TOPIC 11 – LEGALITY OF PRICING POLICIES
OVERVIEW
Many nations regulate pricing in various ways. The most obvious controls relate to
anticompetitive actions. In the EU and the United States, firms cannot collude to set prices and these
kinds of laws are widely enacted although intermittently enforced in various other markets throughout
the world. In the United States, a manufacturer must generally treat each class of customer equally.
That is, the customer who buys a particular quantity of product should receive the same discount as
another customer buying that same quantity.
However, some exceptions to this rule are allowed. Manufacturers can use discriminatory
pricing to meet a competitive threat in a particular market or if it can be proved that their costs to
serve one customer are lower than another.
In setting international prices, another important issue is that of dumping. Dumping simply
means that a product is sold in a particular market at a level less than its cost of production plus a
reasonable profit margin. Anti-dumping penalties have increased in the United States, the EU,
Canada, and Australia and this will continue to be a key issue in international marketing. Managers
must be careful that their pricing decisions can be defended against anti-dumping accusations.
TOPIC 11 – LEGALITY OF PRICING POLICIES
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Transfer Pricing
Competitive Bidding
TRANSFER PRICING
Transfer pricing can have an important effect on pricing decisions. Transfer prices are those
set for goods or services which are bought by one division of a firm from another division. These are
inside or intra-corporate prices.
Transfer prices also refer to the terms and conditions which so-called “associated enterprises”
agree for their “controlled transactions.” Examples of such transactions are the provision of
management services, the supply of goods and the provision of loans. According to this widely used
OECD Transfer Pricing Guidelines (OECD) definition, enterprises are associated if:
(a) an enterprise participates directly or indirectly in the management, control or capital of
another enterprise or
(b) the same persons participate directly or indirectly in the management, control or capital of
two enterprises.
Now we know the concept of associated enterprises. The following example shows this
practice in a graph:
Figure 11 .1
Practice of Associated Enterprises
In the picture you see that Enterprise X manufactures pianos in Malaysia. Enterprise Y
distributes these from Hong Kong. Both X and Y are 100% owned by Enterprise Z. Because Z
participates directly in the capital of both X and Y, they are all associated enterprises.
When selling pianos on the market, Z has no control over the price at which one piano is sold.
The Reason is that prices are set by supply and demand. Currently, the market price for one piano is
USD 5,000. However, Z does control any transactions between X and Y. Therefore, the internal sale
of a piano by X to Y is called a ―controlled transaction. The price charged for this transaction is
what is called a ―transfer price.
Why Are Transfer Prices Important?
Let‘s go back to the Figure 11.1
The price at which one piano is sold by X to Y affects their individual financial results
(remember: this is the controlled transaction). If X charges a high price, X makes more profit. If X
charges a low price, Y makes more profit.
From a commercial perspective, the price doesn‘t matter. The financial results of X and Y are
consolidated. For shareholder Z, it doesn‘t matter which of the two companies makes the profit.
However, from a tax perspective it does matter. X is taxed in Malaysia and Y is taxed in Hong Kong.
The corporate tax rate in Hong Kong is 16.5%. In Malaysia, it is 25%. Z wants to see as much profit
after tax as possible. Z can use its influence as a shareholder to set the prices in such a way that the
profits are highest where taxes are lowest.
How Transfer Prices Work
A transfer price arises for accounting purposes when related parties, such as divisions within a
company or a company and its subsidiary, report their own profits. When these related parties are
required to transact with each other, a transfer price is used to determine costs. Transfer prices
generally do not differ much from the market price. If the price does differ, then one of the entities is at
a disadvantage and would ultimately start buying from the market to get a better price.
For example, assume entity A and entity B are two unique segments of Company ABC. Entity A
builds and sells wheels, and entity B assembles and sells bicycles. Entity A may also sell wheels to
entity B through an intracompany transaction. If entity A offers entity B a rate lower than market value,
entity B will have a lower cost of goods sold (COGS) and higher earnings than it otherwise would
have. However, doing so would also hurt entity A's sales revenue.
