An outcome-based assessment of international transfer pricing policy

Instead of concentrating on the selection of the optimal transfer pricing method, this paper focuses on the consequences of international transfer pricing for multinational entities. A sample of U.S.-based multinational firms is employed to determine if transfer pricing results in measurable financial outcomes. Results of the study indicate that firms employ international transfer pricing to meet a variety of objectives. The dollar value of international transfers and the foreign sales percentage are both significant explanatory variables for the financial outcomes of these objectives.     

Strategic transfer pricing,absorption costing,and observability

This paper analyses the use of transfer pricing as a strategic device in divisionalized firms facing duopolistic price competition. When transfer prices are observable, both firms’ headquarters will charge a transfer price above the marginal cost of the intermediate product to induce their marketing managers to behave as softer competitors in the final product market. When transfer prices are not observable, strategic transfer pricing is not an equilibrium and the optimal transfer price equals the marginal cost of the intermediate product. As a strategic alternative, however, the firms can signal the use of transfer prices above marginal cost to their competitors by a publicly observable commitment to an absorption costing system. The paper identifies conditions under which the choice of absorption costing is a dominant strategy equilibrium.     

Can firm-specific dividend drop-off ratios be used to infer shareholder marginal tax rates?

In a seminal study, Elton and Gruber (1970) argue that ex-dividend day pricing can be used to infer marginal tax rates of shareholders. We examine ex-dividend day pricing for individual firms and ask whether their CFOs could use the history of a firm's ex-dividend price-drop ratios to infer reasonable estimates of shareholders’ marginal tax rates. We use TAQ data for 1,124 US firms that have at least 30 ex-dividend days during the period August 1993 to October 2012. Our results show that ex-dividend day pricing is so noisy as to prohibit sensible estimates of shareholders’ marginal tax rates.     

Overhead cost allocation changes in a transfer pricing tax compliant multinational enterprise

This paper addresses how overhead cost allocation system design in multinational enterprises (MNEs) is affected by transfer pricing tax regulation. Using a case study research strategy we find that the implementation of a transfer pricing tax compliance strategy gives rise to a number of changes to the overhead cost allocation system design. Findings suggests that a contingent relationship exists between overhead cost allocation and transfer pricing tax compliance. We argue that when seeking to understand and explain MNEs’ overhead cost allocation system design for intra-company services, the MNEs’ response to its tax regulatory environment is a significant explanatory variable.     

Timing of Sale,Pricing, and Cost Information: Evidence from the Airline Industry*

This study examines the association between when an airline sells its passenger seats and the pricing method (marginal cost or full cost) it employs. Prior literature suggests that when firms are able to change prices during the selling period, the optimality of full cost pricing or marginal cost pricing depends on when demand information is revealed during the period between capacity commitment decisions and time of sale. Full cost‐based pricing is appropriate in determining capacity commitment and prices simultaneously, while marginal cost provides more relevant information for pricing when capacity has been committed. Using the price and cost data from a sample of four U.S. domestic airlines, we find that full cost explains price variations of first‐day sales robustly. The adjusted R² of the marginal cost pricing model is larger in the sample of sales two days prior to departure than in the sample of first‐day sales. In the analysis of the sample of sales two days prior to departure, we find that, based on the adjusted R² of the full cost pricing and marginal cost pricing models, the explanatory power of marginal cost pricing is relatively weaker than full cost pricing. Our results document the use of different cost information along the dynamic change of price and provide implications in understanding the role of cost information in setting prices.     

