Transfer Pricing and Sourcing Strategies for Multinational Firms

Abstract

Taking advantage of low foreign tax rates using transfer pricing and taking advantage of low production costs using offshoring are two strategies multinational firms (MNFs) use to increase their profits. We identify an important trade-off that MNFs face in setting their transfer prices: the conflict between (i) the incentive role and (ii) the tax role played by the transfer price. For MNFs, we characterize transfer-pricing strategies that motivate divisional management to (i) make good sourcing decisions and (ii) take advantage of favorable tax rates. It is clear that using a dual transfer-pricing system, where one transfer price determines tax liability and the other transfer price determines management compensation will always achieve the first-best solution, but such an approach carries the burden of administrative and possibly punitive costs. In addition to finding the profit-maximizing sourcing and transfer-pricing policies for both single and dual transfer-pricing systems, we quantify the absolute and relative maximum inefficiency in terms of the after-tax MNF's profit change from using a single transfer-pricing system. We show that the highest relative loss is attained when the average outsourcing and offshoring costs, as well as the tax differential, are high. Using numerical experiments, we demonstrate that the absolute loss is attained when the outsourcing cost follows a symmetric distribution and the average outsourcing cost is approximately equal to the offshoring cost. We also extend our results to two practical variations of MNF structures: an MNF that faces operational constraints on its offshoring capacity and an MNF that uses compensation contracts linked to after-tax firm-wide profits. Insights from our analysis should help MNFs' managers identify when to use single and dual transfer-pricing systems.