FOCUS ON INTERNATIONAL ISSUES The issue of transfer pricing is mostly relevant to performance evaluation of investment centers and their managers. If a company does business in only one country, transfer prices do not affect the overall profit of the company because the cost that will be recorded as an expense for the company as a whole is the actual cost incurred to produce it, not its trans- fer price. However, the situation can be different if the producing division is in one country and the acquiring division is in another. This difference occurs because income tax rates are not the same in all countries. Assume the Global Tool Company manufactures a product in South Korea for the equivalent of $10. The product is transferred to another segment that operates in the United States where it is ulti- mately sold for $18. Now, assume the income tax rate is 40 percent in South Korea and 30 percent in the United States. Ignoring all other costs, what amount of taxes will the company pay if the transfer price is set at $10? What amount of taxes will the company pay if the transfer price is set at $18? CSpaces ImagesBlend Images - If a $10 transfer price is used, then all of the company's $8 per unit profit ($18-$10) will be recognized in the United States. Since the item is assumed to have been "sold" in South Korea at an amount equal to its production cost, there will be no profit for the South Korean division of the company ($10-$10-$0). The U.S. division will pay $2.40 in taxes ($8 x 0.30-$2.40). Conversely, if the transfer price is $18, then all of the profit will be reported in South Korea, and $3.20 per unit of taxes will be paid ($3 x 0.40 = $3.20). The Internal Revenue Service has rules to prevent companies from setting transfer prices simply for the purpose of reducing taxes, but many companies have been accused of such practices over the years. Remember, it is often impossible to prove exactly what the best transfer price should be. Even though the company in our hypothetical example could not get away with such extreme transfer prices as $10 or $18, it might by to set the price a bit lower than it should be in order to shift more profit to the segment in the United States, where the assumed tax rate is lower. Despite the difficulties of proving what proper transfer prices should be, the IRS does pursue companies it believes are violating the law. In fact, as of 2006, the largest settlement in the history of the IRS involved a transfer pricing case against the British-based pharma- ceutical company GlaxoSmithKline. The company agreed to pay the IRS $3.4 billion to settle charges that its American unit had improperly overpaid the parent company, thus shifting profits from the United States to the United Kingdom from 1989 through 2005. More recently. Coca-Cola announced in September 2015 that the IRS had notified the company that it may have to pay up to $3.3 billion in additional taxes due to improper international transfer pricing. In November 2020 the United States Tax Court ruled that Coke had violated IRS rules, but did not set an amount that the company owed in back taxes. Coke continues to believe the charges are without merit, and indicated that it planned to appeal the Tax Court's decision. The issue will probably take years to settle. The IRS does not always win these cases. The IRS had been seeking a $1.5 billion payment from Amazon related to transfer pricing issues involving its subsidiary in Luxemburg. In March 2017 the U.S. Tax Court sided with Amazon, ruling that it did not owe the extra taxes. Tax disputes related to transfer pricing are not just a problem in the United States. In May 2017 an Australian court ruled that Chevron owed the country $250 million in additional taxes related to the interest rates it charged its subsidiaries in Australia. By charging its Austra lian subsidiaries higher than market rates of interest, the profits in Australia were reduced, thus reducing the taxes Chevron paid to Australia. Transfer pricing covers the price for a lot of things, not just physical things like equipment parts or retail inventory items. With respect to the settlement at Glaxo, the commissioner of the IRS stated, "We have consistently said that transfer pricing is one of the most significant challenges for us in the area of corporate tax administration." Sources: "IRS Accepts Settlement Offer in Largest Transfer Pricing Dispute," from the IRS website, September 11, 2006; Coke's Form 8-K, September 18, 2015; The Woll Street Journal's website, March 23 and May 23, 2017; and "Tax Court Rules Against Coca-Cola, The Wall Street Journal, November 19, 2020, p. B-4.
