7
In a dialogue with our seminar participants we
show that tax-based transfer prices and the
question of reliable measurement of internal
performance can be connected.
as the payment term, the delivery conditions (“Inco-Terms”)
and other ancillary services. The term “transaction” is
broadly defined in this regard: besides commodities, prod-
ucts and services, it also includes, for example, assigning
clients, IT support, marketing support, brand usage, licens-
ing or other know-how transfers.
A so-called function and risk analysis of the two participating
companies should be performed for every transaction. This
analysis determines the relationship between the individual
group companies. Companies that perform (relatively) few
functions or are exposed to limited risks are called routine
companies. In contrast, if the functions and risks are strong-
ly pronounced, the company in question is a strategy carrier.
Routine companies are awarded a limited, but stable profit.
In other words, transfer prices must be designed so that
routine companies generate a guaranteed profit, but are only
marginally profitable. This also means that in the case of a
looming loss (or if it appears likely that the minimum margin
for tax purposes will not be achieved), adjustments to the
transfer prices need to be made during the year. This im-
provement in the earnings of the routine company is made at
the expense of the strategy carrier. Of course, this rule also
applies when the opposite occurs, namely when the forecast
indicates that the earnings of the routine company will be
too good. In this case, the transfer prices must be increased.
The strategy carrier receives the remaining group profit, i.e.,
minus the shares attributable to the routine companies. The
functions and risks are most pronounced in the strategy
carrier, and its profit therefore fluctuates the most. It is a
“residual profit” in the truest sense of the word.
Apart from some special circumstances, this means that
the EBIT (Earnings Before Interest and Tax) of the routine
company is not suitable as a performance metric or for
variable compensation purposes. After all, the company
always achieves a profit, even when the company’s busi-
ness is poorly managed. On the other hand, great success
is penalised by increases in the transfer prices. From a local
perspective, EBIT therefore loses its appeal as a motivational
metric. This applies analogously to the strategy carrier. Other
metrics must therefore be found for both sides, or there
needs to be an additional internal transfer price in the form
of a “shadow price”. This price would be tracked only for
internal management reporting purposes; in other words,
it would have no relationship to external financial reporting.
From the perspective of internal management, i.e., the view
of the controller, this issue must be addressed.
More than 50 nations have already adopted requirements
for transfer pricing documentation at companies in order
to understand the approach the companies have taken and
to provide a basis for tax auditors to audit them. It must be
readily apparent that the documentation reflects a serious
effort by the company to enable a knowledgeable third
party to obtain an insight into the company’s transfer pricing
policies within a reasonable period of time. Otherwise, in
the worst case, the tax auditor might reject the documenta-
tion, which could cause serious financial consequences.
Investment (subsidiary) controllers should therefore insist on
“complete” and current documentation for all internal trans-
actions, something that should never happen without close
contact with the tax department!
In light of the high penalties, it is not surprising that many
companies today focus on the tax aspects of transfer prices.
But that should not obscure the fact that although penalties
reduce profits, the avoidance of penalties does not create
them. Avoiding penalties, i.e., compliance with tax legislation
for transfer pricing, is an important sub-responsibility, but it
does not achieve good returns per se. The issue, therefore,
is not about tax law versus performance measurement, but
rather the merging of the two. As controllers, we must ac-
cept this new challenge.
Workshop Stage five
Presentation and Mo-
deration – June 2015
