Special features of multinational corporations. Out the main objectives of a transfer pricing system. Modernisation of business processes of enterprise, use of innovative technologies. Preparing the profit and loss account of the company of Crystal ltd.
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1. Theoretical aspects
1.1 Special features of multinational corporations
1.2 Transfer pricing backgrounds
2. Transfer pricing principles of Crystal ltd. Company
2.1 Transfer pricing scenarios
2.2 Coverage of transfer pricing methods
transfer pricing modernisation
Transfer pricing is the set of mechanisms which is used to attach prices to goods or services which are traded between two divisions of the same company. The classic example involves one division (the “selling division”, or “SD”) which produces a component which is required by another division (the “buying division”, or “BD”). The component is used by the BD in the manufacture of a product which it sells on the open market.
In case all of this sounds a bit abstract, let's consider a simple example of a company in which the SD manufactures car engines and the BD manufactures cars. A couple of things are obvious:
1. The BD needs the output of the SD, because the BD needs car engines in order to make cars. Alternatively, the BD may be able to buy engines from an external supplier if, for example, the BD and SD cannot agree on a transfer price for the engines.
2. The SD can sell its output either to the BD or to external customers (in this case, these external customers would be other car manufacturers, many of which would be only too happy to buy in a ready-made engine).
The transfer price represents a source of revenue to the SD, and a cost to the BD. Therefore, there is potential for inter-divisional conflict (or at least a need for inter-divisional negotiations) since the SD will want to maximize the transfer price while the BD will want to minimize it.
When we are preparing the Profit and Loss Account of the company as a whole, the transfer price is neither a cost nor a revenue. The transfer price is not taken into account in the calculation of company profit, since it is simply the price attaching to an intra-company transaction.
It is therefore reasonable to ask whether, from the company's point of view, it really matters what level the transfer price is set at. The answer is that it matters a great deal. If the “wrong” transfer price is set, then this creates incentives for divisions to act in ways which are detrimental to the best interests of the company as a whole. In other words, suboptimal transfer pricing destroys goal congruence. This will be illustrated by means of a series of linked examples in the next section.
To conclude this introductory section, it is useful to set out the main objectives of a transfer pricing system:
1. To achieve goal congruence. The transfer prices should be such that actions which will have the effect of increasing a division's reported profit will also have the effect of increasing the company's reported profit. This maximises the likelihood that the division managers will act in the company's best interests.
2. To ensure that divisional autonomy is maintained. In principle the top management of a company could simply issue precise instructions to divisions as to what goods to transfer to each other, in what quantities, and at what prices. This would seem to solve the problem of transfer pricing at a stroke, and to achieve optimization (for the company as a whole) by diktat. However, most organizations are unwilling to go down this road, because of the enormous benefits of allowing divisional autonomy. It would be very difficult to make division managers accountable for their profits if they were not given a free hand in making important decisions.
3. To ensure that the information provided (e.g., division Profit & Loss Accounts) is useful for evaluating the economic performance of divisions and the managerial performance of division managers.
1. Theoretical aspects
1.1 Special features of multinational corporations
One of the economic hope and aspirations to get out poverty and under development which had plagued the developing world from the time immemorial is to attract foreign direct investments (FDI) into their various economies. It therefore becomes a dream come true when Multinational Corporations (MNCs) decide to invest in developing countries. Currently, there are over 35,000 multinational corporations globally, controlling more than 15,000 foreign subsidiaries and accounting for about one-third of the entire world production. The developing countries that received the most multinational investment are those perceived to have the highest growth potential. They are generally known as the newly industrialized countries and include Asian countries such as China, Singapore, Malaysia, Thailand and Latin American countries such as Mexico, Brazil and Argentina. The ten biggest recipient of foreign direct investment receive nearly 95% of the total, while all the African countries put together receive less than 4%. The poorest 50 countries of the world between them receive less than 2%.
Originally, most MNC investment in developing countries was in mines and plantations. Today mining accounts for only 6% with manufacturing and services accounting for over half and Oil & Gas for about one-third of the total. The value of the total MNC worldwide is estimated to be more than $1.5 trillion of which approximately one-third is in the developing countries .
Virtually many of the world largest companies such as Coca cola, Shell, IBM, Guinness Breweries, General motors to mention a few have managed to spread their tentacles in most parts of the world. In terms of turnover, some of them exceed the national incomes of many smaller countries like our country, but I must hasten to add that there are also thousands of very small specialists multinationals which are a mere fractions of the above mentioned ones, that are also operating significantly in the global system. MNCs cover the entire spectrum of business activity from manufacturing to extraction agricultural production, chemical processing, service provision and finance and therefore there is no peculiar line of activity of the multinationals.