A model of cost-based transfer pricing

In most decentralized organizations, goods and services are transferred between divisions. These transfers are frequently recorded in the accounting books of the divisions; the term transfer price refers to the dollar amount of the interdivisional exchange. This study considers two main issues: (i) the costs and the benefits of delegating decisions through a system of transfer pricing and divisional performance evaluation, and (ii) the performance of one common method of pricing intrafirm transactions: cost-based transfer pricing.The study analyzes a firm in which each divisional manager has better information about the divisional environment than what is known by the firm's top management. The first half of the paper demonstrates that the firm can attain the optimal level of profits with a compensation system utilizing (i) reports by divisional managers describing in complete detail each manager's private information, and (ii) divisional performance evaluation with cost-based transfer pricing. Next, a situation is considered in which divisional managers are not able to communicate their private information to the firm's top management because of complexity of divisional environments or managers' specialized expertise. In this bounded-rationality setting, a managerial-compensation system employing cost-based transfer pricing allows the firm to earn strictly higher expected profits than if all decisions are made by the firm's top management relying on divisional managers' reports.Financial support from the Unisys Corporation is gratefully acknowledged.     

External and Internal Pricing in Multidivisional Firms

Multidivisional firms frequently rely on external market prices in order to value internal transactions across profit centers. This paper examines market‐based transfer pricing when an upstream division has monopoly power in selling a proprietary component both to a downstream division within the same firm and to external customers. When internal transfers are valued at the prevailing market price, the resulting transactions are distorted by double marginalization. The imposition of intracompany discounts will always improve overall firm profits provided the supplying division is capacity constrained. Under certain conditions it is then possible to design discount rules so that the resulting prices and sales quantities are efficient from the corporate perspective. In contrast, the impact of intracompany discounts remains ambiguous when the capacity of the selling division is essentially unlimited. It is then generally impossible to achieve fully efficient outcomes by means of market‐based transfer pricing unless the external market for the component is sufficiently large relative to the internal market.     

Cost-based transfer pricing

This paper compares the performance of alternative cost-based transfer pricing methods. We adopt an incomplete contracting framework with asymmetric information at the trading stage. Transfer pricing guides intra-company trade and provides incentives for value-enhancing specific investments. We compare actual-cost transfer prices that include a markup over marginal costs with standard-cost transfer prices that are determined either by the central office ex ante (centralized standard-cost transfer pricing) or by the supplying division at the trading stage (reported standard-cost transfer pricing). For the actual-cost methods, we show that markups based on the joint contribution margin (contribution-margin transfer pricing) dominate purely additive markups (cost-plus transfer pricing). We obtain the following results. (1) Centralized standard-cost transfer pricing dominates the other methods if the central office and the divisions ex ante face low cost uncertainty. (2) The actual-cost methods dominate the other methods if the central office and the divisions ex ante face high cost uncertainty and later, at the trading stage, the buying division receives sufficient cost information. (3) Reported standard-cost transfer pricing dominates the other methods if the central office and the divisions ex ante face high cost uncertainty, and the buyer has insufficient cost information at the trading stage.     

Towards an organizational theory of the transfer pricing process

Understanding the transfer pricing issue as it arises in large decentralized firms is important, because it represents a pervasive problem in the design of managerial accounting and control systems in complex organizations. This paper draws on the growing literature on the economics of internal organization to develop an understanding of the strategic, organizational and transactional conditions under which transfer pricing (and related control) issues arise, and the organizational processes used to implement intra-firm transfers of products and to determine transfer prices. The objective of the paper is to develop a theory of the transfer pricing process and to reduce hypotheses from the theory.     

Corporate environments and international transfer pricing: an empirical study of China in a developing economy framework

This paper investigates the international transfer pricing methods adopted by multinational corporations (MNCs) in China and how their choices are affected by their specific corporate attributes in the context of the business environment in China. Empirical test results based on structured interviews indicate that MNCs having a local (Chinese) partner in management tend to adopt market-based transfer pricing methods. The influence of local partners on the choice of transfer pricing methods is modified by the impact of the source of foreign investment, as the analysis reveals that US-sourced MNCs are more likely to use cost-based pricing methods for international transfers. The influences of these two variables on the choice of transfer pricing methods are significant both directly and interactively. There is also some evidence that export-oriented enterprises are more likely to adopt cost-based transfer pricing than those aiming at China's domestic market. By providing empirical evidence on the impact of key corporate attributes on transfer pricing which have not been studied by prior research in the context of a developing economy, this research contributes to a more comprehensive understanding of transfer pricing in developing countries.     

