Tax Differences and Global Supply Chain Architecture

Abstract

This paper examines the influence of tax rate differences and international transfer pricing regulations on the profit-maximizing supply chain structure of a multinational firm (MNF). We show how an MNF that sells its products in multiple markets and manufactures multiple inputs used for its own production can optimize its tax strategy by jointly selecting its transfer pricing approach and the location of the manufacturing divisions. The optimal choice of transfer pricing and supply chain structure balances the gains from locating input production in the low-tax country to enable profit-shifting with the losses that occur due to distorted quantity choices in the high-tax country. First, in contrast to existing literature, we find that the MNF should always fully exploit its profit-shifting opportunities by selecting the maximum admissible arm's length transfer price for international transactions. Second, for products that use multiple complementary inputs there is a close connection between the national and international transfer prices: the MNF's trade-off between the gains or losses can be moderated by setting an adjusted domestic transfer price for transactions between the divisions in the high-tax country. Third and finally, we also point out circumstances where the MNF should use the market price for a base product sold on an external market as an internal arm's length standard.