Journal of International Financial Management & Accounting 23:1 2012

Transfer Prices: A Financial Perspective

Nilufer Usmen
Department of Economics and Finance, Montclair State University, Montclair, NJ, 04043 e-mail: usmenn@mail.montclair.edu

Abstract
The arguments for and against transfer pricing schemes so far have focused on protseeking approaches based on tax dierentials, or on evasion of government enforced goods and fund ow restrictions. This article shifts to a value-seeking framework where transfer prices act as strategic tools that may enhance value for the multinational with a foreign aliate by exploiting nancial and/or tax arbitrage that also lead to ownership arbitrage. The results show that there is an optimal level of transfer price depending on the specic exchange rate distribution when the cost structure allows for a penalty for overcharging. Moreover, this article introduces a new form of tax arbitrage benet of transfer prices that is based on present value of tax shields.

1. Introduction
Within a multinational rm, it is not uncommon to transfer goods, services and loanable funds between the parent and an aliate or between any two of its alliances. The transfer prices1 attached to these ows can be adjusted by the parent following certain methods that are supervised by the tax jurisdictions and other government authorities where the companies are incorporated. It is well documented that due to tax dierences, import duties, quotas imposed by host countries and/or exchange restrictions or restrictions on ownership, it may be in the best interest of prot maximization to assign a higher/lower price to the transferred goods, services or funds than arms length.2 In practice, multinationals do have the schemes in place to charge prices that are legitimate and that can be substantiated but also that may vary from their true values. The degree of arbitrariness in setting transfer prices depends on whether these products or services are traded in the open market. Even with traded products and services, it is possible to vary the transfer price by using dierent credit terms. Therefore, we may assume that the MNCs have considerable leeway to adjust the level of transfer prices charged to their aliates. The arguments for and against transfer price schemes thus far have focused on prot maximization within regulations imposed by government authorities. The analyses have shown how to regulate
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Nilufer Usmen

transfer prices to increase after-tax prots for the parent company in the presence of dierential taxes, import duties, partial ownership, deferred repatriation of income and dierent dividend pay-out ratios. In these past analyses, the uncertainty about exchange rates has been often overlooked notwithstanding the fact that most transfer pricing situations involve cross-border cash ows. Moreover, there has been a decline in the interest for doing research in this area in nancial economics even though the role played by transfer prices has become more signicant as a result of globalization of businesses and corresponding increase in intra-rm trade and fund ows across borders.3 This article will explore the role played by transfer prices in multinational nancial decision making within an intertemporal valueseeking framework, in the sense that input decisions are made now while the revenues occur in the future. In this framework, the future uncertain revenues will further be impacted by exchange rate volatility. To my best knowledge, this article will be the rst in transfer pricing literature to account for both cash ow and exchange rate uncertainties and their interactions simultaneously. It will view transfer prices as a scheme that can create or destroy value for the rm as it shifts revenues within the network of alliances and the parent. There are four features of the model developed in this study. One is market segmentation that leads to nancial arbitrage, the second is the covariance between exchange rates and foreign currency cash ows and the third is the tax dierential that leads to tax arbitrage. The fourth is the transfer price/cost structure that allows for transfer price to dier from cost but also limits the deviation by a penalty brought by government authorities. These four features, one by one or jointly aect the incentives to set the transfer price that will enhance the value of the multinational parent. Specically, in the present analysis, transfer prices will be presented as a strategic tool that can be used to exploit the benets of nancial and tax arbitrage which lead together to ownership arbitrage to increase the value of a multinational. Financial arbitrage is prevalent in a world where capital markets are eectively segmented due to direct and indirect investment barriers, as evidenced in previous research.4 It is documented that direct barriers, such as taxes or restrictions on foreign ownership of domestic securities, as well as indirect barriers, such as dierences in information, accounting statements, investor preferences or political risk, result in segmentation of
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Value Enhancing Transfer Prices

