Study on Transfer Pricing Strategy of Intermediate Products for Multinational
Corporation (MNC): for Tax Avoidance
Abstract
Given the context of economic globalization, the free flowing of capital and
technology among the open markets is the common status for the current cross- nation
economic connections. That Multinational Corporations (MNCs) have established
subsidiaries in different countries and markets is the main manifestation of the free flowing
of capital and technology. Undoubtedly, pricing the intermediate products which flow
among the subsidiaries is one of the main decision-making goals. But the differences in
each county’s tax rate weighs considerably important when MNC are pricing the
intermediate products of their subsidiaries.
This paper, based on the linear demand functions and no external market existing in
intermediate products of subsidiaries, first introduces differential tax rates of different
markets and economies into MNC’s intermediate product pricing. Then it does some
studies on transfer pricing methods of intermediate products and finally comes to the
conclusion that MNC is able to reach reasonable tax avoidance and its corporation’s
overall profits maximization by the transfer pricing method proposed in this paper.
Key words: external market, Multinational Corporation, intermediate product, transfer
price, tax rate, tax avoidance
1. Introduction
International transfer pricing refers to Multinational Corporations (MNCs) for the
global business target, establishing price policy when goods and services are transferred
between their independent accounting subsidiaries. Through the application of the pricing
tool, MNCs make their subsidiaries follow the global strategic targets and achieve the
multiple goals of profits and capital investments adjustments, market control, tax
avoidance and the overall company’s profits maximization. Besides, the application of
transfer pricing will have important effects on the balance of international payments and
foreign trades as well as on economic development modes. MNCs transfer pricing mainly
aims to minimize the global taxation and maximize their profits. On methods of transfer
pricing, Horst found that the method of transfer pricing to maximize the after-tax profits
under the assumption of two subsidiaries by establishing the mathematical model (Horst,
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1971). Sansing established resale price method (RPM), comparable uncontrolled price
method (CUP), comparable profit method (CPM), cost-plus method (CP), and profit split
method (PS) transfer pricing model. It’s concluded that when the parent company is
upstream company, compared with CUP, CPM assigns more profits; when the parent
company is downstream, compared with CUP, CPM assigns the controlled subsidiaries
fewer profits, but CP and RPM assign them much fewer profits; when investment of
upstream is more than that of downstream company, compared with CUP, PS assigns the
subsidiaries with more investment with more profits (Sansing, 1997). In addition,
Samuelson, Smith, Srinidhi & Halperin and Kan, respectively under different conditions
analyzed and compared CPM and CUP, and obtained the optimal transfer pricing strategy
under each condition (Samuelson, 1982; Srinidhi, Halperin, 1982; Srinidhi, Halperin,
1996; Kant, 1988; Smith, 2002). Choi, by analyzing the balance between MNC tax
reduction and internal motivation, obtained that when the host-nation tax rates of the
subsidiaries are different, the transfer pricing strategy should focus on how to reduce the
total taxation of the company; when the host-nation tax rates of the subsidiaries are the
same, the transfer pricing strategy should focus on considering the coordination of the
multinational taxation reduction and the internal subsidiaries motivation (Choi, 1998).
At present, the studies on multinational transfer pricing method are mainly conducted
in Europe and some other developed countries, and most of Chinese multinational transfer
pricing research work is of qualitative analysis. For example, Xu Jiang-bo analyzes the
factor affecting international transfer pricing (Xu Jiang-bo, 2007). Cai Mei proposes the
strategic theory that transfer pricing is used in international supply chain management to
enhance the competitiveness of the supply chain (Cai Mei, 2007). Dong Yi and Ma Jun
expound the current and trends on international regulation rules, and propose some
suggestions on how to reasonably apply the rules to reduce the operating risk (Dong, Yi,
Ma Jun, 2007). Li Ning from the concept of transfer pricing behavior expounds the impacts
of transfer pricing on China’s national economy and puts forward some suggestions on
China’s transfer pricing tax system (Li Ning, 2007). Ji Hong, Liu Jia and Yan Cai-xia
explore the transfer pricing endogenous factors, its realizing methods and the negative
effects on economic growth and countermeasures and work out the countermeasures to
evade and manage multinational transfer pricing (Ji Hong, Liu Jia, 2007; Yan Cai-xia,
2007).Wang Jing-jing using project investment decision making method studies the choice
of transfer pricing strategies under the assumption of business performance optimization
