International Transfer Pricing and Income Shifting: Implications for the
Multinational Manufacturing Enterprise and Research
Robert Hutchinson
University of Toledo
Toledo, OH 43606, USA
419.530.4004
roberthutchinson@alumni.duq.edu
ABSTRACT
Implications of globalization on accounting and tax functions have largely remained an afterthought of corporate
strategy until recently. This is changing; however, as more multinational manufacturing firms recognize the
potential to arbitrage the various market imperfections arising from exchange process differentials across borders.
Commonly known as transfer pricing, and viewed as a legitimate business opportunity by transnational corporations,
internal pricing between subsidiaries is often manipulated in order to misrepresent financial performance and evade
taxation. This paper provides a review of existing research on international intra-firm pricing and discusses its
implications for research at the interface of other research areas.
Keywords: international manufacturing, transfer pricing, income shifting, intra-firm trade, arm’s length standard
INTRODUCTION
Transfer pricing is an accounting convention that concerns the terms that connected parties use when they conduct
business with each other, trading both goods and services. The issue of internal transfer pricing is of particular
importance for multinational manufacturing enterprises that conduct business across international boundaries,
selling raw materials, intermediary products, and finished goods between business units and affiliates. The transfer
pricing policy of such firms will often have a significant effect on the amount of profit or loss that is recognized in
each of the countries in which they do business.
As globalization continues to extend to encompass almost every country and every industry, so too has the
importance of intra-firm trade and international transfer pricing policy. The Economist (2004) estimates that a full
60% of the world’s trade takes place within multinational firms, i.e. through the transfer of goods and services
among their subsidiaries, making intra-firm trade by far the single largest component of global business. Many
firms today have global brands, research and development, and manufacturing, and, quite simply, the only reason for
maintaining regional profit centers and accounts is that governmental tax authorities require it. Even so, it becomes
exceedingly difficult to say quite where global firms’ profits are truly generated.
High levels of cost transfers within corporations not only create significant opportunities for tax minimization and
financial management, but also create potential problems with the overall management of company resources.
Balancing these considerations is of primary importance to management, and presents a unique opportunity for
academic researchers in the areas of strategy, organizational behavior, supply chain management, and international
business to better understand the impact of transfer pricing policy on firm performance.
Beyond the tax and accounting implications of internal transfer pricing, this paper will also address the significant
managerial implications that a particular system for internal transfer pricing can have on firm performance.
Although they do not usually rank high in organizational hierarchies or in academic research models, the fact is that
the firm’s accounting systems provide the ultimate scorecard used in all aspects of the business management and
strategy. As summarized by Zimmerman (2003), managerial accounting system should exhibit the following
characteristics:
1. Provide the information necessary to identify the most profitable products and the pricing and
marketing strategies to achieve desired volume levels.
2. Provide information to detect production inefficiencies to ensure that the proposed products and
volumes are produced at minimum cost.
246
3.
4.
5.
When combined with the performance evaluation and reward systems, create incentives for managers
to maximize firm value.
Support the financial accounting and tax accounting reporting functions.
Contribute more to firm value than it costs.
The objectives of management accounting are to assist managers and to influence their behavior in a way that results
in goal congruent actions. (Anthony, 1989) Figure 1 presents a framework for organizational change and
management accounting’s roll in driving the action that leads to firm value. Changes in business environment
should lead to new strategies and ultimately to changes in the firm’s organizational architecture, including changes
in the accounting system, in order to better align the interests of the employees and create incentive structures
congruent to the objectives of the organization. (Zimmerman, 2003)
Figure 1: Framework for Organizational Change and Management Accounting (Anthony 1989)
Business
Environment
Business Strategy
Organizational Architecture
> Decision - Right Assignment
> Performance Evaluation
> Reward System
Incentives and Action
Firm Value
Information provided by the managerial accounting system should assist the firm’s management in setting profit
goals, establishing departmental targets in the form of budget plans, evaluating the effectiveness resource usage
against those plans, investigating successes and failures in terms of specific manufacturing processes and support
tasks, and taking action on adjustments and improvements necessary to keep the entire manufacturing enterprise
moving towards the established corporate objectives. When a firm manipulates its accounting income via
international transfer pricing, it also reduces the usefulness of accounting information for strategic decision making.
