Examining the Tensions Between the Fiscal Arm's Length Principle and the Management Control Role of Cross-Border Transfer Pricing

Abstract

Transfer pricing attracts considerable attention by the tax authorities these days. Out of fear for multinational enterprises (MNE) manipulating transfer prices to reduce their total tax burden, the authorities have strengthened the fiscal rules and have augmented the number of transfer pricing audits undertaken. The fiscal rules are built around the 'arm's length principle', which is widely accepted as the international yardstick to ensure fair transfer prices in each jurisdiction. In this paper, we investigate whether the need to comply with the arm's length principle in the fiscal requirements influences the role of transfer pricing as an instrument within the management control system and how MNEs cope with potential tensions that can arise between both aspects. In line with a number of domestic transfer pricing studies (Spicer 1988, Van der Meer-Kooistra 1994, Colbert and Spicer 1995), Transaction Cost Economics (TCE) (Williamson 1979) serves as the broad theoretical framework for this study. Williamson's version has been extended by explicitly incorporating MCS aspects and processes/dynamics (Ghoshal and Moran 1996, Boyns et al. 1999, Covaleski et al. 2003). The 'transactional' level is the main unit of analysis. Under the TCE approach the choice of the governance system for a certain transaction is determined by transaction and production cost minimising. TCE therefore justifies the use of different conditions, including a different price, for internal versus open-market transactions. However, the arm's length principle forces MNEs to account for all internal transactions at a price that would be used under market governance (Piciotto 1992, Eden et al. 2001). The transactions under investigation consist of a series of cross-border transfers of three different types of products in the context of one MNE. Design and analysis of the three case studies are based on Eisenhardt (1989), Yin (1994) and Miles and Huberman (1998). In addition, the analysis is supported by the computer package NU*DIST N5. A first conclusion of the study is that the fiscal 'arm's length' transfer pricing methods do not create tensions between the fiscal role and the MCS role of transfer pricing. When the MNE motivates the prices it applies with a detailed functional analysis, national tax authorities are accepting them in an increasingly flexible way. The reasoning behind the functional analysis is in accordance with TCE: the functions, risks and assets under investigation match the concepts of complexity/uncertainty and asset specificity. TCE constructs can therefore explain the use of transfer pricing methods for MCS. A second conclusion is that the tension between the arm's length principle and the internal governance of transactions depends on the strategic focus of the product being transferred. The tension is higher for unique processes and products, while it can be solved for standard products that are available on the market and for which the MNE focuses on cost competitiveness.