and comes to the conclusion that foreign exchange control is the key factor affecting some
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MNCs in China to make transfer pricing (Wang Jing-jing, 2007). Yet the analysis of
multinational transfer pricing methods is quite limited in China. Yang Qi, based on the
linear programming method of operations research, studies the existence and conditions of
the maximum after-tax profit which is related to the multinational internal transfer pricing
tax planning (Yang Qi, 2006). Liao Jin-zhong establishes a game model for China
multinational group against host country tax authorities in transfer pricing strategy choice,
and arrives at a Nessler’s balance on mixed strategy (Liao Jin-zhong and Pan Xiang-dong,
2002). Mu Yin-ping and some others more comprehensively study the transfer pricing
without considering the tax. For example, in the condition of none external market for
intermediate products, they study the internal products transfer pricing of the vertically
integrated business enterprise groups composed by n subsidiaries, get the conclusion that
the optimal transfer pricing equals the marginal cost of intermediate products (Tang Xiaowo, 2002). In the case of tax not being taken into consideration, the decision-making
problems of business enterprise groups’ transfer pricing under the existence of production
and price competition and asymmetric competition is analyzed and the relationship
between transfer price and marginal cost in the condition of the existence of various
competition (Mu Yin-ping, Tang Xiao-wo, MaYong-kai, 2005; Yin-ping, Tang Xiao-wo,
MaYong-kai, 2005) is concluded. In no consideration of the taxation situation, Liao
respectively studies the transfer pricing decision-making of intermediate products with
external monopolistic market and the transfer pricing decision-making of the company
under the conditions of asymmetric information, proposes the transfer pricing strategy of
intermediate products price discrimination (Mu Yin-ping, et al, 2003). He also analyzes
internal transfer pricing decision-making problems of the multi-product production group,
reaches that balanced transfer pricing strategy should be diverse by the various
relationships between final products of Group Company (Mu Yin-ping, Tang Xiao-wo, Liu
Ying, 2005).
The main drawbacks of most studies outside China fail to give the systematic analysis
on determining optimal intermediate products transfer price in depth discussions. The
current researches do not focus on linear demand function yet. The relevant researches
currently conducted in China only focus on qualitative research of enterprise transfer
pricing without considering the taxation and multinational transfer pricing. This paper
based on tax consideration, analyzes the method of pricing intermediate products in MNCs
under the linear demand function, namely, under the assumption of linear demand function
and excluding the existence of external market, considering the taxation, from the stand of
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tax avoidance, discusses how Multinational Corporations price intermediate products to
minimize total taxation and maximize global profits for its parent company when MNCs’
subsidiaries reach two or more.
2. Model Specification
This paper assumes that multinational subsidiaries 1,2,3,  ,…, n -1, n in different
host countries participate in the completion of a product , and each of the subsidiaries
1,2,3, , n -1 independently provides one of the intermediate products which doesn’t exist
external market to subsidiary n which further processes the provided inter mediate
products into final product for sale to consumers. In order to simplify the analysis process,
this paper is limited to the situations that import and export tariffs between subsidiaries
follow the specific unit taxation, namely the unit commodity tax is for certain. The amount
of intermediate products subsidiary i (1,2,3,, n  1) sells to subsidiary n is Qi , and the
production of the end product produced by subsidiary n is Qn . This paper for the sake of
simple discussion processing, assumes that every final product just needs each upstream
company providing one intermediate product which means Q1 = Q2 = Q3    Qn1  Qn .
Assuming the unit total cost for each upstream subsidiary to produce and export
intermediate products is C i (1,2,3,, n  1) and the unit total cost for downstream subsidiary
n to import masteries except for inter mediate products and process into final product is
C n , We can get that the market inverse demand function on of final product is p n =a-b Qn .
p n is the market price of the final product, p i is the internal transfer price of intermediate
product, and a , b in formulas above are positive constant.
Subsidiaries’ and the parent company’s profits after tax respectively are showed as
follows:
Suppose the after-tax profits of subsidiary i , subsidiary n and the parent company
are respectively  i ,  n and  , and the host-nation tax rates of subsidiary i and n are
 i and  n respectively.（0≤  i ＜1， i ＝1,2,3, , n  1 ）, Ai  1   i ( i ＝1,2,3, , n ), then
 i  Ai ( pi Qi  Ci Qi )
i  1,2,3, , n  1
n 1
 n  An  (a  bQn  C n )Qn   pi Qi
(1)

