Separate But Unequal

When tax-based transfer prices fall short, a second managerial system helps some companies measure internal profits better.

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Jon Flaxman needs to solve a vexing problem. As CFO of Hewlett-Packard Corp.’s Enterprise Computing organization, in Palo Alto, California, he presides over a mishmash of interdivisional transfer-pricing mechanisms, based on various financial and tax-accounting regulations. Transfer prices, the charges recorded by a corporation when its units do business with each other, serve to establish the internal profit structure on which taxes are paid. At HP, as at many other companies, these pricing mechanisms also form the backbone of the divisional bonus system.

“We currently reward product managers based on their product margins, as they are created by our transfer-pricing system,” says Flaxman. The problem is, managers often get “caught up in negotiations with each other” to produce a profitable result both for their divisions and for themselves personally. That negotiation process, in turn, hampers sales representatives as they set the prices that end-users will pay for the packages of products and services that the corporation markets. In determining what HP actually will receive for its goods, the sales reps lack “flexibility between hardware profits and software profits [and] service revenues and other revenues.”

In short, transfer prices, while essential for tax reporting, create major headaches for Flaxman when applied to management reporting at the HP Enterprise Computing organization.

And Flaxman is hardly alone. Companies like HP, with extensive international operations, have the biggest transfer-pricing difficulties because intracompany transactions across borders must reflect widely varying foreign tax requirements. But domestic companies grapple with transfer pricing also, when divisions carry on transactions across state lines.

Managers Make A Difference

In both multinational and domestic companies, tax laws permit various techniques for calculating transfer prices, including cost plus profit, arm’s-length price less a set discount (“resale minus,” as it is known to some), or formulas based on comparable prices or margin measurement. Traditionally, regulations allow for some managerial discretion in how basic factors–like charges for general and administrative costs and intangibles, and profits attributable to all activities prior to the transfer in question– are included in the mix.

“The biggest problems are when the measured profitability of a business unit has more to do with the skill of its manager in negotiating his transfer prices within the company than [it does with] its economic profits and the factors that drive shareholder- value creation,” says Jay Tredwell, director of CEO Solutions for AnswerThink Consulting Group, based in Hudson, Ohio.

In the past, companies could adjust more easily to quirks in transfer-pricing requirements by bending tax rules that often weren’t monitored closely by regulators. Lately, though, the authorities have been much more aware of how corporations manage their transfer prices, as governments have sought to increase the amount of income reported and taxed in their jurisdictions. That has led corporate tax officers and controllers to tighten transfer-pricing policies and international tax strategies, and to err on the side of caution to avoid tax controversies. And this new strictness– forcing the use of numbers that may not reflect internal realities–has helped popularize the use of a second managerial set of transfer-pricing numbers for interdivisional purposes.

An AnswerThink survey among a select group of companies with more than $2 billion in annual revenues, in fact, shows that fully 77 percent now use separate reporting systems to track internal pricing information, compared with about 25 percent of large companies outside that “best practices” group.

That separate-reporting approach is probably the one HP’s Enterprise Computing business will choose. It needs to “take a fresh look at all of this data, and come up with new decision-making and compensation-measurement tools,” according to Flaxman. In HP’s case, that’s likely to mean establishing a more- flexible arrangement, which will coexist with the system that regulators require. The new reporting model would weigh data from the sales channels of its units, from variable costs, and from contribution margins.

Separate Realities

Building a separate channel for transfer pricing isn’t right for every company. At Racine, Wisconsin-based Case Corp., a $6 billion farm and construction equipment maker, for example, “We are absolutely opposed to separating our statutory and internal reporting measures,” says controller Robert Naglieri. “Not only does it cost a lot more to maintain two systems, but we also want our people around the world to be dealing with the real changes in their profitability levels when exchange rates shift, when a region’s costs increase, and so on.”

Case, which recently agreed to be purchased by New Holland NV, had the luxury of building its tax-based transfer-pricing system from scratch five years ago, when Tenneco spun it off. “We had the opportunity to rethink the way transfer prices had been set and used in the old company, and made some important decisions to set things up the way they should be,” says Naglieri. Case now keeps all accounts around the world in U.S. GAAP (generally accepted accounting principles), with management results and compensation based on actual transfer prices used by divisions for tax purposes. “When we talk internally about R&D or marketing costs,” the controller notes, “it’s the same as when we talk externally.”

Still, says AnswerThink’s Tredwell: “Having a separate system can give senior managers a better view of…real profitability [as opposed to] their ‘tax profitability.’ And it can be used to drive managers to behave in ways that are more profitable for the company overall, not just for their division or entity.”

