UNDERSTANDING TRANSFER PRICING

Transfer pricing is the general term for the pricing of cross‐border, intra‐firm transactions between related parties. “Transfer pricing” therefore refers to the setting of prices at which transactions occur involving the transfer of property or services between associated enterprises, forming part of an MNE group.  These transactions are also referred to as “controlled” transactions, as distinct from “uncontrolled” transactions between companies that, for example, are not associated and can be assumed to operate independently (“on an arm’s length basis”) in reaching terms for such transactions.    

In simple terms transfer pricing is the price at which related parties are assumed to transact, and if this price is subjected to tests, it is the same price at which independently trading companies would have transacted.

A simple explanation of transfer pricing is given below.

There is company A Inc which is incorporated in Turkey manufacturing shoes. The same company forms a subsidiary company B Inc in Uganda and it distributes the manufactured shoes in Uganda and East Africa.

Company A inc incurs a cost of production for one pair shoes of $150, however it has set a transfer price of $200 for each pair of shoes it sends to B Inc. Company B Inc also incurs additional operational costs of $50 per pair. The question is what would be the selling price of company A Inc and what cost should Company B Inc declare in its books of account?

Under normal circumstances Company A Inc would have a selling price of $200, and company B Inc would have total cost of $250, however since these companies are trading under controlled conditions, since the actions of company B Inc in Uganda are controlled by Company A Inc in Turkey, the selling price of $200 should be subjected to tests to see if an independent company would sale the same product (Shoes) to company B Inc at the same price.

Secondly since these companies are essentially the same, the shoes should be transferred to Company B Inc incorporated in Uganda at $150 and therefore the cost of production would be $200 and not $250.

For tax purposes to allow the transfer price it must be subject to tests to remove the effects of “arm’s length” transactions. Many companies have been involved in aggressive tax planning and taken advantage of multi-national trade to use the availability of differing tax treatments to reduce their tax obligations and also to pay as little tax as possible.

For example: let’s assume Turkey has an income Tax rate of 20% and Uganda has a tax rate of 30%. Under this assumption it is advantageous if more profits are apportioned to the parent company since the tax rate is low, and low profits in Uganda since the tax rate is high. How is this possible? The parent company A Inc would have to transfer products and services at high prices to B Inc in Uganda, so that they can reduce the effect of tax exposure due to the high tax rate.

For example A Inc sends 100 shoes to B Inc. The other costs of A include License Fees $200.

The Profit and Loss Account for A Inc the parent Company in Turkey would look like this at the transfer price of $200.

ItemUnitTotal ($)
Sales$200*10020,000
Cost of production$150*10015,000
Gross Profit 5000
Less: operating Expenses 200
Profits 4,800
Tax @ 20% 960
Total EAT 3,840
The Accounts of B Inc the subsidiary incorporated in Uganda receiving shoes at the transfer price of $200 with a selling price of $300 and operational costs of $50 per pair of shoes
ItemUnitTotal ($)
Sales$300*10030,000
Cost of production$20*10020,000
Gross Profit 10,000
Less: operating Expenses$50*1005,000
Profits 5,000
Tax @ 30% 1,500
Total EAT 3,500
If Company B Inc was to use the transfer price of $150, incurring operational costs of $50 per pair of shoes and having the same selling price of $300, this would be the effect.
ItemUnitTotal ($)
Sales$300*10030,000
Cost of production$150*10015,000
Gross Profit 15,000
Less: operating Expenses$50*1005,000
Profits 10,000
Tax @ 30% 3,000
Total EAT 7,000
Performance Report of A Inc.
ItemsTaxEAT (Earnings After Tax)
Transfer price to B Inc of $2002,4607,340
Transfer price to B Inc of $1503,96010,840

From the workings above, it is very clear that A Inc incurs a high tax exposure in Uganda; therefore what it would do is to ensure that it maximizes sales in Turkey and apportions more costs and costs of production to B Inc in Uganda so that the tax exposure is reduced. Therefore instead of setting a transfer price of $200 it can set a price of $400 so that profits are maximized in Turkey and reduced in Uganda yet the actual trading of goods, the actual value is added at the distribution level that is in Uganda which distributes the shoes to the final consumers and retailers.
Conclusion
Under OECD each company is taxed independently and it is very important that the Revenue Bodies carry out transfer pricing audits to verify the arm’s length principle in the transfer of services, products and rights among related companies of Multi National Enterprises (MNE).

LEAN MANAGEMENT AS A TOOL FOR BUSINESS RECOVERY FROM ECONOMIC DEPRESSION

Lean or Lean management is a business approach for maximizing customer value while minimizing waste. It is based on the principles of the Toyota Production System (TPS) and aims to create a culture of continuous improvement in an organization. 
 
