Abstract
This study examines how a strategic tax auditor affects a multinational firm’s transfer pricing in a tax compliance game. Our model uses a divisionalized firm, in both a low-tax and a high-tax country, that decides to implement a transfer-pricing regime with either one or two sets of books. After observing its unit costs, the firm reports a compliant or noncompliant tax transfer price. In a regime with one set of books, the single transfer price coordinates the quantity decision and determines the tax payments. In a regime with two sets, different transfer prices serve those tasks. In contrast to previous studies, our analysis incorporates a strategic tax auditor, who observes the tax transfer price and decides whether to audit the firm. Real-world regulations suggest larger penalties for detected noncompliance under a two-sets-of-books transfer-pricing regime. Our analysis identifies the mixed strategy equilibria and examines how variations in the tax regulation—the tax rate difference and the penalty difference—affect the firm’s tax aggressiveness. We show that a firm acts less tax aggressively with a higher tax rate difference. Additionally, the model predicts that the firm either increases or decreases the probability of keeping one set of books for a smaller penalty difference.
Highlights
Transfer prices are necessary for computing divisional profits in a multinational firm whenever its divisions engage in intra-firm trade
After identifying the mixed strategy equilibria, we find that the penalty difference determines the first-stage implementation decision about using OSB or two sets of books (TSB)
Proposition 3 states that a decreasing penalty difference ambiguously affects the implementation of the transfer-pricing regime: for intermediate audit costs and a smaller penalty difference caused by an increase of δOSB, the probability of OSB increases, if TSB with noncompliance of the low-cost multinational is the alternative action in equilibrium, that is, in equilibrium III
Summary
Transfer prices are necessary for computing divisional profits in a multinational firm whenever its divisions engage in intra-firm trade. The finding stems from the presence of the strategic tax auditor, who incorporates a higher penalty for detected noncompliance under OSB and the multinational’s incentives for switching toward more TSB in his or her audit decision, thereby increasing audit incentives. Kant (1988), Smith (2002), Hyde and Choe (2005), and Choe and Hyde (2007) study the impact of a penalty for noncompliance on multinational’s transfer prices They neither examine the presence of a strategic tax auditor nor consider whether the multinational keeps OSB or TSB. OSB serves as a commitment device for softening competition in external markets While this strand of the literature assumes that the competitors observe the multinational’s transfer-pricing regime, we do not make a similar assumption for the tax auditor.
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
