In Search of Increasing Profits

The demand for commercial organizations to produce ­ever-increasing profits has become incessant. If you don’t believe that, then open your Internet search engine and put in the words the need for increased ­profitability. Using Google, the return was more than 96 million results in a fraction more than one-tenth of a second. Yahoo! provided an even greater return of 187 million results and many, if not most of them, were promoting ways to increase profits. Our capitalist system has a lot to answer for!

Francis Fukuyama5 has a view on that and he is convinced that the triumph of the West, Western ideas, and the alleged exhaustion of viable alternatives to liberalism has anointed capitalism as the dominant social, economic, and political system of this era. Remember, the main rule in capitalism is to increase profits as quickly as possible and the driving forces behind capitalism are our commercial organizations. Those most prominent are the multinational and transnational corporations listed on various bourses around the world, which, goaded by financial markets, are obsessed with the creation of ever greater annual profit. Figure 1.2 provides a simple illustration of this obsession, which is achieved through the creation of a variety of networks, the optimization of advances in information technologies, and, quite often with the support of national governments, the exploitation of poorer communities and the destruction of trade barriers.

Figure 1.2. Demanding more and more.

Recognizing the fact that they are essentially private organizations, governments have created laws to require these organizations to priori­tize the welfare of their owners above all else. In commercial parlance, this translates to increasing their wealth, in itself usually accomplished by growing the profitability of the organization. This has become a systemic requirement of capitalism that is being achieved through the use of a variety of strategies, such as financial engineering; cost reduction; and even tax minimization, avoidance, and evasion. The commercial organization has become very powerful indeed, perhaps even more powerful today than the East Indies Companies were at their pinnacle.

Yet, the power of these organizations is not necessarily being used in the wider social interest. Although created through law and numerous social contracts, these organizations do not owe allegiance to any nation, community, or locality, yet they clearly recognize the increased dependence of their host on private capital to stimulate economic activity. It seems that all the best cards are in the hands of commercial organizations and they utilize them to the fullest to extract the greatest profit possible. Despite the claimed advances in transparency, accountability, and corporate social responsibility, bending the rules to enhance the wealth of owners is not unheard of and in many quarters is seen as an entrepreneurial skill. Nowhere is this more evident than in the establishment of transfer prices in MNEs.

Changes in the Transfer Pricing Model

In the years leading to the end of the 20th century, transfer pricing was almost always associated with the exchange of goods between different divisions or subsidiaries of the same organization. The base for determining an acceptable transfer price was the sum of direct costs and variable overhead (or full costs in some cases) with a margin or a markup added to cover other costs and give some profit to the originating division or subsidiary. There was rarely any consistency in application. Transfer prices from the supply units, such as component factories or production units, to assembly or sales units were calculated differently depending on whether it related to deliveries to a new unit or delivery of a new product to a unit where there was already an established relationship. Depending on the maturity and profit situation of the receiving units, transfer prices were set up differently.

Quite possibly, there were good business reasons for such ­variability. As long as they were well understood within the organization’s ­management circles and performance-measurement criteria reflected the differences, it didn’t present much of a problem. With the passing of time, the structure of organizations, whether local, regional, national, multinational, or transnational, and the nature of their operations changed. These changes resulted in a streamlining of business processes, usually by way of simplification and standardization. Organizational doctrine insisted on a focus on core activities, which led to an increase in outsourcing and subcontracting, particularly between units of the same parent organization. The outcome, quite naturally, was an increased focus on transfer pricing principles and their meaning.

Furthermore, with the spread of globalization, the exchange of goods between different units of the same organization intensified, raising the issue of transfer pricing even higher on the management team’s agenda. From the discussions and debates on this developing business problem came an opinion which suggested that transfer prices should be equal for all receiving entities. But why? The circumstances surrounding each and every situation requiring a transfer price, as it is with assorted external customers, was likely to be different. How could an identical transfer price be acceptable in all cases?

Unfortunately, the vagaries of transfer pricing were becoming a topic of interest in places other than inside commercial organizations. Revenue authorities in the supplying or receiving country, or both, were becoming increasingly concerned with transfer pricing being used as a vehicle for manipulating profits resulting in reduced tax revenues. This was particularly noticeable when there were significant differences in the marginal tax rates of the countries involved. The cost factor attributable to government, represented by taxation, in all of its guises, now became a significant factor in determining transfer prices.

No matter what was being transferred from one unit to another across jurisdictional boundaries, revenue authorities were asking pointed questions about the transfer price—what was the underlying cost of the item being transferred and what was the margin or markup and how was it determined? Initially lacking clear rules or understanding, these investigations placed organizations under increasing pressure to justify ­transfer prices and led to an increasing number of disputes with the ­revenue authorities because the old principles were no longer always valid. Looking to reduce the frequency and cost of these disputes, many revenue authorities, especially those with substantial resources, sought to establish rules and guidelines for the taxation of cross-border transactions between related organizations in an MNE.

An internationally accepted approach to the problem by revenue authorities was to insist that organizations price related party international dealings in the same way that truly independent parties would have done in the same situation: in other words, using the arm’s length principle. In this way, it was thought that pricing for international dealings between related parties would reflect a fair return for the activities carried out, the assets used, and the risks assumed in carrying out these activities.

Unfortunately, the outcome in many instances was artificial transfer prices determined to satisfy the revenue authorities. This resulted in the distortion of organizational performance leading to imperfect or unreasonable business decisions. One area in particular, that of research and development, suffered from these transfer pricing policies. They led to an imbalance among investment, costs, and profit because of a failure to reflect the impact of intellectual capital and how it added value to products and services. The only way this is likely to be rectified is through the development of a suitable frame of reference for value-related transfer pricing while at the same time eliminating many of the elements of risk.