Optimal Transfer Pricing When Tax Rates Differ

Abstract

The problem of finding the appropriate transfer prices to be used in transactions between branches in a vertically integrated enterprise is well known. Transfer prices are important in enterprises where decision-making is decentralized, since the transfer prices chosen will determine the production decisions of the various divisions. The problem is to choose these prices so that the profits of the firm as a whole will be maximized. The result obtained by Hirshleifer [3] is that under conditions of demand and technological independence between branches of the firm, the transfer prices should equal marginal cost. An implication of this result is that decentralized decision-making results in the same output levels for the branches as would occur if the decision-making was centralized. The present paper is concerned with the modifications necessary where earnings of the different branches of the firm are taxed at different rates. The importance of tax rates has arisen in the literature on multinational corporations, where subsidiaries in different countries are taxed at different rates. The result obtained by Horst [4] is that if a subsidiary in a low tax area is exporting to a subsidiary in a high tax area (assuming there are no tariffs), the transfer price should be set as high as possible so that profits are declared in the location with the lower tax rate. This policy will maximize the after tax earnings of the corporation as a whole. The existence of different tax rates will thus lead to an incentive for the formation of

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