international capital markets. The asset-valuation implication of segmented markets is that each market assigns a dierent premium to the same risk leading to dierent valuations of the same cash ows in two markets. If the markets were integrated, assets with equal risk located in dierent countries would yield the same expected returns in a common currency. This article will also note that although nancial arbitrage, a product of market segmentation, is partially caused by tax dierences, tax dierences are not the only reason to have different valuations in dierent countries. This article, hence, will present a base case where taxes are assumed away but value dierentials and nancial arbitrage opportunities are still possible due to other barriers in international capital markets. The impact of tax dierences on value will be introduced later and termed as tax arbitrage. Whether the value gain is due to nancial or tax arbitrage or both, there will be a resulting ownership arbitrage as to who should own the subsidiary. This article begins with a denition of nancial arbitrage (ownership arbitrage) in international capital markets in a state-preference framework, and under risk neutrality. This hinges on the covariance between foreign cash ows and exchange rates. The next section will show that although the above denition of segmented capital markets requires that dierent risk premiums be attached to the same risk; a ner description of segmentation and nancial arbitrage reveals that the same cash ows can still have dierent valuations under risk neutrality due to the covariance term. Based on this denition, the dierential value of a foreign aliate to a parent nanced by equity is derived. This is the value dierence of the foreign aliates cash ows between the foreign and domestic capital markets that are partially segmented. In this value dierential equation, transfer prices become a decision variable that determines the value gain to the parent. Hence, the multinational should set the total transfer prices charged to its aliate as to increase this value dierential whenever positive. This article proceeds to introduce dierential taxes for the countries that host the parent and the aliate. The impact of the tax dierences on dierential values and the interactions between the two sources of arbitrage opportunities, namely nancial and tax arbitrage are explored. The model uses a cost structure where prots from intra-rm trade and fund ows resulting from setting transfer prices above production cost are allowed, but there is also a penalty for unsubstantiated high
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transfer prices charged to the aliate that would trigger scrutiny from the government authorities. Hence, the prot potential of increasing transfer prices are oset by this countervailing cost such that the parent may seek an optimal level of transfer price that should be charged to the aliate to maximize the dierential value whenever positive. Note that this value gain is independent of tax dierentials or nancial arbitrage. Hence, the overall value gain for the parent depends on the combined impact of nancial arbitrage, tax arbitrage and prots to be made on intra-rm trade and fund ows. This article will trace each component of value gain to its roots and look at their interactions as well. The model developed in this paper is an easy optimization problem where the optimal levels of transfer prices to be charged to the aliate are jointly determined with who should own the aliate which is termed as ownership arbitrage. In short, the parent has to decide whether it is worthwhile to maintain the ownership of the aliate along with what transfer price to charge to maximize its gains. As stated above, the source of value gains for the parent equity holders are nancial arbitrage, tax arbitrage, and prots to be made from charging the aliate for the goods, services and funds transferred above their production cost. Furthermore, the framework of the model is constrained to the totally owned aliates with 100 per cent repatriation of dividends with no tax deferral but with allowance of full tax credit. As noted in previous research, tax avoidance policies that prescribe shift of income to low tax jurisdictions will not be applicable in this set-up. Nevertheless, this article nds a new source of tax arbitrage when the home and host countries have dierent taxes based on present value of tax shields. This result favors increasing transfer prices for aliates in countries with higher tax rates. The numerical simulations of the model reveal a number of results. In a base case where taxes are assumed away, the covariance of cash ows and exchange rates determines whether the parent should maintain the ownership of the aliate. This covariance becomes sole determining factor for country of ownership in segmented markets where nancial arbitrage is possible for risky assets but not for risk-free ones. Whenever this covariance is strongly positive, parent should own the particular aliate otherwise the aliate should be carved o and sold to host country investors. Hence, the decision to set the transfer prices and ownership of the aliate are determined simultaneously by the aliate cash ows and exchange rates. In this base case where only
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Value Enhancing Transfer Prices

nancial arbitrage is possible, transfer prices play a role in increasing value to the parent only if uncovered interest rate parity (UIRP) is violated for risk-free assets of the two countries and favors parent ownership. Whenever the value dierential is positive and parent ownership is supported, the optimal transfer price is determined at a level that is above the expected trigger price. This nding results from the cost structure developed in this article. When tax arbitrage is also considered, ownership decision may be reversed in the case of strong negative covariance between aliate cash ows and exchange rates that would have otherwise indicated host country ownership. Specically, for high tax rates in host country that allows for tax arbitrage gains of our model to be signicant, parent ownership becomes optimal. Once again, under the cost structure of this article high transfer prices increase prots and hence value beyond the impact of nancial and tax arbitrage, but a penalty on transfer prices set above a reasonable limit osets this advantage. The optimal transfer prices obtained when taxes are considered, however, are lower for aliates in higher tax rate countries but higher for lower tax rate countries compared to the base case. The numerical simulations demonstrate how a manager of a multinational can easily implement the model and obtain an optimal level of transfer price by using cash ow and exchange rate distributions and estimated values of parameters such as its prot margin.