Governments in the developing countries are always on the look-out to attract Foreign Direct Investment (FDI) and are prepared to put up considerable finance by making considerable concessions because of employment. MNCs investment constitutes a stimulus to economic activity and employment creation. The employment that MNCs create is both direct in the form of people employed in the new production facility and indirect through the impact that the MNC has on the local economy. The Ghanaian economy for example has benefited immensely with the influx of many mining, petroleum, banking and telecommunication companies like MTN, Vodafone, and Zain to mention but a few. This has accounted for an increase in the domestic incomes and expenditure and hence the stimulus in domestic business as lots of jobs had been created. The workers also gain from the technology imported by the MNCs (technology transfer).
Taxation is also a plus in the operations of the MNCs for the domestic economy. MNCs and domestic producers are required to pay taxes and therefore contribute to the public finances. Giving the highly profitable nature of many MNCs, the level of tax revenue raised from this source is mostly significant. The host country's balance of payment position is also likely to improve on a number of counts as a result of MNC investment. Firstly, the investment will represent a direct flow of capital into the country and secondly, in the long term, the MNC investment is likely to result in both import substitution and export promotion, for, goods previously purchased as imports could now be produced locally. Despite the gains, multinational investment may not always be beneficial either in the short or long term with particular reference to the developing world. It is possible that jobs created in one region of a host country by a new MNC with its superior technology and working practices may cause businesses to fold else where and thus increase in the level of unemployment in those region. Profits repatriation which constitutes capital flight might effectively undermine many or all of the potential gains from multinational investment. In addition to these concerns, there are also the following problems .
There is much uncertainties associated with the operations of MNC. They are highly dynamic and therefore can simply close down their businesses in the foreign countries and move. This is especially likely with older plants which would need upgrading if the MNC were to remain or with plants that can be easily sold without much loss. If a country has a large foreign multinational sector within the economy, it will become very vulnerable and face great uncertainty in the long term. It may thus be force to offer the multinational perks in the form of grants, special tax relief and other concessions in order to persuade them to remain all of which are costly to the tax payers in the developing countries.
The fact that MNC can shift production locations not only gives them production advantages or economic flexibility, but it enables them to exert control over their host nations. This is particularly the case in many of the developing nations where MNCs are not only major employers but in many cases the principal wealth creators. Thus attempts by the host state, for example to improve workers safety and welfare or impose pollution controls may go against the interest of the MNCs. MNC might thus oppose such measures or even threaten to withdraw from the country if such measures are not modified or dropped, rendering those developing economies vulnerable to serious economic fluctuations and shocks.
Like domestic producers, MNCs are always finding ways to reduce their tax liabilities. One unique way that an MNC can do this is through the process know as transfer pricing. This enables the MNC to reduce its profits in countries with high rate of profit tax, and increase them in countries with low rates of profit tax. This can be achieved by simply manipulating its internal pricing structure. For example, take a MNC where subsidiary A in one country supplies materials to subsidiary B in another country. The price at which the materials are transferred between the two subsidiaries will ultimately determine the costs and hence the level of profit made in each country. Assume that in the country where subsidiary A is located, the level of corporate tax is half of that of the country where subsidiary B is located. If materials are transferred from A to B at very high prices, the B's costs will rise and its profitability will fall. On the other hand, A's profitability will rise. The MNC clearly benefits as more profits is taxed at a lower rather than higher rate. Had it been the other way around, with subsidiary B facing the lower rate of tax, then the materials would be transferred at a low price. This would increase subsidiary B's profits and reduce A's.
Many MNCs are accused of simply investing in countries to gain access to natural resources, which are subsequently extracted in a way that is not sensitive to the environment. We often put premium on the short run gains from the MNCs presence than on the long run depletion of precious natural resources or damage to the environment. Perhaps, we are a victim of this circumstance as a nation as far as the mining sector of the country is concerned. Governments in the developing world often have a very short run focus. They are concerned more with their political survival through the ballot box rather than the long term interest of their people. Many of the benefits and costs of MNC investment that we have considered so far are most acutely felt in developing countries. The poorest countries in the world are most in need of investment and yet are most vulnerable to exploitation by multinationals and have the least power to resist it.
Although MNCs employ only a small proportion of the total labor force in the developing countries, they have a powerful effect on these countries' economies. They also often exert considerable power and influence over political leaders and their policies and are frequently accused of meddling in politics in certain developing countries. It is easy to see the harmful social, environmental and economic effects of multinationals on developing countries and yet governments in these countries are so eager to attract overseas investment and to turn a blind eye on many of their excesses [1, 2].
