Description This case was written to illustrate a transfer pricing problem in a service setting here an investment management company. The issues and solutions are not as obvious as in a manufacturing setting where one division produces parts that are transferred to another division for further processing, The case is a disguised version of a real conflict in which emotions were running high. The case exposes students to a broad range of issues that can be raised when negotiating transfer pricing. These include cost allocation methods, managers' interests and perceptions, organizational roles and conflicts, taxes, ownership structure and manager compensation, and ethics. The case also illustrates that there are often no obvious, clean solutions to transfer pricing problems. The Company's Profit Model Addressing the transfer pricing problem requires an understanding of how Global Investors (GI) creates value. The basic business model is essentially as follows: 1. Sales to institutional investors were done primarily by corporate sales staff. Almost all sales to individual investors were made by independent broker/dealers. 2. Deciding how to invest the clients' money was largely a centralized function performed by highly trained specialists in New York or contractors hired by corporate. The local subsidiaries had people who traded financial assets following headquarters' guidelines. 3. Some corporate specialists focused on improving cost efficiencies, such as by generating economies of scale in trading activities and by improved use of technology But then the situation gets a bit muddled: 1. Client service was largely a local function. If the client was based in the UK, the service was performed primarily by the London office. 2. Two of the subsidiaries-those based in Tokyo and London-had built up small staffs of advisors who specialized in providing investment advice for clients wanting to invest locally and who developed local funds which did not necessarily follow the investment strategies developed by headquarters But in all cases, local clients were assigned a New York-based client service contact and received investment information from Gl headquarters. This raises the question, then, of how much value is being provided by the local subsidiaries vs. headquarters? It is difficult to tell without doing a study. The relative value created by each function and each location could vary markedly across clients. Transfer Pricing Alternatives Alternative 1-Current transfer pricing system The case states that GI's current measurement system treated the subsidiaries as costfocused profit centers, instead of mere cost centers, because each is assigned a revenue figure (Reimbursement from Parent) that provides a 110% reimbursement of their direct controllable costs. Thus, on the operating income line, each subsidiary looks like it is earning a profit (see case Exhibit 5). The current measurement system provided some real advantages for GI. It ensured that the subsidiaries would look financially sound to local regulators and clients. It gave the impression to tax authorities that each subsidiary was earning a profit. And it was simple But the current system had some drawbacks. Alistair Hoskins, CEO of the London subsidiary, was the most vocal in pressing for change. He seemed to have several concerns. He was concerned that if the London subsidiary was ever sold, it might be valued simply at a multiple of earnings or earnings before interest, tax, depreciation and amortization (EBITDA). He believed that the subsidiary generated more profit than it was given credit for. He was also concerned that I would face serious consequences if the local regulatory authorities learned that the subsidiaries' real profits were higher than were being reported. To date, Gl had never had to undergo a tax audit, so the tax authorities had never detected this problem. The transfer pricing alternatives proposed, which are outlined in detail in the case, are remarkable in their arbitrariness Alternative 2-Hoskins first proposal Hoskins first proposal was to allocate revenues to subsidiaries based on a proportion of the assets under management and to have the subsidiaries pay corporate a royalty of 50% of revenues for the use of their trading strategy advice. No justification was provided for the 50% royalty rate. This measurement method would make all the subsidiaries look hugely pro table That, in itself, would provide some tax savings for GI because the New York tax rates were higher than those GI faced in any other tax jurisdiction. Alternative 3-Davis' first proposal Jack Davis, the corporate Operations VP rejected Hoskins method. He argued that to a Large extent the subsidiaries were just following instructions from headquarters. And, further, many of the funds the subsidiaries were managing belonged to New York clients. He proposed instead to allocate revenues based on the origin of the clients, not the current location providing Alternative 3-Davis' first proposal Jack Davis, the corporate Operations VP, rejected Hoskins' method. He argued that to a large extent the subsidiaries were just following instructions from headquarters. And, further, many of the funds the subsidiaries were managing belonged to New York clients. He proposed instead to allocate revenues based on the origin of the clients, not the current location providing the service. This transfer pricing method would cause all the subsidiaries to report large losses on their operating income line. Alternative 4-Hoskins' second proposal Hoskins then did some industry benchmarking and found that the industry standard" was to split fee revenues equally