A Seeking Alpha article this morning discusses China Transfer Pricing, among other topics – ‘transfer pricing’ section reading time 2 minutes.  Transfer Pricing is something that in all the Blog Posts and Stock Research Portal e-mails that I have written over the past three years I have never thought to discuss – in circumstances where in my valuation consulting practice over the years I have had a fair amount of exposure to multi-national companies, and actually think I know something about Transfer Pricing and what I think are likely prospective transfer pricing issues.  That said, I believe knowledge of what transfer pricing is, how it works, and how it impacts the profitability and free cash flows of international businesses ought to be on the agenda of every equity investor across all industry sectors, including the resource industries – although in some respects resource companies may enjoy some isolation from problems that can arise out of ‘transfer pricing issues’.

Transfer Pricing in concept is not particularly complicated but, like most things ‘the devil is in the detail’ and the practical application of Transfer Pricing can be extremely complicated.  At a high ‘overview level’, transfer pricing is all about how companies with operations in more than one income tax jurisdiction ‘intercompany price’ the activities that occur among those operations.  By way of simple example, assume Company A is incorporated and headquartered in the United States, that it owns a manufacturing plant in Singapore, owns a manufacturing and sub-assembly plant in China, and in the United States owns a head office, a research and development facility, a ‘final’ assembly plant, and a product distribution network.  Finally assume Company A only sells its product in the United States, and that on a consolidated basis generates both accounting profits and free cash flow, and each country it operates in has different income tax rules and rates.  In this example Company A is motivated to minimize the consolidated income tax it pays on its consolidated profit.  On the other hand, each of China, Singapore, and United States is motivated to maximize the income tax paid to each of them by Company A.

So how is this ‘multi-party’ respective self-interest ‘tension’ dealt with?  Through a mechanism established by Company A called a ‘Company A Transfer Pricing System’ that, through the application of so-called ‘arm’s length equivalent’ tests, results in Company A’s aggregate pre-tax profits being allocated – subject to scrutiny by the taxation authorities of each of China, Singapore, and the United States – to each of the three countries in which Company A has operations.

I believe that Transfer Pricing ‘tensions’ among individual multi-nationals and the income tax regimes of the countries in which operate will become an increasingly more to the fore as individual income tax jurisdictions continuously look more aggressively for sources of tax revenues.  I further believe Transfer Pricing is something equity investors need to be aware of and think about.  I plan to comment further on this issue in subsequent e-mails.

A Subscriber posted the following question yesterday to Stock Research Portal’s Investment Education Q&A Forum:  “Why might it be useful to research a mining company whose insiders are purchasing shares in the open market? I noticed with interest that in the Stock Research Portal daily e-mails I am receiving that they now include a table (see ‘Yesterday’s Insider Trade Highlights‘ below) that list the companies where insiders the previous day reported open market share purchases.  I am curious as to how much weight I should put on this information when making a decision as to whether to invest in a particular mining company”.

When I saw that question, I realized that I simply began to insert that table about two weeks ago without any accompanying reason for doing so.  The table has proven to be popular with readers, and so prior to reading that question yesterday the penny of ‘setting out a reason for the table’s existence’ hadn’t dropped for me.  My answer to that question, which you can also read on our Investment Education Q&A Forum, follows:

“Assuming (1) insiders of a company have a good working knowledge of the operations, strategies, and general prospects of that company, and (2) that if an insider buys shares of a company in the open market he/she does so believing at the time of the transaction the market is undervaluing the company’s shares – or otherwise he/she would not have purchased the shares – then an ‘insider purchase event’ may well make the company ‘worth researching’ as a possible investment or trading opportunity.

Having said that, the fact an insider has made an open market purchase doesn’t mean investors and traders should necessarily buy shares in that company.  As I see things, such a transaction is simply a ‘flag’ that says ‘here is what a supposedly company knowledgeable person has done’ – and ‘perhaps it is worthwhile to expend some research time to determine (if possible) what factor(s) might have caused the insider to purchase shares at that time, and in the quantities they did’.  By conducting research on that company investors and traders can then determine (perhaps with the help of professional advisors) whether the company shares represent a buying opportunity that they might not otherwise have identified, but for taking note of the insider trade ‘flag’.”

The following table summarizes the companies in Stock Research Portal’s Company Universe for who our system yesterday reported insiders who filed reports indicating they had acquired shares through ‘purchase’ transactions.  You can research each of these companies by clicking on the company name in the table.