1.2 Transfer pricing backgrounds
Transfer pricing is the setting of prices among divisions within an enterprise. Transfer prices are charges for goods and services between controlled (or related) legal entities, i.e., within an enterprise. Legal entities considered under the control of a single corporation include branches and companies that are wholly or majority owned ultimately by the parent corporation. Certain jurisdictions consider entities to be under common control if they share family members on their boards of directors.
In principle a transfer price should match what the seller would charge an independent, arms-length customer. While unrealistic transfer prices do not affect the overall enterprise directly, they become a concern when they are misused to lower profits in a division of an enterprise that is located in a country that levies high taxes, and raise profits in a country that levies no or low taxes, as a tax haven.  Transfer pricing is the major tool for corporate tax avoidance. 
The term "transfer pricing" covers the setting, analysis, documentation, and adjustment of charges made between related parties for goods, services, or use of property (including intangible property). Transfer prices among divisions of an enterprise should to reflect allocation of resources among such components.
Setting Transfer Prices enables multinational corporation's to attribute net profit (or loss) before tax among the countries where it does business. An alternative approach is formulary apportionment, where corporate profits are allocated according the metrics of activity in the countries.
Because countries impose different corporation tax rates, a corporation that has a goal of minimizing the overall taxes to be paid will set transfer prices to allocate more of the worldwide profit to lower tax countries. Many countries attempt to impose penalties on corporations if the countries consider that they are being deprived of taxes on otherwise taxable profit. However, since the participating countries are sovereign entities, obtaining data and initiating meaningful actions to limit tax avoidance is hard. A publication of the Organisation for Economic Co-operation and Development (OECD) states, “Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.”
Over 60 governments have adopted transfer pricing rules. Transfer pricing rules in most countries are based on the “arm's length principle” - that is to establish transfer prices based on analysis of pricing in comparable transactions between two or more unrelated parties dealing at arm's length. The OECD has published guidelines based on the arm's length principle, which are followed, in whole or in part, by many of its member countries in adopting rules. The United States and Canadian rules are similar in many respects to the OECD guidelines, with certain points of material difference. A few countries, such as Brazil and Kazakhstan, follow rules that are materially different overall. Since Tax Havens do not attempt to collect taxes, they can ignore the issue.
The rules of nearly all countries permit related parties to set prices in any manner, but permit the tax authorities to adjust those prices (for purposes of computing tax liability) where the prices charged are outside an arm's length range. Rules are generally provided for determining what constitutes such arm's length prices, and how any analysis should proceed. Prices actually charged are compared to prices or measures of profitability for unrelated transactions and parties. The rules generally require that market level, functions, risks, and terms of sale of unrelated party transactions or activities be reasonably comparable to such items with respect to the related party transactions or profitability being tested.
Most systems allow use of multiple methods, where such methods are appropriate and are supported by reliable data, to test related party prices. Among the commonly used methods are comparable uncontrolled prices, cost-plus, resale price or markup, and profitability based methods. Many systems differentiate methods of testing goods from those for services or use of property due to inherent differences in business aspects of such broad types of transactions. Some systems provide mechanisms for sharing or allocation of costs of acquiring assets (including intangible assets) among related parties in a manner designed to reduce tax controversy.
Double taxation can occur if one country does not accept the taxation imposed by another country, perhaps because it considers the that country a Tax haven, where unrealistically low taxes are collected. Most tax treaties and many tax systems provide mechanisms for resolving disputes among taxpayers and governments to reduce the potential for double taxation. Many systems also permit advance agreement between taxpayers and one or more governments regarding mechanisms for setting related party prices.
Many systems impose penalties where the tax authority has adjusted related party prices. Some tax systems provide that taxpayers may avoid such penalties by preparing documentation in advance regarding prices charged between the taxpayer and related parties. Some systems require that such documentation be prepared in advance in all cases.
The discussion in this section explains an economic theory behind optimal transfer pricing with optimal defined as transfer pricing that maximizes overall firm profits in a non-realistic world with no taxes, nocapital risk, no development risk, no externalities or any other frictions which exist in the real world. In practice a great many factors influence the transfer prices that are used by multinational corporations, including performance measurement, capabilities of accounting systems, import quotas, customs duties, VAT, taxes on profits, and (in many cases) simple lack of attention to the pricing.
From marginal price determination theory, the optimum level of output is that where marginal cost equals marginal revenue. That is to say, a firm should expand its output as long as the marginal revenue from additional sales is greater than their marginal costs. In the diagram that follows, this intersection is represented by point A, which will yield a price of P, given the demand at point B.
