Integrating Managerial and Tax Objectives in Transfer Pricing

39 Pages Posted: 16 Jul 2003  

Tim Baldenius

New York University (NYU) - Department of Accounting

Nahum D. Melumad

Columbia Business School - Accounting, Business Law & Taxation

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: March 2003

Abstract

This paper examines transfer pricing in multinational firms when individual divisions face different income tax rates. Assuming that a firm decouples its internal transfer price from the arm's length price used for tax purposes, we analyze the effectiveness of alternative pricing rules under both cost- and market-based transfer pricing. In a tax-free world, Hirshleifer (1956) advocated that the internal transfer price be set equal to the marginal cost of the supplying division. Extending this solution, we argue that the optimal internal transfer price should be a weighted average of the pre-tax marginal cost and the most favorable arm's length price. When the supplying division sells the intermediate product in question also to outside parties, the external price becomes a natural candidate for the arm's length price. We argue that for internal performance evaluation purposes firms should generally not value internal transactions at the prevailing market price if the supplying division has monopoly power in the external market. By imposing intracompany discounts, firms can alleviate attendant double marginalization problems and, at the same time, realize tax savings which take advantage of differences in income tax rates. Our analysis characterizes optimal intracompany discounts as a function of the market parameters and the divisional tax rates.

Keywords: transfer pricing, multinationals, taxes, decentralization

JEL Classification: F23, M41, D42, L22, H25

Suggested Citation

Baldenius, Tim and Melumad, Nahum D. and Reichelstein, Stefan J., Integrating Managerial and Tax Objectives in Transfer Pricing (March 2003). Available at SSRN: https://ssrn.com/abstract=408260 or http://dx.doi.org/10.2139/ssrn.408260

Tim Baldenius (Contact Author)

New York University (NYU) - Department of Accounting ( email )

44 West 4th Street
New York, NY 10012
United States

Nahum D. Melumad

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
611 Uris
New York, NY 10027
United States
212-854-2475 (Phone)

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1129 (Phone)
650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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