BA 511Transfer Pricing
Ram Mudambi10/11/2005
A Discussion of the Impact of Transfer Pricing Policy Decisions for an Indian Subsidiary of a U.S. Multinational Enterprise
Bob Whipple
BA 511 - Globalization
Ram Mudambi
October 11, 2005
INTRODUCTION
Transfer pricing policy decisions play a central role in the decision making of any multinational enterprise; particularly those MNEs with subsidiaries that operate within tax concession-friendly economies such as India. The growth of MNEs and vertical integration of host country subsidiaries into the domestic parent’s operations and supply chain have both created the need for transfer pricing policies (TPP), but have also added further complexity to management decisions. The central premise of TPP under the Organization for Economic Cooperation and Development (OECD), and applicable IRS regulations, is arm’s length pricing. In other words, when a parent transfers intangibles, services, or actual materials to one of its multinational subsidiaries, the price must be accounted for as if it were a transaction outside of the company. The documented price must include the typical free-market mark up that an outside enterprise would experience in the form of a profit margin. This creates several potential management issues in terms of accounting for profits in a parent vs. subsidiary, human resource factors, and double taxation.
The selection of a TPP has a business impact on one entity (usually the domestic parent), and a reciprocal impact on the other (subsidiary host); the business impact results can then have a negative human resources impact (Lund). The Ganley Enterprise case illustrates how transfer pricing decisions are not only difficult to make, but impact two widely distributed aspects of an organization’s business:
- Business Results
- Short vs. Long Term Decisions
- Intra-competition with other host country subsidiaries
- Double Taxation
- Human resources
- Morale
- Productivity
- Compensation
This case analysis will discuss the OECD TPP that Ganley should implement based on the corporation’s vision vis a vis its Indian subsidiary. This case will also discuss the potential impact of Ganley Inc.’s Indian subsidiary business model decisions on both human resources and business results in light of OECD recognized transfer pricing policies, as well as sources of friction between host and parent when knowledge is controlled by the parent (Mudambi).
OECD TRANSFER PRICING POLICY RECOMMENDATION FOR GANLEY INC.
Ganley could pick from two OECD TPPs – the Comparable Uncontrolled Price (CUP) method, or the Cost Plus Method. There are tradeoffs associated with each decision. The CUP method simply compares the uncontrolled transaction price (free market/retail) with that of an internal transaction controlled price. If they are the same, or similar, then the argument is that the controlled price is not at arm’s length and violates the central premise of TPP. This is the most straight forward of all OECD TPPs, but in this particular case it is probably the best decision due to the favorable prices that Ganley-India was fielding from Indian suppliers. Ganley Inc. could fairly use these quoted external prices in India to peg its uncontrolled price, and thus use this favorable price as its TPP for the transfer of all intangibles, services, and materials.
However, as mentioned above, there is a tradeoff in making this decision. As Phillip Beutel describes in his June, 2005 paper in Managing Intellectual Property, “Beware the transfer pricing trap.”, there are significant intellectual property (IP) implications when determining a TPP. For example, if Ganley chooses to use this favorable Indian supplier price to peg its TPP using the CUP method, then any damages in an IP infringement case that Ganley pursues against a competitor can very well be capped by this low price that it has used to determine its Indian subsidiary TPP. During litigation, the defendant’s counsel will most likely discover this policy, and use it to create a ceiling in any settlement – which would not be the desired outcome for Ganley. Damages in IP infringement cases under U.S. patent law are typically based on a reasonable royalty for a hypothetical license of its patent to the infringer. (Beutel)
An alternative TPP that Ganley could employ would be the Cost Plus Method. Using this method, Ganley would simply determine the appropriate markup of the intangibles, services, and materials that it is transferring to its Indian subsidiary when determining the appropriate TP. This markup would be added to its base costs, along with other typically accepted and associated costs used in calculating appropriate prices. This method may be the best to employ in light of the above stated IP implications if Ganley were to use the CUP method in this case; additionally, the OECD states that the Cost Plus Method is best used when unfinished goods are to be transferred. This would be the case with most of the property that is being transferred to Ganley-India: parts for manufacturing appliances to be sold later; however, the obvious tradeoff in making this decision is that a less favorable price would be used to determine its TP.
As has been alluded to already in this paper, the determination of this price has great implications for management in terms of business results and human resource policy. The recommendation would be to take advantage of the CUP method, using the documentation of Indian supplier low price offers to peg its TP. This recommendation is based on the relatively low technology market that Ganley Enterprises competes in (low IP infringement damages risk), and the need for a competitor to have massive international production capabilities to leverage economies of scale to compete.