When a firm is selling some of its product to itself, and only to itself (i.e. there is no external market for that particular transfer good), then the picture gets more complicated, but the outcome remains the same. The demand curve remains the same. The optimum price and quantity remain the same. But marginal cost of production can be separated from the firm's total marginal costs. Likewise, the marginal revenue associated with the production division can be separated from the marginal revenue for the total firm. This is referred to as the Net Marginal Revenue in production (NMR) and is calculated as the marginal revenue from the firm minus the marginal costs of distribution.
It can be shown algebraically that the intersection of the firm's marginal cost curve and marginal revenue curve (point A) must occur at the same quantity as the intersection of the production division's marginal cost curve with the net marginal revenue from production (point C).
If the production division is able to sell the transfer good in a competitive market (as well as internally), then again both must operate where their marginal costs equal their marginal revenue, for profit maximization. Because the external market is competitive, the firm is a price taker and must accept the transfer price determined by market forces (their marginal revenue from transfer and demand for transfer products becomes the transfer price). If the market price is relatively high (as in Ptr1 in the next diagram), then the firm will experience an internal surplus (excess internal supply) equal to the amount Qt1 minus Qt2. The actual marginal cost curve is defined by points A, C, D.
If the firm is able to sell its transfer goods in an imperfect market, then it need not be a price taker. There are two markets each with its own price (Pf and Pt in the next diagram). The aggregate market is constructed from the first two. That is, point C is a horizontal summation of points A and B (and likewise for all other points on the Net Marginal Revenue curve (NMRa)). The total optimum quantity (Q) is the sum of Qf plus Qt.
General tax principles
Commonly controlled taxpayers often determine prices charged between such taxpayers based in part on the tax effects, seeking to reduce overall taxation of the group. OECD Guidelines state, at 1.2, “When independent enterprises deal with each other, the conditions of their commercial and financial relations (e.g., the price of goods transferred or services provided and the conditions of the transfer or provision) ordinarily are determined by market forces. When associated enterprises deal with each other, their commercial and financial relations may not be directly affected by external market forces in the same way.” Recognizing this, most national and some sub-national income tax authorities have the legal authority to adjust prices charged between related parties. Tax rules generally permit related parties to set prices in any manner they choose, but permit adjustment where such prices or their effects are outside guidelines. 
Transfer pricing rules vary by country. Most countries have an appeals process whereby a taxpayer may contest such adjustments. Some jurisdictions, including Canada and the United States, require extensive reporting of transactions and prices, and India requires third party certification of compliance with transfer pricing rules.
Transfer pricing adjustments have been a feature of many tax systems since the 1930s. Both the U.S. and the Organization for Economic Cooperation and Development (OECD, of which the U.S. and most major industrial countries are members) had some guidelines by 1979. The United States led the development of detailed, comprehensive transfer pricing guidelines with a White Paper in 1988 and proposals in 1990-1992, which ultimately became regulations in 1994.  In 1995, the OECD issued the first draft of current guidelines, which it expanded in 1996.  The two sets of guidelines are broadly similar and contain certain principles followed by many countries. The OECD guidelines have been formally adopted by many European Union countries with little or no modification.
The OECD  and U.S.  systems provide that prices may be set by the component members of an enterprise in any manner, but may be adjusted to conform to an arm's length standard. Each system provides for several approved methods of testing prices, and allows the government to adjust prices to the midpoint of an arm's length range. Both systems provide for standards for comparing third party transactions or other measures to tested prices, based on comparability and reliability criteria. Significant exceptions are noted below..
Government authority to adjust prices
Most governments have granted authorization to their tax authorities to adjust prices charged between related parties. Many such authorizations, including those of the United States, United Kingdom, Canada, and Germany, allow domestic as well as international adjustments. Some authorizations apply only internationally.  Most, if not all, governments permit adjustments by the tax authority even where there is no intent to avoid or evade tax. 
Adjustment of prices is generally made by adjusting taxable income of all involved related parties within the jurisdiction, as well as adjusting any withholding or other taxes imposed on parties outside the jurisdiction. Such adjustments generally are made after filing of tax returns. For example, if Bigco US charges Bigco Germany for a machine, either the U.S. or German tax authorities may adjust the price upon examination of the respective tax return. Following an adjustment, the taxpayer generally is allowed (at least by the adjusting government) to make payments to reflect the adjusted prices.
