1. CASE STUDY:
TAX COMPLIANCE AND
RISK CONTROL – BEST
PRACTICES IN
ESTABLISHING A
TRANSFER PRICING
FUNCTION WITHIN A TAX
DEPARTMENT

2. Introduction
• Multinational enterprises (MNes) typically operate within a wide
range of markets, customer segments, business cultures,
specialisms and technologies. Managers at various levels of the
multinational enterprises are required to make decisions within
their area of responsibility, because there is no one individual or
group of people with the capability to manage the whole of a
complex cross-border organisation. With decision making often
dispersed throughout organisations, the role of performance
measurement and assessment within divisions and across legal
entities becomes vitally important. Transfer Pricing is one of the
means by which performance and tax compliance is managed,
measured, and risk controlled and it has the potential to be, and
often is, one of the most hotly contested aspects of management
control.

3. The Subject matter
• Transfer pricing is typically ‘owned’ by tax departments which are
mainly concerned with compliance aspects of Transfer Pricing
policies. Tax departments are well acquainted with the arm’s length
principle which requires organisations to treat different legal
entities as if they were independent profit-driven companies for tax
compliance purposes. However, transfer pricing design in
organisations goes beyond fiscal compliance and plays an important
role in ensuring that semi-autonomous business divisions / sub-units
behave in a way that contributes towards the achievement of
corporate and not merely divisional objectives, that is, overall
maximised profit for the group.
• An effective transfer pricing system should encourage divisional
managers to pursue the interest of the organisation automatically
whilst endeavouring to optimise the performance of their own
business unit.

4. THE TRANSFER PRICING CHALLENGE
• Determining an appropriate transfer pricing policy may not be as
straight forward as it initially appears. There are numerous
competing factors that come in to play when designing TP policies:
• •External influences: Challenges such as differential international
tax rates, foreign exchange rates, varying government regulations,
non-compliance penalty regimes, and the financial and reputational
risk of non-compliance all have a bearing on transfer pricing policy
and motivate MNEs to give high priority to transfer pricing tax
compliance. As TP regulations across the world have become more
detailed in recent years and tax authorities have put transfer pricing
at the forefront of audit strategy, transfer pricing compliance has
continued to move up the agenda for many MNEs.

5. Continuation…
• • Transfer pricing objectives: Transfer pricing systems are
designed to accomplish the following objectives:
• 1. Tax compliance and efficiency optimisation: TP policy can be
influenced by a range of considerations, including: avoidance of
double taxation, mitigation of duties and other tariffs on imports
and exports, reduction in Effective Tax Rate on profits, reduction in
foreign exchange risk, avoiding conflicts with host authorities,
managing cash flows and competing in global markets

6. • 2. Management control function: Facilitating performance
measurement of the business units involved is another reason for
implementing a transfer pricing policy within a tax department.
When designed correctly the policy should be consistent with
performance evaluation, motivate subsidiary / divisional managers
and achieve goal congruence.
• 3 Overall goal: Any MNE’s overall goal will be to maximise
profit. Transfer pricing may be used as a tool to induce goal-
congruent decisions within an organisation.

7. MANAGEMENT CONTROL VERSUS TAX
COMPLIANCE
More often than not MNEs opt for a single set of transfer prices for
both tax compliance and management control purposes. Generally, it
is considered by tax departments that a single comprehensive
transfer pricing policy not only guarantees tax compliance, but eases
the administrative burden on the company and avoids confusion at
divisional or country manager level.
Furthermore, MNEs frequently implement uniform profit margins
and mark-ups for all similar stages in the supply chain, irrespective of
jurisdiction and varying external economic factors.
It has been evidenced in academic studies that such approaches
adopted for tax compliance, administrative simplification and ease of
understanding have in many cases led to a reduction in the sense of
autonomy for sub-unit managers, and suboptimal decisions as a
result of the loss of negotiation power.

8. Continuation…
• For compliance purposes we typically consider transfer pricing policy as a
product of functional and economic analysis. However, behavioural
problems can arise when inappropriate prices are set that result in ‘wrong
signals’ being sent and non-optimal decisions being made.
• There is clearly a potential conflict between tax and behavioural aspects
of transfer pricing design. Intragroup products and services are
increasingly sold across international jurisdictions. As demonstrated by
the increasing number of MNEs undertaking supply chain reorganisations,
in such situations it is possible to reduce total group taxes by
accumulating risk and profit potential in legal entities that have lower tax
rates. In addition to operational savings this represents a real cash tax
opportunity and has proven to be attractive for many MNEs.
Consequently transfer prices are often set in order to manage compliance
requirements and fit enterprise-level operational strategy rather than to
motivate performance and improve decision-making at the entity level.