IMPLICATIONS OF TRANSFER PRICING POLICY
From a corporation standpoint, Ganley Enterprises has stated that the objective with regard to its Indian subsidiary is one of long term growth by leveraging the expected explosion of the Indian economy. In other words, rather than leveraging the low external supplier costs in India and using Ganley-India as a high margin exporter of appliances to the Asian market, it would like to cultivate the growing domestic Indian market for future returns.
Impact on Business Results – Short vs. Long Term Decision
Clearly, Ganley-India feels strongly that it can turn a quick and healthy profit by leveraging both low Indian supplier prices, and robust Indian economic policy tax concessions. So, from a Ganley-India perspective, the corporate decision to forego this approach for the above outlined strategy does not make good business sense. To focus instead on a longer term vision of developing the local Indian market seems illogical – there will likely be no positive return for a few years, whereas there could be considerable contribution to division and corporate profit via an Asian export strategy. This point will be somewhat mitigated by the decision of Ganley Enterprises to choose the lower price CUP method of TP based on the local Indian supply cost. As a result, any business transactions that the Indian subsidiary does engage in will not be subject to a typically higher arm’s length price when determining net profits.
However, from a corporate perspective, this decision seems to be the more prudent and strategically smart decision. Ganley Enterprises has identified that there is substantial opportunity in a growing Indian market. They need the local talent and expertise of Ganley-India in order to begin to leverage this longer term growth opportunity. The challenge for corporate management will be their confidence in this decision vis a vis loss of possible shorter term gains, as well as managing morale and compensation issues that could percolate as a result from this decision.
Intra-Competition
Another argument that corporate management gives Ganley-India for their longer term strategic decision to focus on the domestic Indian market is one of redundancy and intra-corporation competition with Ganley-Germany. When Ganley-India proposes the Asian export business model to corporate, one of the reasons that is given is that Ganley-Germany already has a strong hold on the Asian export business, and this would be an inefficient duplication of effort. Furthermore, since Ganley-India would have to make some local manufacturing adjustments if they were to use locally supplied materials, corporate argues that this would lead to another redundancy since as a corporation all of this work is already being done in the U.S. However, one perspective to take is that Ganley Enterprises should be careful to not make this decision in haste. It may be possible that Ganley-India would have the better market knowledge, lower supplier costs to create increased margins, and lower distribution costs due to country proximity. Furthermore, it is quite possible that Ganley-India could begin its Asian export business, and begin to develop the domestic Indian market in parallel. Ganley Enterprises needs to be certain that its decision to continue to let its German subsidiary lead the Asian export business, and let Ganley-India concentrate on cultivating the domestic market is the wisest decision financially. At first blush, given a favorable TPP via the CUP method, and the advantages stated above for a Ganley-India Asian export business, it may be more prudent to either redirect the Ganley-Germany efforts, or downsize this subsidiary.
Double Taxation
One very important consideration in TPP decisions is that of double taxation. Virtually all countries that participate in the OECD protect against double taxation (but may require up to a 5 year waiting period for resolution), however the notion of being taxed twice arises when a country interprets a TPP as unfair or inaccurate. For example, the most visible example of this is the recent GlaxoSmithKline (GSK) vs. the IRScase. In this case, the IRS wants GSK to pay over $5B in taxes, interest, and penalties – more than half of its operating cash flow – due to the TP treatment that GSK gave for the sale of its anti-ulcer drug Zantac as it relates to marketing services provided by its U.S. subsidiary (Fink). The argument is that GSK charged far too low for these marketing services, and the IRS argues that marketing was a large reason for the success of Zantac (vs. R&D) since it is not first to market, but instead a “me too” drug. So, in effect, the U.S. wants U.K. based GSK to pay taxes – which would be in addition to that already paid to the U.K.
Ganley Enterprises must be weary of a similar scenario with regard to its Indian subsidiary. If corporate management sees the future growth in India as a large source of its future business, then it must be careful not to undercharge Ganley-India for the presumed marketing muscle it will provide in this market. Clearly, marketing is far more important than R&D in the home appliance business. Corporate must take this into account when determining its accounting and launch planning for the Indian market; erring on the conservative and working with Indian tax officials to ensure it is not under-valuing any marketing or OECD TP eligible “back office” services will be integral in avoiding any double taxation scenarios that could arise.
Impact on Human Resources
There is a clear disconnect with the decision that Ganley Enterprises has made and with that of the local Indian subsidiary’s management incentive and morale. Ganley-India was excited to leverage its local opportunities to launch a successful Asian export business, and there was obvious disappointment when corporate management communicated the decision to instead stay in the domestic Indian market. This is natural and expected, and is a common management obstacle with MNE subsidiaries. For one, to meet many country’s economic policies to be eligible for favorable tax concessions and other economic treatments most MNE subsidiaries must meet certain autonomy requirements from the parent to be eligible. For example, in India, to be eligible for their tax holidays and other generous concessions a subsidiary must not constitute a foreign parent’s permanent establishment (PE); in other words, the Indian subsidiary must provide evidence that their central management and control remains in India, and there is absence of a dependent agency relationship, e.g. separate boards of directors (Makhijani).