Most rules require that the tax authorities consider actual transactions between parties, and permit adjustment only to actual transactions.  Multiple transactions may be aggregated or tested separately, and testing may use multiple year data. In addition, transactions whose economic substance differs materially from their form may be recharacterized under the laws of many systems to follow the economic substance.
Arm's length standard
Nearly all systems require that prices be tested using an "arm's length" standard.  Under this approach, a price is considered appropriate if it is within a range of prices that would be charged by independent parties dealing at arm's length. This is generally defined as a price that an independent buyer would pay an independent seller for an identical item under identical terms and conditions, where neither is under any compulsion to act.
There are clear practical difficulties in implementing the arm's length standard. For items other than goods, there are rarely identical items. Terms of sale may vary from transaction to transaction. Market and other conditions vary geographically or over time. Some systems give a preference to certain transactional methods over other methods for testing prices.
In addition, most systems recognize that an arm's length price may not be a particular price point but rather a range of prices. Some systems provide measures for evaluating whether a price within such range is considered arm's length, such as theinterquartile range used in U.S. regulations. Significant deviation among points in the range may indicate lack of reliability of data.  Reliability is generally considered to be improved by use of multiple year data.
Most rules provide standards for when unrelated party prices, transactions, profitability or other items are considered sufficiently comparable in testing related party items. Such standards typically require that data used in comparisons be reliable and that the means used to compare produce a reliable result. The U.S. and OECD rules require that reliable adjustments must be made for all differences (if any) between related party items and purported comparables that could materially affect the condition being examined. Where such reliable adjustments cannot be made, the reliability of the comparison is in doubt. Comparability of tested prices with uncontrolled prices is generally considered enhanced by use of multiple data. Transactions not undertaken in the ordinary course of business generally are not considered to be comparable to those taken in the ordinary course of business. Among the factors that must be considered in determining comparability are:
- the nature of the property or services provided between the parties,
- unctional analysis of the transactions and parties,
- comparison of contractual terms (whether written, verbal, or implied from conduct of the parties),and
- comparison of significant economic conditions that could affect prices, including the effects of different market levels and geographic markets.
Nature of property or services
Comparability is best achieved where identical items are compared. However, in some cases it is possible to make reliable adjustments for differences in the particular items, such as differences in features or quality. For example, gold prices might be adjusted based on the weight of the actual gold (one ounce of 10 carat gold would be half the price of one ounce of 20 carat gold).
Functions and risks
Buyers and sellers may perform different functions related to the exchange and undertake different risks. For example, a seller of a machine may or may not provide a warranty. The price a buyer would pay will be affected by this difference. Among the functions and risks that may impact prices are: 
1. Product development
2. Manufacturing and assembly
3. Marketing and advertising
4. Transportation and warehousing
5. Credit risk
6. Product obsolescence risk
7. Market and entrepreneurial risks
8. Collection risk
9. Financial and currency risks
10. Company- or industry-specific items
Terms of sale
Manner and terms of sale may have a material impact on price. For example, buyers will pay more if they can defer payment and buy in smaller quantities. Terms that may impact price include payment timing, warranty, volume discounts, duration of rights to use of the product, form of consideration, etc. 
Market level, economic conditions and geography
Goods, services, or property may be provided to different levels of buyers or users: producer to wholesaler, wholesaler to wholesaler, wholesaler to retailer, or for ultimate consumption. Market conditions, and thus prices, vary greatly at these levels. In addition, prices may vary greatly between different economies or geographies. For example, a head of cauliflower at a retail market will command a vastly different price in unelectrified rural India than in Tokyo. Buyers or sellers may have different market shares that allow them to achieve volume discounts or exert sufficient pressure on the other party to lower prices. Where prices are to be compared, the putative comparables must be at the same market level, within the same or similar economic and geographic environments, and under the same or similar conditions. 
Types of transactions
1. Most systems provide variations of the basic rules for characteristics unique to particular types of transactions. The potentially tested transactions include:
2. Sale of goods. Identical or nearly identical goods may be available. Product-related differences are often covered by patents.
3. Provision of services. Identical services, other than routine services, often do not exist.
4. License of intangibles. The basic nature precludes a claim that another product is identical. However, licenses may be granted to independent licensees for the same product in different markets.
5. Use of money. Comparable interest rates may be readily available. Some systems provide safe haven rates based on published indices.
6. Use of tangible property. Independent comparables may or may not exist, but reliable data may not be available.
Testing of prices
Tax authorities generally examine prices actually charged between related parties to determine whether adjustments are appropriate. Such examination is by comparison (testing) of such prices to comparable prices charged among unrelated parties. Such testing may occur only on examination of tax returns by the tax authority, or taxpayers may be required to conduct such testing themselves in advance or filing tax returns. Such testing requires a determination of how the testing must be conducted, referred to as a transfer pricing method.