If, on the other hand, entity A offers entity B a rate higher than market value, then entity A
would have higher sales revenue than it would have if it sold to an external customer. Entity B would
have higher COGS and lower profits. In either situation, one entity benefits while the other is hurt by a
transfer price that varies from market value.
Regulations on transfer pricing ensure the fairness and accuracy of transfer pricing among
related entities. Regulations enforce an arm‘s length transaction rule that states that companies must
establish pricing based on similar transactions done between unrelated parties. It is closely monitored
within a company‘s financial reporting.
Transfer pricing requires strict documentation that is included in the footnotes to the financial
statements for review by auditors, regulators, and investors. This documentation is closely
scrutinized. If inappropriately documented, it can burden the company with added taxation or
restatement fees. These prices are closely checked for accuracy to ensure that profits are booked
appropriately within arm's length pricing methods and associated taxes are paid accordingly.
Transfer Pricing Methods
Transfer pricing methods (or ―methodologies) are used to calculate or test the arm‘s length
nature of prices or profits. Transfer pricing methods are ways of establishing arm‘s length prices or
profits from transactions between associated enterprises. The transaction between related
enterprises for which an arm‘s length price is to be established is referred to as the ―controlled
transaction. The application of transfer pricing methods helps assure that transactions conform to the
arm‘s length standard
The good thing about transfer pricing is that the principles and practices are quite similar all
around the world. The OECD Transfer Pricing Guidelines (OECD Guidelines) provide five common
transfer pricing methods that are accepted by nearly all tax authorities.
The five transfer pricing methods are divided in to two general categories of methods ―traditional
transaction methods and ―transactional profit methods.
1. Traditional Transaction Methods measure terms and conditions of actual transactions
between independent enterprises and compare these with those of a controlled transaction. This
comparison can be made on the basis of direct measures such as the price of a transaction but also
on the basis of indirect measures such as gross margins realized on particular transactions.
2. Transactional Profit Methods don ‘t measure the terms and conditions of actual
transactions. In fact, these methods measure the net operating profits realized from controlled
transactions and compare that profit level to the profit level realized by independent enterprises that
are engaged in comparable transactions. The transactional profit methods are less precise than the
traditional transaction methods, but much more often applied. The reason is that application of the
traditional transaction methods, which is preferred, requires detailed information and in practice this
information is not easy to find.
In short:
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Traditional transaction methods rely on actual transactions.
Traditional profits method relies on profit levels.
The Five Transfer Pricing Methods
As mentioned, the OECD Guidelines discuss five transfer pricing methods that may be used to
examine the arm‘s-length nature of controlled transactions. Three of these methods are traditional
transaction methods, while the remaining two are transactional profit methods. We list the methods
here.
Traditional transaction methods
1. CUP method
2. Resale price method
3. Cost plus method
Transactional profit methods
1. Transactional net margin method (TNMM)
2. Transactional profit split method.
Figure 11.2
Transfer Pricing Methods
There are five basic methods for establishing transfer prices outlined in the OECD
guidelines:
COMPARABLE UNCONTROLLED PRICE (CUP) METHOD
The Comparable Uncontrolled Price (CUP) Method compares the terms and conditions (including
the price) of a controlled transaction to those of a third party transaction. There are two kinds of third
party transactions.
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Firstly, a transaction between the taxpayer and an independent enterprise (Internal Cup).
Secondly, a transaction between two independent enterprises (External Cup).
The example below shows the difference between the two types of CUP Methods:
Figure 11.3
Comparable Uncontrolled Price
(CUP) Method
CUP Method Example
An example of the application of the CUP method:
A manufacturing company (X) manufactures the “Buster 3.0.” This is a high-quality vacuum cleaner. It
is up to 10 times stronger than the models of most competitors. The only competing manufacturer
that can provide a vacuum cleaner performing similarly is the Dust Company, with its renowned
“Dragon Buster.” X and Z sell their vacuum cleaners via both associated and third party distributors. X
and Y operate completely similar.