A very separate and autonomous subsidiary is created as a result of requirements such as these, and with that the expected motivations of success and performance of the Indian subsidiary. A decision such as this that impacts the way that Ganley-India can easily and accurately monitor its own performance is frustrating to the subsidiary management, and it also raises real issues for morale, motivation, and incentives.
There are two alternatives that Ganley-India can employ to help with these issues. First, Ganley-India (with corporate agreement) could keep two separate sets of books: one for tax reporting reasons, and one to reward performance. This would allow Ganley to properly record taxes with appropriate TPPs applied, and use a Ganley-India book to show performance without TPP applied. A second alternative would be for Ganley Enterprises (corporate) to migrate to a corporate wide incentive and performance based model. This would eliminate the local frustrations created by division/subsidiary incentives and performance management. From a purely philosophical perspective (as well as from a local tax eligibility treatment perspective), division specific incentives and performance management is more appropriate. A MNE will be recognizing its different businesses by incenting each of its divisions to perform at their best. However, as this case points out, it may not be realistic to apply this method if TPP clouds the ability to accomplish this.
Control of Knowledge & Parent-Host Friction
The above discussion regarding MNE subsidiary autonomy leads us to discuss how this relates to the sharing of knowledge, as well as increased R&D efforts by some MNE subsidiaries. For example, in the Ganley case the Indian subsidiary is certainly motivated to be successful from an Indian division perspective; this motivation is seemingly more than that of corporate wide success. As discussed above, local economic policy also encourages this sentiment by forcing autonomous existence from the parent corporation for tax reasons. This notion that the subsidiary motivations diverge from the firm’s overall objectives and the role that subsidiary management plays in this can be rationalized as a subsidiary’s desire to have bargaining power within the firm (Mudambi).
Ganley-India had a plan of action that had the best interests of its own performance, and would be aligned with local management motivations. The corollary decisions that Ganley-India proposed such as going with a domestic, external supplier and beginning its own R&D and manufacturing adjustments in order to leverage its Asian export desires are a result of both internal and external motivations. At first blush it would seem that Ganley-India’s motivations to compete within the Asian market are purely based on its external desire for shareholder return and for high performance as a subsidiary of Ganley Enterprises. However, this would have other internal implications as well in terms of bargaining power within Ganley Enterprises; e.g. a high performing subsidiary would be targeted for a commensurate distribution of resources and reinvestment by the firm as a whole, in order to sustain this performance.
This case begs the question as to whether Ganley Enterprises made the most appropriate choice in expanding its operations to India, as opposed to executing an in-licensing deal to accomplish its domestic Indian market goals. “Internationalization theory predicts that a firm should establish its own operations overseas only if it possesses intangible assets and capabilities that give it competitive advantages that cannot be transferred through licensing across firm boundaries.” (Mudambi) It has also been found that it is primarily R&D intangibles, and to lesser extent marketing intangibles, that is typically the reason for FDI. (Mudambi) Ganley-India has expressed great interest in participating in Ganley’s R&D efforts, but this interest of course has been squashed by the firm’s direction for its Indian subsidiary. It would seem that Ganley Enterprises is participating in efforts to control its Indian subsidiary’s bargaining power, and desire for the MNE’s “crown jewels” of R&D; or, this is just a poorly thought out example of FDI by a MNE into India.
SUMMARY
This case discussed the implications of Transfer Pricing Policy decisions, specifically in the case of Ganley Enterprises and its Indian subsidiary. The recommended OECD approved TPP method would be CUP, in order to leverage the low price point offered by Indian suppliers to Ganley-India. This would in effect, lessen the negative impact on Ganley-India’s revenues since a smaller price would be charged to it for the transfer of assets and intangibles. The decision by corporate management to forego Ganley-India’s proposal of an Asian export business is frustrating to the Indian subsidiary since it destroys the revenue generation that it had in its sights. This also has management incentive and performance implications since there will be no immediate results to show for its efforts to cultivate the domestic Indian market. In order to alleviate these management and moral issues, it is recommended that Ganley-India keep two different books: one for tax purposes and one for compensation purposes with TP excluded. It is also recommended that Ganley Enterprises be prudent in its TP treatment of marketing services to avoid any future double taxation, as evidenced by the GSK v. IRS case. Finally, it is interesting to point out the autonomy and independence that is created in part by a country’s economic policies for tax concession eligibility, and the resulting desire for division performance, bargaining power, and knowledge seeking by a MNE subsidiary that results in parent-host friction. It begs the question of proper decision making in determining whether to in-license or create a wholly owned subsidiary to avoid much of the possible management challenges discussed in this paper.