Best method rule
Some systems give preference to a specific method of testing prices. OECD and U.S. systems, however, provide that the method used to test the appropriateness of related party prices should be that method that produces the most reliable measure of arm's length results. This is often known as a "best method" rule. Under this approach, the system may require that more than one testing method be considered. Factors to be considered include comparability of tested and independent items, reliability of available data and assumptions under the method, and validation of the results of the method by other methods.
Comparable uncontrolled price (CUP)
Most systems consider a third party price for identical goods, services, or property under identical conditions, called a comparable uncontrolled price (CUP), to be the most reliable indicator of an arm's length price. All systems permit testing using this method, but it is not always applicable. Further, it may be possible to reliably adjust CUPs where the goods, services, or property are identical but the sales terms or other limited items are different. As an example, an interest adjustment could be applied where the only difference in sales transactions is time for payment (e.g., 30 days vs. 60 days). CUPs are based on actual transactions. For commodities, actual transactions of other parties may be reported in a reliable manner. For other items, "in-house" comparables, i.e., transactions of one of the controlled parties with third parties, may be the only available reliable data.
Other transactional methods
Among other methods relying on actual transactions (generally between one tested party and third parties) and not indices, aggregates, or market surveys are:
1. Cost-plus (C+) method: goods or services provided to unrelated parties are consistently priced at actual cost plus a fixed markup. Testing is by comparison of the markup percentages.
2. Resale price method (RPM): goods are regularly offered by a seller or purchased by a retailer to/from unrelated parties at a standard "list" price less a fixed discount. Testing is by comparison of the discount percentages. 
3. Gross margin method: similar to resale price method, recognised in a few systems.
Some methods of testing prices do not rely on actual transactions. Use of these methods may be necessary due to the lack of reliable data for transactional methods. In some cases, non-transactional methods may be more reliable than transactional methods because market and economic adjustments to transactions may not be reliable. These methods may include:
1. Comparable profits method (CPM): profit levels of similarly situated companies in similar industries may be compared to an appropriate tested party. See U.S. rules below.
2. Transactional net margin method (TNMM): while called a transactional method, the testing is based on profitability of similar businesses. See OECD guidelines below.
3. Profit split method: total enterprise profits are split in a formulary manner based on econometric analyses.
CPM and TNMM have a practical advantage in ease of implementation. Both methods rely on microeconomic analysis of data rather than specific transactions. These methods are discussed further with respect to the U.S. and OECD systems.
Two methods are often provided for splitting profits: comparable profit split and residual profit split. The former requires that profit split be derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are comparable to the transactions and activities being tested. The residual profit split method requires a two step process: first profits are allocated to routine operations, then the residual profit is allocated based on nonroutine contributions of the parties. The residual allocation may be based on external market benchmarks or estimation based on capitalised costs.
Tested party and profit level indicator
Where testing of prices occurs on other than a purely transactional basis, such as CPM or TNMM, it may be necessary to determine which of the two related parties should be tested. Testing is to be done of that party testing of which will produce the most reliable results. Generally, this means that the tested party is that party with the most easily compared functions and risks. Comparing the tested party's results to those of comparable parties may require adjustments to results of the tested party or the comparables for such items as levels of inventory or receivables.
Testing requires determination of what indication of profitability should be used. This may be net profit on the transaction, return on assets employed, or some other measure. Reliability is generally improved for TNMM and CPM by using a range of results and multiple year data. [13, 14]
Intangible property issues
Valuable intangible property tends to be unique. Often there are no comparable items. The value added by use of intangibles may be represented in prices of goods or services, or by payment of fees (royalties) for use of the intangible property. Licensing of intangibles thus presents difficulties in identifying comparable items for testing. However, where the same property is licensed to independent parties, such license may provide comparable transactional prices. The profit split method specifically attempts to take value of intangibles into account.
Enterprises may engage related or unrelated parties to provide services they need. Where the required services are available within a multinational group, there may be significant advantages to the enterprise as a whole for components of the group to perform those services. Two issues exist with respect to charges between related parties for services: whether services were actually performed which warrant payment, and the price charged for such services. Tax authorities in most major countries have, either formally or in practice, incorporated these queries into their examination of related party services transactions.