Although many senior executives feel that transfer pricing issues are simply problems for the tax accounts, this is a
great misconception. The methodology used for transfer pricing does not simply shift income among the various
subsidiaries, strategic business units, groups, and countries, with little effect other than on performance evaluations;
rather it has a great effect on the primary operations and the overall profits of the firm. Although much of the
attention focuses on how multinational firms employ transfer pricing to avoid paying income taxes, it is increasingly
apparent that attempting to minimize the tax burden is only one of the objectives of an international transfer pricing
strategy. (Cravens, 1997) Transfer pricing is increasingly becoming strategic rather than simply procedural.
(Cravens, 1997; Spicer, 1988; Eccles, 1985)
INTRA-FIRM TRADE AND TRANSFER PRICING SCOPE
The significance of intra-firm transfer pricing continues to increase with the continued intensification of
globalization. According to the UNCTAD in the early 1990s there were approximately 37,000 international
companies with 175,000 foreign subsidiaries. By 2003 this number had risen to 64,000 international companies
with 870,000 foreign subsidiaries. The international significance of transfer pricing can be gauged from the sheer
amount of global intra-firm trade estimated the Economist (2004) at roughly 60% of all international trade, and one
third of total world trade, valued in the ballpark of $1.6 trillion, according to estimates by the International Monetary
Fund, the Organization for Economic Cooperation and Development, the United Nations Conference on Trade And
Development, and the World Trade Organization.
247
These current estimates support past empirical research on cross-border intra-firm trade. In 1986, approximately
36% of the United States’ imports and exports were transactions between US firms and their foreign subsidiaries.
(Cho, 1990) This is consistent with more recent estimates that 40% of all US international trade is intra-firm trade.
(Clausing, 2003) Approximately 55% of trade between the European Union and Japan, 40% of the trade between
the EU and the US, and 80% of the trade between Japan and the US is between parent companies and foreign
subsidiaries. (Stewart, 1993)
EXPLOITING MULTINATIONALITY
Through its multinationality, the manufacturing enterprise may maximize its objectives by exploiting the market
imperfections that arise from exchange process differentials. (Cravens, 1997; Leitch & Barret, 1992) There is a
long-held belief that international transfer pricing is used by multinational firms to minimize global tax liability,
which would be a rational economic response to market imperfections created by national governments. Global
market imperfections are created by host government policies to attract and retain multinational company
investments. (Emmanuel, 1999; Leitch & Barrett, 1992) Multinational firms are therefore provided with strong
incentives to adjust their international transfer pricing policies to secure the benefits offered by host governments
and would not be acting rationally, in economic terms, and would fail to create wealth for their shareholders if their
transfer pricing policies did not recognize the opportunities created by market imperfections. (Emmanuel, 1999;
Borkowski, 1996)
Following a similar methodology employed by Clausing (2003), Kant (1995), and Horst (1971), a simple
mathematical model can be developed that supports the prediction that intra-firm trade prices will be affected by tax
minimization strategies of the multinational firm. Consider the case of a multinational manufacturing firm, with a
large degree of market power, which is operating in two countries. It produces and sells in each country, and also
exports part of its production from the home country (H) to the fully-owned foreign affiliate abroad (F). Profit
functions are thus:
πH = RH (sH) – CH (sH + m) + pm
(1)
πF = RF (sF) – CF (sF + m) + pm
(2)
Where πH is the profit in the home country, which depends on revenues (RH) that are a function of sales (sH), and
costs (CH ) that are a function of production. Production includes both those goods sold at home and those exported
to the foreign affiliate m at a transfer price p.
Considering the case where the tax rates at home are greater than the tax rates abroad (tH > tF) and deferral is
allowed, let f represent the fraction of profits that are repatriated. The effective tax rate on income earned in the
affiliate country is then;
teF = tF + (tH – tF) f
(3)
Thus the net profit function for the firm’s global operations is;
π = (1-tH) πH + (1- teF) πF
(4)
To illustrate how the firm would likely choose a transfer price in order to maximize these net profits, take the
derivative of equation (4) with respect to the transfer price p.
πp = (1-tH) m - (1- teF) m
(5)
A simple substitution of teF using equation (3) and rearranging the terms:
πp = - (tH –tF) (1- f) m
(6)
248
Therefore if tH > tF, the above expression is negative, and the firm’s global net profits decrease with the transfer
price. Thus, firms have an incentive to under price goods sold to low tax countries in order to shift profits to low tax
locations or, conversely, to overprice goods sold to high tax affiliates when tF > tH.
