The Capitool Company, with headquarters and main manufacturing plant in Racine, Wisconsin, in the United States, produces a line of capital equipment for use in a variety of industries, especially for automobiles, trucks, farm equipment, and construction equipment. The company was founded over 70 years ago, with sales (turnover) growing slowly to about US$60 million by the end of World War II, and since then more rapidly to more than US$3.5 billion at present. After-tax profits have grown correspondingly, usually amounting to about 3–4% of turnover.

Capitool has been a leader in offering an advanced line of products. Heavy research and product development expenditures coupled with customer orientation have enabled the company to achieve a dominant position in the US market.

In order to continue to grow rapidly and profitably Capitool decided in the mid-1950s to move into foreign markets. The company had exported a number of products for many years, but increasing foreign demand made it not only feasible, but desirable, to establish manufacturing facilities abroad. Within a 10-year period Capitool had wholly owned manufacturing plants in New Zealand, England, and Germany; joint ventures in Germany and Italy; and licensees in England, Argentina, and Turkey.

In addition to manufacturing facilities, Capitool has sales branches in England, Argentina, and Turkey to handle the marketing of the products of licensees in those countries. Since the licensees take only a part of their output of the licensed products for use in their own end products, the remainder is marketed to third parties by the Capitool sales branches.

In areas of the world not served by Capitool manufacturing or licensing affiliates, Capitool Exports Ltd, a wholly owned subsidiary incorporated in Bermuda, functions as an ‘offshore’ trading company. Capitool Exports Ltd has 20 regional offices located strategically to serve about 100 independent distributors who act as sales and service outlets in more than 100 countries.

The German subsidiary company The Capitool Company GmbH, a wholly owned manufacturing subsidiary in Germany, is responsible for the operation of two factories, one in Duisburg and one in Düsseldorf.

The Düsseldorf plant manufactures components for various items of capital equipment, and has customers throughout Europe. Sales are concentrated in Germany, with a large proportion going to a joint venture with a large US automobile manufacturer; the joint venture is incorporated under the name Genforsler-Capitool GmbH.

The Duisburg plant manufactures a piece of equipment that is a mainstay in the Capitool line in the United States and worldwide. The prices of this piece of equipment range from US$90 to US$700, depending on the size and performance characteristics of the item. The Duisburg plant and three major German competitors account for over 95% of sales of the piece of equipment in Germany.

The fact that the Duisburg and Düsseldorf plants are part of the same company permits a ‘tax loss carry forward’ from the Duisburg plant to be used to minimize the total German tax obligation. By itself, the Düsseldorf plant is quite profitable. Recently the Duisburg plant has also become profitable. The ‘tax loss carry forward’ is expected to be depleted within the next three or four years.
The total Capitool investment in the Duisburg plant since the mid-1950s has been US$10,500,000. The plant has an area exceeding 221,000 square feet and employs over 1100 people currently. Capacity to produce exceeds demand by about 20%. Within three years demand is expected to exceed capacity, and expansion will be required.
The output of the Duisburg plant is sold throughout the European continent, England, Canada, and Mexico. Annual sales of the Duisburg plant exceed US$10 million.

Although the Duisburg plant is a manufacturing operation, only 35% of the contents of the product are actually manufactured at the Duisburg plant or in Düsseldorf. Local German suppliers furnish about 30% of the finished components, and the remaining 35% are imported from one of Capitool’s divisions in the United States. Components are purchased from the United States when one or more of the following conditions apply to a specific component:
● technically adequate manufactured components are not available in Germany;
● the total of the US transfer price (as defined below)
plus freight, insurance, and duty is less than the purchase price in Germany;

● delivery from the United States is faster than from the German supplier, and the need warrants use of the fastest source.
Transfer pricing policies Corporate policy on transfer pricing is as follows:

● If there is a market price for the item, the basis for establishing the transfer price will be the market price.
● If the product is available elsewhere but there is no market price, the basis is negotiation between the selling and buying division. Negotiation is guided by

(a) costs,

(b) outside competitive bids, if realistic bids are available. If not available, an estimate of a realistic outside quote is made.

● If the product is not available elsewhere, that is, if it is a unique part which is made only by Capitool, the basis for establishing the transfer price is negotiation based on:

(a) costs,

(b) anticipated volume, and

(c) an ‘equitable’ markup.

The policy with regard to ‘international’ transfer pricing is basically the same, but with some additional complications.

A major additional consideration is to minimize unnecessary Customs duties and taxes. In addition, the policy depends in part on the types of overseas operations, for example:

1. If the transfer price is to a subsidiary that is 100% owned, the policy would be to price as near to cost as possible. The policy is designed to accomplish two objectives:

(a) to minimize Customs duties, and

(b) to let the maximum amount of profit be taken by the subsidiary so as to minimize taxes, while at the same time satisfying the US Internal Revenue Service authorities that there is no intent to avoid legitimate taxes by shifting profits abroad.

