 Hello and welcome to the session. This is Professor Farhat and this session, we would look at the objective of international transfer pricing. Specifically, we're going to be focusing on performance evaluation. This topic is covered in international accounting or taxation course, as well as on the CPA and ACCA exam. As always, I would like to remind my viewers to connect with me on LinkedIn. If you haven't done so, YouTube is what you would need to subscribe. I have 1,500 plus accounting, auditing, tax and finance lectures. Those are, this is a list of all the courses that I cover, including the number of lectures, including CPA material. On my website, you will have access to additional information and additional material, such as PowerPoint slides, notes, through-folds, multiple-choice, quasi-CPA simulations and 2,000-plus CPA questions. So one of the objectives of international transfer pricing is you want to make sure you have it aligned with proper performance evaluation, because to fairly evaluate the performance of both parties and an intercompany transaction, the transfer price should be acceptable to both parties. Simply put, if you're asking two parties to buy from one another, well, for both parties to be evaluated fairly, the price should be negotiated. You should have the best price. Now, what is the best price? The best price should be a market price. When does a market price exist? When you have an outside competitive market or give both parties the ability to negotiate the price this way, neither party will feel they are at a disadvantage in the negotiation, okay? So policies for establishing prices for domestic transfer generally should be based on objectives that generate reasonable measure for evaluating performance. So you gotta let them negotiate or let them use market prices. This way you can evaluate them. So if they're profitable or not, if they are meeting the profit margin for the company, if they're meeting the return on investments, otherwise what's gonna happen, this functional manager behavior could occur and goal congruence will not exist. Goal congruence is when the different subsidiaries all working in the same direction for the overall profit of the company. For example, forcing one manager of an operating unit to purchase parts from a related operating unit at a price that exceeds the external market price is not a good behavior. Why? If somebody asks you to buy something from another part of the company at a higher price than what you can buy it from an external party, well, your cost, it's gonna be higher. Simply put, let's assume you need raw material and you can buy from an outside party at $8 per unit but the parent company says you need to buy from inside the company at $10 per unit. So you're forcing me to pay two additional dollars where I can get that unit from somewhere else. That's gonna result in an unhappy manager. Unit profit will be less, okay? Because I'm paying $2 more. My salary and my bonus will be lower, okay? In addition, what's gonna happen when my division or when my department shows less profit because my unit cost is higher, I'm gonna have less and less resources allocated to me and as less and less resources are allocated to my division, I'm gonna be less and less efficient and less profitable most probably. So that's why it's very important to let different departments or different division negotiate the price or let them use an external price. So the best way to illustrate this is to work with some examples. Let's assume alpha company and manufacturers and beta company a retailer. So alpha manufacturer sells it to B and B sells it to the consumer. Alpha produces DVD players at a cost of $100. That's the cost for alpha and sells them to beta into unrelated parties. So alpha don't only sells to beta, which is part of the company, it's subsidiary, but also it sells it to outside party. Beta purchases DVD players from alpha and from unrelated suppliers and sells them for 160. So beta, they sell each DVD player for 160. So the total gross profit for the company is $60 because if we produce it alpha, produces it for $100, that's the cost for alpha, then beta sells it for 160. So overall, this is beta. So this is sold at 160. It means the company makes profit of $60. Okay, that's the overall profit for the company. Alpha company can sell the DVD player to unrelated customers for 127 per unit. So alpha, they can sell it for 127.50 per unit to unrelated party. And beta can purchase the DVD player for 132.50 per unit. What does that mean? It means we have 127 here, 127.50. 