FCAS, MAAA, Ruparelia, 2012). If N has insufficent control over its transfer pricing, N would be likely to trigger massive penalties and immediate tarnish of reputation.
Besides, the cost needed to undertake transfer pricing can be daunting for N. Transfer Pricing Compliance Directive has imposed Information Document Requests (IDRs) which proper document is mandatory for audit’s inception. (Sanschagrin, 2014). When tax return was filed, such documentation must be prepared to avoid any penalties. Also, administrative cost should be taken into consideration. According to Sanschagrin (2014), audit for a middle-market company on transfer pricing could lead to lost of plentiful productivity hours for the company. In fact, the advisory cost could gone up to $100,000 and above for an issue.
Furthermore, management would exprience loss of autonomy in transfer pricing. Negotiation of transfer prices was prohibited as it provides insufficient and invalid proof of arm’s length transaction. (Slagmulder, 2010). Slagmulder (2010) has conducted several interviews with plant managers of multinational companies and found out that such blanket transfer pricing policy was incompatible with their responsibility to conduct autonomous profit centres. Such inability to negotiate and uniform profit margins is found to be demotivating, as well as hindering managers to make sound decisions. Also, simplicity of blanket transfer pricing policy which is welcomed from administrative point of view could lead to suboptimal decision making. (Slagmulder, 2010). Reduction in complexity would result in strengthening of an element and neglecting the effect would have on others.
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