Objective: The arguments for and against transfer pricing schemes so far have focused on profit seeking approaches based on tax differentials, or on evasion of government enforced goods and fund flow restrictions. This paper shifts to a value-seeking framework where transfer prices act as strategic tools that may enhance value for the multinational (MNC) with a foreign affiliate by exploiting financial and/or tax arbitrage.The conditions for MNCs to set transfer prices at an optimal level in such an environment are explored.
Data/Methods:
The paper develops a differential valuation model under risk neutrality where the level of transfer prices the parent charges its affiliate become a decision variable. The differential value is the difference between the values of foreign cash flows of the affiliate in the host country versus home country whose capital markets are partially segmented. The parent will maintain the ownership of the affiliate if the differential value is positive and set transfer prices to maximize it. The model also takes into account the differential taxes in the two countries and charges a penalty if transfer prices are set at a level that may trigger authorities to intervene. This countervailing cost will result in an optimal level of transfer prices given the parameters of a specific parent. The implications of the model are demonstrated with numerical simulations.
Results:
The results show that there is an optimal level of transfer price depending on the specific exchange rate distribution when the cost structure allows for a penalty for overcharging. Moreover, the present paper introduces a new form of tax arbitrage benefit of transfer prices that is based on present value of tax shields. The model developed in the paper is an easy optimization procedure that can be applied by MNC managers.