The Optimal Focus of Transfer Prices: Pre-Tax Profitability versus Tax Minimization

38 Pages Posted: 13 Dec 2007 Last revised: 28 Nov 2014

See all articles by Jan Thomas Martini

Jan Thomas Martini

Bielefeld University - Department of Business Administration and Economics

Date Written: October 27, 2014

Abstract

This paper studies transfer prices influencing managerial decisions and determining corporate taxes in a multinational firm. Common sense suggests that the transfer price decision should be made to maximize the firm's after-tax profit and thus achieve the optimal trade-off between pre-tax profitability and tax minimization. Based on a model of a decentralized firm facing asymmetric information with respect to operations, I examine why this conclusion does not hold in general. In particular, I demonstrate that a policy of negotiated transfer pricing, under which the divisions exploit their superior information but select the transfer price to maximize the firm's pre-tax profit, is the firm’s optimal organizational choice if the high-tax division's productivity is high. With respect to the firm's discretion over the transfer price, I identify situations where the firm's optimal policy choice does not depend on the arm's length range and where less discretion increases the firm's profitability.

Keywords: Transfer Pricing, Multinational firm, Taxation, Decentralization, Management Control

JEL Classification: C78, H25, L23, M41

Suggested Citation

Martini, Jan Thomas, The Optimal Focus of Transfer Prices: Pre-Tax Profitability versus Tax Minimization (October 27, 2014). Available at SSRN: https://ssrn.com/abstract=1053641 or http://dx.doi.org/10.2139/ssrn.1053641

Jan Thomas Martini (Contact Author)

Bielefeld University - Department of Business Administration and Economics ( email )

P.O. Box 100131
D-33501 Bielefeld, NRW 33501
Germany

HOME PAGE: http://www.wiwi.uni-bielefeld.de/lehrbereiche/bwl/ctrl/martini

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