Transfer Pricing

Transfer price is the internal price charges for a raw material, goods, or service as it moves from one related organizational entity to another within a consolidated enterprise group, including divisions, subsidiaries, affiliates or joint ventures (Cravens, 1997; Horngren et al., 2002; Atkinson et al., 2004; Gao and Zhao, 2015). Such transfers can be of intermediate goods, produced by one affiliate company and sold to another, or they can include a license or royalty fee paid for the right to use intellectual property owned by another part of the group (Keuschnigg and Devereux, 2013). Transfer price plays as a device for the allocation of costs, income, revenues, and profits within various subunits (Sikka and Willmott, 2010). For an integrated enterprise, transfer price is a payment from the downstream to the upstream division as a compensation for delivery of the intermediate product (Haake and Martini, 2013).

Transfer price can provide internal signals that direct the allocation of resources and profits in the enterprise group (Adams and Drtina, 2008). Kaplan (1982) shows that inappropriate transfer pricing mechanisms can lead firms to perform poorly and to sustain monetary losses. It is commonly agreed that a major function of transfer

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pricing is to achieve coordination among the divisions of a firm (Edlin and Reichelstein, 1995).

In decentralized firms (comprising production and marketing divisions), costs are reported from production division to marketing division through transfer prices. The reasons why transfer prices are different from marginal costs mainly come from asymmetric information and divergence of preferences (e.g., Ronen and Mckinney, 1970; Harris et al., 1982; Eccles, 1985; Ronen and Balachandran, 1988; Christensen and Demski, 1990; Holmstrom and Tirole, 1991; Mookherjee and Reichelstein, 1991;

Edlin and Reichelstein, 1995; and Vaysman, 1996).

In the accounting and management fields, many studies emphasize that decentralization of firm activities is the main cause of transfer pricing problem (Amershi and Cheng, 1990; Grabski, 1985; Halperin and Srinidhi, 1991; Hansen and Kimbrell, 1991). Zhao (2000) finds that vertically integrated MNE may use transfer pricing to manipulate profit distribution across branches to take advantage of its unintegrated competitor. Transfer pricing can be used as a rent-shifting device by a partially decentralized MNE to compete with its rival. If the rival is fully integrated, decentralization and competition will lower transfer prices.

Wu and Sharp (1979) and Tang (1980) empirically reveal that global profit maximization and the subsidiaries performance evaluation are the main objectives for transfer pricing. Schjelderup and Sørgard (1997) argue that multinational firm sets the price that applies to intra-firm trade between the firm’s affiliates at a central level, but delegates decisions about national prices (or quantities) to national affiliates. When these affiliates encounter competition, it is shown that delegation of authority and the nature of competition changes the role of the transfer price. It becomes both a strategic and a tax saving device.

Johnson, Johnson, and Pfeiffer (2016) examine a dual transfer pricing problem between two divisions of a decentralized firm and allow the selling division to be credited for an amount that differs from the amount charged to the buying division.

They find that optimal transfer prices will be linear functions of the market price.

Even the upstream division faces multiple internal buyers or faces a binding capacity constraint, these results still hold.

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2.1.1 Strategic Tool

Past researches show that MNEs can use transfer pricing as a strategic device when they delegate product prices (or quantities) decisions to its affiliates under pure oligopoly (e.g., Schjelderup and Sogard, 1997; Nielsen et al., 2003). In decentralized oligopolistic settings, a decrease in transfer price increases the sales quantity of the product, thus improving a subsidiary’s competitive advantage in the final product market, and vice versa (Alles and Datar, 1998; Gabrielsen and Schjelderup, 1999;

Zhao. 2000).

Strategic factors may influence the choice of costs on which product prices are based (Horngren et al., 1994; Kaplan and Atkinson, 1989). Alles and Datar (1998) develop a model with two oligopolistic firms. They show that firms may select their cost-based transfer prices strategically and cross subsidize their products. Therefore, transfer prices will have a strategic component to them. Transfer pricing is a strategy rather than a procedure (Eccles, 1985; Spicer, 1988) to ensure goal congruence between the firm and its divisions (Abdallah, 1989; Tippett and Wright, 2006).

Schjelderup and Weichenrieder (1999) argue that a country that switches from price-related transfer pricing rules to profit-related measures can reduce imports without changing firms' transfer prices. They show that trade effect makes the change of transfer pricing rules a potential instrument of protectionism and strategic trade policy.

2.1.2 Tax Evasion Device

Horst (1971) analyzes the choices of a monopolistic firm selling in two countries simultaneously. The author shows that the firm chooses either the lowest or highest transfer price depending on comparing the tax rates between the importing and exporting countries with the tariff rate. Transfer pricing focuses on how multinational firms employ transfer prices to avoid paying part of income taxes. One of the objectives of an international transfer pricing strategy is attempting to minimize the tax burden (Cravens, 1997). When MNEs encounter different tax schedules, they will shift profits toward lower tax countries to reduce their overall tax liability by manipulating transfer prices on intra-firm traded goods and services between divisions of the MNEs that are resident in different countries (Clausing, 2000; Copithorne, 1971;

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Horst, 1971; Keuschnigg and Devereux, 2013; Yao, 2013). Haufler and Schjelderup (2000) analyses optimal taxation of corporate profits when governments can choose both the rate and the base of the corporation tax. They suggest that it is optimal for each government to distort investment decisions in order to reduce tax rates and limit the incentive for profit shifting. Sikka and Willmott (2010) examine the transfer prices practices in developing and developed economies. They argue that transfer pricing practices enhance private gains but contribute to social poverty by avoiding the payment of public taxes. For host government, collecting corporate taxes has therefore become a challenging task with the increasing amount of MNEs. Focused on the profitability of affiliates in different countries, many empirical studies indicate that transfer prices are influenced by tax considerations (Clausing, 2000).

