Integrating Managerial and Tax Objectives in Transfer Pricing

Abstract

This paper examines transfer pricing in multinational firms when individual divisions face different income tax rates. Assuming that a firm decouples its internal transfer price from the arm's length price used for tax purposes, we analyze the effectiveness of alternative pricing rules under both cost- and market-based transfer pricing. In a tax-free world, Hirshleifer (1956) advocated that the internal transfer price be set equal to the marginal cost of the supplying division. Extending this solution, we argue that the optimal internal transfer price should be a weighted average of the pre-tax marginal cost and the most favorable arm's length price. When the supplying division also sells the intermediate product in question to outside parties, the external price becomes a natural candidate for the arm's length price. We argue that for internal performance evaluation purposes firms should generally not value internal transactions at the prevailing market price if the supplying division has monopoly power in the external market. By imposing intracompany discounts, firms can alleviate attendant double marginalization problems and, at the same time, realize tax savings due to differences in income tax rates. Our analysis characterizes optimal intracompany discounts as a function of the market parameters and the divisional tax rates.

Discussion of “Divisional performance measurement and transfer pricing for intangible assets”

“…Thus, firms should optimally set their transfer prices in a decoupled but not independent fashion. This result extends an earlier finding in Baldenius, Melumad, and Reichelstein (2004) obtained in a setting without specific investments.…”

Cost-based transfer pricing under R&D risk aversion in an integrated supply chain

“…When consumers' preferences are uniformly distributed along a segment of a product space like the Hotelling model, a straight-line demand function in Assumption 1 is derived as a result of the optimization behavior of consumers. Accordingly, subsequent management studies that construct analytical transfer pricing models frequently employ the linear demand schedule (e.g., Narayanan and Smith, 2000;Baldenius et al, 2004;Baldenius and Reichelstein, 2006;Shor and Chen, 2009;Matsui, 2011aMatsui, , 2011c. Following the literature, we employ the linear demand function in our simulation analysis.…”

Divisional performance measurement and transfer pricing for intangible assets

“…See Durst (2002) for a more extensive discussion of the costs and benefits of decoupling. 9 See Sahay (2003) and Baldenius et al (2004), for example. pricing system and explores both uniform and decoupled solutions.…”

“…8 Few academic papers on transfer pricing have focused on the effects of decoupling internal transfer pricing rules from tax transfer prices. Among those that do, most focus only on the role of decoupling in providing managers with appropriate production decisions and ignore fixed-cost investments (see, for example, Baldenius, Melumad, & Reichelstein, 2004;Choe & Hyde, 2005). This paper allows for decoupled transfer prices and examines the effects of a royalty-based tax transfer price on the choice of internal transfer price.…”