127.50 in 132.50. Okay, so alpha, they sell it for 127.50 to anyone. This is price to anyone. So if you want the DVD player from alpha, you can buy it for 127.50. Beta, they can go to alpha and buy it for 127.50 or they can buy it from somewhere else at 132.50. So basically, what does that mean? It's the minimum we should sell it to beta is 127.50 and the maximum should be 130.50 because if alpha tried to say, I'm gonna sell it for 135 to alpha, alpha's gonna, I'm sorry, if alpha says I'm gonna sell it for 135 to beta, beta says that's not acceptable because I can buy it for 130.50. Why are you selling it at 135 to me? So what should be a fair price will be someplace in between. That's the fair price. Okay, this is how we determine the fair price or this is what would be considered a fair price. So the manager of alpha should be happy selling the DVD to beta for 127.50 or more. And the manager of beta should be happy to purchase the DVD player up to 132.50. So anything in between, it's acceptable to both because alpha, as long as you sell it for more than 127.50, they're happy. And beta is happy as long as you sell it for less than 132.50. And this is why I said the price between 127.50, 127.50, and 132.50, 127.50, and 132.50, this is the price that both parties will be happy as long as it's within that price. So a transfer price somewhere in between will be acceptable to both. So let's assume we're gonna sell it, we're gonna determine a transfer price of 130. What would the profit looks like? Okay, let's take a look at the income statement for alpha. Alpha, it costs alpha 100, sells it at 130 to beta. They have a profit of 30. The income tax effect, assuming they're pay US rate, $6.30, after tax profit is $23.70 for alpha. Beta, they buy it at 130, therefore their cost is 130. They sell it at 160. They have a profit of 30, same thing, same tax rate in the US, $6.30, a profit of 23.70. Together, so the total sales for the parent company, 160, total cost of goods sold 100, total profit 60, total tax 12.60, and a profit of $47.40. So everything is good, the deal is fair. Now let's change the scenario from a domestic scenario to international scenario. Let's assume that alpha is located in Taiwan and beta is located in the US. The income tax rate in Taiwan is only 17% compared to the US, which is 21, okay? So the parent company would like to make as much of the $60 profit, gross profit to be earned by alpha as possible. So the goal is to do that. So rather than allowing the two managers to negotiate the price, okay? Assume the parent company intervene and they establish what's called a discretionary transfer price of 150. So now what we're saying is this, we want alpha rather than selling it to you. For 130, we're gonna change this to 150. What does that mean? It means the price of beta will be 150. And let's see what happened if we change the transfer price. So alpha is gonna sell it for 150. Their cost is 50. They make a profit of $50. In Taiwan, they are charged 17%. The after tax profit is 41, 41, 50. Now beta, they have a cost of 150. They sold it for 160. They make a profit only of $10 in the US. They are taxed at $2.10. The total profit is $7.90, $7.90. Let's take a look at the overall. 160, the overall sales cost of goods sold is 100. Total profit of 60. The total tax here is 1060. So notice the total tax. The total tax stands 60 versus 1260 earlier, versus 1260 earlier, which is we made $2 of extra profit, $2 of extra profit on the bottom line. So overall, what's the result? Obviously the chief officer of the parent company is pleased because now we have two extra dollars. Now add zeros to this dollars, two million or two billion. But the point is we have extra money. Okay, so consolidated income for the parent company increased by $2. The cash flow when alpha and beta remit their after tax profit, it's gonna be higher. The dividend will be higher, which is good. The president of alpha will be happy because of this transfer price because now they're selling everything for 150 rather than 130. Their compensation will be higher. Their bonus will be higher and managers are happy at alpha company because it's good. Now what happened to beta? Beta will not be happy. So beta is less pleased with the situation. Their profit is less because they have to pay more. Okay, it's less than because they can buy it. Remember, beta, they can buy this DVD at a maximum price of 130 to 50. So that's why that's not good. They would receive a bonus for the year. That's less than what they should. And they might be starting to think about leaving the company if that's the case. Also top management, as we said, might allocate less resources to them. So this is the one objective of international transfer pricing is performance evaluation. We wanna make sure we don't go into this situation where beta is not happy because now it's not goal congruence in the sense that you want beta to work as hard as possible and everything to be fair, okay? In the next session, we would look at the other objective of the second objective of international transfer pricing and we'll talk about cost minimization. And when we talk about here, we're gonna focus more on the taxes in a sense we looked at the taxes but there's other costs we need to look at. As always, I would like to remind you to visit my website because I do have additional resources, additional lectures, not only this course and I suggest you subscribe. It's an investment in your career. Good luck and study hard, stay motivated.