(2)
i 1
n 1
n i
i 1
i 1
   Ai ( pi Qi  Ci Qi )  An  (a  bQn  C n )Qn   pi Qi

(3)
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2.1. Based on taxation factors, analysis on intermediate products transfer pricing of
MNC which is composed of two subsidiaries：
Assume that the MNC only has two subsidiaries 1 and 2 which are in different host
countries, then the after-tax profits of subsidiaries and the parent company can be
expressed as follows:
 1  A1 ( p1Q1  C1Q1 )
 2  A2  (a  bQ2  C2 )Q2  p1Q1
(4)

  A1 ( p1Q1  C1Q1 )  A2  (a  bQ2  C2 )Q2  p1Q1
(5)

(6)
2.1.1. The after-tax profit condition of independent operation without cooperation among
subsidiaries
Because subsidiary 2’s demand for intermediate products depends on the market demand
for final products, so the demand function of intermediate products is determined by that of
the final products.
First, according to market demand function, determine the optimal production of final
products for downstream subsidiary 2. Calculate the extremum of formula (5), and then
get:
 2
 A2 (a  2bQ2  C 2  p1 )  0
Q2
(7)
From formula (7)，the optimal production of final products is：
Q2 
(a  C 2  p1 )
2b
(8)
Seen from formula (8), the final product output is a decreasing function of the price of
intermediate products.
Because when subsidiary 2 produces a unit final product it just needs subsidiary 1 provide
one unit intermediate products, the production of intermediate products should equal to
that of final production. Means:
Q1  Q2 
(a  C2  p1 )
2b
(9)
Substitute formula (9)into (4)，and calculate the extremum of p1 ，then get the optimal
sale price of intermediate products under the condition of certain market demand for final
product, when the upstream subsidiary 1 produces independently is:
5
p1* 
(C1  a  C 2 )
2
(10)
Respectively substitute formula (9)and(10) into (4)and(5)，and achieve the profits of the
two subsidiaries without cooperation is：
1 
A1 (a  C 2  C1 ) 2
8b
(11)
2 
A2 (a  C 2  C1 ) 2
16b
(12)
A1 (a  C 2  C1 ) 2 A2 (a  C 2  C1 ) 2
  1   2 

8b
16b
2
(2 A1  A2 )( a  C 2  C1 )

