Transfer Pricing Problems, International Tax and Repatriation of Funds

A Nigerian manufacturer sells components to its new subsidiary in a neighbouring country and the subsidiary assembles and sells the finished product there. The group finance director notices that the subsidiary’s country taxes profit at 35% and charges a further 10% withholding tax on dividends sent home, while Nigeria taxes the parent at 30%.

If the components are priced a little higher, profit moves from the subsidiary to the parent and the group pays less tax overall. The group’s pre-tax profit has not changed at all; only the place where it is reported has. The tax authority of the neighbouring country, which sees its tax base shrinking, may object. This is where transfer pricing meets international taxation.

This topic covers the problems of transfer pricing inside a company (external intermediate markets, goal congruence, opportunity costs), then the effect of taxation and the repatriation of funds in international groups: tax rates, double taxation agreements, withholding tax, the tax rules on transfer prices, how profit is shared, how funds are brought back to the parent, and the risks.

It builds on the earlier topic on transfer pricing methods and the optimal transfer price. The next topic covers value chain analysis for performance management.

Problems with transfer pricing

Divisional behaviour

Transfer pricing succeeds if it lets divisions act autonomously while still serving the group. In practice divisional managers often put their own interests before those of the company, particularly if they are rewarded on divisional profit or ROI. A division may take action that maximises its own profit but reduces another division’s profit and the group’s. This is the lack of goal congruence that decentralisation can cause.

External intermediate markets

The main problems arise when there is an external intermediate market for the item: the selling division can sell externally instead of transferring, and the buying division can buy externally instead of from its sister division. Each manager will choose the option that maximises their own division’s profit.

As a general rule, where there is no external market, the transfer price is based on cost; where there is one, it is based on the market price.

But if the selling division has limited capacity, or demand in the external market is limited, opportunity costs must be considered: the selling division loses the contribution from lost external sales, and the buying division’s opportunity cost is the price it would pay outside.

Other problems

• Market price may be unreliable: temporary, affected by volume, or difficult to identify because rivals’ products differ.
• Cost-based prices give the selling division no incentive to control costs if actual costs are passed on, so standard costs should be used. Full cost makes the buyer treat fixed cost as variable.
• Negotiation can fail, needing arbitration, and reflect the managers’ skill and power.
• Dual pricing and head office imposition reduce autonomy.
• Performance measurement: a distorting price makes divisional ROI or residual income unfair; effects of one division on another (for example shared capacity) are outside the manager’s control.
• Cost of operating the system: complex data and time.

The methods themselves have benefits (flexibility, transparency of cost-based methods, realism of market methods, fairness through negotiation) and limitations (complexity, data difficulty, lack of transparency, cost-based methods not reflecting the market).

Taxation and the repatriation of funds

Why tax matters

The objective of a multinational company, like any company, relates to profit and returns for shareholders. It operates in countries with different tax systems and tries to improve earnings by minimising its worldwide tax. It will invest in countries with favourable tax systems, for example where capital investment earns relief. Some multinationals have been accused of using transfer prices to reduce tax.

Transfer prices have no effect on total pre-tax group profit; they share it between the companies concerned, and therefore between tax jurisdictions.

Tax rates and the direction of the price

As a general principle, the group wants profit to arise where the tax rate is lower. If a parent in a country with a tax rate of 20% sells goods to a wholly owned subsidiary in a country at 30%, the price should be set as high as the rules allow, which raises the parent’s profit (taxed at 20%) and cuts the subsidiary’s (taxed at 30%).

The reverse applies if the seller is in the higher-tax country: a low price, so that less profit arises there. Always work out where the seller and buyer are, and which has the lower effective tax rate, including withholding tax.

Double taxation agreements

There is usually a double taxation agreement between the two countries.

• If the foreign tax rate is higher than the parent’s, the subsidiary pays tax at the local rate and no further tax is payable in the parent’s country on those profits.
• If the foreign rate is lower, the subsidiary pays tax locally, and the parent also pays the difference between tax at the home rate and the tax already paid abroad.

Withholding tax

Withholding tax is tax deducted at source when a company pays interest or dividends (and sometimes royalties and fees) to a foreign investor. Payments from the subsidiary to the parent suffer it. It is credited against home tax under the agreement, where the credit is allowed, but increases the effective tax rate on profit that is brought home.

For example, foreign tax of 35% plus withholding tax of 10% on the remitted after-tax profit gives total foreign tax of 35% + 10% × 65% = 41.5% of pre-tax profit.

Tax rules on transfer prices

Tax authorities know that transfer prices can be set artificially to reduce tax. Tax rules in most countries make it difficult to charge inter-company prices that differ much from market prices: they apply the arm’s length principle (the price that independent parties would agree) and may adjust the profit of a company, impose penalties, and require documentation.