In order to better illustrate the tax implications of transfer pricing methodologies on a firm, it may be helpful to look
at a simple fictional case study of a multinational manufacturing firm, Robert Hutchinson International (RHI), maker
of widgets. In this scenario model, RHI manufactures widgets at its plant in the Netherlands, and ships them to its
Australian subsidiary, which sells the widgets for 85 Australian Dollars. The variable cost of manufacturing the
widgets is 50 Euros, while the exchange rate we assume to be fixed at 0.70 Australian Dollars to 1 Euro. Let us
further assume that the Dutch corporate tax rate is 30% compared with an effective tax rate is 40% in Australia.
Now suppose that the transfer price of widgets is variable, and that RHI is allowed to set the transfer price anywhere
between 80 and 110 Euros. The following table demonstrates that international transfer pricing methodologies do
not only determine profit allocations between business units, but also may greatly affect the overall profits to be
divided. Figure 2 shows the net tax affects to RHI based on two possible transfer pricing methods:
Figure 2: Scenario Model of Transfer Pricing Between Netherlands and Australia for RHI
80 Euros
Transfer Price
Taxes Paid in the Netherlands:
Revenue (transfer price)
Variable Cost
Taxable Income
Tax Rate
Dutch Taxes
110 Euros
80.00
(50.00)
30.00
0.30
9.00
Taxes Paid in Australia:
Revenue
Transfer price in Euros
X Exchange rate 0.70 A$/Euro
Transfer price as A$
Taxable Income
Tax Rate
Australian Taxes
Converted to Euro (÷0.70)
110.00
(50.00)
60.00
0.30
18.00
85.00
80.00
0.70
Sum of Dutch and Australian Taxes (Euros)
85.00
110.00
0.70
(56.00)
29.00
0.40
11.60
16.57
(77.00)
8.00
0.40
3.20
4.57
25.57
22.57
Both the mathematical model and the RHI case study are rather simplistic; however, they serve the purpose of
demonstrating the possibility for the firm to exploit its multinationality to mitigate its overall global tax burden. Of
course, in the arcane world of international taxation, nothing is quite as simple as these two previous examples. For
instance, under the Subpart F provisions of the US tax code, US firms are not eligible to defer taxation on foreign
income not repatriated that is derived from passive investments or foreign base company income, including foreign
income derived from sales of goods between related parties where the goods are manufactured and sold for use
outside the base country. And, woe to the company that faces a tax audit for pushing the envelope too far.
Kant (1990) reminds us that managers must balance potential penalties, if manipulation of transfer prices becomes
too flagrant, and consider minority interests, as foreign affiliates may not be wholly owned. Governments are
cracking down on income manipulation according to the Economist (2004), recognizing the impact of such practice
on government revenues. A report by the United States Senate in 2001 claimed that multinationals evaded up to $45
billion in taxes in 2000. Although it is hard to substantiate this number, some of the more flagrant offenses do
further fan the flames, as one firm sold toothbrushes between subsidiaries valued at $5,655 each.
Complexity of international organizations and of tax codes is a double edged sword for both governmental taxing
authorities and the multinational manufacturing firm alike. For just as difficult for the multinational manufacturing
249
firm to determine where profits are actually made is it for governmental taxing authorities to prove otherwise.
Mehafdi (2000) demonstrates that international tax litigation cases involving multinational manufacturing firms
become exponentially complex as a function of the number of divisions and subsidiaries across the number of
countries. Even a relatively simple example (figure 3) of a multinational firm with only three subsidiaries becomes
complex in terms of sourcing and pricing decisions.
