 Hello and welcome to this session. This is Professor Farhad and this session we would look at the objective of international transfer pricing, specifically cost minimization. This topic is an extension of the previous topic, which was objective of international transfer pricing performance evaluation. This topic is covered in international accounting and taxation could be covered on the CPA exam and it's definitely covered on the ACCA exam. As always, I would like to remind you to connect with me on LinkedIn. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing, finance and tax lecture. This is a list of all the courses that I cover with the number of lectures on my website. You can find additional information such as PowerPoint slides through false multiple choice exercises, quasi CPA simulations. And if you're studying for your CPA 2000 plus CPA questions, I strongly encourage you to visit the website. What would be helpful before you start the session is to look in the description and look at the prior session because as I said, this session is a extension of the prior session. And in the prior session, we looked at two companies, two subsidiaries, Alpha and Beta, and they belong to the same parent company. And what we said, we said Alpha sells the beta and beta sells to the consumer. Alpha sells the beta, the unit, the DVD players were selling DVDs for $130, the cost of Alpha is $100, the profit for Alpha is $30, Alpha pays 21% taxes, the U.S. tax rate, $6.30, and they have profit $23.30. Now the cost, the sale for Alpha become the cost for beta. Beta sells the item for $160, their cost is $130, their profit is $30, they pay $6.30 and their profit is $23.70. Overall, this is the overall profit for the whole company, $160 in sales, $100 in cost, $60 in profit, $12.60 in taxes and $47.40. Then we said, let's assume that Alpha is located in Taiwan and Beta is located in the United States. And what we said, if we change the scenario, the income tax rate in Taiwan is 17% compared to the U.S. tax rate of 21%. The parent company would like as much of the $60 gross profit to be taxed in Alpha because the tax rate is lower in Taiwan. So we're going to change the transfer price. So rather than allowing the two managers to negotiate a price based on external market value, assume that the parent company intervened and established a discretionary price for $150. Simply put, we're going to tell Alpha sell to Beta, not for $130, for $150. And we discussed this scenario in the prior session. If we sold it for $150, the profit for Alpha is $50, their income tax is $8.50, their profit is $41.50. Beta will sell it to the external users for $160, but their cost becomes $150. They only have a profit of $10. They pay $2.10 in taxes and their after-tax profit is $7.90. And overall, the company make two additional dollars or $2 million or $2 million in profit. What happened in this scenario? What happened in this scenario? The parent overall is better off. The chief executive officer of the parent company is pleased. The consolidated net income for the company is increased by $2 per unit. The cash flow, when Alpha and Beta remit their after-tax, it's better when that happens because we're remitting more. The president of Alpha is happy because their profit is higher, but Beta, Beta, they're going to look bad. Beta, they're going to look bad. If they are getting their bonus based on the profit, it's not going to look good because their cost is higher. Their profit is artificially inflated because they were forced to buy the DVD player at $1.50 and they would lose their bonus and they might lose more resource allocation from the parent company because they might look as unprofitable. So simply put, there's a conflict in objectives. There's an inherent conflicting between the performance evaluation and cost minimization objectives. So if you want to minimize cost, someone's not going to be happy. That's the point. So to minimize cost, the top managers must dictate a discretionary transfer price. And what happened now, the benefit of decentralization can go away. So what do companies do under those circumstances? Company can employ something called dual pricing. One way that company can do is dual pricing. And once dual pricing, you would have two basically records. The official record for tax and financial reporting are based on cost minimization for transfer pricing purposes, but when it comes to performance, the actual, when it comes to the, to evaluate performance, the actual records are adjusted to reflect the prices acceptable to both parties to the transaction factoring out the effect of discretionary prices. So what you do, you would say, okay, for tax purposes and financial purposes, we're going to use discretionary prices. When it comes to evaluating you, we're going to be using the market prices. So actual transfer prices are invoiced. So as to minimize cost, but evaluation is based on simulated prices. So hopefully this makes sense. So it's basically keeping two sets of books. Now, let's look at other strategies that we could employ in transfer pricing to avoid withholding taxes, to avoid minimizing our cost in general. So a company might want to avoid receiving cash payment from its foreign subsidiaries in form of dividend interests and royalties because withholding taxes will be paid to the foreign government. So if you have a subsidiary and the subsidiary made a profit and that subsidiary is transferring the money to the parent company, the hosting company, not the company, might have some withholding tax. So what can the company, what can the subsidiary do rather than sending the money? Well, instead cash can be transferred in form of sales prices for goods and services provided to the foreign subsidiaries by its parent company and other affiliate. So simply put, what we do is we're going to sell you product and guess what? We'll sell you product at a higher cost, okay? And this way you pay us the money and there is no withholding for the purchase of goods. Simply put, let me show you this. We have the parent company and we have a subsidiary. Now the subsidiary made a profit, but the subsidiary is located in Mexico. I'm just giving Mexico as a, just as a