Now say that X has received an order from distribution company Y for the supply of 1 Buster
3.0. X and Y have the same shareholder (Z). X wonders what transfer price it should apply. This
means that X should find the terms and conditions (here: the price) of a comparable transaction.
Under the CUP method, there are now 2 options:
1. X looks at the price for which it sells 1 “Buster 3.0” to a third-party distributor (Internal CUP).
2. X looks at the price for which Z sells 1 “Dragon Buster” to a third-party distributor (External
CUP).
Obviously, option 1 is the easy option here and would be acceptable. But option 2 would also
be acceptable and provides a better defense towards tax authorities (because “X is doing what an
independent enterprise does”).
The example below summarizes the use of the CUP Method in this case:
Figure 11.4
Comparable Uncontrolled Price
(CUP) Method Example
Use of CUP Method in Practice
The CUP method is the most direct and reliable way to apply the arm‘s length principle to a
controlled transaction. However, it is often difficult to find a transaction that is sufficiently comparable
to a controlled transaction. Therefore, this method is used when there is a lot of available data.
In practice, the CUP method is often used for financial transactions such as group loans. For
these types of transactions there is a lot of data available and market standards help determine terms
and conditions. For example, most banks work with the same formulas to determine credit ratings of
borrowers. This serves as a basis for the interest rate of a loan. This method is also often used to
determine prices of intellectual property (IP) charged for the use of brands and licenses.
The CUP Method with Example – Conclusion
The CUP Method is one of the 5 common transfer pricing methods provided by the OECD
Guidelines. It compares the terms and conditions (including the price) of a controlled transaction to
those of a third-party transaction. The CUP Method is the most direct and reliable way to apply the
arm‘s length principle to a controlled transaction. But, in practice it is often difficult to find sufficiently
comparable transactions. The method is often applied to financial and IP transactions.
THE RESALE PRICE METHOD
The Resale Price Method is also known as the ―Resale Minus Method. As a starting
position, it takes the price at which an associated enterprise sells a product to a third party. This price
is called a ―resale price.
Then, the resale price is reduced with a gross margin (the ―resale price margin), determined by
comparing gross margins in comparable uncontrolled transactions. After this, the costs associated
with the purchase of the product, like custom duties, are deducted. What is left, can be regarded as
an arm‘s length price for the controlled transaction between associated enterprises.
The below image is an example of the Resale Price Method:
Figure 11.5
Resale Price Method Example
Resale Price Method Example
With the above image in mind, let‘s look at a Resale Price Method example: Apple & Pear,
based in Hong Kong, brews a very exclusive non-alcoholic beverage called “the Mountain.” It sells
this beverage to high-end nightclubs around Asia via associated distributors. The market price for one
can of “the Mountain” is USD 100. Apple & Pear does not sell the beverage to independent
distributors. Also, there is no company in Asia that brews a comparable beverage.
However, there are comparable distributors that sell “the Vulcano.” This is a competing
alcoholic beverage brewed by Gin & Juice, a company also based in Hong Kong. The market price
for one bottle of “the Vulcano” is USD 100. In addition, distributors report USD 5 gross margin per
bottle sold with 2 USD on custom duties.
Apple & Pear wants to set the transfer price for the supply of “the Mountain” to the associated
distributors. There is no Internal Cup (no third party transactions by Apple & Pear) or External Cup
(no comparable transactions). Therefore, the CUP method can’t be applied here (The CUP Method
with example).
In our example, the distributors of “the Vulcano” are comparable to the distributors of “the
Mountain.” The result is that the gross margin and custom duties reported can be used as input for
the Resale Price Method.
This would look as follows:
In this example, when using the Resale Price Method, Apple & Pear needs to charge a transfer price
of 93 USD to its associated distributors.
Use of Resale Price Method in practice
The Resale Price Method requires that third party transactions are comparable with the
controlled transaction. As a result, there can be no differences that have a material effect on the
resale price margin. Because each transaction is unique, it is quite difficult to meet this requirement.