The main goal of Lean management is to improve efficiency and effectiveness by reducing the time spent on non-value-adding activities and optimizing the flow of work. 
The Lean concept can be successfully applied to any business or production process, from manufacturing to healthcare, engineering, and software development. 

Lean is based on five (5) principles that govern its implementation and its application, the five principles of lean management include:

  1. Defining value
  2. Mapping the value stream
  3. Creating flow
  4. Using the pull system
  5. Pursuing perfection.

We will go through each of these and see how businesses can use lean management as an effective tool for recovery, especially now that different economies are trying to recover from the gross negative effects caused by the Covid-19 pandemic.

Organizations need to optimize activities which produce value, and element any waste so that they can give quality products and services to their customers. Lean management is all about creating value for the customer and reducing waste in the organization

DEFINING VALUE:

This involves the organization understanding what value means in the eyes of the customer, they need to get feedback from their customers about what adds value and what does not add value. For example; a consultancy firm that offers consultancy services needs to find out what the clients want, is it timeliness in execution of projects?, quality advice (data based)? 

Value has been defined as anything that exceedingly brings satisfaction to a consumer of a product or services; value has also been defined as the ability for a product to satisfy the needs of the end user.

Organizations need to focus on the value adding process and qualities that the customers want, so that they do not waste money in making products that are not needed or coming up with innovations that have no value for the customers. This information can be got through interviews, requesting for feedback from clients on the services provided and on the products they consume. It is very important that organizations concentrate only on those items and innovations that add value.

With the scarcity of resources as companies recover from the effects of the pandemic, it is very important that companies concentrate on things that will add value to their customers and cut out any non-value adding processes or items on the products that they make.

MAPPING THE VALUE STREAM

The second principle of lean is mapping out value in the organization’s processes, insight of what has been defined as value from the customers’ view. The organization need to redesign their processes from the view point of the customer.

Two critical types of waste come out clearly at this stage; value adding and necessary, and non-value adding and un-necessary waste. At this stage companies need to totally eliminate the non-value adding and un-necessary waste in their processes or from the products they make, this will also help to reduce the un-necessary costs of production.

An example;  after interviewing their customers, a brewing company finds out that 85% of respondents showed that they do not like the new brand of beer that is being produced, and from the market survey the company also further finds out that the sales for that particular brand are lower than the actual costs of production, it would be reasonable that this particular brand is removed from the production line, over the years we have seen numerous brands of beer dropped by different brewing companies.

It is imperative that companies use this similar approach to drop all non- value adding processes and items which are just waste and non-productive waste. In the next article we will give a detailed explanation and break down of the various wastes that the different organizations have and need to eliminate.

CREATE FLOW

After identifying the waste and eliminating it, the next process is to create systems, processes, and work flows to ensure that waste is not brought back into the production system or way of work. This can be through making SOPs that clearly define how a certain task should be accomplished, training staff and showing them where waste is and waste is, clear guidelines should be made to ensure that everyone in the organization knows what to do, how to do it and when to do it.

Creating flow goes a long way to ensuring that costs are controlled and quality is maintained. It is through this that controls are maintained at the work place and in organizations. Without controls in place, it is very likely that everyone will be doing whatever they want and this can be very costly to the organization in terms of costs, quality of products and organization brand. 

ESTABILISH A PULL SYSTEM

Inventory is considered one of the biggest wastes in any production system. The goal of a pull-based system is to limit inventory and work in process (WIP) items while ensuring that the requisite materials and information are available for a smooth flow of work. In other words, a pull-based system allows for Just-in-time delivery.

Pull-based systems are always created from the needs of the end customers. By following the value stream and working backwards through the production system, you can ensure that the products/ services produced will be able to satisfy the needs of customers.

It is very important that businesses manage stock and WIP, they should only stock what has been ordered for, and establish channels through which stock can be quickly brought in, incase need arises. The cost of stocking and also keeping stock can be overwhelming on the business, and at this time when businesses are trying to recover from the shocks of the Covid-19 pandemic it is very important that such a waste is managed accordingly.

Service companies should also concentrate on works that have been ordered for, and give more time to work where the customers have made commitments in terms of payments, this will enable these organizations to minimize the risk of doing work for clients who do not pay for the work done. This can be done by developing working contracts and also including payment terms which implore clients to make certain percentage of the payment before the work can be started.

PURSUE PERFECTION

This last stage establishes a very important aspect of the business, which is for the business to thrive it must ensure that it pursues quality in everything it does, and it should also strive for continuous improvement. Continuous improvement entails continuous learning, continuous innovation and development, and it calls upon all the members of the company to be part of the continuous improvement program.

It is very important that companies keep pursuing perfection and continuous improvement so that they keep looking for cost effective ways of doing business.