country as an example. And the parent company is in the U.S. of A. If we send the profit back to the U.S., I mean this is not a good example for the U.S. because now we can send the profit. Remember that the law has changed, but let's assume it's between two different countries. But if the subsidiary sends the dividend, the Mexican government will withheld some taxes. So rather than sending the dividend, the parent company will sell product at a high inflated prices and the subsidiary will send the money, okay? In this way, when we pay for goods and services, no taxes are withheld. So the higher price charged for the foreign subsidiary, the more cash can be extracted from the foreign subsidiary without incurring a withholding tax. So this is one way to do it. And let's take a look at an example to see how this all worked. Maybe I should have just waited for the example. Assume that the European subsidiary of K Corporation purchases finished goods from its foreign affiliate from the foreign parent at a price of 100 euro per unit. Then they sell the good to the consumer for 130. So the bike 100, they sell it for 130. And they remit 100% of the profit to the parent company, which is the profit is $30. But there is a 30% withholding. It means if they make $30, they're going to have to withheld 30% of that. 30% of $30 is $9. So they have to keep $9. So the only amount they can remit is $21, okay? So basically, hopefully this makes sense. So they can remit $121 net, which is 100 plus 21 because what's going to be left is the $21. So let's assume instead, let's assume instead K company, let's assume the K company raised the price, raised the selling price to its European subsidiaries to 120. Now what's going to happen? We're going to transfer the price rather than 100. We're going to tell you our price is 120. The price is 120. You're going to sell it for 130. If the price is, if I'm going to sell it for 130 and my cost is 120, the subsidiary is only going to be making $10 of profit. $10 of profit, if you send it back to me, you're going to have to pay 30% on it. You're going to pay $3. Simply put, I'm going to send it back to the parent company to 120 plus the 7. I'm going to be sending back to the parent company $127. So raising the price, okay, raising the price even further to $130, then you have no profit at that point. But again, all these issues we're going to have to deal with later from what the government do under those circumstances, the host and government. I'm just telling you those cases to kind of build the idea of transfer prices, okay? So basically put selling goods and services to a foreign subsidiary, which is a downstream sale at a higher price, reduces the amount of the profit earned by the foreign subsidiary that will be subject to dividend tax, okay? Sales of goods and services by a foreign subsidiary to its parent at a lower price would achieve the same objective. So this is what we are doing here. We are managing the cost. You sell me at a higher cost, I'm going to show lower profit. I show lower profit. When I send back the money, I will send less taxes, okay? Another strategy is to minimize tariffs. It's to minimize tariffs. Basically, what is tariff? Tariff is when you import goods from another country, the government might make you pay taxes. So countries generally assess a tariff on the value of the goods being imported into your country. So if you're bringing stuff inside the US, you might have to pay a tariff on it. And this is a big deal right now with the US government because of the negotiation that's going on between China and the US. One major issue is tariffs. Like what are we going to do with tariffs? Are we going to raise them, lower them, so on and so forth? So that's interesting. So what do you think we would do if we want to minimize our taxes on tariffs? Do we assume higher prices? Do we transfer at higher prices or lower prices? So remember, the tariff is based on the invoice price. What you do, you would transfer the item at lower price. So those are based on value. So one way to reduce the ad valorem, it's based on the value, is to transfer the good at lower prices. So notice, sometimes we have to raise the price, sometimes we have to lower the price. OK, now let's look at strategy for circumvention of profit repatriation restriction. What does that mean? That means the company that's hosting you, they're putting restriction, they're putting restriction on transferring the money back to your parent company. There is restriction on capital repatriation. OK, so what do you have to do? So some countries, just let's make sure we are specific about this. So some countries restrict the amount of profit that can be paid as a dividend to a foreign subsidiary. So let's assume you are operating in France. You make a profit. The French government might say, guess what? You made a million dollars of profit. Our law says you can only send 30% of it back to the US and you have to keep 70%. So they restrict the capital transfer from your profit. So a company might be restricted to paying a dividend equal to or less than a certain percentage of the annual profit or a certain percentage of the capital contribution to the company by its parent. So simply put, you cannot transfer the money because the hosting government put a restriction on you. So what do you do now? Well, when such restriction exists, what do you think we should do? Well, the parent can get around the restriction and remove the profit indirectly by setting higher transfer prices. So what you do, just the same strategies that we saw earlier. When you transfer the goods and services, when you transfer goods and services, you transfer it at higher prices in this way. The profit in France, we thought we said we were operating in France. The profit in France is lower. The profit in France is lower. Therefore, what's going to happen is you transfer that money back indirectly. OK, this strategy is consistent with avoiding withholding taxes. Another way we have to deal with is protection of cash flow from currency devaluation. What is currency devaluation? Currency devaluation when you have the foreign currency, but that foreign currency is losing value quickly. So what you need