Figure 3: Transfer Pricing Linkages in a Hypothetical 3-Division Decentralized Multinational Manufacturing
Enterprise (Adapted from Mehafdi 2000)
Key: Flow of intra-firm trade of intermediate products ( 2 to 3 and 4; 3 to 4)
1. Multinational Manufacturing Firm
(Headquarters in Home Country)
Trading in intermediate product markets (selling to/buying from is permitted,
restricted, or prohibited: 2 & 3 to 5; 3 & 4 from 5)
Trading in the final product market (4 to 6)
Internal Pricing Decision
Interest charges, royalties, management fees ( 1 to 2, 3 & 4)
2. Division X
(Transferor)
International
intra-firm
trade @
$ transfer price
3. Division Y
(Transferee &
Transferor)
Domestic
intra-firm
trade @
$ transfer price
4. Division Z
(Transferee)
International intra-firm trade
@ $ transfer price
Sourcing Decsion
5. Intermediate
Product Markets
6. Final Product
Market
Despite organizational complexities and tax regulations ad infinitum, empirical research supports the mathematical
proofs that firms do in fact shift income to avoid taxation. Hines and Rice (1994) find that a 1% difference in tax
rates between countries are associated with a 2.3% difference in reported pretax profitability. This finding is
consistent with the Clausing (2003) that found a tax rate 1% lower in the country of destination/origin is associated
with intra-firm export prices that are 1.8% lower and intra-firm import prices that are 2.0% higher relative to nonintra-firm goods. This evidence is particularly noteworthy in the context of large empirical literature on taxmotivated transfer pricing that has relied almost entirely on indirect evidence. (Clausing, 2003)
Tax incentives are certainly not the only motivation for multinational manufacturing firms, and the trend towards
diversifying the manufacturing base of the will continue to grow exponentially as managers try to take advantage of
the combination of factors relating to ownership, location, and internationalization. According to Leitch and Barrett
(1992) these ownership advantages include (1) capital assets that give an organization a competitive edge, (2)
economies of scale, (3) access to markets, (4) products to distribute, and (5) diversity of products. With the
advantages relating to location including (1) material sourcing, (2) good labor market, (3) cooperative governmental
policies -including tax policies, (4) governmental service and infrastructure, and (5) access to local markets. And
the advantages relating to internationalization including (1) stable supplies, (2) control of markets, (3) exploitation
of technology, (4) vertical integration economies, and (5) larger markets.
As transfer pricing continues to play an ever larger role in the overall operations of the multinational manufacturing
firm, it becomes increasingly important to better understand the scope of its impact on corporate strategy not just on
tax compliance. Increasingly firms become aware of the potential of transfer pricing policy to impact the overall
strategic direction of the firm. In a domestic environment, issues related to management evaluation and
performance is generally the major concern with transfer pricing. However the multinational firm is faced with
numerous complicating factors within the global marketplace such as taxation, competitive advantage, foreign
exchange, cash controls, and inflation. (Cravens, 1997)
250
TRANSFER PRICING METHODOLOGIES
The discussion thus far may seem very interesting to the accountant or tax manager, but to the average high-level
executive, the tax profits are not really useful to the overall corporate strategy and direction of the company. What
is most useful to the executive manager is information for decision making. Because firms are organized into
responsibility centers, whether it be by group, strategic business unit, or individual projects, each is center is
measured on its individual performance. Ensuring a fair and useful measurement means that meaningful transfer
prices must be established, which reflects the economic reality of the firm and give the executive a basis for
rationalizing resources within the firm.
When we consider that executive managers must make investment, purchasing, and production decisions based on
this performance, it becomes clear how meaningful transfer pricing is to the overall economic profits of the firm.
Establishing transfer prices that simply attempts to minimize overall global tax liability may in fact cause managers
to make inappropriate decisions, thus reducing the value to the overall firm. There is also evidence that managers’
perceptions on the interests of local partners and maintenance of good relations with the host government play a role
in the selection of an international transfer pricing methodology. (Chan & Lo, 2004) The three most commonly
discussed methodologies for transfer pricing are discussed in the following:
Separate and Unequal
One potential solution to the problem of balancing tax issues with managerial issues that has often been suggested,
and practiced by many firms, is to maintain two separate transfer pricing systems, one to be used for tax purposes
and another to be used simply for managerial decision making. While this appears to be an ideal solution of giving
the top executives a clear view of ‘real’ profitability, while minimizing tax profitability, Michael Patton, a Senior
Partner at Ernst & Young disagrees:
An essential problem with separated reporting is that transfer prices already reflect the profitability of a
division or project. If you are trying to make decisions about new activities or facilities, and trying to judge
the return on invested capital, you need good benchmarks to judge these by, and good transfer prices
provide that. Basically, then, the question is whether your current transfer prices reflect economic reality or
not. If they do, there’s little need for a new system. If not, the tax authorities may have a question or two
for you on audit in a few years’ time. (Springsteed, 1999)
So the response to this all too often used solution is to maintain two sets of records at your own risk of audit, not to
mention the significant cost of duplication caused by maintaining two separate sets of books for this purpose.