Therefore, the Resale Price Method is not often used. However, in case sufficient comparable
transactions are available the Resale Price Method can be useful to determine transfer prices. The
reason is that in such a case, third party sales prices are easily found.
Resale Price Method with Example – Conclusion
The Resale Price Method is one of the 5 common transfer pricing methods provided by the
OECD Guidelines. First, it takes as a starting position the price at which an associated enterprise
sells a product to a third party (the ―resale price). It then reduces this price with a gross margin (the
―resale price margin). This margin is determined by comparing gross margins in comparable
uncontrolled transactions.
The Resale Price Method is not often used. The reason is that it is difficult to find comparable
transactions. However, in case those can be found, the Resale Price Method is suitable to examine
gross margins of associated enterprises engaged in sales and distribution to third parties.
THE COST PLUS METHOD
The Cost Plus Method compares gross profits to the cost of sales. Under the Cost Plus
Method, the first step is to determine the costs incurred by the supplier in a controlled transaction for
products transferred to an associated purchaser. Secondly, an appropriate mark-up has to be added
to this cost, to make an appropriate profit in light of the functions performed. After adding this (marketbased) mark-up to these costs, a price can be considered at arm‘s length.
The application of the Cost Plus Method requires the identification of a mark-up on costs
applied for comparable transactions between independent enterprises. An arm‘s length mark-up can
be determined based on the mark-up applied on comparable transactions among independent
enterprises.
It is explained in this figure:
Figure 11.6
Cost Plus Method
Cots Plus Method Example
With this in mind, let‘s look at an example of the application of the Cost Plus Method: Candy
Casing (X) manufactures Iphone cases for associated enterprises. There are many companies
around that manufacture Iphone cases, including independent enterprise Ali Accessories (B). B and X
manufacture similar Iphone cases.
Now say that X is asked by associated enterprise Y to manufacture 100,000 Iphone cases. X
wonders what transfer price it should charge. This means that X should find the terms and conditions
(here: the price) of a comparable transaction. Under the Cost Plus Method, X should then first
compare its cost base with the cost base of B when manufacturing 100,000 Iphone cases for a third
party client.
Provided that the cost base is comparable, the next step is to identify the mark-up on costs applied by
B. That mark-up should be added to the cost by X. The result is the arm’s length price.
The below image illustrates this example:
Figure 11.7
Cost Plus Method Example
Use of Cost Plus Method in Practice
The Cost Plus Method can be helpful to assess the arm‘s length remuneration of low-risk,
routine-like activities. An example of such activities is contract manufacturing, where there is a
manufacturing enterprise which contracts exclusively with one client (principal) and assumes limited
risks. A lot of car producing MNEs operate under that model. Another example is the provision of
simple administrative services.
The downside of the Cost Plus Method is that it requires controlled and uncontrolled
transactions to be highly comparable. To establish such level of comparability, detailed information on
the transactions should be available. Examples are the types of products manufactured, actual
activities, cost structures and the use of intangible assets. In case this information is unavailable, the
Cost Plus Method cannot be applied.
In practice this makes that the Cost Plus Method is not often used.
Conclusion
The Cost Plus Method is one of the 5 common transfer pricing methods provided by the OECD
Guidelines. The Cost Plus Method is a traditional transaction method. The Cost Plus Method
compares gross profits to the cost of sales. Firstly, you determine the costs incurred by the supplier in
a controlled transaction. An appropriate mark-up has to be added to this cost to achieve the correct
transfer price. The Cost Plus Method is often applied to low-risk routine-like activities such as
manufacturing. In practice, it is often difficult to find information on sufficiently comparable
transactions.
Transactional Profit Methods are used in transfer pricing to determine the appropriate prices for
transactions between related parties, ensuring that they comply with the "arm's length principle."
These methods compare the profits from a transaction to those that would be earned by independent
parties in a comparable situation.
