Multinationals Own Transfer Prices May Be Best

by Mike Godfrey, Tax-News.com, Washington

15 June 2009

Prof. Romana Autrey of Harvard Business School and Francesco Bova, an assistant professor of accounting at the Rotman School of Management at the University of Toronto have co-authored a study entitled 'Gray Markets and Multinational Transfer Pricing', which argues that gray markets may cause unintended social welfare consequences when domestic governments mandate the use of arm's length transfer prices between international subsidiaries. 'Our paper shows that both the firm and the domestic economy may be better off if governments simply allow multinationals the discretion to set their own internal transfer prices,' says Prof. Bova.

'Gray markets' arise when products meant for foreign sale end up back in the local market, often at reduced consumer prices, through unauthorized distribution channels. Cars, pharmaceuticals and computer software are all popular gray market goods. Multinational corporations sometimes adjust internal transfer prices for products transferred to foreign subsidiaries to counteract such problems.

Multinationals also adjust transfer prices to shift profits from high tax to low tax jurisdictions. As a result, many governments have mandated the use of "arm's length" transfer prices - which are higher than those the multinational would otherwise choose - between international subsidiaries. By mandating the use of arm's length transfer prices, domestic governments are assured of a larger share of international tax revenues.

However the study shows that higher arm's length transfer prices, while generating higher tax revenues domestically, can also increase prices in the foreign markets that are the source of gray market goods. This increases the cost base of the gray market and makes the gray market a weaker competitor when it "leaks" products back to the domestic market. Less competition means higher prices for local consumers.

According to Prof. Bova, allowing firms the discretion to set their own internal transfer prices represents "a trade-off" for governments which may lead to lower domestic tax revenues, but which may ultimately lead to net benefits to the local economy from stronger competition. This is particularly the case when the foreign goods that are "leaked" back into the domestic market provide the only means of domestic competition for a firm's product - as in the case of proprietary software or patented pharmaceuticals.

Transfer pricing and gray markets are hot topics under the Obama administration, says Prof. Bova, because of a need to boost US tax revenues. These findings could point the way for tax regulators as they reexamine the implications of mandated transfer pricing policies and decide on which multinationals to target for arm's length enforcement.

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