16b
(13)
2.1.2. The profits condition when the head office makes the transfer price and enforces
subsidiary i to take, and subsidiaries cooperate positively.
First, according to market demand function, determine the optimal production of final
products for the downstream subsidiary 2. Calculate the extremum of formula (5), and get:
Q1  Q2 
(a  C2  p1 )
2b
(9)
Substitute formula (9)into(6)，and calculate the extremum of p1 ，then achieve that under
the condition of certain market demand for final products ，the optimal sale price of
upstream products is：
p *1 
( A2  A1 )( a  C 2 )  A1C1
A2  2 A1
(14)
Due to the sale price p1 should satisfy that： C1  p1  (a  bQ2  C 2 )
So the optimal sale price p1 should also satisfy that： C1  p1*  (a  bQ2  C2 )
*
Then we get：  2  1
That means when the host-nation tax rate of subsidiary 2 is greater than or equal to that of
subsidiary 1, the optimal sale price for subsidiary 1's products is:
p *1 
( A2  A1 )( a  C 2 )  A1C1
A2  2 A1
(14)
Substitute formula (6) and (11) into (3) ，and get the total profits of the MNC with
cooperation among subsidiaries as：
6
' 
A12 (a  C 2  C1 ) 2
4b(2 A1  A2 )
(15)
When  2  1 ，it is obviously that the optimal price should be the marginal cost C1 ，and
calculate the extremum of formula (3)，then get the optimal production is：
Q1  Q2 
*
*
(a  C 2  C1 )
2b
(16)
Substitute formula (13) into (3)，get the total profits of the MNC with cooperation among
subsidiaries as：
A2 (a  C 2  C1 ) 2
 "
4b
(17)
2.1.3 The amount of tax avoidance in subsidiaries equals the increment of the total profits
of MNC.
When  2  1 , which means the host-nation tax rate of subsidiary 2 is greater than or
equal to that of subsidiary 1, the amount of tax avoidance  is：
(a  C 2  C1 ) 2 A22
>０
     
16b(2 A1  A2 )
'
(18)
When  2  1 , which means the host-nation tax rate of subsidiary 2 is less than that of
subsidiary 1, the amount of tax avoidance  is:
   "   
(a  C 2  C1 ) 2 (3 A2  2 A1 )
>0
16b
(19)
Conclusion 1 When MNC is composed of two subsidiaries, subsidiary 1 produces
products and provides to subsidiary 2, subsidiary 2 processes them into final products, and
both the subsidiaries follow the specific unit taxation, under the linear demand condition,
the transfer price of the intermediate products for the two subsidiaries should be different
by the different tax rates. When the host-nation tax rate of subsidiary 1 is greater than that
of subsidiary2, transfer price of intermediate products should be the marginal cost; when
the host-nation tax rate of subsidiary 1 is less than or equal to that of subsidiary 2, transfer
price of intermediate products should take the strategy according to formula (11) which is
related to tax rate.
2.2. Based on taxation factors, analysis on intermediate products transfer pricing of
MNC which is composed of multiple subsidiaries：
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2.2.1. The after-tax profit condition of independent operation and no cooperation among
subsidiaries
Because subsidiary n ’s demand for intermediate products depends on the market demand
for final products, so the demand function of intermediate products is determined by that of
the final products.
Firstly, according to market demand function, determine the optimal production of final
products for downstream subsidiary n . Calculate the extremum of formula (2)，then get:
n 1
 n
 An (a  2bQn  C n   pi )  0
Qn
i 1
(20)
From formula (4)，the optimal production of final products is：
n 1
Qn 
(a  C n   pi )
i 1
(21)
2b
Seen from formula (18), the final product output is a decreasing function of the price of
intermediate products.
Because when subsidiary n produces a unit final product it just needs subsidiary i to
provide one unit intermediate products, the production of intermediate products should
equal that of final production. Means:
n 1
Qi  Qn 
(a  C n   pi )
i 1
2b
(22)
Substitute formula (22)into (1)，and calculate the extremum of p i ，then get the optimal
sale price of intermediate products under the condition of certain final product market
demand, when the upstream subsidiaries produce independently as:
pi* 
n 1
1
(C i  a  C n   p j )
2
j 1
(23)
j i
Respectively substitute formula (22)and(23) into (1)and(2)，and achieve the profits of the
subsidiaries without cooperation is：
n 1
Ai (a  C n  C i   p j ) 2
i 
j 1
j i
8b
(24)
8
n 1
An (a  C n  Ci   p j ) 2
j 1
j i
n 
(25)
16b
n 1
n 1
j 1
j i
n 1
 ''    i   n  
i 1
n 1
Ai (a  C n  C i   p j ) 2
j 1
j i

8b
i 1
An (a  C n  C i   p j ) 2
n 1
n 1
i 1
j 1
j i
16b
(2 Ai  An )( a  C n  C i   p j ) 2