Transactional Net Margin Method (TNMM)
The TNMM compares the net profit margin relative to an appropriate base (like costs, sales, or
assets) that a company earns from a controlled transaction to the net profit margins of comparable
independent companies.
Key Characteristics:
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It focuses on net profit, not gross profit or operating profit.
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The net margin is compared across similar companies or transactions.
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It's typically applied to only one party in the transaction (usually the less complex party), unlike
the profit split method, which looks at both sides.
Example: Suppose Company A, based in the U.S., sells products to its subsidiary, Company B, based
in another country. Company A charges Company B $100 per product. To check whether the price
complies with transfer pricing regulations, the tax authority applies the TNMM. They compare the net
profit margin earned by Company A to the net margins of independent companies selling similar
products in comparable circumstances.
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If Company A has a 10% net profit margin, and comparable independent companies have an
average margin of 12%, the tax authority might conclude that the transfer price should be
adjusted to align Company A's margin with the market standard.
Transactional Profit Split Method
The Profit Split Method allocates the combined profits from intercompany transactions based on how
independent parties would share profits. It’s used when multiple entities contribute to the creation of
value and it’s difficult to assess the value of each entity’s contribution separately.
Key Characteristics:
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Suitable for highly integrated operations where both parties contribute significantly to value
creation.
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Profits are split based on factors like assets, risks, and functions performed by the parties.
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This method is often used for complex transactions, like joint ventures or partnerships in
research and development (R&D).
Example: Suppose Company A and Company B are related entities that jointly develop a patented
product. Company A contributes the technology, while Company B handles the manufacturing. The
total profit from selling the product is $1 million. To determine how much each company should earn,
the Profit Split Method considers each company's contribution (e.g., research investment,
manufacturing efforts, risks taken). If Company A’s contribution is considered 60% of the total value
and Company B’s is 40%, then profits would be split accordingly: Company A would receive $600,000
and Company B would receive $400,000.
Summary:
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TNMM looks at the net profit margin of one party and compares it to similar companies.
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Profit Split Method divides profits based on each party’s contributions to value creation.
These methods ensure that related companies within multinational organizations don't manipulate
transfer prices to shift profits across borders and minimize taxes.
Transfer Pricing Policy
Companies often spend a lot of time and money to analyze and document their transfer pricing
arrangements. But proper implementation is equally important.
A transfer pricing policy ensures that everyone within the firm is ―on the same page.
Moreover, it demonstrates that transfer pricing has been considered and implemented correctly,
creating a record for internal and external stakeholders.
These days, Multi National Enterprises (MNEs) operate internal policies for almost everything.
Such PDF documents formalize guidelines and protocols in specific areas, ranging from employment
policies to risk management.
A transfer pricing policy is similar. Its laws down the MNEs policy regarding the application
and implementation of transfer pricing rules. It can concern one or more companies transactions.
It spells out for different departments what they need to do and how they need to do it.
Moreover, it helps the tax/finance department to ensure correct pricing.
The Objective of a Transfer Pricing Policy
The objective of transfer pricing policies is two-fold:
1. Harmony. Ensure that everyone in the firm is ―on the same page when it comes to the
transfer pricing arrangements. Successful implementation of transfer pricing only works if there is
―buy-in from stakeholders. Before becoming reality, it needs to be understood.
Example I: The finance department wants to know what amounts to charge to which group
entity (and when), the risk department wants to ensure that transfer pricing arrangements do
not create risks, and the manager wants to know whether his/her financial results are affected.
2. Compliance. Demonstrate towards tax authorities that transfer pricing has been considered and
implemented the right way. It shows a proactive attitude which is highly appreciated by tax authorities.
It sets you apart from the crowd.
Example II: During a tax audit, tax authorities normally check whether compliance/
documentation requirements are met. Besides showing the customary 100-page transfer
pricing report, it is powerful if a MNE can show exactly how the transfer pricing arrangements
have been implemented and are being complied with.
