Essay: Transfer pricing refers

Background information

In a broad way, transfer pricing refers to the pricing of tangible and intangible assets, services and funds which are transferred within divisions of the same company. The division transferring its output to another division deems such transaction to be a sale and there is a defined policy to determine this transfer price set by the management of the company itself. Domestic transfer pricing exists when assets are transferred between divisions of the company in the same country, for example, where goods are transferred from the production division to the marketing division in the same country. On the other hand, in the case of a multinational company where the divisions of the company are disseminated on an international scale, the transfer of assets between one division in one country and another division abroad is referred to as international transfer pricing.

Since the products and services would be transferred within the company itself, the external market mechanism to set transfer prices may not necessary apply. The method by which transfer prices are set is determined by management and can be any of the following five broad systems:

1. Market-based transfer prices – when an external market exists for the item being transferred between the company’s divisions, the transfer price is set equal to the market price.
2. Marginal cost transfer prices – the goods or services are transferred at the marginal cost of producing the item. Many a times, marginal cost is approximated by the short-run variable cost.
3. Full cost transfer prices – the selling division transfers the asset at a price equal to the full production cost of the product or service. To achieve full cost, many companies usually add a mark-up percentage to the variable cost of the good or product to ensure covering fixed costs committed to production.
4. Cost-plus a mark-up transfer prices – the products or services are transferred at a price equal to cost plus a profit mark-up so that the supplying division will be able to show a profit on such transfers.
5. Negotiated transfer prices – managers of the supplying and receiving department will negotiate the inter-divisional transfer price between them, having regard of the market price and costs of the product or service.

The main objectives of transfer pricing can be classified as follows:

1. To achieve goal congruence – the actions of the managers to seek their own self-interest is aligned to the interests of the overall company.
2. To maintain autonomy of the different divisions – although the divisions of the company would be highly integrated, it is important that managers feel they are driving their division so that they are motivated to improve their performance. In addition, one division should not become totally dependent on another one.
3. To enable performance measurement of the different divisions – it is important that the system permits management to accurately appraise the contribution that each division is making towards the overall profitability of the company. This also provides a basis for structuring incentive schemes based on the performance of the different divisions.
4. Facilitate the preparation of the financial statements of the company’s divisions

Different transfer pricing methods are aimed at achieving different objectives and a method which aims at attaining one particular purpose may be in conflict with other ones. It is difficult to implement a method which enables management to achieve all the objectives simultaneously. Thus, it is important for management to first determine the goal which will be pursued, and then implement the transfer pricing method which best achieves that object.

International transfer pricing raises further issues to be considered in addition to those presented under domestic transfer pricing. The choice of the transfer price will influence the allotment of profits to the different departments of the company. In the case of international transfer pricing, the transfer pricing method will determine the profit levels in each different jurisdiction, thus, determining the tax amounts paid in different countries. Fiscal authorities are aware of the possibility of tax emigration and many regulations have been enacted to deal with unfair transfer of profits.

Most of the pharmaceutical companies have become multinational companies with manufacturing plants distributed across the world to source the best resources worldwide. Manufacturing and marketing functions are usually decentralized in various global divisions, while research and development functions are centralized. The divisions of such companies are very integrated. However, they make use of international transfer pricing to emulate autonomy across the divisions of their global network.

There are some characteristics of the pharmaceutical industry which have a considerable impact on the use of transfer pricing. Research and development costs are incurred centrally; however, these have to be apportioned across the worldwide divisions of the company. A constantly increasing level of research and development costs has to be apportioned upon a decreasing amount of active substances. In addition, ground-breaking drugs are unique and there is no market against which to compare their value. Transfer pricing becomes an important tool in the hands of management as it takes into consideration these characteristics to devise a system with the ability of assessing performance, emulating autonomy, motivating, and, at the same time, controlling managers spread across the company’s global network. International transfer pricing thus becomes an indispensable tool for the management and control of a global company in the pharmaceutical industry.