Microsoft Corp. is one company that is “delinking” tax-based transfer pricing, as the process is sometimes called. It draws the data from a new base of managerial numbers designed to help its leadership team make better decisions on how to spend marketing resources, when to launch new products, and how to minimize actual product costs. The software behemoth recently unveiled an internal measurement system–coyly named Microsoft Accounting Principles, or MAPs–that essentially uses a separate set of company- designed rules and accounts.

“Our old systems gave us a view of the company that was consistent with our statutory reporting, as we had a fairly straightforward, traditional buy-sell arrangement between company entities,” says Microsoft controller Scott Boggs, who helped craft the separate system. “But in the early 1990s, as we moved to an Irish manufacturing and distribution center for Europe, for instance, our tax arrangements became more complex. We were essentially setting up all our other entities in Europe as commissionaires, with no revenue attributed to them.”

“Maps” For Accountability

Microsoft particularly wanted to make local sales and marketing managers accountable for the actual profitability of products, and to establish appropriate sales and marketing spending levels for every line. “So we created MAPs, which gives us a fully burdened P&L for every product in every region,” Boggs says. And that view also allows Microsoft’s leadership to compensate key managers based on a combination of MAPs results and GAAP results, depending on their place in the company’s hierarchy.

While MAPs is more or less similar to GAAP, the key differences are in how Microsoft prefers to allocate G&A costs and R&D expenses within sales divisions. “This can get fairly complex in GAAP, so we make some arbitrary sharing decisions for MAPs and get past any negotiations or complexities quickly for those purposes,” Boggs says. “Occasionally, a manager will feel he or she has too much allocated to them, but we have a set chain of dispute resolution for that, and it gets decided fairly quickly whether to adjust the level or not.”

Companies that, like Case, resist the delinkage solution often cite a lack of significant difference between their transfer prices for tax purposes and any other managerial numbers. The cost and complexity of establishing parallel systems, or concerns that resulting changes in compensation could be disruptive, may also figure into their reasoning.

“An essential problem with separated reporting systems is that transfer prices already reflect the profitability of a division or a project,” says Michael Patton, a partner for transfer pricing at Ernst & Young. “If you are trying to make decisions about new activities or facilities, and trying to judge their returns on invested capital, you need good benchmarks to judge these by, and good transfer prices provide part of that.” Basically, then, the question is whether your current transfer prices reflect economic reality or not. If they do, there’s little need for a new system, Patton says. If not, he adds, the tax authorities may have a question or two for you on audit in a few years’ time.

Realities change, of course. And, in an added benefit, companies with separate management- reporting systems are finding it easier these days to channel newer, nontraditional income streams to the appropriate products. HP’s Enterprise Computing organization, for example, wants its new system to include the increasing flow of “transaction-fee-type or pay-for-performance models that don’t fit into our current transfer-pricing and compensation,” says CFO Flaxman. Current HP models don’t apply Web-site income throughout the HP system–even though associating Web revenue with product could give a better picture of what internally provided goods and services are worth.

AnswerThink’s Tredwell believes that even some multinationals may not require a system separate from traditional transfer pricing.”If transfer prices are set up right from the start to provide good information, as well as to be tax optimal, then great. But in many cases, especially when companies grow very fast internationally, or have unique tax situations,” he says, “that doesn’t work.” If you’re looking for increased visibility and accountability through the cost chain, “a separate management reporting system can help achieve that view, when [traditional] transfer prices cannot.”

———————————————– ——————————— Why Change?

Drawbacks to using tax-based transfer pricing for management purposes.*

  • Distortions in various tax and accounting codes may prevent the traditional numbers from reflecting the realities of intracompany transactions.
  • Standard transfer pricing may encourage the wrong behavior by managers.
  • Using only the tax-based internal prices may create an artificial rigidity in internal accounting, depriving marketing people of the freedom to establish prices that reflect realistic profit margins, for example.

*As suggested by companies that have established separate managerial-reporting systems.

———————————————– ——————————— Two’s A Charm

Some suggestions for supplementing current transfer-pricing arrangements with a managerial reporting model.

  1. Base the managerial reporting on underlying business economics, not statutory and legal requirements.
  2. Realize that while tax optimizations are reflected in transfer-pricing policy, tax strategy doesn’t affect management performance numbers.
  3. Maintain consistent policies and procedures globally, in both transfer pricing and management reporting.
  4. Draw up clear procedures for dispute resolution in each area.
  5. Adjust managerial targets for the impact of transfer pricing on results.
  6. Use common data definitions for both transfer-pricing and management reporting systems.
  7. Let both management and statutory reporting systems use the same data source, such as a data warehouse.

Source: AnswerThink Consulting Group, Best Practices in Global Management Reporting, Executive Summary, 1999

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