to do, you need to transfer it back to the parent company and turn it back into, let's assume, again, we'll talk about the US, turn it back into US dollars. So in many cases, some amount of the net cash flow generated by a subsidiary will be moved out of that country as soon as possible. If not for other reason, then they distribute it to dividend to the stockholders of the parent company. So as the foreign currency devalued, the parent currency value of any foreign cash decrease. So if the value, I mean, I could have billions of dollars in the Turkish lira in Turkey, but if the value of that lira going down, I'm going to be losing value every day. So I'm better off transferring it as soon as possible and turn it into US dollar. So for operations located in country whose currency is prone to devaluation, the parent might want to accelerate the removal of the cash from that country before any more devaluation. So one method to do it is to set a high transfer prices for goods and services provided to the foreign operation by the parent and other related companies. So one way to do it is to charge high prices, send us the money and we can transfer it back. Another way for companies to use transfer prices is to gain a competitive advantage in a foreign country. So sometime to penetrate that new market, to penetrate that new market, you may start with establishing in sales subsidiary. You're going to sell your product, but you want to capture the market. So what can you do to capture the market? Well, you want to increase your sales. How can you increase your sales? You lower your price and let's see how that works. To capture market share, the foreign operation must compete aggressively on price providing its customers with significant discounts. What we do is we sell you the product, what we sell it to you at a discount. For one thing, that's going to also help if there is import in that country, you're going to pay less import, but also we're giving you the product at a discount so you can sell it and compete. To ensure that the new operation is profitable, while at the same time expecting it to compete on a price, the parent can sell the finished goods to the foreign subsidiaries at low prices. In fact, basically giving them the discount and the parent company will have to absorb that discount. So the parent company may want to improve the credit status of a foreign subsidiary so it can obtain local financing at lower interest rate. And once you are profitable in that country, you can go to the bank, tell them, look, I'm profitable, I need to borrow some money, maybe the cost of borrowing is lower. So it starts to generate some positive feedback. So this generally involve improving the balance sheet by increasing asset. Obviously you have more assets, more cash, more profit and by product, better retained earning. So this objective can be achieved by setting low transfer prices for inbound goods to the foreign operation and high transfer prices for outbound goods from the foreign operation thereby improving profit and cash flow. So those are the various techniques. So let's look at them in a summary. So when do company utilize high transfer prices? Well, when they want to minimize worldwide income taxes, you would transfer to a higher tax country. So if that's the case, that's what you do. You'll transfer it at a high prices. High prices means high cost, high cost means low profit, low profit means low taxes. Also, if you want to reduce your withholding, parent company selling to a subsidiary, you would give them high cost, high cost give them lower profit. When they make the profit, when they transfer it, it's lower because their cost is high. Also, if you want to get that money back from that country, you'll show lower profit. Lower profit by utilizing high transfer prices. Or you want to protect foreign currency cash from the valuation, get that money out as soon as possible, set high price. When do you utilize low transfer prices? Well, when you want to minimize your worldwide income tax by transferring it to a low tax country. So when you have a low tax country, what you do is you transfer at low price. Why? Because in that country, it's low tax, they have a high profit, not a big deal. We can take the, we can absorb the profit because the tax rate is lower. If we want to reduce our withholding tax sales, it's upstream sales going from a subsidiary to the parent company. When we want to minimize import duties, when we're importing product and we want to pay less taxes, we would use low prices. And if we want to improve obviously our competitive position as we talked about earlier, we want to give advantage to our no subsidiaries to gain more market share. And this is a summary of the objectives that we just talked about, summarizing it here, when do we use low prices, when do we use high prices? And we talked about this in detail. Now, there in mind, there is a conflict between those cost max minimization objective because think about it. For example, a higher transfer price to a foreign affiliate would reduce withholding taxes paid to the foreign government, but it may increase import duties. So sometime you have to kind of find out what is the best, what's the best price. So companies would employ linear programming techniques to determine the optimum transfer price when two or more cost minimization objectives exist. Also, you can use Excel, Excel spreadsheet and so I have an Excel spreadsheet here, just as a sample to let you know, they have many, many other, you can do some linear programming and Excel minor linear programming to determine the optimal transfer price. If you have any questions, any comments about this topic, please email me. In the next session, we would look at government reaction or reactions for that matter, not reaction because the government's not gonna sit around and let you play this game, but I just showed you the games that, not the games, the strategies and the techniques that companies can utilize. If you have any questions, please email me and I strongly encourage you to visit my website where I have additional lectures about more courses. Please subscribe, it's an investment in your career, study hard and good luck.