between Client Services and Investment Management. We inquired Gl management as to the rationale behind this standard, and no one could explain it to us. The primary rationale seemed to be a general recognition that both functions created value, but that it was too difficult or too costly to measure the relative proportions of value creation Hoskins interpreted the method to mean that the Client Service revenue should be allocated based on the origin of the clients, and the Investment Management revenue should be allocated based on a proportion of the assets being managed. He proposed still to pay a 50% royalty to corporate for the investment Management revenue. This alternative, too, would have made each subsidiary look quite profitable. Alternative 5-Davis' second proposal Davis' counter-proposal tweaked with this 50-50 proposal. He proposed to leave all of the Investment Management revenue in New York, since the investment strategies were almost exclusively developed at headquarters. But the subsidiaries would be reimbursed for their Investment Management-related costs, plus a 10% mark-up. This alternate would have caused most of the subsidiaries, including London, to report losses, as is shown in case Exhibit 6. Not surprisingly, Hoskins rejected this approach. Other Alternatives Utilize Hoskins' second proposal, but allow for the negotiation of the royalty rate provided to headquarters for their trading strategy advice. Royalty rate adjustments could be based on the degree of customization of the trading strategies to local client needs. Utilize Davis' second proposal, but give the subsidiaries full recognition of the investment management revenue generated by the local funds that follow trading Davis' counter proposal tweaked with this 50-50 proposal. He propuse leave a UI the investment Management revenue in New York, since the investment strategies were almost exclusively developed at headquarters. But the subsidiaries would be reimbursed for their Investment Management-related costs, plus a 10% mark-up. This alternate would have caused most of the subsidiaries, including London, to report losses, as is shown in case Exhibit 6. Not surprisingly, Hoskins rejected this approach. Other Alternatives Utilize Hoskins' second proposal, but allow for the negotiation of the royalty rate provided to headquarters for their trading strategy advice. Royalty rate adjustments could be based on the degree of customization of the trading strategies to local client needs. Utilize Davis' second proposal, but give the subsidiaries full recognition of the investment management revenue generated by the local funds that follow trading strategies that differ from those developed at the headquarters Recognize the full revenue at the subsidiary level and search for market data (such as the Lipper data for investment management and sub-advisory fees) to determine the rate that the subsidiaries should pay to the headquarters for their investment strategies and advisory services. This method also would provide evidence of an arm's length relationship. But would such an approach be (too) costly to implement (such as due to extensive benchmarking data collection efforts)? QUESTION 1 Opc What transfer pricing model is in the best interest of Global Investors, Inc.? Some suggestions below: it is important to recognize all of the purposes served by the company's performance measurement system and, in particular, its transfer pricing system, including: a. Reporting to regulators (income tax authorities and financial regulators); b. Possible valuation of subsidiaries (e.g., multiple of EBITDA); c. Management evaluation and compensation (although that seems not to be a major purpose here); d. Understanding the subsidiaries performance to improve strategic decision making: e. Aligning subsidiary incentives to the overall strategies and goals of the corporation, mitigating any conflicts between generating value for the subsidiary and achieving the broader corporate goals. Corporate strategic considerations are particularly important in this company as recognizing the value-added by subsidiaries of developing local funds may be counter-productive given that Gi's differentiation strategy is focused on following corporate trading strategies developed by prominent academics. Do the GI top executives prefer to discourage the development of local funds following other strategies? TTT Arial : 3(12pt) TEE QUESTION 2 0 poil If management evaluation and compensation were the primary purpose of the transfer pricing system, how should the choice of the transfer pricing method be made? Some suggestions below: It must also be recognized that the subsidiaries' financial reports can affect managers' self esteem and sense of fairness. Failure to please them in those areas can create conflict and demotivation. Deciding which purposes to emphasize can suggest a preferred alternative. If c. (in the list above) were a more important purpose of the measurement system, how should the choice of transfer pricing method be made? This is a difficult question to answer. With the current system, there would seem to be a tendency for subsidiary managers to increase their direct controllable costs since those costs are reimbursed 110% by corporate. But corporate managers would certainly have visibility into those costs and would have ways of controlling them. Choosing a system that allocated revenues based on a proportion of the origin of the clients or the investment services provided could have significant effects on the subsidiaries' actions and hence, organizational teamwork QUESTION 3 How should Bob Mascola run the transfer pricing task force meeting