Other important considerations from the managerial perspective when establishing transfer pricing may include
balancing the marketing and financial management strategies of the corporation. Besides taxation and investment
decision making, internal pricing may have a great effect on the competitive position of the company in a particular
market. One strategy, for which the United States had often accused the Japanese automakers, is to subsidized
product dumping in foreign markets with the high prices charged in protected domestic markets. The World Trade
Organization is one of the global organizations charged with reducing this practice worldwide.
High transfer prices might be used to circumvent or significantly lessen the impact of national controls. Many
governments have restrictions on the amount of profits which a firm can remove at any one point, thereby creating
difficulties for profitable subsidiaries to transfer funds back to the corporate office. However, overpricing the goods
shipped to a subsidiary in such a country would make it possible to for the funds to be taken out. This method will
then circumvent any government regulations, penalties, or restrictions. (Gray et al., 2001) On the other hand, the
more important management perceives foreign exchange controls in transfer pricing, the more likely the firm will
chose a cost-based method. (Chan & Lo, 2004)
Opportunity Cost
The importance given to the issue of transfer pricing is evident. From the managerial perspective, one rule exists for
transfer pricing. The transfer pricing rule is quite simple to state: the optimal transfer price for a product or service
is its opportunity cost – it is the value forgone by not using the transferred product in its next best alternative use.
251
(Zimmerman, 2003) Unfortunately, the simple solution is not as simple as it may first appear. If perfect
information were available to the executive, transfer prices would simply be set to opportunity cost. The
manufacturing plant of RHI, from the example above, would produce widgets to the point where the variable cost of
production is equal to the transfer price, and the Australian subsidiary would continue to purchase as long as its
revenues cover the transfer cost. In this ideal situation, both divisions will be maximizing their economic profits.
Economists will argue that this is the optimal solution for setting transfer prices; however, as we all know, economic
reality is that perfect information is extremely difficult, if not impossible, to obtain. The high cost of obtaining such
symmetrical information from executives who have incentives to see their own responsibility center maximize its
profits can most often greatly outweigh the benefits. As a practical matter, marginal cost information is rarely
known to anybody in the firm, because it depends on the opportunity costs that vary with capacity use. And, even if
marginal cost information were available, there is no guarantee that it would be revealed in a truthful fashion for the
purpose of determining an optimal transfer price. (Holstrom & Tirole, 1991) Therefore, the firm must often rely on
the least difficult method for setting transfer costs, and the most common are based on market price, variable costs,
full costs, or other variations.
Market Pricing – Arm’s Length Standard
The examples in the previous clearly shows what governments wish to circumvent in their efforts through the OECD
to establish international guidelines for transfer pricing. Transfer pricing methods can deprive governments of their
fair share of taxes from global corporations and expose multinationals to possible double taxation. No country –
poor, emerging or wealthy – wants its tax base to suffer because of transfer pricing. The arm’s length principle can
help. (Neighbour, 2002)
In an effort to minimize the potential problems caused by the various methodologies for internal transfer pricing, the
Organization for Economic Cooperation and Development (OECD) released a new set of guidelines in 1999 revising
its original guidelines publish in 1995. These guidelines are based on the ‘arm’s length’ principle (ALP) – that a
transfer price should be developed as if the two associated enterprises involved were completely independent of one
another. The details of this principle can be found in Article 9 of the OECD Model Tax Convention, and is used as a
framework for bilateral treaties between OECD and non-OECD governments alike. The following is the definition
of ‘Associated Enterprises’ according to Article 9:
Where:
a) an enterprise of a Contracting State participates directly or indirectly in the management,
control or capital of an enterprise of the other Contracting State, or
b) the same persons participate directly or indirectly in the management, control or capital of
an enterprise of a Contracting State and an enterprise of the other Contracting State,
Though the arm’s length principle is an agreeable one, and inherently just to both governmental tax authorities and
to multinational enterprises, the actual application and adherence to this policy becomes increasingly fastidious.
