APPENDIX 20

A.20.1 TRANSFER PRICING

Transfer pricing is a device used by Multinational Corporations to price
intracorporate exchange of goods and services in a manner designed to maximise
overall after-tax profit. It allows the parent company to control the amount and
direction of intra-corporate transfers towards the attainment of a number of vital
but often conflicting objectives. In recent years opportunities in this direction are
being severely restricted by legal constraints placed by many governments on the
practice of transfer pricing.
Essentially, transfer pricing involves charging prices for intracorporate
transactions which are different from those used for identical goods and services
in transactions with third parties. The latter are called arms length prices.
Suppose a multinational drug company has a subsidiary in a developing country.
The parent supplies bulk formulations to the subsidiary. The tax rate in parent's
country is low while that in the subsidiary's country is high. By charging high
prices -higher than arms length prices - for the inputs supplied to the subsidiary,
the reported taxable profit of the subsidiary is reduced while that of the parent is
increased thus reducing the overall tax liability.
Apart from tax saving, transfer pricing may be used to serve one or more
of the following objectives :

1. Positioning of funds in locations that will suit corporate working capital

policies.
2. Reducing exchange exposure and circumventing exchange
controls and other restrictions on profit repatriation so that
transfers from affiliates to the parent can be maximised.
3. Reducing customs duty payments and overcoming quota
restrictions on imports.
4. "Window dressing" operations to improve the apparent
i.e.reported financial position of an affiliate so that its credit
rating may be enhanced.
Many giant MNCs have employed the device of re-invoicing centres
located in tax havens such as Bahamas, Cayman islands etc. to co-ordinate
transfer pricing around the world. Intracorporate transactions e.g. between two
affiliates of the same parent or between the parent and an affiliate are routed
through the re-invoicing centre. The latter takes title to the goods sold by the
selling unit and resells them to the receiving unit. The prices received by the
seller and the prices charged to the buyer are determined so as to achieve one or
more of the above objectives. There is no interference with the actual flow of
goods which are shipped from the seller to the buyer but with the documentation
showing the two-stage transfer. The purpose is to siphon profits away from a
high-tax parent or affiliate to low tax affiliates and position funds in locations
with strong currencies and virtually no exchange controls.
The main constraint on the ability of an MNC to employ transfer pricing
arises from the provisions in the tax codes of most countries which enable the tax
authorities to reallocate and recompute corporate income. These provisions

attempt to establish "correct prices" for intracorporate transactions in line with

arms length prices whenever the latter are available. In addition the law may also
provide for other penalties if a case is established against the management.
Another factor is the involvement of local interests in a joint venture. Siphoning
profits away from an affiliate will hurt the interests of the local partners in the
venture and they will resist such policies.
Some of the objectives stated above may be mutually contradictory. In
order to overcome a quota set in value terms by the government of a developing
country, if the parent charges low transfer prices to the affiliate in that country, it
will conflict with the objective of siphoning profit away from a "soft" currency
and (most likely) a high tax country. Very often, transfer pricing may be primarily
motivated by exchange control and restrictions on profit repatriation. Overall tax
minimisation may be a secondary objective.

A.20.2 An Example of the Options Approach to Projects

We will illustrate the limitations of the traditional NPV analysis by
considering a highly simplified situation wherein there is an option to abandon
the project at some point during its life. We will use the technique of decision
trees to incorporate this possibility in the evaluation of the project.
ABC Ltd. An Indian firm long active in the wines and spirits business
has an opportunity to acquire a brewery in New Zealand for a price of
15 million New Zealand dollars (NZD). The output of the brewery will be
sold in the local market and sales will depend upon the state of the New
Zealand economy. The brewery will be in a working order for two years
after which it will have to be scrapped. Apart from the state of the New

Zealand economy, the exchange rate between the Indian rupee and New
Zealand dollar is also a source of uncertainty. The company has examined
alternative scenarios and come up with the possibilities shown in exhibit
A.20.1. The firm can liquidate the plant at the end of year 1 for a salvage
value of NZD 12 million

Exhibit A.20.1
Exchange Rate and Net Cash Flow Scenarios
Year 1

Year 2
(31.8125, 30.0)

(27.5, 20.0)
(24.0625,25.0)
(24.0625,10.0)
(17.5, 10.0)
(15.3125,7.0)

In each pair of numbers in the parentheses the first number corresponds to the
NZD/INR exchange rate and the second to the net cash flow from the plant in
millions of NZD. The current spot rate is INR 20.0 per NZD. Thus in year 1, the
exchange rate may go up to 27.5 with the net cash flow being 20.0 million NZD
or, the exchange rate may plunge to 17.5 and then the cash flow will be 10.0
million NZD. Both outcomes are equally likely with 50% probability of
occurrence. Given the outcome in year 1, in year 2 again there are two equally
likely possibilities; thus if in year 1, boom conditions prevail, the exchange rate
may further rise to 31.8125 with the net cash flow rising to 30.0 million or the
economy may slow down with the exchange rate falling to 24.0625 and the net
cash flow to 25.0 million. If the economy is depressed in year 1, the year 2
outcome may be (24.0625, 10.0) or (15.3125, 7.0), each with probability 50%.
We will first determine the expected net present value of acquiring the brewery
without considering the abandonment option.
The four possible scenarios, the rupee net cash flows under each and the NPV of
these cash flows are shown in exhibit A.20.2

Exhibit A.20.2
Project NPV without Abandonment Option
________________________________________________________
Net Cash Flows
(Million Rupees)
Total
Scenario
Year 0
Year 1
Year 2
NPV
Probability
(Mill.Rs.)
________________________________________________________
I
-300
550
954.38
899.93
0.25
II
-300
550
601.56
633.15
0.25
III
-300
175
240.63
34.13
0.25
IV
-300
175
107.19
-66.77
0.25
_________________________________________________________
To obtain the expected NPV of the acquisition, multiply the total NPV under
each scenatio by the probability of that scenario and sum across all the
scenarios :
(899.930.25) + (633.150.25) + (34.130.25) - (66.770.25) = 375.12
Now let us incorporate the abandonment option. If the economy is depressed in
year 1 with the exchange rate at 17.5, the firm can sell off the plant at a net
salvage value of NZD 12 million thus sacrificing the cash flow of the second
year. The NPV calculations are now as shown in exhibit A.20.3
Exhibit A.20.3
Project NPV with Abandonment Option
________________________________________________________
Net Cash Flows
(Million Rupees)
Total
Scenario
Year 0
Year 1
Year 2
NPV Probability
(Mill.Rs.)
________________________________________________________
I
-300
550
954.38
899.93
0.25
II
-300
550
601.56
633.15
0.25
III
-300
385
---34.78
0.50
_________________________________________________________
If the economic conditions in year 1 are depressed, the firm gets a net cash flow
of Rs.175 million from operations and Rs.210 million from sale of the assets for

a total net cash flow of Rs.385 million in year1. The expected NPV of the project
is now
(899.930.25) + (633.150.25) + (34.780.50) = 400.66
Thus the possibility of abandoning the project after one year increases the
expected NPV by over Rs.2.5 crores making the project more attractive.
This highly simplified example serves to illustrate the importance of
incorporating such built-in operational flexibility in the appraisal process. In most
real life situations, many more options may be available- timing of investment,
expanding or contracting the scale, temporary closure or abandonment and so
forth- and some of them are inter-related in complex ways. The option pricing
approach can be fruitfully employed in some of these cases.