Abstract This study examines how transfer pricing, in the presence of differential taxation, affects the resource allocation and profitability of a decentralized multinational enterprise (MNE) that uses the same transfer price for tax and performance evaluation purposes. An analytical model is built in which a foreign manufacturing division transfers a single product to a U.S. distribution division, which, in turn; sells it in the marketplace as part of a final product. It is assumed that both divisions have complete information concerning at cost and revenue functions and that tax rates are higher in the United States than abroad. Given this assumption, it is shown that it is in the interest of both division to cooperate with each other, and a cooperative equilibrium is used throughout the analysis. When differential tax rates exist, but there are no transfer-pricing rules imposed by the taxing authorities, it is shown that the MNE's optimal. resource allocation is the same as in the absence of taxes; however, firm- wide profits are not maximized. When the resale-price method of computing transfer prices (Reg. §1.482-2(e)(3)) is used, the results differ, depending on the manufacturing division's bargaining power. At low levels of bargaining power, the distribution division will guarantee" a certain level of profit to the manufacturing division, and firm wide after-tax profits will be maximized. As the manufacturing division's bargaining power increases beyond a certain point, however, firm wide optimal profits will no longer be achieved. In addition, the final product and the most similar product (as defined by Reg. §1.482-2(e)(3)) will be produced beyond the firm wide after-tax optimum. When transfer prices are computed in accordance with the cost-plus method (Reg. §1.482-2(e)(4)), it is shown that production of the final product first decreases, then increases, and production of the most similar product increases as the distribution division's bargaining strength increases. In addition, there is no guarantee of profit to the manufacturing division. Accordingly, it is unlikely that firmwide after-tax profits will be maximized. Demonstration of these results is achieved with the use of numerical examples. The study concludes with a discussion of the tax policy implications of these results.
Hulperin et al. (Tue,) studied this question.