 Hello and welcome to this session. This is Professor Farhad and this session would look at introduction to transfer pricing. This topic is covered in an international accounting course or an international taxation. The topic is also covered on the CPA as well as the ACCA exam. As always, I would like to remind you to connect with me on LinkedIn, YouTube is what you would need to subscribe. I have 1500 plus accounting, auditing, tax and finance lectures and I covered lectures in all courses, financial accounting, managerial accounting, income tax, advanced accounting, governmental, so please check out my YouTube. On my website, you have access to additional information such as notes, PowerPoint slides, multiple choice through faults and if you're studying for your CPA exam, 2000 plus CPA questions. Transfer pricing refers to the determination of the price at which transaction between related parties will be carried out. Now who are the related parties? Well the transfer could be from a subsidiary to a parent, so we're going to assume this is the parent. So the subsidiary could sell something to the parent which is called an upstream sale, a sale from the parent to another subsidiary. This is a downstream sale or it could be a sale between the subsidiaries themselves. So all of these transactions are known as related party or intercompany transactions because they are within the same parent company. Now intercompany transaction represent a significant portion, billions of dollars in international trade and that's why tax plays a big role in this topic because when transfer pricing occur between those units, there are serious tax consequences when these units are located in different countries. And to illustrate the point, let's work a simple example just to lay the ground. We have a manufacturing company that sells product to its subsidiary and the subsidiary sells the product to a retailer. So we're going to call this company A and this is company B. And they are located in two different countries. Company A manufactured the product at a cost of 500,000, sells it to company B for 700,000. They make a taxable income of 200,000. They pay taxes in that country at 30% rate and they pay taxes of $60,000. When company B gets the product, your sale becomes my cost, sells it for 900,000, maybe repackage it a little, then sells it for the final consumer. Taxable income is 200,000. The tax rate is 10%, therefore they pay taxes in that country for 20,000. Now notice this company A, B, they're the same unit, but they are located in two different countries. Therefore all the main corporation, the parent company paid in taxes $80,000. Now can anything, can we change anything to make a difference to the total tax? Well let's see what we can do. Let's go back to the same example and let's assume company A sells the product to company B rather than 700, sells it for 600,000 rather than 700. Company A profit is 100,000. Company A profit will pay taxes of 30,000 which is 30%. Now company B's cost 600,000, they would sell the product for 900,000, they have a taxable income of 300,000, they have to pay 10% tax, they pay 30,000 in taxes. Now the total tax for the whole corporation A and B now is 60,000. What does that mean? It means they save $20,000 in taxes. Now in the real world you can take this 20,000 and add zeros to it to see the savings when that happens. So by just changing the transfer price, so this is the transfer price, it was 700,000, they change it to 600,000. So you change the transfer price, it changed your tax bill and why can you do so because these companies A and B, the subsidiaries are located in different countries. So each country will pay taxes based on their jurisdiction. Now in the real world two factor will influence the manner in which international transfer prices are determined. The first one is how would the company like to control management, control and performance evaluation? How would the parent company like to manage the subsidiaries? That's one factor, for example, based on profit, based on what are you looking for? So how are you evaluating the performance? Usually it's profit and other objectives relate to the minimization of one or more type of cost. Usually what we're talking about here is various types of tax cost. So those are the two main factors. And these two factors kind of in a sense they conflict why? Because sometime if a division wants to make a profit, if they're going to make a profit they're going to have a higher tax bill. Maybe sometime we want that division not to make a lot of profit, to make less profit then we pay less taxes. But guess what? If you're going to evaluate it maybe it's on profit and you're telling me don't make a profit then I'm not going to look good. So the point is those two conflict and we're going to talk a little bit more about one and two, much, much more in detail in future lectures. But the point is those are the two factors and we need to explain this. So the second factor, a factor in international transfer pricing is the law governing the manner in which intercompany transaction that cross border may be priced. So how do we price those? How do we price those transactions? So this is number two, how can we minimize our cost by pricing those transactions? Now you want to make sure countries that are already aware of this. So countries around the world they know that companies do this. So they have laws exist to make sure that those multinational are not able to avoid paying taxes or paying their fair share of taxes or import duties by just operating in multiple jurisdiction. So there are specific rules and regulation and specifically we're going to go over the US rules on what you can and what you cannot do and what are your options as a company. So companies are walking a fine line here because you have to be careful of how you price your product internally between different between intercompany divisions. And believe it or not 30% of respondents by a recent survey identified this issue transfer pricing is the most is the most pressing or important issue facing their tax division. So determining the appropriate appropriate tax appropriate transfer price is important in determining your tax bill and it's very important to get that number right. Otherwise you're going to be audited subject to fines. We're going to see later what are the consequences. Another related topic to this is the concept of decentralization and goal congruence. What is decentralization? Decentralization when you give your various companies the ability to negotiate the price among themselves versus centralization. Centralization we have one center. This is the center like the parent company and they tell everyone what to do. You tell everyone what to do. So business enterprise often organized by division. Most mostly a division could be a profit center or profit center is something that's responsible for revenues and expenses or could be just an investment center that's only responsible for asset. So in a company that's organized by division top managers delegate or decentralize. This is the important concept. We need to understand authority and responsibility to the division. So basically you say you would say you make your own decision. You delegate or you decentralize authority. So what are the advantages of decentralization? Well, you allow now local managers, people that working on the frontline to respond quickly to changing environment and motivating local managers who otherwise would be frustrated if asked only to implement a decision made by other. So you give them more authority. The assumption is they're going to be more motivated. That's what research shows anyway. Pitfalls of decentralization mean disadvantages. Sometimes the managers might make decisions that are in their self-interest, but they're not in the self-interest of the company as a whole. So the corporate accounting system and control system should be designed in a way. It provides incentive for those managers to make a decision that are consistent with the overall company. So you have to create a system that's congruent. And that's what we invite system congruence because here's what happened. When you sell me something, it's revenue to you, it's cost to me. So when they negotiate, well, I'm selling you something and we're both within the same company. What I sell you is my revenue. What you get is your cost. So appropriate transfer pricing can ensure that each division or subsidiary profit accurately reflect its contribution to the overall company profit. Okay. And here what we do is when we do so, we provide a basis for efficiency allocation of resources. So that's what we want. We want to have appropriate pricing between divisions. This way, I will get, I contribute my fair share. You contribute your fair share. So everyone feel they are contributing equally and they are being evaluated equally because your performance might be based on the profit of that division. Okay. So to achieve this transfer prices should motivate local managers to make decision that enhance corporate performance. Well, at the same time provide basis for measuring evaluating and recording local rewarding local managers performance in a way that managers perceive as fair. So if you're going to give them the right to make their own decision, decentralization, well, they might have to negotiate the price. And as long as they think it's fair and it's in the best interest of the company, everyone is good. Otherwise, if that does not happen, okay, then the potential benefit of decentralization may be lost because you're telling them, okay, you're decentralized, make your own decision, then you don't let them make their own decision because you tell them that's not in the best interest of the company, you have to change your prices. Then it's the benefit of decentralization is basically gone. Okay. So in the next session, what we're going to be doing, we're going to be looking at different transfer pricing method. We're going to be looking at three different transfer pricing methods, such as the cost-based transfer transfer price, market-based transfer price, and negotiated transfer price. Anyhow, if you need more lectures about these topics, please visit my website where I have many, many more courses covered 1,500 lectures. This is the website. I strongly encourage you to contribute to subscribe. It's an investment in your career. Good luck and study hard.