There may be tax advantages obtained for the group if one member charges another member for services, even where the member bearing the charge derives no benefit. To combat this, the rules of most systems allow the tax authorities to challenge whether the services allegedly performed actually benefit the member charged. The inquiry may focus on whether services were indeed performed as well as who benefited from the services. For this purpose, some rules differentiate stewardship services from other services. Stewardship services are generally those that an investor would incur for its own benefit in managing its investments. Charges to the investee for such services are generally inappropriate. Where services were not performed or where the related party bearing the charge derived no direct benefit, tax authorities may disallow the charge altogether.
Where the services were performed and provided benefit for the related party bearing a charge for such services, tax rules also permit adjustment to the price charged. Rules for testing prices of services may differ somewhat from rules for testing prices charged for goods due to the inherent differences between provision of services and sale of goods. The OECD Guidelines provide that the provisions relating to goods should be applied with minor modifications and additional considerations. In the U.S., a different set of price testing methods is provided for services. In both cases, standards of comparability and other matters apply to both goods and services.
It is common for enterprises to perform services for themselves (or for their components) that support their primary business. Examples include accounting, legal, and computer services for those enterprises not engaged in the business of providing such services. Transfer pricing rules recognize that it may be inappropriate for a component of an enterprise performing such services for another component to earn a profit on such services. Testing of prices charged in such case may be referred to a cost of services or services cost method. Application of this method may be limited under the rules of certain countries, and is required in some countries e.g. Canada.
Where services performed are of a nature performed by the enterprise (or the performing or receiving component) as a key aspect of its business, OECD and U.S. rules provide that some level of profit is appropriate to the service performing component. Canada's rules do not permit such profit. Testing of prices in such cases generally follows one of the methods described above for goods. The cost-plus method, in particular, may be favored by tax authorities and taxpayers due to ease of administration.
Multi-component enterprises may find significant business advantage to sharing the costs of developing or acquiring certain assets, particularly intangible assets. Detailed U.S. rules provide that members of a group may enter into a cost sharing agreement (CSA) with respect to costs and benefits from the development of intangible assets. OECD Guidelines provide more generalized suggestions to tax authorities for enforcement related to cost contribution agreements (CCAs) with respect to acquisition of various types of assets. Both sets of rules generally provide that costs should be allocated among members based on respective anticipated benefits. Inter-member charges should then be made so that each member bears only its share of such allocated costs. Since the allocations must inherently be made based on expectations of future events, the mechanism for allocation must provide for prospective adjustments where prior projections of events have proved incorrect. However, both sets of rules generally prohibit applying hindsight in making allocations. 
A key requirement to limit adjustments related to costs of developing intangible assets is that there must be a written agreement in place among the members. Tax rules may impose additional contractual, documentation, accounting, and reporting requirements on participants of a CSA or CCA, which vary by country.
Generally, under a CSA or CCA, each participating member must be entitled to use of some portion rights developed pursuant to the agreement without further payments. Thus, a CCA participant should be entitled to use a process developed under the CCA without payment of royalties. Ownership of the rights need not be transferred to the participants. The division of rights is generally to be based on some observable measure, such as by geography.
Participants in CSAs and CCAs may contribute pre-existing assets or rights for use in the development of assets. Such contribution may be referred to as a platform contribution. Such contribution is generally considered a deemed payment by the contributing member, and is itself subject to transfer pricing rules or special CSA rules.
A key consideration in a CSA or CCA is what costs development or acquisition costs should be subject to the agreement. This may be specified under the agreement, but is also subject to adjustment by tax authorities.
In determining reasonably anticipated benefits, participants are forced to make projections of future events. Such projections are inherently uncertain. Further, there may exist uncertainty as to how such benefits should be measured. One manner of determining such anticipated benefits is to project respective sales or gross margins of participants, measured in a common currency, or sales in units.
Both sets of rules recognize that participants may enter or leave a CSA or CCA. Upon such events, the rules require that members make buy-in or buy-out payments. Such payments may be required to represent the market value of the existing state of development, or may be computed under cost recovery or market capitalization models.
Penalties and documentation
Some jurisdictions impose significant penalties relating to transfer pricing adjustments by tax authorities. These penalties may have thresholds for the basic imposition of penalty, and the penalty may be increased at other thresholds. For example, U.S. rules impose a 20% penalty where the adjustment exceeds USD 5 million, increased to 40% of the additional tax where the adjustment exceeds USD 20 million. 
The rules of many countries require taxpayers to document that prices charged are within the prices permitted under the transfer pricing rules. Where such documentation is not timely prepared, penalties may be imposed, as above. Documentation may be required to be in place prior to filing a tax return in order to avoid these penalties. Documentation by a taxpayer need not be relied upon by the tax authority in any jurisdiction permitting adjustment of prices. Some systems allow the tax authority to disregard information not timely provided by taxpayers.