2. Financial Arbitrage
Financial arbitrage will be modeled in a state-preference framework.5 Suppose there is an asset that generates state contingent cash ows, R (s), in foreign currency, and there is also a domestic substitute with cash ows, [R(s)e(s)], where e(s) are the state contingent exchange rates. A domestic investor can sell the foreign asset and convert the proceeds to domestic currency at e0, the spot exchange rate, to buy the domestic perfect substitute. To avoid arbitrage the following must hold: e0 Rs Rsbs Rs Rsesas 1

In the above expression, a(s) and b(s) are the state contingent risk adjustment factors (pricing vectors, state contingent discount rates) in the domestic and foreign markets, respectively.
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Nilufer Usmen Sucient conditions for (1) to hold are hs esas e0 bs 0 for every s 2

However, in a fully integrated market where all securities should be priced the same in the two markets the condition in (2) is necessary, too. However, given that in reality capital markets around the world are somewhat segmented, it is more likely that hs 6 0 for some s 3

Condition (3) furnishes a formal description of market segmentation in a state-preference framework which is consistent with the standard denition and empirical evidence. The validity of this condition rests upon the fact that in an imperfect world capital market, arbitrage cannot take place instantaneously and eectively, especially for longer maturities and for arbitrage opportunities that demand high volume of funds. Hence, h(s) represent the nancial arbitrage opportunities present in the market. If h(s) is positive, the same unit of income in foreign currency will have a higher value in the domestic market in that state. If the reverse is true and h(s) is negative, then the foreign market places a higher value for the same unit of income in foreign currency in state s. It is also well-known that 1 1 ra and rb Rs as Rs bs 4

where ra and rb are one plus the risk-free interest rates in the two countries. Under risk neutrality, a(s) and b(s) become p(s)/ra and p(s)/rb respectively where p(s) are state probabilities that are assumed to be the same for both set of investors. In this case, to avoid arbitrage   es e0 RRs ps 0 ra rb The above can be simplied to EREh CovR; e=ra 0
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Value Enhancing Transfer Prices where   Ee e0 Eh ra rb

Expressions in (5) and (6) are descriptions of the UIRP relationship under risk neutrality. Note that for risky assets with cash ows R(s), E(h) = 0 is not sucient for arbitrage to disappear totally. For these assets, Cov(R,e) will still lead to value discrepancies in segmented capital markets. The above expression implies that even if arbitrage is not possible on the average and for risk-free assets whenever E(h) = 0, deviations can still occur in specic h(s). These deviations are captured by the covariance term. It should be noted that this covariance term would not exist if the two capital markets were perfectly integrated and nancial arbitrage could take place in every state for every risky asset. If it exists, it may also be interpreted as a nonlinear impact of exchange rates on value.

3. The Valuation Model: Base Case

In this article, there is a parent with an aliate in a foreign country. The parent is all equity nanced and the aliate will also be nanced by equity alone. The aliate will be wholly owned by the parent in the sense that the parent will not share decision-making control with any other shareholder in the host country as would have been the case with a joint venture.6 However, the ownership of the aliate by parent is not automatic and will depend on market valuations. For strategic reasons, the parent would like to retain the ownership whenever optimal. The aliate generates state contingent cash ows, R(s), in foreign currency net of costs that are not associated with intra-company transfers. The parent company charges to the aliate a lump sum price C in foreign currency for intra-company transfer of goods, services and funds. The transfer price may be denominated in the foreign currency for purposes of natural hedging or for other operational reason.7 Although in practice it may be wiser to show a detailed list of specic items charged to the aliate to make it easier to substantiate the prices to the local government authorities, for the purposes of this article a single price C will be used. This price may cover physical goods and services transferred to the subsidiary, corporate overhead, royalties, licensing fees and interest payments on inter-company loans. Once the
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total level of C is determined by the parent, the parent will have latitude to assign individual prices to each item that is charged. C is a contractual price that is determined by the parent today and that is to be charged to the aliate at a future date. The real known cost of producing this portfolio of goods, services and funds to parent will be xed at C* in home currency of the parent. Moreover, a countervailing cost will be introduced where there will be a penalty to parent if C is increased to a level that will trigger authorities to intervene in setting the transfer price. In particular, if C is raised beyond a level that exceeds the standard prot margin of the parent, the additional prots will be penalized by a that is >1. In other words, if C* is the true cost and p is a mark-up that is slightly above the prot margin that the parent earns on its similar business with third parties, the parent will be penalized whenever Ce(s) > C*(1 + p), the trigger price. The penalty will be the loss of abnormal prots, as Ce(s) will be forced to a lower level within the reasonable range [C* C*(1 + p)], and some more as penalty and litigation costs; hence a > 1. Basically, this countervailing cost structure is based on the premise that government authorities have reasonable diligence and penalize the rm when transfer prices are set signicantly above arms length price. Initially, to rid the results of this article from potential gains of tax arbitrage and import tari/duty avoidance, we exclude taxes, taris and duties to arrive at a base case. If the aliate was valued by host country investors, it would have a value of Vb ER C=rb 7

