Motivation. Optimized Transfer Pricing Model for Asia Pacific. Author: Kelly Liang Advisor: Jonathan Byrnes. MIT SCM ResearchFest.

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1 Optimized Transfer Pricing Model for Asia Pacific Author: Kelly Liang Advisor: Jonathan Byrnes May th, 2011 Motivation Corporate Profit Taxes Hong Kong 16.5% China 25.0% Japan 41.0% South Korea 25.0% Taiwan 25.0% Singapore 17.0% Indoesia 25.0% Malaysia 25.0% Macau 12.0% Thailand 30.0% Vietnam 25.0% Australia 30.0% New Zealand 28.0% 2 1

2 Background Transfer Price: a price at which a subsidiary of a company charge and trade with each other Role of transfer price Profit determination Example: Subsidiary 1 (20%) sells product A to subsidiary 2 (40%) for sales in Country 2 Transfer price = $100, Price 2 = $200 Profit = ($100)(.8)+($100)(.6) = $140 Transfer price = $50, Price 2 = $200 Profit = ($50)(.8)+($150)(.6) = $130 Globalization Multinational Enterprises and the governments Organization for Economic Cooperation and Development (OECD) Regulations 3 Research Objective What is the optimal transfer price to employ for goods in Asia, taking into account the constraints of different tax laws and tariffs? Expected Outcome A mathematical model that determines the optimized transfer price for goods in Asia Pacific Sensitivity analysis 4 2

3 Methodology 5 Transfer Pricing Methods 5 areas in which transfer price is applicable Sales of tangible property Transfer or use of intangible property Rentals Loans Performance of various business services 6 common methods to determine transfer price 2 types Transaction-based Profit-based Advantages & Disadvantages 6 3

4 Determinants Factors that influence the value of transfer price Taxes Tariffs Factors that influence the setup of the transfer pricing model Organizational Structure Centralized vs. Decentralized Organization One transfer price vs. two transfer prices External vs. Internal Market Comply with the Arm s Length Principle 7 Assumption & Initial Conditions Company X US-based MNE Follow OECD principle Centralized organization 1 transfer price Subsidiary 1: Hong Kong Intermediate Hub Goods transfer to Hong Kong physically Subsidiary 2: Malaysia 8 4

5 Optimized Transfer Pricing Model Equation Combined effects of taxes and tariffs corporate (1 1 )[R 1 tq 2 c 1 (Q 1 Q 2 )] (1 2 )[R 2 c 2 (Q 2 ) (1 a )tq 2 ] Keys MNE in Country 2 Q = units quantity of goods produced/transferred c = unit cost of good i = pure profit tax rate, where i = {1, 2, corporate} a = ad valorem tariff on the importing country t = transfer price when the firm adopts one transfer pricing model a = Arm s Length Principle value R = revenue, which is a function of the quantity sold π = profit function Source: Eden, Lorrain. Taxing Multinationals. Toronto, Canada: University of Toronto Press, Excel Model Manufacturing Country Intermediate Hub Final Desination Countries China Hong Kong Malaysia Tariff 0.00% 12.00% Profit Tax 16.50% 25.00% Price $60.00 $67.53 Quantity Cost $15.00 $15.33 Objective Function Optimized Profit Optimized Method Optimized Transfer Price $9, RPM $27.01 Decision Variables Method CUP RPM PSM TNMM Transfer Price $60.00 $27.01 $48.75 $60.00 Price 2 $67.53 $67.53 $66.18 $67.53 Profit $9, $9, $9, $9, Equation Variables Hong Kong Tax 16.5% Malaysia Tax 25% HK $60.00 Quantity HK 150 Quantity Malaysia 150 Costs for goods sold in HK $15.00 include all production costs Costs for goods sold in Malaysia $15.33 add on extra transportation costs Malaysia 12% Gross Margin 300% Price 3rd party (CUP) $60.00 % of Retail Price (RPM) 40% Profit Splitting (PSM) $33.75 Margin (TNMM) $45.00 Model: -Excel - Only 4 methods are considered 10 5

6 Sensitivity Analysis: Changes in Tariffs and Taxes Profit [$] $9, Sensitivity Analysis (Effects of Tariffs & Tax Rates) $9, $9, $9, $9, $9, Observation: $9, $27.01 $48.75 $60 $60 3.5% -0.5% Žp corporate =((1- t Žt 1 )- (1- t 2 )(1+t a ))Q 2 =[(t 2 - t 1 )-t a (1- t 2 )]Q 2 At 3.5% Lower the transfer price, higher the profit At -.5% Higher the transfer price, higher the profit 11 Transfer Pricing Method Sensitivity Analysis: Changes in Incremental Costs $25.00 Sensitivity Analysis (Effects of Incremental Costs) Tax Saving [$] $20.00 $15.00 $10.00 $5.00 $- $(5.00) Tax Saving [$] $(10.00) $(15.00) Incremental Cost [$/unit] Observation: Shipping costs as well as other incremental costs plays an important role in determining the optimal transfer price 12 6

7 Managerial Insights Depends heavily on the organizational structures and management decision The optimal transfer price depends on the relationship between the tax differential and the effective tariff rate Employ different transfer price for different product lines and countries Economic Decision Factors Book-keeping Lead-Time Considerations Intermediate Hub Decisions 13 Q & A 14 7

8 Transaction-Based Methods Source: Eden, Lorraine. Taxes, Transfer pricing, and the Multinational Enterprise. Oxford, UK: Oxford University Press Profit-Based Methods Source: Eden, Lorraine. Taxes, Transfer pricing, and the Multinational Enterprise. Oxford, UK: Oxford University Press 8