CASE QUESTIONS
- What factors should James and Gold evaluate when setting a transfer price? How does each factor relate to PrimeCo and SubCo?
- What are the different methods of transfer pricing acceptable for royalty arrangements? Describe how the factors identified in Question 1 impact PrimeCos choice of transfer pricing methods.
- How does income tax law affect PrimeCos transfer pricing decision? Explain IRC 482s position on transfer pricing.
- What is an Advance Pricing Agreement? Is it possible for PrimeCo and SubCo to establish an agreement? Explain.
- What ethical concerns should James and Gold consider in deciding on an appropriate transfer pricing method? Can PrimeCo use multiple transfer pricing methods? Explain.
INTRODUCTION rimeCo, a leading company in the cellular telephone (cell phone) industry, is facing several complex issues after becoming an international company. It has evolved since 1991 from a provider of batteries to an international player in the cell phone component market. Gregory Vanford, the founder of PrimeCo understood the importance of research and development in this high-tech industry. Accordingly, PrimeCo invested aggressively in extensive research initiatives. Because of the company's commitment to developing innovative products, many patents were awarded. In fact, PrimeCo is considered by many as an up-and-coming firm in the industry. As the market for cell phones grew, so too did the profitability of the company. The increase in revenue allowed PrimeCo to raise investments in the development of new products. As a result of the innovative products developed, PrimeCo's management decided to expand its product line to include a broad array of cell phone components. The most significant new product developed by PrimeCo was the Energy Saver System (ESS), an energy management component that was introduced in 2003. ESS reduces energy usage of phones by 35 percent, thereby increasing the length of time the phone can be operated between charges. Most of the sales of ESS are to U.S. cell phone producers. Internationalization In late 2003, the management team of PrimeCo convened to discuss the possibility of expansion into international markets. The decision was made to enter the Asian-Pacific market, which is expected to experience the highest growth rate in cell phone usage in the near future. The management team at PrimeCo considered a wide array of strategies to enter this expanding market including exporting, licensing, contract manufacturing, strategic alliances, or starting a wholly owned subsidiary. After reviewing the advantages and disadvantages of each strategy, the decision was made to enter the region by setting up a wholly owned subsidiary in Japan. One reason that PrimeCo chose to establish a wholly owned subsidiary rather than using another mode of entry was the relatively low efficiency of the legal system in Japan (Kurtzman et al. 2004). The weak legal system was expected to make it somewhat difficult to establish and enforce contracts with entities in the target country. Under the new operating structure, PrimeCo's new wholly owned subsidiary in Japan was called SubCo. PrimeCo would continue manufacturing the ESS system, along with other cell phone parts in the U.S., while SubCo would manufacture the ESS system, along with other cell phone parts, for the Asian-Pacific markets. Companies purchasing these parts desire uniformity and consistency of cell phone components, and thus they negotiate long-term contracts with reliable suppliers. Cell phone assembly plants prefer suppliers in geographic proximity to ensure easy access, to save on shipping costs, and above all to allow for just-in-time inventory management. Moreover, the Japanese government prefers to have separate subsidiary companies in its own country, hiring Japanese workers, rather than foreign companies bringing in their own foreign workers. Accounting lssues Accounting for transactions between PrimeCo and SubCo gives rise to some very complex issues. Shannon James, CFO of PrimeCo and her counterpart at SubCo, David Gold, have met many times to discuss how to account for these intercompany transactions. After much research, the two accountants determined that since PrimeCo's technology is used by SubCo to produce cell phone components, SubCo should be required to pay PrimeCo a royalty. Payment of royalties for intellectual property is common in today's market. However, determining an appropriate rate (i.e., transfer price) for the use of such assets is a difficult task. James and Gold have had extensive experience with intercompany transactions, but only in domestic cases where tangible assets were involved. Both understand that common goal of transfer pricing is to determine the fair market value at which the transaction would occur between unrelated parties. However, determining appropriate transfer prices for tangible assets is less complex because cost of production and fair market value of endproducts are often more clearly determinable. In the case of intellectual property, expenditures made to develop the product are not always reflected in the market value of the final output. In addition, intellectual property is frequently unique, which makes finding similar exchanges that can be used to approximate arm's-length