If instead, it was valued by the parent country investors, the value of the aliate would be Va X Rs Cesps=ra Ces C ps=ra s X s a Ces C 1 pps=ra
D

where D fs : Ce(s) > C 1 pg

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Value Enhancing Transfer Prices

In (8), e(s) are the state contingent exchange rates, and p(s)/ra and p(s)/rb are state contingent discount factors as noted before. The condition under which the ownership of the aliate should be maintained by parent is DV Va e0 Vb > 0 9

where e0 is the spot exchange rate. If DV is negative, the aliate should be carved o and sold to investors in the host country.8 DV in (9) can be expressed as: DV ER CEh fCovR; e CEe C X Ce C 1 ppsg=ra a
D

10

This result can be interpreted as ownership arbitrage and it partially stems from the covariance term and states that the rm may want to sell the foreign entity to foreign owners facing a dierent covariance structure. However, it should also be noted that the covariance term appears in the rst place due to existence of risky nancial arbitrage. C is bounded by zero on the lower end, meaning only the cases where the parent is charging the aliate a positive C will be relevant. Moreover, the model allows for C values to exceed R(s) values in some states. This implies that the parent ex ante is willing to absorb losses from the aliate in some contingencies if that is going to increase value today. As there are no outside claimants, this is a reasonable assumption. There is also an assumption in the model that exchange rate uctuations do not have an impact on the cash ows and value of domestic operations. Otherwise, the multinational may want to sell the domestic entity to foreigners. It will suce to assume that exchange rate uncertainty has a greater impact on the value of the foreign subsidiary than on parent. The goal of the parent is to set C such that DV has the largest positive value. If DV were negative, the optimal decision for the rm would be to spin-o and sell the aliate to foreign investors and collect cash. In determining maximum positive DV, however, C remains as a crucial decision variable to exploit the benets of nancial arbitrage (ownership arbitrage) embedded in market conditions, as well as to boost prots from intra-rm trade and fund ows.
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There may be two interpretations of the case where deviations from UIRP are observed. One is when nominal interest rate dierential does not predict the nominal exchange rate changes. This may be exploited by means of traditional nancial arbitrage whereby country-a investors move funds but continue to value at country-a discount rate. Second is real interest rate dierentials do not predict real exchange rate changes which can only be exploited by means of arbitrage of real assets. The rm can move production between the domestic and the foreign entity in response to real deviations. This may be called production arbitrage. As we do not observe much ownership arbitrage such a response may be more realistic and tells us that the multinational has other ways of achieving the same. The model accounts for both interpretations.9 In particular, if risk-free arbitrage is possible and E(h) < 0, increasing C would increase value to the parent and guarantee parent ownership as well. Otherwise, parent should set C low to increase this dierential value to make it conducive to parent ownership. Another term that results from segmented markets paradigm of this article is the covariance term between aliate cash ows and exchange rates. This term is independent of the level of C. Hence, for nancial arbitrage gains C is a decision factor only for cases where UIRP for riskfree assets is violated under risk neutrality. When risk-free arbitrage is not possible but risky arbitrage is still prevalent, the covariance structure of cash ows and exchange rates lead to ownership arbitrage. Hence, if we further assume E(h) = 0, and that arbitrage is only possible for risky assets but not for risk-free ones, we obtain DV fCovR; e CEe C aED Ces C 1 pg=ra 11 The rst term is what is left of the impact of market segmentation on dividends repatriated which is independent of C, and hence parent can no longer use C to exploit risk-free nancial arbitrage. However, risky nancial arbitrage is still a signicant factor in determining the ownership of the aliate due to the covariance term. The other two terms appear as a result of the cost structure of the model. The second term shows the increase in value to parent by raising C to the highest possible level; the third term is the penalty if C is increased beyond a reasonable level to government authorities. In those states where Ce(s) exceeds the trigger price there will be a loss of a per cent of value.
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Value Enhancing Transfer Prices Hence, @DVR Ees aED es @C ra ra and an optimal C is reached when Ees aED es

11

12

13

Note that the distribution of e(s) over states and its nonlinearity on value is crucial to this result. The right hand term is the expected exchange rate restricted to the states where the set transfer price exceeds the trigger price. The optimal C is reached when this conditional expected value in D equals the unconditional expected value of the exchange rate distribution.