2. Transfer pricing principles of crystal LTD. Company
2.1 Transfer pricing scenarios
Drury (2004, p. 885) states that `no single transfer price is likely to perfectly serve all of the [objectives of transfer pricing]'. This is true, but there is one fairly straightforward principle which can be used to identify optimal transfer prices in many cases.  This principle is as follows:
The transfer price should be equal to the marginal cost of producing the transferred product or service, plus the opportunity cost of making the transfer. (The opportunity cost arises because of the fact that if a product is transferred from the SD to the BD, then the SD loses the opportunity to earn some profit margin by selling the product to an external customer).
The reasons for this principle, and its practical implications, will become clear as we review a series of four transfer pricing scenarios in this section. These examples are all based on a hypothetical company called Cristal Ltd.
Crystal Ltd. is a thermoelectric company with many years experience in research and development of thermoelectric products including thermoelectric materials and modules. Crystal Ltd. is a leading company in Crystal group of companies. Our company generally recognized as an expert in manufacturing of Bi2Te3 thermoelectric elements and high quality thermoelectric modules.
It has a complete production cycle: from scientific and engineering development of perspective products to their mass production. It supplies various types of thermoelectric modules and elements for many special, industrial, automotive and consumer applications. 
This company has a Molten Glass Division, and the following is a summary of that division's activities last year:
The company also has a Glass Bottles Division, which needs 10,000 tons of molten glass per annum in order to manufacture its bottles. At present, however, the Glass Bottles Division buys all of its molten glass from an external supplier at a price of €105 per ton.
Obviously, since the Molten Glass Division produces something which the Glass Bottles Division needs, the possibility of these two divisions doing some business with each other should at least be considered. Let's look at a number of possible scenarios.
Scenario 1: No spare capacity in the Molten Glass Division
This means that the Molten Glass Division cannot increase its output above the level of 40,000 tons per annum which it is already producing (and selling to external customers).
Therefore, if any tons of molten glass are sold to the Glass Bottles Division, then there will have to be a corresponding reduction in the quantity sold to external customers. Applying the principle set out earlier, the Molten Glass Division will want to set the transfer price as follows:
- Marginal cost of producing molten glass = €65 per ton.
- Opportunity cost of making the transfer = lost contribution from foregoing the sale to the external customer = [€120 selling price - €65 marginal cost] = €55 per ton.
- Hence: Transfer price = [Marginal cost incurred up to the point of transfer] + [Opportunity cost of making the transfer] = €65 + €55 = €120 per ton.
The Molten Glass Division will not want to transfer their product for less than €120, since to do so would reduce the division's profits.
However, the Glass Bottles Division will not be willing to pay this price, or indeed any price higher than the €105 which they are currently paying to the external division. Therefore the two divisions will not be able to agree on a transfer price, and will not want to trade with each other.
We can show that this outcome is goal congruent (i.e., it is in the best interests of Cristal Ltd. as a whole) and that any other transfer price would be potentially detrimental to the company's best interests. Suppose, for example, that the Molten Glass Division were to match the price (€105) being offered by the Glass Bottles Division's external supplier. How would the divisions, and Cristal Ltd. as a whole, be affected?
- Glass Bottles Division: No change in profit (because it would still be paying the same price as before for molten glass, albeit to the Molten Glass Division rather than to the external supplier).
- Molten Glass Division: Reduction in sales revenue, and therefore reduction in profit, of [(€120 - €105) * 10,000 tons] = €150,000.
- Cristal Ltd.: Loss of revenue = (€120 * 10,000 tons = €1,200,000); Reduction in payments to external suppliers = (€105 * 10,000 tons = €1,050,000); Hence reduction in profit = (€1,200,000 - €1,050,000 = €150,000).
Scenario 2: Spare capacity in the Molten Glass Division
Assume now that the Molten Glass Division has the capacity to increase its output above the current level of 40,000 tons per annum, but that there is no demand from external customers for these potential additional tons. This means that it is now possible to produce some extra molten glass for sale to the Glass Bottles Division without any reduction in the quantity sold to external customers. In other words, where spare capacity exists, there is no opportunity cost associated with making the transfer. The minimum transfer price acceptable to the Molten Glass Division for units produced using spare capacity can be calculated as follows:
- Marginal cost of producing molten glass = €65 per ton.
- Opportunity cost of making the transfer = Nil.
- Hence: Transfer price = [Marginal cost incurred up to the point of transfer] + [Opportunity cost of making the transfer] = €65 + Nil = €65 per ton.
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