that will include Gl's CEO? Some suggestions below: The Process It is useful to note how expensive this process was. The task force was comprised of a high-level group of executives who invested a significant amount of time in the meetings and preparations for the meetings over a seven-month period of time. In the real company, Gary Spencer, GI's CEO, just wanted this issue to go away. He did not want to change the system, for the reasons discussed above. He agreed to have a task force address the issue just to appease the subsidiary managers who were complaining. You need to think about what outcome Mascola might value. With his boss in the meeting. Mascola might try to direct the group toward a no change outcome. But perhaps the complaining subsidiary managers need to be appeased. Hoskins acceptance of the various alternatives seems to be related to the level of the operating profits reported in London. Thus, some minor compromise might be entertained to allow more profits to be shown in the subsidiaries in the hope that Hoskins will stop voicing his objections. An alternative is to commission a study to try to determine just how much value is created in the Client Service and Investment Management areas by personnel in headquarters vs. the local subsidiaries. But this would be difficult and costly, and it is unlikely that Spencer would agree to spend the money for this study In the real company situation, Hoskins came to understand Spencer's indifference, and he realized that he did not have the power to sell his proposed model(s. Further, unless and until he increased the size of his client base, he was better off with the current, cost-plus system than with the last system proposed by Davis. So he backed down. No change was made. T rial 2012 - QUESTION 4 Discuss the cost allocations from cost centers to business units. Useful proposals might include the following: Allocate costs directly from cost centers to business units, once only (thus eliminating allocations from cost centers to cost centers). This should simplify the calculations and remove the need for using the more complex reciprocal allocation method to arrive at the final cost allocations to each business unit. . Rather than rely on the individual judgment of cost center managers, base cost center allocations on actual business unit usage, which could be documented in a Service Level Agreement (SLA) between the cost center and the affected business units. An added feature of SLAs is that they could be used as part of the due diligence process for the Global Transfer Pricing taxation review by GI's auditor, which must be carried out before the arrangements are finalized, to ensure the taxation consequences are satisfactorily dealt with. The first proposal emphasizes simplification, the second one documentation for tax compliance Description This case was written to illustrate a transfer pricing problem in a service setting here an investment management company. The issues and solutions are not as obvious as in a manufacturing setting where one division produces parts that are transferred to another division for further processing, The case is a disguised version of a real conflict in which emotions were running high. The case exposes students to a broad range of issues that can be raised when negotiating transfer pricing. These include cost allocation methods, managers' interests and perceptions, organizational roles and conflicts, taxes, ownership structure and manager compensation, and ethics. The case also illustrates that there are often no obvious, clean solutions to transfer pricing problems. The Company's Profit Model Addressing the transfer pricing problem requires an understanding of how Global Investors (GI) creates value. The basic business model is essentially as follows: 1. Sales to institutional investors were done primarily by corporate sales staff. Almost all sales to individual investors were made by independent broker/dealers. 2. Deciding how to invest the clients' money was largely a centralized function performed by highly trained specialists in New York or contractors hired by corporate. The local subsidiaries had people who traded financial assets following headquarters' guidelines. 3. Some corporate specialists focused on improving cost efficiencies, such as by generating economies of scale in trading activities and by improved use of technology But then the situation gets a bit muddled: 1. Client service was largely a local function. If the client was based in the UK, the service was performed primarily by the London office. 2. Two of the subsidiaries-those based in Tokyo and London-had built up small staffs of advisors who specialized in providing investment advice for clients wanting to invest locally and who developed local funds which did not necessarily follow the investment strategies developed by headquarters But in all cases, local clients were assigned a New York-based client service contact and received investment information from Gl headquarters. This raises the question, then, of how much value is being provided by the local subsidiaries vs. headquarters? It is difficult to tell without doing a study. The relative value created by each function and each location could vary markedly across clients. Transfer Pricing Alternatives Alternative 1-Current transfer pricing system The case states that GI's current measurement system treated the subsidiaries as costfocused profit centers, instead of mere cost centers, because each is assigned a revenue figure (Reimbursement from Parent) that provides a 110% reimbursement of their direct controllable costs. Thus, on the operating income line, each