16b
2.2.2. The profits condition when the head office makes the transfer price and enforces
subsidiaries i to take, and subsidiaries cooperate positively.
If  n   i ， obviously that the optimal transfer price for subsidiary i should be the
marginal cost C i ，and the after-tax profits of subsidiary i , subsidiary n and the parent
company  i ,  n and  can be written as:
 i  Ai ( pi Qi  Ci Qi )
i  1,2,, n  1
 n  An [( a  bQn  Cn )Qn 


 n  i

 n  i
(1)
pi Qi 
Ai ( pi Qi  C i Qi )  An  (a  bQn  C n )Qn 

 n  i

 n  i
Ci Qi ]
pi Qi 

 n  i
(26)
C i Qi

(27)
Firstly, according to market demand function, determine the optimal production of final
products for subsidiary n . Calculate the extremum of formula (26), and get:
(a  C n 
Qi  Qn 
 p   C )
 n  i
i
n i
i
2b
(28)
Substitute formula (28) into (27)，and calculate the extremum of p i ，

1
  ( Ai  An )( a  Cn   p j   C j )   A j p j   A j C j
pi 2b
 n  j
 n  j
 n  j
 n  j
  0 (29)
Then obtain that under the condition of certain demand for final products，the optimal
sale price of upstream products is：
9
( An  Ai )( a  C n 
p
 n  i
*
i


 n  j
pj 
j i
C
 n  j
j
)
A C
 n  j
j
An  2 Ai
j

A
 n  j
j i
j
pj
(30)
Substitute all p i* into formula (27), and the result gotten is the total profits of the MNCs
within the positive cooperation among subsidiaries.
Conclusion 2 When MNC is composed of multiple subsidiaries, subsidiaries
1,2,3, , n -1 produce intermediate products to provide to subsidiary n , subsidiary n
processes them into final products, and both the subsidiaries follow the specific unit
taxation, under the linear demand condition, the transfer price of the intermediate products
for the two subsidiaries should be different by the different tax rates. When the host-nation
tax rate of subsidiary i is greater than that of subsidiary n , transfer price of intermediate
products should be the marginal cost; when the host-nation tax rate of subsidiary i is less
than or equal to that of subsidiary n , transfer price of intermediate products should take
the strategy according to formula (30).
This paper studies the principle and method of tax rate used in transfer pricing of
intermediate products in MNCs when multiple subsidiary companies are involved and the
goal is tax avoidance, and under the assumption of linear demand function, how MNCs
choose the transfer pricing strategy when transferring intermediate products is discussed.
When the cost functions of intermediate products and final product and the demand
function of final product are determined, following the specific unit taxation, the
intermediate products transfer pricing should take the different strategy according to the
different tax rates of subsidiaries. Choosing the reasonable strategy can help the MNCs
reduce the total tax, and maximize the after-tax profits. This paper works out the
calculating formula under some specific conditions with some theoretical and practical
values.
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A Brief Autobiographical Note of Authors
1. Shu-rong Zhao, Professor;
Institution: Department of Public Administration, School of Political Science and
Public Administration, University of Electronic Science and Technology of China
Chengdu, P.R. China 611731
Email: zhaoshurong2001@163.com; zhaoshurong@uestc.edu.cn
Tel: 86-(0)28-61831756
Fax: 86-(0)28-61831756
Mob: 86- 13608001266
Professional Biography: is a professor at School of Political Science and Public
Administration of UESTC with research focus on International Strategic Management,
Governmental Behaviour and Strategy in International Relations, Comparative studies
in Government and Policy and MNCs' Strategy in the context of globalization. She has
published extensively in national and international academic journals including 5 books
and book chapters. She is author of 102 articles with 20 top journal articles and up to 40
articles of International conference proceedings were collected by EI, ISTP and ISSHP.
2. Shao-gang Chen, Professor;
Institution: School of Mathematical Sciences, University of Electronic Science and
Technology of China Chengdu, P.R. China
3. Shuang-xia Sui, Postgraduate; University of Electronic Science and Technology of China,
Chengdu, P.R. China
4. Shao-pei Cheng, Postgraduate. University of Electronic Science and Technology of
China, Chengdu, P.R. China
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