Transfer Pricing and the Decision-Making Authority of the Tax Function in Multinational Companies

Abstract

The allocation of decision rights is a fundamental issue of organizational design. We study the allocation of decision-making authority within firms’ transfer pricing function where tax and managerial objectives typically conflict. Exploring unique survey data, we investigate whether centralizing transfer pricing decision-making at the tax department is associated with a higher likelihood of (external) tax audit conflicts and (internal) coordination conflicts. We find that disputes with local tax authorities are more likely, and thus tax risk is higher, when the tax department has ultimate authority over transfer pricing decisions. This result is consistent with theory predicting that central tax managers focus on firm-wide profits instead of easing local tax audits of single subsidiaries. We find that internal coordination, on average, seems to be unaffected by the allocation of decision rights to the tax department. Yet, such centralized transfer pricing decision-making is associated with internal coordination conflicts when it is paired with less sophisticated tax planning strategies and when pricing intrafirm trade is more complex, i.e. when intrafirm trade involves services and intellectual property. Results of cross-sectional tests suggest that firms benefit from centralizing decision-making authority at the tax department in terms of lower tax risk and fewer coordination conflicts if firms employ sophisticated planning tax strategies.

Keywords: transfer pricing, decision-making, coordination, tax risk