Traditional results suggest that the decision making of transfer price is to maximize the firm’s after-tax profit. Martini (2015) demonstrates a policy of negotiated transfer pricing is the firm’s optimal organizational choice if the high-tax division’s productivity is high. For tax-driven mechanism, Jenkins and Wright (1975) examine the profitability of U.S. oil companies and find that affiliates in low–tax rate countries are more profitable. Yao (2013) finds that heavy corporate tax rate will make MNE to locate its subsidiary toward market center to reduce consumers’

transportation cost and then raise its sales quantity. But, Cravens (1997) examines the results of a survey of executives of US-based multinational firms and finds that international transfer pricing on taxation is not the primary objective for the executives. On the contrary, MNEs employ transfer pricing to assist in achieving competitive advantage and other corporate objectives as well.

Corporate income tax evasion is more complicated. When a firm decides to escape taxes, it takes the risk of being detected by the tax authorities. Tax evasion through transfer pricing creates distortion on managers’ effort and reduces their efficiency. Thus increases the profit retained by the firm not only at the risk of being detected, but also at the cost of efficiency loss in internal control (Chen and Chu, 2005). Gordon and MacKie-Mason (1995) model the trade-off for home and host governments to employ either corporation tax or tax on wages. They find that increasing corporation tax leads to international income shifting by transfer pricing while positive tax differential between the tax rates on wages and profits will induce

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domestic income shifting from labor income to profit income.

The main result of transfer pricing in the decentralized MNFs is that in the absence of tax rate differentials across countries, the transfer price is the marginal cost of the upstream branch; in the presence of tax rate differentials, the transfer price is either the upper bound or the lower bound, exogenously imposed by regulating governments (Zhao, 2000). Based on a sample of 286 multinational U.S. firms over the 2006-2012 period, Richardson and Taylor (2015) show that transfer pricing are positively associated with tax haven utilization. In reducing corporate tax liabilities, tax havens play a major role (US Senate Permanent Subcommittee, 2006; Department of the Treasury, 2007; GAO, 2008a, 2008b). The Internal Revenue Service (IRS), the Government Accountability Office (GAO) and other government agencies including the Homeland Security and Governmental Affairs (HSGA) has expressed a great concern.

The reform of existing corporate tax systems in the OECD countries has been a long-standing issue both in policy and in academic debate (Haufler and Schjelderup, 2000). Even the tax havens receive increased scrutiny from the G-20 Industrialized Nations, the OECD and various tax authorities with regards to the problem of corporate tax avoidance (Gravelle, 2013). Ernst & Young (2006, p.5) claims that

“transfer pricing continues to be, and will remain, the most important international tax issue facing MNEs”.

Transfer pricing taxation is a significant source of tension between Multinational Firms (MNFs) and tax authorities. The tension relates to the different perspectives of MNFs and tax authorities.

2.1.3 Negotiation and Bargaining Supporter

Transfer pricing practices in two broad categories: administered and negotiated.

In administered transfer pricing, the firm postulates rules to govern transfer prices.

Under negotiated transfer pricing, divisional managers are free to negotiate on intracompany transfers, quantity transferred, and the transfer prices (Vaysman, 1998).

Past surveys indicated that negotiated transfer pricing is a common way of accounting for the exchange of goods and services between the divisions within a firm (e.g., Price Waterhouse, 1984; Eccles, 1985). Kaplan and Atkinson (1998) show that negotiated

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transfer pricing is more advantaged than administered pricing when a perfectly competitive market for the intermediate product does not exist. Baldenius et al. (1999) develop a symmetric information model with continuous quantities to compare the performance of standard cost and negotiated transfer pricing. They conclude that negotiated transfer pricing is the dominant mechanism for yielding efficient trade.

Edlin and Reichelstein (1995) assume that divisional managers can make irreversible specific investments to enhance the value of intrafirm trade. They find that negotiated transfer pricing will lead to efficient outcomes if the divisions can sign fixed-price contracts before making investment decisions. Baldenius (2000) compares the performance of standard-cost with negotiated transfer pricing under asymmetric information. The author finds that negotiated transfer pricing generally achieves higher expected contribution margins, for this method is tend to more efficient in aggregating private information into transfer price. However, standard-cost transfer pricing confers more bargaining power to the supplier and generates better incentives for this division to engage in specific investments. Vaysman (1998) develops a model of negotiated transfer pricing incorporating private divisional information. The author demonstrates that the firm can design managerial-compensation schemes and bargaining infrastructures for the negotiated transfer-pricing structure to reach the maximum profits.

Zhao (1998) studies the relationship between transfer pricing and the determination of wages and employment when a subsidiary of the MNE is located in a unionized labor market. The author suggests that the union of the subsidiary prefers to negotiate with parent enterprise instead of with the subsidiary managers, while the MNE prefers the opposite, because the MNE can use transfer pricing as a bargaining tool in decentralized labor management negotiations and provides higher negotiated wage and union employment. Enderwick (1985) and Kujawa (1978) also empirically receive the same conclusion.