subsidiary looks like it is earning a profit (see case Exhibit 5). The current measurement system provided some real advantages for GI. It ensured that the subsidiaries would look financially sound to local regulators and clients. It gave the impression to tax authorities that each subsidiary was earning a profit. And it was simple But the current system had some drawbacks. Alistair Hoskins, CEO of the London subsidiary, was the most vocal in pressing for change. He seemed to have several concerns. He was concerned that if the London subsidiary was ever sold, it might be valued simply at a multiple of earnings or earnings before interest, tax, depreciation and amortization (EBITDA). He believed that the subsidiary generated more profit than it was given credit for. He was also concerned that I would face serious consequences if the local regulatory authorities learned that the subsidiaries' real profits were higher than were being reported. To date, Gl had never had to undergo a tax audit, so the tax authorities had never detected this problem. The transfer pricing alternatives proposed, which are outlined in detail in the case, are remarkable in their arbitrariness Alternative 2-Hoskins first proposal Hoskins first proposal was to allocate revenues to subsidiaries based on a proportion of the assets under management and to have the subsidiaries pay corporate a royalty of 50% of revenues for the use of their trading strategy advice. No justification was provided for the 50% royalty rate. This measurement method would make all the subsidiaries look hugely pro table That, in itself, would provide some tax savings for GI because the New York tax rates were higher than those GI faced in any other tax jurisdiction. Alternative 3-Davis' first proposal Jack Davis, the corporate Operations VP rejected Hoskins method. He argued that to a Large extent the subsidiaries were just following instructions from headquarters. And, further, many of the funds the subsidiaries were managing belonged to New York clients. He proposed instead to allocate revenues based on the origin of the clients, not the current location providing Alternative 3-Davis' first proposal Jack Davis, the corporate Operations VP, rejected Hoskins' method. He argued that to a large extent the subsidiaries were just following instructions from headquarters. And, further, many of the funds the subsidiaries were managing belonged to New York clients. He proposed instead to allocate revenues based on the origin of the clients, not the current location providing the service. This transfer pricing method would cause all the subsidiaries to report large losses on their operating income line. Alternative 4-Hoskins' second proposal Hoskins then did some industry benchmarking and found that the industry standard" was to split fee revenues equally between Client Services and Investment Management. We inquired Gl management as to the rationale behind this standard, and no one could explain it to us. The primary rationale seemed to be a general recognition that both functions created value, but that it was too difficult or too costly to measure the relative proportions of value creation Hoskins interpreted the method to mean that the Client Service revenue should be allocated based on the origin of the clients, and the Investment Management revenue should be allocated based on a proportion of the assets being managed. He proposed still to pay a 50% royalty to corporate for the investment Management revenue. This alternative, too, would have made each subsidiary look quite profitable. Alternative 5-Davis' second proposal Davis' counter-proposal tweaked with this 50-50 proposal. He proposed to leave all of the Investment Management revenue in New York, since the investment strategies were almost exclusively developed at headquarters. But the subsidiaries would be reimbursed for their Investment Management-related costs, plus a 10% mark-up. This alternate would have caused most of the subsidiaries, including London, to report losses, as is shown in case Exhibit 6. Not surprisingly, Hoskins rejected this approach. Other Alternatives Utilize Hoskins' second proposal, but allow for the negotiation of the royalty rate provided to headquarters for their trading strategy advice. Royalty rate adjustments could be based on the degree of customization of the trading strategies to local client needs. Utilize Davis' second proposal, but give the subsidiaries full recognition of the investment management revenue generated by the local funds that follow trading Davis' counter proposal tweaked with this 50-50 proposal. He propuse leave a UI the investment Management revenue in New York, since the investment strategies were almost exclusively developed at headquarters. But the subsidiaries would be reimbursed for their Investment Management-related costs, plus a 10% mark-up. This alternate would have caused most of the subsidiaries, including London, to report losses, as is shown in case Exhibit 6. Not surprisingly, Hoskins rejected this approach. Other Alternatives Utilize Hoskins' second proposal, but allow for the negotiation of the royalty rate provided to headquarters for their trading strategy advice. Royalty rate adjustments could be based on the degree of customization of the trading strategies to local client needs. Utilize Davis' second proposal, but give the subsidiaries full recognition of the investment management revenue generated by the local funds that follow trading strategies that differ from those developed at the headquarters Recognize the full revenue at the subsidiary level and search for market data (such as the Lipper data for investment