COMPETITIVE BIDDING
Business to business (B2B) sales are often completed through competitive bids. This is
especially true for government institutions and non-profits such as hospitals. Some non-governmental
firms also use competitive bids.
In some cases, a firm may require a bid for a particular specification and then reserve the right
to negotiate further with the winning bidder. Firms use specification buying especially for large
projects. These firms develop detailed specifications based on the performance or description of a
particular product or service or a combination of both. Firms supplying products or services to the
military or large power plants or other major projects need to develop expertise not only in the bidding
process, but also in the specification process.
“Specmanship” means a firm‘s sales force is expert at helping a customer develop
specifications which will limit the bidders. The most successful salespeople can develop
specifications with requirements that can be met only by their firm. When faced with a potential
competitive bidding situation based on specifications to be developed by a large customer, it is
necessary to spend the required time to influence the design of the specifications to ensure the most
favorable specifications possible before bidding documents are released. Successful solutions
marketing requires a supplying firm to develop a unique offering
It takes as much work to develop a competitive bid as to create a business plan. It is not
unusual for a firm to spend well over €100,000 to complete the analysis required to provide
responsive bids to a particular customer. Before a firm decides to take on this major effort, a
screening procedure should be completed. Table 10.6 shows a procedure for evaluating bid
opportunities.
In this procedure, eight pre-bid factors should be examined. These factors are shown in
Table 11.1. An analysis tool can be used to assign weight to each factor and then rate the firm‘s
capability for this particular bid. Multiplying the weights by the ratings gives a value for each factor
and adding all of the values together gives the firm some idea of whether they should pursue this
particular bid. Of course, if there are other opportunities, these can be compared using this same tool.
Table 11. 1
Evaluating Bid Opportunities
The factors include plant capacity. The firm must consider whether winning this bid will place
an unusual strain on the plant required to make the product or whether the plant is running at a
relatively low level and can use additional work. Competition must be considered as well, both in
terms of the number of competitors and their possible bids. Past experience with competitors will
serve as a guide here.
A third and most important area is the possibility of follow-up opportunities. In some cases, a
firm winning a bid will be placed on a preferred supplier list (such as with a government) and many
additional orders may follow. In addition, a firm may receive orders for associated products or
services. Here, the marketer must be careful because many sophisticated purchasers will indicate a
large follow-up to a particular order with the goal of pushing the supplier to reduce the initial price.
The next factor is quantity. Obviously, a very large order is more attractive than a smaller one.
Large orders for standard product with the same features are more attractive than an order for a mix
of product. If the quantity can create economies of scale for a supplier, it will be more attractive than
one which simply pushes a supplier past a point of diminishing returns.
Delivery is a key consideration as well. In some cases, a large quantity of product is required
to be delivered all at once. This may put an undue strain on the manufacturer‘s facilities. Another
important consideration is the effect of accepting this order on other customers, both from a delivery
and plant capacity point of view. If a large order has the potential of reducing the manufacturer‘s
capability to satisfy loyal customers in the future, it may not be as attractive.
Obviously, profit is critical in deciding whether to move ahead. While this analysis must take
place before final prices are determined, a general idea of the prices required to carry out this order
should be employed so that the firm can make an estimate of the possible profit to be realized. In
some cases, a firm may decide that profit is not the overriding concern and that in order to fill the
plant it will move ahead with a relative unprofitable bid.
Another key factor is experience. As has been said, developing a winning bid for a particular
project may take as much effort as an entire business plan for a new venture. If the firm has
experience in developing bids of this particular kind, it should be looked upon more favorably.
Finally, the bid capability means the availability of people and financial resources to actually
complete the work. There may be times when the firm simply does not have the capability to do the
required work and therefore the project becomes less attractive.
Internationally, insisting on competitive bidding can be a problem in a high-context culture,
where the project will probably be given to the firm the buyers feel is best positioned to do it based on
the past establishment of trust. However, in a low-context culture a firm would develop specifications
and push the supplier to meet the specifications as written (Hall, 1976).