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Multinational Transfer Pricing

Multinational Transfer Pricing. Parent company owns a foreign subsidiary Entity = parent or subsidiary One entity supplies the other a component Transfer price is price paid to the supplier by the entity that receives the component Consolidated firm = parent cum subsidiary

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Multinational Transfer Pricing

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  1. Multinational Transfer Pricing • Parent company owns a foreign subsidiary • Entity = parent or subsidiary • One entity supplies the other a component • Transfer price is price paid to the supplier by the entity that receives the component • Consolidated firm = parent cum subsidiary • Aim: minimize consolidated firm taxes

  2. Minimize consolidated taxes • Tax rule: transfer price must equal the arms-length price, otherwise transfer price is deemed an illegal tax dodge (evasion) • However, arms-length price is not a specific value but a range of values (GlaxoSmithKline) • Some scope for tax avoidance exists • Higher tax entity should pay more/receive less; lower tax entity should pay less/receive more • Succinct rule: High pays high! Low pays low!

  3. Absence of taxes • Entity a pays b transfer price • Proposed shift: a pays X per unit more • For consolidated firm, shift is of no consequence absent taxes; akin to moving a coin from one pocket to another pocket • But if taxes present: a would have a higher tax shield, b would have a higher tax liability • Higher tax entity should pay more/receive less; lower tax entity should receive more/pay less

  4. Tax gain per unit calculation • Entity a pays b transfer price • Proposed shift: a pays X per unit more • Ta = tax rate of entity a • Tb = tax rate of entity b • Tax gain per unit from shift = X (Ta – Tb) • Gain XTa (tax shield from increased expense) but lose XTb (more tax liability)

  5. Parent buys from subsidiary • Current transfer price = $4.50 • Arm’s length price in range ($4 , $6) • Parent Tp = 40%, subsidiary Ts = 25% • Increase transfer price: X = $1.50 • Consolidated firm’s tax gain per unit = $1.50 (40% - 25%) = $0.225

  6. Parent buys from subsidiary • Current transfer price = $4.50 • Arm’s length price in ($4 , $6) • Parent Tp = 25%, subsidiary Ts = 40% • Decrease transfer price: X = -$0.50 • Consolidated firm’s tax gain per unit = -$0.50 (25% - 40%) = $0.075

  7. Subsidiary buys from parent • Current transfer price = $4.50 • Arm’s length price in ($4 , $6) • Parent Tp = 40%, subsidiary Ts = 25% • Decrease transfer price: X = - $0.50 • Consolidated firm’s tax gain per unit = -$0.50 (25% - 40%) = $0.075

  8. Subsidiary buys from parent • Current transfer price = $4.50 • Arm’s length price in ($4 , $6) • Parent Tp = 25%, subsidiary Ts = 40% • Increase transfer price: X = $1.50 • Consolidated firm’s tax gain per unit = $1.50 (40% - 25%) = $0.225

  9. Negative Behavioral Implications • Tax-minimizing transfer pricing • High-tax entity: low profits • Low-tax entity: high profits • Incentive system: managers’ pay based on entity profits • High-tax entity manager: System is unfair! • Solution: incentive pay based on consolidated (not entity) profits

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