Nigeria applies the arm’s length principle to related-party dealings and expects documentation to support the price. The Nigeria Tax Act 2025, in force from 1 January 2026, replaced the older tax statutes; it keeps the headline company income tax rate at 30% for large companies and adds effective-tax-rate rules for large groups, which can require a top-up where a foreign subsidiary is taxed too lightly.

Rates and rules change, so in an exam use the figures given in the question and check the current law for any other use. If one country accepts a high price and the other does not, the group may suffer double taxation on the same profit. A price should therefore be justified by market evidence or a documented method.

Repatriation of funds

The parent also wants to bring profits home (to pay dividends, repay loans, or reinvest). Ways of repatriating funds from a subsidiary include:

• Dividends: paid from after-tax profit; not deductible in the subsidiary; subject to withholding tax; may be restricted by law (distributable profit) or by exchange controls.
• Interest on loans from the parent: normally deductible for the subsidiary, so it reduces local tax, but is taxed in the parent’s country and may suffer withholding tax; limits on interest deductions ( thin capitalisation rules) may apply.
• Royalties and licence fees for the use of brands, patents or know-how: deductible locally, taxable at home, may suffer withholding tax.
• Management charges for head office services: deductible if justified and at arm’s length.
• Transfer prices for goods, as above.
• Leading and lagging of inter-company payments (paying early or late) to move cash.

Issues: exchange controls or blocked funds in the subsidiary’s country; currency risk on amounts remitted; the cost of converting; and political risk. The best route depends on the combination of tax rates, withholding taxes and the rules.

Layouts for international transfer pricing

1. Parent: revenue at the transfer price; costs; profit before tax; home tax; profit after tax.
2. Subsidiary: revenue; transfer cost (converted at the given rate); local costs; profit before tax; local tax; withholding tax on remittance; cash received after conversion.
3. Group: total after-tax profit; compare prices; check that pre-tax group profit is the same.
4. Note risks: tax authority objections, double taxation.

Money is in naira (₦) and local currency (LC); each answer is rounded once, at the end.

Worked examples

1. (a) Price ₦30.
   Parent: revenue 2,400,000 − costs 2,200,000 = 200,000; tax 60,000; after tax 140,000.
   Subsidiary: revenue LC17,600,000; transfer cost LC12,000,000; local variable LC4,000,000; fixed LC400,000; profit LC1,200,000; tax 35% LC420,000; after tax LC780,000; withholding tax 10% LC78,000; remitted LC702,000 = ₦140,400.
   Group after tax ₦280,400.
2. (b) Price ₦32 (LC160).
   Parent: revenue 2,560,000 − 2,200,000 = 360,000; tax 108,000; after tax 252,000.
   Subsidiary: transfer cost LC12,800,000; costs total LC17,200,000; profit LC400,000; tax LC140,000; after tax LC260,000; withholding LC26,000; remitted LC234,000 = ₦46,800.
   Group after tax ₦298,800.
3. Comparison. Group pre-tax profit is the same in both cases (₦440,000: 200,000 + 240,000; and 360,000 + 80,000). The higher price increases group profit after tax by ₦18,400, because group tax falls from ₦159,600 to ₦141,200: profit moves from Outland (41.5%) to Nigeria (30%).
4. Risk. The ₦32 price is 6.7% above the market price. The Outland authority may reject it, adjust Outland profit upwards and tax it again, so that the same profit is taxed twice.

1. Outland:
   the fee is deductible, so Outland tax falls by 35% × 100,000 = ₦35,000.
2. Nigeria: the fee is income, taxed at 30%: tax rises by ₦30,000.
3. Net saving: ₦5,000 (and withholding tax on the fee may reduce it). The fee must be justified as an arm’s length charge for real services.

Expect variants: a table comparing two or three transfer prices, a requirement to state how the answer changes if the tax rates were reversed, a discussion of whether the tax authorities would accept the price, and a requirement to explain the ways of repatriating funds.

Common mistakes

• Setting the price in the wrong direction. Profit should arise where tax is lower.
• Forgetting the withholding tax or applying it to pre-tax profit.
• Forgetting to convert currency at the stated rate.
• Saying a transfer price changes group pre-tax profit.
• Ignoring the arm’s length rules and the risk of adjustment.
• Ignoring exchange controls in repatriation.

Quick revision

• Problems: goal congruence, external markets, opportunity cost, negotiation.
• Tax: group aims to minimise worldwide tax; profit to the lower-tax country; DTA credits; withholding tax; arm’s length rules.
• Repatriation: dividends, interest, royalties, charges, transfer prices; controls and currency risk.

How the marks are earned

• After-tax calculation and comparison.
• Tax factors named and applied.
• Risks and recommendation.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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