Transfer Prices

In any international business, there are normally a large number of transfers of goods and services between the parent company and foreign subsidiaries and between foreign subsidiaries. This is particularly likely in firms pursuing global and transnational strategies because these firms are likely to have dispersed their value creation activities to various "optimal" locations around the globe (see Chapter 12). As noted in Chapter 19, the price at which goods and services are transferred between entities within the firm is referred to as the transfer price.¹²

Transfer prices can be used to position funds within an international business. For example, funds can be moved out of a particular country by setting high transfer prices for goods and services supplied to a subsidiary in that country and by setting low transfer prices for the goods and services sourced from that subsidiary. Conversely, funds can be positioned in a country by the opposite policy: setting low transfer prices for goods and services supplied to a subsidiary in that country and setting high transfer prices for the goods and services sourced from that subsidiary. This movement of funds can be between the firm's subsidiaries or between the parent company and a subsidiary.

Benefits of Manipulating Transfer Prices

At least four gains can be derived by manipulating transfer prices.

1. The firm can reduce its tax liabilities by using transfer prices to shift earnings from a high-tax country to a low-tax one.

2. The firm can use transfer prices to move funds out of a country where a significant currency devaluation is expected, thereby reducing its exposure to foreign exchange risk.

3. The firm can use transfer prices to move funds from a subsidiary to the parent company (or a tax haven) when financial transfers in the form of dividends are restricted or blocked by host-country government policies.

4. The firm can use transfer prices to reduce the import duties it must pay when an ad valorem tariff is in force--a tariff assessed as a percentage of value. In this case, low transfer prices on goods or services being imported into the country are required. Since this lowers the value of the good or services, it lowers the tariff.

Problems with Transfer Pricing

Significant problems are associated with pursuing a transfer pricing policy. Few governments like it.¹³ When transfer prices are used to reduce a firm's tax liabilities or import duties, most governments feel they are being cheated of their legitimate income. Similarly, when transfer prices are manipulated to circumvent government restrictions on capital flows (e.g., dividend remittances), governments perceive this as breaking the spirit--if not the letter--of the law. A number of governments limit international businesses' ability to manipulate transfer prices in the manner described. The United States has strict regulations governing transfer pricing practices. According to Section 482 of the Internal Revenue Code, the Internal Revenue Service (IRS) can reallocate gross income, deductions, credits, or allowances between related corporations to prevent tax evasion or to reflect more clearly a proper allocation of income. Under the IRS guidelines and subsequent judicial interpretation, the burden of proof is on the taxpayer to show that the IRS has been arbitrary or unreasonable in reallocating income. The correct transfer price, according to the IRS guidelines, is an arm's-length price--the price that would prevail between unrelated firms in a market setting. Such a strict interpretation of what is a correct transfer price theoretically limits a firm's ability to manipulate transfer prices to achieve the benefits we have discussed. In reality, however, transfer pricing is still widely practiced, as indicated in the accompanying Management Focus which looks at transfer pricing in the United States and Japan.

Another problem associated with transfer pricing is related to management incentives and performance evaluation.¹⁴ Transfer pricing is inconsistent with a policy of treating each subsidiary in the firm as a profit center. When transfer prices are manipulated by the firm and deviate significantly from the arm's-length price, the subsidiary's performance may depend as much on transfer prices as it does on other pertinent factors, such as management effort. A subsidiary told to charge a high transfer price for a good supplied to another subsidiary will appear to be doing better than it actually is, while the subsidiary purchasing the good will appear to be doing worse. Unless this is recognized when performance is being evaluated, serious distortions in management incentive systems can occur. For example, managers in the selling subsidiary may be able to use high transfer prices to mask inefficiencies, while managers in the purchasing subsidiary may become disheartened by the effect of high transfer prices on their subsidiary's profitability.

Despite these problems, research suggests that many international businesses do not use arm's-length pricing but instead use some costbased system for pricing transfers among their subunits (typically cost plus some standard markup). A survey of 164 US multinational firms found that 35 percent of the firms used marketbased prices, 15 percent used negotiated prices, and 65 percent used a costbased pricing method. (The figures add up to more than 100 percent because some companies use more than one method.)¹⁵ Only market and negotiated prices could reasonably be interpreted as arm's-length prices. The opportunity for price manipulation is much greater with costbased transfer pricing.

Although a firm may be able to manipulate transfer prices to avoid tax liabilities or circumvent government restrictions on capital flows across borders, this does not mean the firm should do so. Since the practice often violates at least the spirit of the law in many countries, the ethics of engaging in transfer pricing are dubious at best.