Discussion of “decentralized capacity management and internal pricing”

Dutta and Reichelstein (2010) study the role of transfer pricing and organizational choice in providing incentives for efficient decisions on the acquisition and subsequent reallocation of capacity within decentralized firms. Their analysis suggests that transfer prices based on the historical cost of capacity facilitate the efficient allocation of resources. They also find that symmetric responsibility center structures are generally better suited for providing efficient investment incentives than hybrid organizations. An important condition for the derivation of the two results is the linearity of the shadow prices of capacity. If shadow prices are nonlinear, transfer prices should be below (above) the historical cost of capacity in order to counteract the managers’ incentives to underinvest (overinvest). Because profit center organizations can use transfer prices for mitigating the inefficiency caused by nonlinear shadow prices, they offer a natural advantage over pure investment center organizations in implementing efficient capacity decisions. Overall, these observations suggest that the curvature of profit functions is an important factor in determining the suitable instruments for decentralized capacity management.     

Unit initial public offerings: Staged equity or signaling mechanism?

We investigate the use of unit (i.e., package) initial public offerings by Australian industrial firms and conclude that their use reflects their role as a signaling mechanism (Chemmanur and Fulghieri, 1997), as distinct from the agency–cost explanation offered by Schultz (1993). From a sample of 394 IPOs between 1976 and 1994, the 66 firms making unit offerings are typically riskier, use less prestigious underwriters and have a lower level of retained ownership than other IPO firms. While these results are also consistent with Schultz's agency cost explanation, other results we report are not. We find no difference in underpricing etween unit IPOs and other IPO firms, nor are there any significant differences in the planned uses of proceeds reported in the prospectus, post–listing failure rates or secondary equity offerings of the type predicted by Schultz. We do however, report evidence consistent with a prediction unique to the signaling explanation. After controlling for the level of ownership retained by insiders, the proportion of firm value sold as warrants is increasing in IPO firms' riskiness.     

Market forces meet behavioral biases: cost misallocation and irrational pricing

Psychological and experimental evidence, as well as a wealth of anecdotal examples, suggests that firms may confound fixed, sunk, and variable costs, leading to distorted pricing decisions. This article investigates the extent to which market forces and learning eventually eliminate these distortions. We envision firms that experiment with cost methodologies that are consistent with real‐world accounting practices, including ones that confuse the relevance of variable, fixed, and sunk costs to pricing decisions. Firms follow “naive” adaptive learning to adjust prices and reinforcement learning to modify their costing methodologies. Costing and pricing practices that increase profits are reinforced. In some market structures, but not in others, this process of reinforcement causes pricing practices of all firms to systematically depart from standard equilibrium predictions.     

Ownership and Production Costs: Choosing between Public Production and Contracting‐Out in the Case of Swedish Refuse Collection

Many comparisons of public and private firms use a public/private ownership dummy variable to capture cost differences. If, however, public and private firms use different production technologies, the dummy‐variable approach is misspecified. Data from public and private firms should not be pooled. Secondly, selectivity bias may arise, making it more difficult to identify cost differentials that actually exist. Thirdly, if data should be pooled, the resulting empirical model may be logically inconsistent. This paper compares public and private firms using the refuse collection costs of 170 firms in 115 Swedish municipalities. First, public production costs were 6 per cent lower than private production costs. Secondly, cost differences did not affect producer choice. It is crucial to adjust for selectivity. Data for private and public firms should not be pooled. The dummy‐variable model is misspecified.     