9. CASE STUDIES
• In the case studies below we examine some of the ways in which
Transfer Pricing models can have unintended consequences caused
by overly focusing on the tax compliance and administrative
aspects of transfer pricing. In addition, we consider ‘solutions’ that
could be used to align compliance and behavioural aspects of
transfer pricing.

10. A. Unintended consequences of an ‘arm’s length ‘agreement:
• A UK headquartered consumer goods group had factories in Ireland and
the UK. There was a bilateral contract manufacturing agreement whereby
the Irish factory charged the UK for production based on a margin over a
fully loaded cost base. As a result of the transfer pricing policy it was
actually cheaper for the UK factory to source from UK third parties. Whilst
the UK factory continued to run capacity shortages, the Irish factory
continued to have a chronic surplus capacity problem, and under-utilised
equipment and workforce.
• There is no single ideal solution to this problem. On the one hand the UK
factory could be incentivised to utilise Irish capacity if the Irish company
priced its goods such that it made marginal contribution but did not
recover overheads. This would reduce manufactured costs to both the UK
Company and the group as a whole, while reducing the loss incurred in
Ireland.
• Alternatively the competitive tension caused by the UK Company opting
to source externally could be seen as encouraging restructuring in the
Irish factory increasing the long term efficiency of group manufacturing.

11. • In another example, a Singapore wholesale trading hub purchased
from third party suppliers and provided certain guarantees to those
suppliers. The Singapore hub then sold to related parties with the
price determined on a profit split basis. As a result of the ‘arm’s
length’ profit split agreement, the Singapore hub was encouraged
to enter into more risky contracts with suppliers as it benefited
from the ‘portfolio effect’. This effect on behaviour is analogous in
some ways to the concept of ‘‘moral hazard’’ in markets where
there is no direct consequence of poor decision making, and it led in
this case to some very bad business decisions being made.
• Consequently, the group reconsidered its transfer pricing design
and adopted a more transactional based policy. Under the revised
transfer pricing policy the Singapore was discouraged from
entering some of the more risky contracts as it retained the loss
when entering into ‘bad transactions’.

12. B. Using transfer pricing to manage competing priorities:
• A chemicals manufacturer operates a classic limited risk distribution
model, with the distributors earning a fixed operating margin. The
principal company sells to US customers via a limited risk
distributor. The local US team is responsible for controlling US logis-
tics procurement. The pricing policy means that on the one hand it
is in the direct financial interests of the US entity to maximise sales
and customer satisfaction, regardless of cost; on the other hand it is
in the group’s interest to control logistics costs.
• In this type of situation, which is common in most limited risk
operating models, competing priorities can be managed in one of
two ways: through TP, by giving the distributor a target margin
before distribution costs, and leaving it at risk for over-spend on lo-
gistics, or through a governance framework that sets limits and
policies centrally and penalises noncompliance. Whether carrot or
stick is the appropriate policy varies from company to company.

13. C. Considering Key Performance Indices (KPIs) as evidence to
support transfer pricing
• :
• A large volume US distributor sold large volumes of product into
the US market from the UK via a US sales and marketing company.
The US Company had one very senior employee who was
responsible for the sales operation in the US. The cost base of this
activity was very small, however the volumes were large. Cost could
be supported for the US entity, or whether the remuneration policy
should default to a return on sales. Ultimately the company opted
for a pricing model based on a return on costs, with the decisive
factor being the remuneration of the US director. He earned fixed
remuneration with no bonus or commission based on sales or
profitability.

14. D. Using KPIs to undermine transfer pricing policy:
• A US headquartered food group had a manufacturing plant in
Europe which operated as a pure cost centre under a toll
manufacturing arrangement. The transfer pricing arrangement
came under review from the local European tax authorities when
they identified a job advertisement for the manufacturing plant
which sought to employ a ‘‘senior commercial manager’’. The
company sought a potential employee who would be a ‘‘self-
starter’’ who would benefit from ‘‘early responsibility’’ and should
have ‘‘real ability to make a difference’’. If nothing else, this episode
demonstrates the need for a two-way dialogue between those who
set Transfer Pricing in a business, and those who run it.

15. Conclusion
• Transfer pricing is a critical component of tax compliance and
managerial risk control, with two main objectives:
• 1. Promote goal congruence, i.e. optimum performance on a group
basis, and
• 2. Provide a suitable system of performance incentivisation,
measurement and evaluation.
• However, transfer pricing policy is often ‘owned’ by tax
departments and finance functions who are mainly concerned with
tax compliance and financial reporting. Consequently, transfer
pricing models can have unintended consequences such as
inefficient utilisation of capacity, unhealthy internal competition
and excessive risk taking behaviour. A well designed transfer
pricing policy, in addition to meeting fiscal requirements, will
encourage the right management behaviour, be consistent with
management KPIs, and can be a force for positive behavioural
change.