4. Numerical Example and Results: Base Case

This section will investigate the relationships characterized by the model between C that is determined by the parent, the cash ows of the aliate and the exchange rates. Table 1 below presents the hypothetical data created to t the model descriptions. The data represents an example of values these variables can take given the desired relationships in the mathematical model. They neither are empirical data nor are they random (ad hoc) selections, but plausible representations of the behavior of these variables in real life. For example, exchange rate values were based on a normalization of an exchange rate distribution where todays spot rate is one and the b currency can appreciate or depreciate within a 3540 per cent band. This is a reasonable representation of exchange rate behavior for many currencies. Cash ows of the example can be scaled up or down with no loss of generality as long as they correlate to exchange rates in the prescribed manner. Variations of the example in Table 1 were also tried but did not change the results in any substantial way. The numerical exercises illustrate the mathematical relationships of the model and the results seem to be robust to variations in inputs. Based on the values in Table 1 and assuming uniform probabilities, p(s) = 1/N, we nd that Cov(R,e1) = 15.1389 and Cov(R,e2) = +17.00. The data in fact shows strong correlations for cash ows and
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Table 1. Data on Model Specications: An example States

1 2 3 4 5 6 7 8 9 10

R(s)
200 220 80 75 50 150 190 250 85 175 e0 = 1.0

e1(s)
0.80 0.70 1.00 1.20 1.40 1.30 0.85 0.65 1.10 0.90 ra = 0.045

e2(s)
1.20 1.40 0.80 0.70 0.65 0.90 1.10 1.30 0.85 1.00

Notes: R(s) is state contingent cash ows of the aliate; e1(s) is an example of state contingent exchange rates that are negatively correlated to R(s); e2(s) is an example of state contingent exchange rates that are positively correlated to R(s); e0 is the spot exchange rate and ra is the risk-free interest rates in the home market.

exchange rates as would be the case with import-based and exportoriented aliates. Also E(e1) = E(e2) = 0.99. The two exchange rate variables have same means, although their variations over states are dierent. As e0 = 1, both e(s) variables do not show any signicant expected change in exchange rates over time. These exchange rate distributions were chosen as such to free the results of the numerical example from a bias in expected exchange rate depreciation or appreciation. The parameter values chosen are ra = 1.045, p = .25 and a = 1.05. These p and a values may vary for dierent rms. Obviously, as p increase the negative impact of the penalty term will be lessened and as a increases the same impact will strengthen. Also, without loss of generality, we assume that ra = rb such that E(h) = 0. Table 2 tabulates the dierential values computed by varying C and using the data in Table 1. Note that CE(s) > C*, meaning sensible corporate policy is to set the expected income to the parent from transferring goods and services at the minimum to equal to the cost of producing the goods and services and funds charged to the aliate. Hence, letting C* = 50 in home currency, C = 50/0.99 = 50.5 is chosen to be the minimum transfer price that may be set by the parent. Simulation results in Table 2 show that when cash ows and exchange rates are strongly negatively correlated as would be the case for an export-oriented aliate, there is not much room for the parent to maintain the ownership of the aliate by manipulating transfer prices in the absence of tax arbitrage. Note that this result may change
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Value Enhancing Transfer Prices

Table 2. Dierential Values Without Taxes C
50 55 60 75 80 85 90 95 100 110 115

13

V1
16.16 13.37 11.27 7.81 7.7 7.87 8.1 8.67 9.54 11.44 12.39

V2
14.68 17.48 19.58 23.03 23.15 22.96 22.74 22.17 21.31 19.41 18.45

Notes: V1, dierential value based on R(s) and e1(s); V2, dierential value based on R(s) and e2(s). The bold values indicate local maxims.

if the negative correlation is weak or E(h) is not equal to 0. Every parent should design its transfer pricing policy based on the UIRP conditions in the market and its aliates cash ows. In the other case where cash ows and exchange rates are strongly positively correlated, as would be the case with an import-based aliate, the aliates ownership should be maintained by the parent and the optimal C should be set at 80 which is above the trigger price based on expected e(s), e.g., (50(1 + 0.25))/0.99 = 63. Given the uncertainty in the set D, the set of states where Ce(s) > C*(1 + p), the parent must choose a transfer price C that is above the expected trigger price, ex ante, to maximize value.