The local pharmaceutical industry is flourishing, with many international companies establishing manufacturing plants in Malta to take advantage of our favourable legislation, skilled workforce, and incentive packages emanating from the Business Promotion Act. Many of these companies produce generic drugs, in other words, drugs which are produced and distributed without patent on the active substance of the drug. Maltese legislation is very attractive in this regard as it incorporates the Bolar exemption. Malta’s interpretation of the provision allows a company developing low-priced, generic versions of patented pharmaceuticals to begin developing copycat products six years after a pharmaceutical company first applies for authorisation to market a new drug, even while the drug is still under patent protection (Kelleher 2006). While Malta’s Medicines Act stipulates a six-year period, other EU member states have a ten-year period. This shorter time period represents an advantage that Malta has over its European counterparts, making this the main reason why the pharmaceutical industry in Malta is expanding significantly. Malta has obtained derogation from the EU upon negotiating its accession to the union to extend this period to ten years only after 2020.

Objectives of the study

The main objective of the dissertation is to evaluate the transfer pricing systems used by local pharmaceutical companies. Amongst other things, the study will identify the methods used for international transfer pricing in these multinational companies, the objectives behind such transfer pricing systems, and the persons responsible for setting international transfer prices. An assessment of these systems will follow taking into consideration the ability of the system to measure performance, motivate managers, achieve goal congruence across company divisions, and promote the autonomy of such divisions. Although the study takes a management accounting perspective, being a research on international transfer pricing, inevitably the study would have to discuss aspects of international taxation and possible conflicts that tax considerations might have with other objectives of the transfer pricing system. Furthermore, suggestions will be provided to ameliorate the current transfer pricing system in local pharmaceutical companies.

Need for such a study

Many researchers agree that international transfer pricing is highly applicable in the pharmaceutical industry insomuch as many transactions in such industry are carried out amongst companies in the same group of companies on a global basis. In view of the expansion of the pharmaceutical industry in Malta and the relative importance of international transfer pricing in the pharmaceutical industry, a study is considered indispensable to explore and assess the various transfer pricing methods used and the objectives pursued through such systems.

Research Methodology

Qualitative research is considered to be more appropriate in this case due to the nature of the study. Qualitative methods are considered to be more flexible and spontaneous than quantitative methods and allow the interviewer to discuss various aspects of the study in greater detail by asking open-ended questions rather than yes or no queries. Due to its flexibility, a qualitative approach also allows the interviewer to discuss issues which are unknown to him but arise during the course of the discussion, or ask the participant to clarify or further explain particular issues when required. Comparative research will then be used to compare the responses of the participants. However, qualitative methods are more subjective than quantitative ones and are more difficult to analyse due to their flexibility.

The study will be conducted amongst the local pharmaceutical companies which utilize transfer pricing. However, there is no one reliable source to identify the whole population and several sources had to be consulted to identify the population. The population is made up of companies manufacturing pharmaceuticals and does not include any importers of pharmaceuticals or subsidiaries of multinational companies which are marketing centres. Therefore, the study will be conducted amongst these companies:

• Manufacturers of generic and branded pharmaceuticals
• Manufacturers of chemicals used in the production of generic pharmaceuticals

A population of 9 companies fulfilling these criteria was identified. Due to the small population, it was decided to conduct the study on the whole population rather than identifying a sample.

Semi-structured interviews will be conducted with the financial controllers and production managers of the participant companies to obtain insights on the use of international transfer pricing. The interviews will deal with aspects of organisational structure, transfer pricing administration, methods of transfer pricing, objectives of the systems, and will provide valuable insights on the transfer pricing system to enable a meaningful evaluation.

The participants will be asked permission to record the conversation to enable an accurate analysis to be carried out.

Dissertation Overview

The structure of the dissertation is illustrated below:

Chapter one will provide an introduction to the topic, outlining the main theme to be discussed in the dissertation. The second chapter will provide an analysis of the diverse articles and books discussing the topic. The following chapter will illustrate the methods that will be used to collect data and information to be able to conduct the research. Chapter four will exhibit the findings of the study; while, chapter five will discuss and analyse such findings. Finally, chapter six will conclude the study, provide recommendations that can be implemented to ameliorate the transfer pricing policy of the local pharmaceutical industry, and identify other areas for further study.

Support

The following pharmaceutical companies are willing to participate in the study:

• Aurobindo Pharma (Malta) Ltd.
• Amino Chemicals Ltd.