management and sub-advisory fees) to determine the rate that the subsidiaries should pay to the headquarters for their investment strategies and advisory services. This method also would provide evidence of an arm's length relationship. But would such an approach be (too) costly to implement (such as due to extensive benchmarking data collection efforts)? QUESTION 1 Opc What transfer pricing model is in the best interest of Global Investors, Inc.? Some suggestions below: it is important to recognize all of the purposes served by the company's performance measurement system and, in particular, its transfer pricing system, including: a. Reporting to regulators (income tax authorities and financial regulators); b. Possible valuation of subsidiaries (e.g., multiple of EBITDA); c. Management evaluation and compensation (although that seems not to be a major purpose here); d. Understanding the subsidiaries performance to improve strategic decision making: e. Aligning subsidiary incentives to the overall strategies and goals of the corporation, mitigating any conflicts between generating value for the subsidiary and achieving the broader corporate goals. Corporate strategic considerations are particularly important in this company as recognizing the value-added by subsidiaries of developing local funds may be counter-productive given that Gi's differentiation strategy is focused on following corporate trading strategies developed by prominent academics. Do the GI top executives prefer to discourage the development of local funds following other strategies? TTT Arial : 3(12pt) TEE QUESTION 2 0 poil If management evaluation and compensation were the primary purpose of the transfer pricing system, how should the choice of the transfer pricing method be made? Some suggestions below: It must also be recognized that the subsidiaries' financial reports can affect managers' self esteem and sense of fairness. Failure to please them in those areas can create conflict and demotivation. Deciding which purposes to emphasize can suggest a preferred alternative. If c. (in the list above) were a more important purpose of the measurement system, how should the choice of transfer pricing method be made? This is a difficult question to answer. With the current system, there would seem to be a tendency for subsidiary managers to increase their direct controllable costs since those costs are reimbursed 110% by corporate. But corporate managers would certainly have visibility into those costs and would have ways of controlling them. Choosing a system that allocated revenues based on a proportion of the origin of the clients or the investment services provided could have significant effects on the subsidiaries' actions and hence, organizational teamwork QUESTION 3 How should Bob Mascola run the transfer pricing task force meeting that will include Gl's CEO? Some suggestions below: The Process It is useful to note how expensive this process was. The task force was comprised of a high-level group of executives who invested a significant amount of time in the meetings and preparations for the meetings over a seven-month period of time. In the real company, Gary Spencer, GI's CEO, just wanted this issue to go away. He did not want to change the system, for the reasons discussed above. He agreed to have a task force address the issue just to appease the subsidiary managers who were complaining. You need to think about what outcome Mascola might value. With his boss in the meeting. Mascola might try to direct the group toward a no change outcome. But perhaps the complaining subsidiary managers need to be appeased. Hoskins acceptance of the various alternatives seems to be related to the level of the operating profits reported in London. Thus, some minor compromise might be entertained to allow more profits to be shown in the subsidiaries in the hope that Hoskins will stop voicing his objections. An alternative is to commission a study to try to determine just how much value is created in the Client Service and Investment Management areas by personnel in headquarters vs. the local subsidiaries. But this would be difficult and costly, and it is unlikely that Spencer would agree to spend the money for this study In the real company situation, Hoskins came to understand Spencer's indifference, and he realized that he did not have the power to sell his proposed model(s. Further, unless and until he increased the size of his client base, he was better off with the current, cost-plus system than with the last system proposed by Davis. So he backed down. No change was made. T rial 2012 - QUESTION 4 Discuss the cost allocations from cost centers to business units. Useful proposals might include the following: Allocate costs directly from cost centers to business units, once only (thus eliminating allocations from cost centers to cost centers). This should simplify the calculations and remove the need for using the more complex reciprocal allocation method to arrive at the final cost allocations to each business unit. . Rather than rely on the individual judgment of cost center managers, base cost center allocations on actual business unit usage, which could be documented in a Service Level Agreement (SLA) between the cost center and the affected business units. An added feature of SLAs is that they could be used as part of the due diligence process for the Global Transfer Pricing taxation review by GI's auditor, which must be carried out before the arrangements are finalized, to ensure the taxation consequences are satisfactorily dealt with. The first proposal emphasizes simplification, the second one documentation for tax compliance