INTRAFIRM TRANSFERS Since the multinational firm is made up of subsidiaries located in different

political jurisdictions, transferring funds among divisions of the firm often depends on what governments will allow. Beyond the transfer of cash, as covered in the preceding section, the firm will have goods and services moving between subsidiaries. The price that one subsidiary charges another subsidiary for internal goods transfers is called a transfer price. The setting of transfer prices can be a sensitive internal corporate issue because it helps to determine how total firm profits are allocated across divisions. Governments are also interested in transfer pricing since the prices at which goods are transferred will determine tariff and tax revenues.

The parent firm always has an incentive to minimize taxes by pricing transfers in order to keep profits low in high-tax countries and by shifting profits to subsidiaries in low-tax countries. This is done by having intrafirm purchases by the high-tax subsidiary made at artificially high prices, while intra-firm sales by the high-tax subsidiary are made at artificially low prices.

Governments often restrict the ability of multinationals to use transfer pricing to minimize taxes. The U.S. Internal Revenue Code requires arm’s-length pricing between subsidiaries—charging prices that an unrelated buyer and seller would willingly pay. When tariffs are collected on the value of trade, the multinational has the incentive to assign artificially low prices to goods moving between subsidiaries. Customs officials may determine that a shipment is being “underinvoiced” and may assign a value that more truly reflects the market value of the goods.

Transfer pricing may also be used for “window-dressing”—that is, to improve the apparent profitability of a subsidiary. This may be done to

Financial Management of the Multinational Firm 177

evaluate each subsidiary on the basis of its contribution to corporate income. Any artificial distortion of profits should be accounted for so that corporate resources are efficiently allocated.

Table 9.2 provides an example of transfer pricing for the Waikiki Shirt Co. Waikiki Shirt Co. manufactures shirts in a low-tax country, country L, and then ships the shirts to a distribution center in a high- tax country, country H. The tax rate in L is 20 percent and the tax rate in H is 40 percent. Given these differential tax rates, Waikiki Shirt Co. will increase its global profit if profits earned by the high-tax distribution operation in country H are transferred to country L, where they would be taxed at a lower rate. The top half of the table provides the outcome when the firm uses arm’s-length pricing in transferring shirts from the manufacturing operation to the distribution operation. The manufactured shirts produced in country L are sold to the distribution operation in country H at a price of $5. Since shirts cost $1 to produce, the pre-tax profit in country L is $4 per shirt. With a tax rate of 20 percent, there is a tax of $0.80 per shirt so that the after-tax profit of the manufacturing operation is $3.20. The distribution center pays $5 per shirt and then sells the shirts for $20, earning a pre-tax profit of $15 per shirt. With a 40 percent tax rate in country H, the firm must pay $6 tax per shirt so that the after-tax profit is $9 per shirt. By summing the

Table 9.2 Transfer Pricing Example Waikiki Shirt Co. makes T-shirts in low-tax country L (with a 20% tax rate) and ships them to a distribution center in high-tax country H (with a 40% tax rate)

Distribution country H Arm’s-Length Pricing

Manufacturing country L

Sales price

$20 Cost

$5 Pre-tax profit

$6 (0.4 3 $15) After-tax profit

$9 Global profit 5 $12.20

Distorted Prices

178 International Money and Finance

after-tax profit earned in countries L and H, the firm earns a global profit of $12.20 per shirt.

Now suppose the firm uses distorted transfer pricing to lower the global tax liability and increase the global profit. This involves having the manufacturing operation in the low-tax country L charge a price above the arm’s-length (true market) value for the shirts it sells to the distribution operation in the high-tax country H. The bottom half of Table 9.2 illustrates how this might work. Now the manufacturing operation sells the shirts to the distribution operation for $10 per shirt. The cost of production is still the same $1 so the pre-tax profit is $9 per shirt.

A 20 percent tax rate means that a tax of $1.80 per shirt must be paid, and the after-tax profit is $7.20 per shirt. The distribution operation now pays $10 for the shirt and still sells it for $20, so the pre-tax profit is $10. At 40 percent, the tax is $4 per shirt, and the after-tax profit is $6. Summing the after-tax profit of the operations in country L and country

H, we find that the global profit is $13.20 per shirt. The firm is able to increase the profit per shirt by $1 through the transfer pricing distortion of the value of the shirt transferred from country L to country H. In this manner, firms can increase profits by shifting profits from high-tax to low-tax countries. Of course, the tax authorities in country H would not permit such an overstatement of the transfer value of the shirt (and consequent underpayment of taxes in country H), if they could determine the true arm’s-length shirt value. For this reason, tax authorities frequently ask multinational firms to justify the prices they use for internal transfers.

INTRAFIRM TRANSFERS Since the multinational firm is made up of subsidiaries located in different