5. The Valuation Model with Dierential Corporate Taxes

Dierences in corporate tax rates between the parents home country and the host country of the aliate are a major consideration in setting transfer prices. The prot maximization rule says that transfer prices should be set to maximize taxable income in the country with the relatively lower corporate tax rate. For example, if the tax rate in host country is higher, the parent should set transfer prices high to reduce the taxable income under that jurisdiction and vice versa. This rule does not work, however, when the parent company gives full tax credit for taxes paid in the foreign country, and 100 per cent of prots are repatriated with zero deferral of taxable income as in the framework of this paper.10
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In this section, the dierential value model developed in (10) will be extended to include dierential corporate taxes. As in the base case, 100 per cent ownership by the parent and 100 per cent payout of dividends are targeted. Foreign dividend withholding tax is zero. There are no taris/duties and the parent country allows for full foreign tax credit for taxes paid in the host country and tax deferral is not allowed. The parent has enough income from other sources to use the tax credits in full. Let ta equal the corporate tax rate in the home (parent) country, and tb equal the corporate tax rate in the host country of the aliate. Then, the after-tax value of the aliate is VTb X
s

Rs C1 tb ps=rb

14

whereas the aliate has an after-tax value, VTa, in the home country represented by, VTa X
s

Rs C1 ta esps=ra Ces C 1 ta ps=ra 15

X
s

X a Ces C 1 p1 ta ps=ra
D

Note that with full foreign tax credit, the eective tax rate at home is equal to the home corporate tax rate ta and it seems as if there is no tax advantage to maximize taxable income in the home/host country even if tb 6 ta. The dierential value of the aliate after taxes is DVT VTa e0 VTb ; which can be represented by, DVT 1 ta DV fta tb ER CEesg=ra 16

It is surprising that, in spite of the assumptions of full tax credit and 100 per cent repatriation of dividends, there is still tax arbitrage gains possible as is captured by the second term in (16). As noted
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15

