Abstract
Tax officials judge whether a multinational’s transfer price is consistent with the arm’s-length standard, the price at which two independent firms would carry out a similar transaction, by using data from comparable but independent transactions. In vertically integrated industries, the only source of comparable data may be from controlled (nonindependent) transactions. Conventional wisdom asserts that standard arm’s-length methods cannot perform well in such markets because the comparability rules encourage the integrated firms to collude tacitly on transfer prices in a way that amplifies tax-differential incentives. In this paper, we show that strategic linkages between vertically integrated firms operating in the same final good market moderate, and can possibly reverse, tax-differential incentives if the correct comparison method is used. The Cost-Plus method turns out to be the most effective in limiting the equilibrium amount of profit-shifting out of the high-tax country and it yields the highest tax revenues for the high-tax country. These benefits are shown to strengthen when the firms have private cost information.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
Alles, M., & Datar, S. (1998). Strategic transfer pricing. Management Science, 44, 451–461.
Ault, H., & Bradford, D. (1990). Taxing international income: an analysis of the U.S. system and its economic premises. In A. Razin, & J. Slemrod (Eds.), Taxation in the global economy. NBER, University of Chicago Press.
Baron, D., & Myerson, R. (1982). Regulating a monopolist with unknown costs. Econometrica, 50, 911–930.
Bond, E. (1980). Optimal transfer pricing when tax rates differ. Southern Economic Journal, 47, 191–200.
Bond, E., & Gresik, T. (1996). Regulation of multinational firms with two active governments: a common agency approach. Journal of Public Economics, 59, 33–53.
Calzolari, G. (2004). Incentive regulation of multinational enterprises. International Economic Review, 45, 257–282.
Copithorne, L. (1971). International corporate transfer prices and government policy. Canadian Journal of Economics, 4, 324–341.
Elitzur, R., & Mintz, J. (1996). Transfer pricing rules and corporate tax competition. Journal of Public Economics, 60, 401–422.
Fershtman, C., & Judd, K. (1987). Equilibrium incentives in oligopoly. American Economic Review, 77, 927–940.
Gresik, T., & Nelson, D. (1994). Incentive compatible regulation of a foreign-owned subsidiary. Journal of International Economics, 36, 309–331.
Halperin, R., & Srinidhi, B. (1996). U.S. income tax transfer pricing rules for intangibles as approximations of arm’s length pricing. The Accounting Review, 71, 61–80.
Harris, D., & Sansing, R. (1998). Distortions caused by the use of arm’s length transfer prices. Journal of the American Tax Association, 20(Supplement), 40–50.
Haufler, A., & Schjelderup, G. (2000). Corporate tax systems and cross country profit shifting. Oxford Economic Papers, 52, 306–325.
Horst, T. (1971). Theory of the multinational firm: optimal behavior under differing tariff and tax rates. Journal of Political Economy, 79, 1059–1072.
Levinsohn, J., & Slemrod, J. (1993). Taxes, tariffs, and the global corporation. Journal of Public Economics, 51, 97–116.
Narayanan, V., & Smith, M. (2000). Impact of competition and taxes on responsibility center organization and transfer prices. Contemporary Accounting Research, 17, 497–529.
OECD. (1995). Transfer pricing guidelines for multinational enterprises and tax administrations. OECD.
OECD. (2001).Transfer pricing guidelines for multinational enterprises and tax administrations. OECD.
OECD. (2003). Transfer pricing: the OECD launches an invitation to comment on comparability issues. http://www.oecd.org/EN/document/0,EN-document-107-nodirectorate-no-26-40784-22,00.html.
Prusa, T. (1990). An incentive compatible approach to the transfer pricing problem. Journal of International Economics, 28, 155–172.
Samuelson, L. (1982). The multinational firm with arm’s-length transfer price limits. Journal of International Economics, 13, 365–374.
Sansing, R. (1999). Relationship-specific investments and the transfer pricing paradox. Review of Accounting Studies, 4, 119–134.
Schjelderup, G., & Weichenrieder, A. (1999). Trade, multinationals, and transfer pricing regulation. Canadian Journal of Economics, 32, 817–834.
U.S. Department of the Treasury. (1994). Intercompany transfer pricing regulations under Section 482: final regulations. Federal Register, 59(130), 34971–35033.
Weichenrieder, A. (1996). Transfer pricing, double taxation, and the cost of capital. Scandinavian Journal of Economics, 98, 445–452.
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Gresik, T.A., Osmundsen, P. Transfer pricing in vertically integrated industries. Int Tax Public Finance 15, 231–255 (2008). https://doi.org/10.1007/s10797-007-9019-y
Received:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s10797-007-9019-y