This is particularly true today when multinational firms become more service oriented and products become more
intangible in nature. Even for traditional manufacturing firms it often becomes difficult to separate out the goods
from the services, which become bundled into hard-to-price intangible products.
Market pricing is often the easiest internal pricing method to implement, and most authorities agree, that given a
highly competitive market for the product outside the firm, this method comes closest to representing full
opportunity cost. It often works best in commodity-type products, where markets set the price without much
variation. However, if no external market for the intermediate products exists, or when large synergies exist
between the various subsidiaries, market pricing becomes less accurate. Under such conditions variable cost
transfers, or some form of this method, may be the most effective alternative. Empirical evidence suggests that the
market method is most likely to be used where managers perceive a high level of importance at maintaining good
relations with the host government. (Chan & Lo, 2004) However, variable cost transfers are often unpopular with
manufacturing divisions, and there are many cases in which internal fighting among the marketing and
manufacturing divisions have led to either full cost transferring methods, or variable costs plus some additional fixed
distribution fee.
252
SELECTED LITERATURE
Despite its evident impact for both researchers and practitioners, little empirical research has been done in this area.
This is largely due to the sensitivity of the issue and potential for penalties. In 1992 the United States Treasury
introduced extensive transfer pricing documentation requirements coupled with non-negotiable penalties and
aggressive enforcement of regulations of section 482 of the Tax Code. Other countries, such as Australia, Canada,
France, Korea, and Mexico have already developed or are in the process of developing their own formal transfer
pricing requirements along with corresponding penalties. In the face of draconian regulation, it is understandable
that many companies are hesitant to offer much data in the form of case studies. Thus, academic research to
discover evidence of income shifting by international transfer pricing tends to be indirect, survey-based, and with a
general focus rather than investigating specific cross border trades. (Emmanuel, 1999)
Utilizing a scenario experimentation methodology, Lin and others (1993) investigated the ability of multinational
firms operating in Asian-Pacific countries, given tax and other economic factors, to maximize cash flows through
arbitrary transfer pricing schemes. The potential differences are so great that they conclude that multinational firms
would, quite rationally, use international transfer pricing to arbitrage the government-induced market imperfections
in order to improve cash flows.
Emmanuel (1999), following a similar methodology to Lin and others, finds major variations in after-tax income of
subsidiaries operating under different combinations of fiscal regimes and international transfer pricing policies.
While differential rates between the three countries used in the study (USA, Greece, and Taiwan) have minor
significance on the parent company’s total global after-tax income, the absence of any one particular form of tax,
such as withholding tax, can provide substantial opportunities to maximize global after-tax income through the
choice of transfer price methodology.
Utilizing a unique data monthly set from 1997 through 1999, made available by the US Bureau of Labor Statistics,
Clausing (2003) finds important differences in the behavior of intra-firm trade prices when compared with true
arms-length trade, indicating the influence of tax-motivated income shifting on US intra-firm trade. The paper finds
evidence that tax-motivated income shifting is consistent with theoretical expectation and robust to different
approaches and specifications, i.e. using both statutory and effective tax rates as explanatory variables and
controlling for other influences that may affect trade prices. One of the noted limitations; however, was the fact that
this study was unable to detect other methods of tax-motivated income shifting, such as altering manufacturing
overhead cost allocations or manipulating the terms of financial transactions within the firm.
Using a sample of all non-financial and non-utility firms listed on the Tokyo Stock Exchange from 1977 through
1997, from the PACAP-Japan database TM, Gramlich and others (2004) found that the pre-tax return and marginal
tax rate status of listed firms is significantly moderated by membership in a major Keiretsu. This was a very
interesting study for international business in that it identified another benefit to the Keiretsu business model in
Japan. The evidence suggests that all keiretsu members shift income to work towards a collective lower tax rate,
despite any localized incentives not to undertake this shifting.
In a survey of 82 of the 500 largest multinational firms from The World Directory of Multinationals, Cravens (1997)
found in contrast to a purely tax-driven mechanism, international transfer pricing can be considered as a means to
accomplish corporate objectives and thus create strategic consequences. In general executives perceive that transfer
pricing does influence measures of corporate performance and contributes towards achieving corporate objectives.