2. In the case where products are sold to a 50–50 joint venture, the policy is to set the price as high as possible, but to keep it competitive (since the joint venture could buy outside). This policy permits the profits to be earned by the Capitool Company rather than shifting it to the joint venture so that the foreign partner shares it. The joint venture is in this way limited to the profits that are properly earned as a result of its operations and efficiency.

A limiting factor is the trade-off in taxes or in duties. For example, if the duty is exceedingly high, the Capitool Company share of joint venture profits might be enough to make a low transfer price more profitable than a high transfer price.

In some cases, the transfer prices are covered in the joint venture contract; that is, an upper limit may be set. When there is a specific price ceiling it is renegotiable periodically.
However, in the special case of the Genforsler-Capitool joint venture (special because Genforsler-Capitool produces machines for sales only to Genforsler and to Capitool) the philosophy is for Genforsler-Capitool to develop a high-volume operation by operating just above the break-even point, and charging both Genforsler and Capitool as low a price as possible while earning enough profit to satisfy German tax authorities.
In the case of a joint venture in which the transfer price has not been specified, the policy is to take as much of the profit as possible in the transfer price.
Since the company goal is to maximize corporate profits rather than divisional profits, there inevitably arise situations where a domestic division must take a reduced profit (by lowering the transfer price) in order that the International Division may capitalize on a favorable tax or Customs duty situation, or vice versa. Usually, the division that must give up the profits sees the reason clearly, and there is no friction. However, in complex situations, transfer price negotiations between divisions can result in disputes. When such an occasion arises, and when the dispute cannot be resolved satisfactorily, it is referred to the Control Committee.

This committee consists of the financial vice president of the corporation (the chairman of the committee), the corporate controller, the controller of the domestic division that is involved, and the International Division controller.
Company officials are reviewing their transfer pricing policy on components shipped to the Duisburg plant. When the original policy was established, the following considerations were evaluated in determining the transfer price:

● At what price would corporate profits be greatest?
Capitool GmbH is in a ‘tax loss carry forward’ position.

● What price would be most advantageous for computing shipping insurance, freight, and duty? These costs are estimated at 40% of the FOB US price.

● What transfer price would the US Internal Revenue Service consider adequate for determining taxable income for the Capitool Company?
● What transfer price would the German authorities consider adequate for determining the taxable income of Capitool GmbH?
● What transfer price would the German authorities consider adequate for determining a duty base?
● Should the company encourage Capitool GmbH to seek maximum indigenous content through high transfer prices?
● What is the relative quality of German-sourced components versus US components?
● What transfer price is necessary to keep the landed cost of components at a level that will allow Capitool GmbH to price their machines competitively and obtain a satisfactory gross margin?

Currently the FOB US transfer price on components shipped from the US plant to the Duisburg plant is the sum of:

● actual direct material;
● actual direct labor;
● full manufacturing expense;
● 14.2% markup on cost.

This formula has been reviewed and approved by the United States Internal Revenue Service and the German Income Tax and Customs Authorities as the lowest acceptable basis for determining:

(a) taxable profits at each location and

(b) the value to be used in assessing Customs duty payments.

Company officials have been concerned about the meaning and usefulness of transfer prices. In the past the policy has been one of decentralization of authority to managers that head profit centers. Profit centers have been used both as a managerial incentive (so that a manager can see the profits for which he can take credit), and as a method of measuring the performance of executives.

Under such a system, whenever there are intracompany transfers of products, a ‘transfer price’ must be established. Company officials are concerned that there are inequities in the system, since maximum corporate profit may not be achieved simply by letting divisions maximize profits individually.

One company official went so far as to suggest that perhaps it would be better to determine all transfer prices at headquarters; and that the ‘profit’ centers should be changed to ‘cost’ centers. The general manager of each cost center would have no control over centrally administered transfer prices; he or she would simply be forced to accept them as they are set by headquarters.

Under this arrangement managers would be evaluated not on profits but according to other measures, for example, share of market, sales increases, cost reductions, and so forth. The company’s tax counsel pointed out that this policy would cause problems with tax and Customs authorities.

Another company official expressed the view that managers of cost (or profit) centers should be permitted to buy wherever landed cost is lowest, except when the corporate interest is served by ‘buying’ internally, for example: 

(1) when there is excess capacity (probably there would be no difficulty in this regard if the ‘selling’ division were willing to set the price as near to marginal cost as necessary to be competitive), 

(2) when tax or duty factors make it desirable to transfer at a ‘higher than competitive’ price.

Questions

1. What should be Capitool’s general policy on the formulation of international transfer prices?
2. What methods should be used to set Capitool’s transfer prices and who should be involved in the process?
3. Should Capitool have a system of multiple transfer prices:

(a) for different products,

(b) to different countries, or

(c) to different classes of customers?