transactions less common. Therefore, determining an appropriate transfer price for the use of the ESS system is a difficult task and required much research. James found a paper written by Glenn DeSouza in a 1997 issue of Business Economics that was very helpful in addressing these issues, while Gold reviewed a paper written by Wagdy Abdallah and Athar Murtuza, which appeared in an issue of International Tax Journal in 2006. International aspects of the transfer pricing also increased the complexity of this situation. Variations in the level of transfer prices in domestic markets are unlikely to impact consolidated corporate profits. In contrast, the choice of an international transfer price will likely impact the overall tax liability and, therefore, profitability of the company. In addition, competitive factors and environmental risks play a role in determining transfer prices for multinational transactions. After analyzing alternative methods for transfer pricing, Gold strongly favors techniques that produce a lower transfer price. He argues that a lower transfer price is only fair because the company has just begun operations in Japan and needs time to establish itself. In addition, if SubCo requires financing, the lower transfer price would enhance profitability and make the firm more attractive to potential lenders. Finally, Gold contends that the transfer price should be low because "a high transfer price would reflect poorly on my ability to effectively manage this firm." Gold adds, "It does not cost PrimeCo anything to let us use their technology." James wonders if Gold's judgment is clouded by the fact that his compensation is strongly tied to the profitability of SubCo. Tax law in both the U.S. and Japan must be clearly understood before a solution to PrimeCo's transfer pricing problem is reached. In the U.S., Internal Revenue Service Code (IRC) $482 governs international transfer pricing transactions. In Japan, the National Tax Agency (NTA) has adopted the Organization for Economic Co-Operation and Development (OECD 2001) guidance for transfer pricing. Because James and Gold's experience with transfer pricing is exclusively in the U.S., they must review the tax law in both countries to ensure compliance. James and Gold began their analysis by reviewing the IRC $482 along with OECD discussion of transfer pricing. In addition Gold found a paper by Karl Gruendel, Ken Okawara, and Mark Campbell in a 2006 issue of International Tax Review that specifically addressed the issue of transfer pricing for intellectual property in Japan. After examining the tax issues related to transfer pricing, James maintains that setting a high transfer price is in the best interest of the company. She says, "If the transfer price is set high, then SubCo would show lower income and PrimeCo would report a higher income to their respective tax authorities. Since corporate tax rates are lower in the U.S. than in Japan, the firm as a whole would be more profitable because the overall tax liability would be lower." Gold is concerned with this strategy because he feels it increases the probability of a tax audit. He observes, "Since I arrived in Japan, I have had extensive interaction with tax authorities. The tax laws involving transfer prices have recently been strengthened. In fact, the majority of tax evasion cases in Japan involve transfer pricing. I don't think it is in the best interest of the company to implement an aggressive tax strategy that might land us in tax court. In addition, Motorola was recently accused of inappropriate transfer price practices and may have to pay the IRS $500 million!" James suggests that they explore the possibility of an advance pricing agreement (APA). She says, "If we can get the Japanese and U.S. tax authorities to agree on a transfer price using an APA, we will reduce the risk of an audit." Given their lack of experience in international transfer pricing, neither James nor Gold knows whether the tax authorities in the two countries would accept such an arrangement. The two accountants decided to explore the possibility in more detail. Ethical Issues Ethical issues related to international transfer pricing also play a role in the decision. With many complex accounting issues, there is considerable judgment involved in establishing appropriate transfer prices. In such a complex setting, it is important to examine the impact of a decision on all parties involved in order to facilitate making the best choice for the company. James feels that if the transfer price satisfies the tax authorities in both Japan and the U.S., then the company would be acting ethically. Gold believes that the issue is more complex than simply satisfying the tax law. He argues that 'much of my employees' compensation is based on the profitability of SubCo. They have worked hard to get this company up and running. I don't feel it is appropriate to cheat them out of their bonuses so the company can save a couple of dollars in taxes." Additionally, Gold feels that the local government officials have "gone the extra mile to make our experience here profitable for the company. It would be inequitable for us to deprive them of tax revenues they expect." These are among the many ethical dilemmas that must be addressed before the company can proceed