Kaplan and others (1992) give an example of a firm that found it necessary to modify its variable cost transfer
pricing structure was Teva Pharmaceutical Industries, Ltd. based in Israel. Because of the stringency of employment
law in Israel, where it is difficult to layoff workers, labor is considered to be a fixed cost, at least in the mediumterm. Senior management originally decided on variable cost transfers for its products to the various marketing
divisions worldwide. This worked well for the marketing divisions, which were free to purchase pharmaceuticals
from competitors as well, but this left the manufacturing division with little incentive to control labor or capital costs.
While this proved to be an easier method than allowing the divisions to negotiate a free-market price, the cost of
manufacturing began to spin out of control. Teva would later replace its variable cost transfer system with full cost
system. However, Kaplan and others (1992) reiterate that full cost transfer systems are not without their own
inherent problems. Even though it often solves the problem of wasteful disputes between divisions and ensures that
253
each division is at a minimum covering all its costs, as was the case in Teva, full cost transfer pricing can often
cause distribution to purchase too few units.
A case of the absurd is presented by Kovac and Troy (1989) as it had occurred at Bellcore, one of AT&T’s research
labs. Bellcore attempted to establish a full cost charge for secretarial services, used by the research engineers and
scientists. The transfer price established for typing included not only the direct secretarial labor and administrative
costs, but also a share of overhead including utilities, rent, and taxes. This pool was then divided by the number of
typing hours and charged to various projects. With an increase in charges, the highly-paid researchers began to do
their own typing in an attempt to control costs over various projects. As the number of typing hours shrank, the full
cost charge per page rose to a point where it cost as much as $50 per page to have a secretary type a memo.
Bellcore solved the problem by subtracting some of the fixed costs.
CONCLUSION & IMPLICATIONS FOR RESEARCH
Internal transfer pricing will continue to be at the forefront of concerns for the multinational firm, governmental
taxing authorities and regulatory agencies, and researchers as globalization continues into the next decade. The
implications not only affect the firm and other stakeholders in the form of taxes, but also have great implications in
terms of investments the firm will make in the future. While those in government and political circles are most
concerned with the effects of transfer pricing decisions on their revenue base, and tax managers with overall global
tax liabilities of the firm, the top executives at the multinational firms have many other issues to consider.
First and foremost on the executive’s mind is the need for clear and objective information, which clearly reflects the
economic realities of the business, and on which rational decisions can be made for capital appropriations. It is clear
from the cases presented above, that the choice for transfer pricing methodology can have a great impact not only on
the way the profits will be distributed, but also on the overall profits of the firm. In choosing a methodology, the
executive manager must balance the costs and the benefits of the system, and attempt to choose the one which most
appropriately reflects the true economic opportunity cost.
For the academic researcher attempting to study the impact of international transfer pricing and income shifting in
terms of strategy, organizational behavior, or supply chain management, the extremely sensitive nature of this
controversial subject makes it almost impossible to conduct survey research with any meaning.
A major defect in the survey approach, despite the guarantees of confidentiality afforded participants, is a
suspicion that respondents would be unlikely to admit to an arbitrary international transfer pricing [policy]
which circumvents tax laws or suggests unethical behavior. An attempt to apply meta-analysis to the
findings of twenty-one surveys was at best marginally successful and failed to reveal any underlying
associations or trends. (Borkowski, 1996)
That is not to say that opportunities do not exist for academic research; quite to the contrary, they are as plentiful as
the quasi-experimental methodologies needed to leverage them. At a macro level there exists a wealth of secondary
data on pricing and international trade, which given even a general knowledge of accounting and tax regulations can
be used effectively in an event study. At the firm level, researchers in this area can utilize scenario experimentation
or simulation to determine the opportunities for the multinational manufacturing firm to maximize after-tax income.
At a micro level, the organizational behavior academician can utilize mathematical modeling or game theoretic
methods to determine a manager’s rational response to given economic conditions.
A particularly interesting potential research project for international business would be to repeat the methodology
employed by Gramlich and others (2004) in other countries such as Korea, with its Chaebol business model, and
Finanz Kapital in Germany, where a similar system of common ownership exists with large industrial banks at the
center. Any findings of higher levels of income shifting in these countries might indicate a cultural collectiveness,
supporting Geert Hofstede’s cultural dimensions.