Transfer Pricing for Corporate Treasury in the Multinational Enterprise

Intercompany financing transactions are becoming increasingly important to multinational enterprises (MNEs) as they expand internationally. Corporate treasurers of MNEs have many responsibilities, including the management of international capital structure and cost of capital, the financing of cross‐border acquisitions, foreign direct investment, international capital budgeting and cash management, management of foreign exchange and transactional risk, and port‐folio and investment management. This article focuses on a corporate function, transfer pricing, that is potentially relevant to each of these activities. Whenever a payment crosses borders in a treasury context—whether to provide a loan, purchase a receivable, provide a guarantee, sweep cash, factor a receivable, provide a hedge or insurance product—a transfer pricing issue is present. Transfer pricing is often viewed as a taxation issue and thus the responsibility of the corporate tax department. This article challenges that view, and makes the case that an integrated, multi‐functional approach to MNE treasury planning in the context of transfer pricing can be an important component in improving the efficiency of cross‐border financial management. The paper uses conceptual and empirical information as well as numerical examples to illustrate relevant tax and transfer pricing concepts for policy planners and others responsible for MNE treasury and tax planning.     

Information technology,organizational design,and transfer pricing

We show how information technology affects transfer pricing. With coarse information technology, negotiated transfer pricing has an informational advantage: managers agree to prices that approximate the firm's cost of internal trade more precisely than cost-based transfer prices. With sufficiently rapid offers, this advantage outweighs opportunity costs of managers’ bargaining time, and negotiated transfer pricing generates higher profits than the cost-based method. However, as information technology improves, the informational advantage diminishes; the opportunity costs of managers’ bargaining eventually dominate, and cost-based methods generate higher profits. Our results explain why firms generally prefer cost-based methods, and when negotiated methods are preferable.     

Can corporate governance deter management from manipulating earnings? Evidence from related-party sales transactions in China

This study investigates whether good governance structures help constrain management's opportunistic behaviors (in the form of transfer pricing manipulations) in one of the world's most dynamic economies. Our data are a unique sample of 266 companies listed on the Shanghai stock exchange that disclose gross profit ratios on related-party transactions. We find that firms with a board that has a higher percentage of independent directors or a lower percentage of “parent” directors (i.e., directors who are representatives of the parent companies of the listed firms), or have different people occupying the chair and CEO positions, or have financial experts on their audit committees, are less likely to engage in transfer pricing manipulations. Overall, our research findings reveal that the quality of corporate governance is important in deterring the use of manipulated transfer prices in related-party sales transactions.     

Foreign macroeconomic and industry-related information transfers around earnings announcements: Evidence from U.S.-listed non-U.S. firms

This study examines information transfer regarding how investors react to new foreign macroeconomic and industry-related information embedded in foreign firms' earnings releases. Using non-U.S. firms listed in the U.S. as our main setting, we find that U.S. investors react significantly to foreign macroeconomic information and to information generated by the interaction between macroeconomic and industry-related information. We also find that the benefits (costs) of processing earnings reports increase (decrease) both types of information transfers. In addition, we find macroeconomic information transfers in an international cross-listing setting and both types of information transfers in an international non-cross-listing setting.     

Accounting restatements and information risk

We examine the association between accounting restatements and the pricing of information risk. Using the Fama and French three-factor model augmented with discretionary and innate information risk factors, we find a significant increase in the factor loadings on the discretionary information risk factor for restatement firms after a restatement announcement. The increase in factor loadings results in an increase in the estimated cost of capital, which is cross-sectionally associated with the short-window price reaction to restatements. We study several potential determinants of the change in information risk pricing and find evidence consistent with the restatement initiator (auditor vs. firm management) and the number of times a firm restates affecting the change in the pricing of discretionary information risk. We also find an increase, of smaller magnitude, in the pricing of discretionary information risk for non-restatement firms in the same industries as the restatement firms, consistent with an information transfer effect.     

Competitive cross‐subsidization

Cross‐subsidization arises naturally when firms with different comparative advantages compete for consumers with heterogeneous shopping patterns. Firms then face a form of co‐opetition, as they offer substitutes for one‐stop shoppers and complements for multi‐stop shoppers. When intense competition for one‐stop shoppers drives total prices down to cost, firms subsidize weak products with the profits made on strong products. Moreover, firms have incentives to seek comparative advantages on different products. Finally, banning below‐cost pricing increases firms' profits at the expense of one‐stop shoppers, which calls for a cautious use of below‐cost pricing regulations in competitive markets.