The growth in opportunities for research in this area is great, as this field has largely remained within the realms of
accounting and economics literature and has remained woefully underdeveloped. How international transfer pricing
decisions interact with other areas such as strategy, organizational behavior, and supply chain management presents
a fertile field in which the academician can sow the seeds of knowledge.
254
REFERENCES
Anthony, R. (1989) ‘Reminiscences About Management Accounting’, Journal of Management Accounting Research,
1(1): 1-20
Borkowski, C. (1996) ‘An Analysis (Meta and Otherwise) of Multinational Transfer Pricing Research’, The
International Journal of Accounting, 31(1): 39-53
Chan, K. H. & Lo, A. W. Y. (2004) ‘The Influence of Management Perception of Environmental Variables on the
Choice of International Transfer Pricing Methods’, The International Journal of Accounting, 39(2): 93-110
Cho, K. R. (1990) ‘The Role of Product Specific Factors in Intra-Firm Trade of US Manufacturing Multinational
Corporations’, Journal of International Business Studies, Q2: 319-330
Clausing, K. A. (2003) ‘Tax-Motivated Transfer Pricing and US Intrafirm Trade Prices’, Journal of Public
Economics, 87: 2207-2223
Cravens, K. S. (1997) ‘Examining the Role of Transfer Pricing as a Strategy for Multinational Firms’, International
Business Review, 6(2): 127-145
Economist (2004) ‘A taxing battle’, January 29: 71-72
Eccles, R. G. (1985) The Transfer Pricing Problem: A Theory for Practice, Lexington Books, Lexington, Mass.
Emmanuel, C. R. (1999) ‘Income Shifting and International Transfer Pricing: A Three Country Example’, ABACUS,
35(3): 252-267
Gramlich, J. D., Limpaphayom, P., & Rhee, S. G. (2004) ‘Taxes, Keiretsu Affiliation, and Income Shifting’, Journal
of Accounting & Economics, 37: 203-228
Gray, S., Salter, S., and Radebaugh, L. (2001) Global Accounting and Control: A Managerial Emphasis, Wiley,
New York
Hines, J. R. and Rice, E. M. (1994) ‘Fiscal Paradise: Foreign Tax Havens and American Business’, Quarterly
Journal of Economics, 109(1): 149-182
Holmstrom, B. and Tirole, J. (1991) Transfer Pricing and Organizational Form, Journal of Law, Economics &
Organization, 7: 201-228
Horst, T. (1971) ‘The Theory of the Multinational Firm: Optimal Behavior Under Different Tariff and Tax Rates’,
Journal of Political Economy, 79(5): 1059-1072
Kant, C. (1990) ‘Multinational Firms and Government Revenue’, Journal of Public Economics, 42(2): 135-147
Kant, C. (1995) ‘Minority Ownership, Deferral, Perverse Intrafirm Trade and Tariffs’, International Economic
Journal, 9(1): 19-37
Kaplan, R., Weiss, D., and Desheh, E. (1997) ‘Transfer Pricing with ABC’, Management Accounting, (May): 21-28
Kovac, E. and Troy, H. (1989) ‘Getting Transfer Prices Right’, Harvard Business Review, (SeptemberOctober):146-154
Leitch, R. A. and Barrett, K. S. (1992) ‘Multinational Transfer Pricing: Objectives and Constraints’, Journal of
Accounting Literature, 11: 47-92
Lin, L., Lefebvre, C., and Kantor, J. (1993) ‘Economic Determinants of International Transfer Pricing and the
Related Accounting Issues, with Particular Reference to Asian Pacific Countries’, International Journal of
Accounting Literature, 28: 40-70
Mehafdi, M. (2000) ‘The Ethics of International Transfer Pricing’, Journal of Business Ethics, Vol. 28(4): 365-381
Neighbour, J. (2002) ‘Transfer Pricing: Keeping it Arm’s Length’, OECD, April
Spicer, B. H. (1988) ‘Towards an organizational theory of the transfer pricing process, Accounting’, Organizations
and Society, 13(3): 303-324
Springsteed, (1999) ‘Separate But Unequal’, CFO Magazine, August
Stewart, T. A. (1993) ‘The New Face of American Power’, Fortune, July 26: 72
Umapathy, S. (1987) Current Budgeting Practices in US Industry, Quorum Books, New York
Zimmerman, J. (2003) Accounting for Decision Making and Control, 4th Edition, McGraw-Hill Irwin, New York
255