before, under these conditions, the previous research had shown that there would be no tax arbitrage opportunity.11 When corporate taxes are considered the dierential value in (16) depends not only on how the host tax rate tb diers from the home tax rate ta, but also on how that dierence weighs on the market valuations of cash ows transferred to parent. The rst term in DVT is a tax reduced version of DV of the base case and stands for ownership arbitrage. As discussed previously, the source of value discrepancy in this term or ownership arbitrage are the nancial arbitrage opportunities as represented by E(h) and Cov(R,e), as well as the cost structure of the model. The second term in DVT is due to tax dierences between the two countries and therefore may be attributed to tax arbitrage. This second term tells us that DVT can be increased or decreased beyond that of nancial arbitrage and pricing gains/losses and the impact comes about by the market value of the cash ows to the domestic shareholders if ta does not equal to tb. Roughly speaking, if tb > ta, every additional unit of C will result in a value loss to domestic shareholders. However, if tb < ta, the domestic shareholders may increase their dierential value by the dierence (ta tb) by increasing C. Here, tax arbitrage suggests that if the host tax rate is higher (lower), maximize (minimize) taxable income in that country by setting transfer prices lower (higher). The implications of this result are contrary to conventional practice, and hence may seem counterintuitive. However, the nding is a complimentary source of tax arbitrage benet and may still exist where the standard tax minimization rule does not apply as explained above. From standard corporate nance theory dating back to Modigliani and Miller (MM) with taxes, we know that a rm can increase its after-tax value beyond a base case by increasing the present value of tax shields. In the classical MM propositions, tax shields were due to tax deductibility of debt whereas in this article they are due to deductibility of transfer prices as cost. The second term in (16) can be interpreted in terms of the present value of tax shields to the parent due to deductibility of transfer prices. Specically, this term can be separated into two parts and one of those parts is (ta tb)CEe(s)/ra. This is the dierence in the present value of tax shields due to the deductibility of transfer prices C, in the host country with a tax rate of tb versus the present value of that tax shield when ta, home country tax rate is applied. In other words, the tax shields are earned at the rate tb but are used at the rate ta, the eective tax rate for the parent. It implies that when tb > ta, the parent should set C
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low to be taxed maximum at the higher rate to end up with the higher present value of tax shields. As the tax credits earned in the host country can be used against tax decits on other income of the parent, they are valuable and increase the value to the parent. The underlying assumption is that the parent can earn excess foreign tax credits in one country and can use them against tax decits from another country when consolidating foreign income at home. This mechanism becomes the source of tax arbitrage in this article. The size of tax arbitrage apparently hinges on the tax codes that allow or restrict companies to use tax credit earned on foreign income fully at home. If the tax codes put limitations on usage of excess foreign tax credits, tax arbitrage opportunities would be bounded.12 These implications will be discussed below with a numerical example. Table 3 will also use the data presented in Table 1 along with various tax rates in potential host countries. Looking at VT1 values, we can see that favorable tax advantage can change the outcome of the base case. This type of an aliate whose cash ows are strongly negatively correlated with exchange rates should have been carved o and sold to host country investors in the absence of tax arbitrage as was shown in the base case. This result is enhanced whenever tb < ta such that the impact on value of tax arbitrage is negative and there is no advantage from the lower tax rates in the host country. However, when tb exceeds ta and tax advantage turns to be favorable, it becomes feasible to maintain the ownership of the aliate. However, in this case, the optimal C is lower at 60 or 75. As ta < tb for these cases the weight put on penalty (1 ta) is greater than the weight put on prots (1 tb), the negative impact of penalty dominates resulting in lower C values, (see footnote 2). The VT2 values are almost all positive and are pointing to the fact that tax arbitrage, favorable or unfavorable, would not alter the outcome that the aliate should be totally owned by the parent if cash ows and exchange rates are strongly positively correlated. It is not surprising that in cases where tb > ta a lower C value than 80 is optimal as explained above, whereas C needs to be raised above 80 to maximize value gains when tb < ta and tax arbitrage is unfavorable. This numerical example demonstrates that nding the optimal C is an easy optimization problem for managers. The only inputs needed are cash ow and exchange rate distributions and estimates of p and a and interest rates. Using these inputs covariances and expected values can be readily estimated and dierential values are computed. Hence,
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Table 3. Dierential Values with Corporate Taxes tb C
50 55 60 75 80 85 90 95 100 110 115

17

0.15 VT1
25.21 22.54 20.36 15.80 15.01 14.42 13.86 13.55 13.45 13.35 13.30

0.20 VT1
20.58 18.15 16.20 12.36 11.80 11.44 11.13 11.10 11.19 11.57 11.76

0.25 VT1
15.94 13.75 12.04 8.91 8.59 8.48 8.40 8.57 8.93 9.79 10.22

0.30 VT1
11.31 9.36 7.89 5.47 5.39 5.51 5.67 6.10 6.68 8.01 8.67

0.35 VT1
6.68 4.96 3.73 2.02 2.20 2.54 2.94 3.58 4.42 6.22 7.13

0.40 VT1
2.05 0.57 0.43 1.42 1.03 0.43 0.21 1.10 2.16 4.44 5.58

0.45 VT1
2.58 3.83 4.58 4.86 4.23 3.40 2.53 1.41 0.09 2.66 4.04

tb C
50 55 60 75 80 85 90 95 100 110 115

0.15 VT2
3.62 0.95 1.23 5.79 6.58 7.18 7.73 8.04 8.14 8.24 8.29

0.20 VT2
1.01 3.44 5.39 9.23 9.79 10.14 10.46 10.53 10.40 10.02 9.83

0.25 VT2
5.65 7.84 9.55 12.68 12.99 13.11 13.19 13.02 12.66 11.80 11.37

0.30 VT2
10.28 12.23 13.70 16.12 16.20 16.08 15.92 15.52 14.91 13.58 12.92

0.35 VT2
14.91 16.63 17.86 19.57 19.41 19.05 18.65 18.01 17.17 15.36 14.46

0.40 VT2
19.54 21.02 22.02 23.01 22.62 22.02 21.38 20.51 19.43 17.15 16.00

0.45 VT2
24.17 25.42 26.17 26.46 25.82 24.99 24.12 23.00 21.68 18.93 17.55

Notes: VT1, dierential value with corporate taxes based on R(s) and e1(s); VT2, dierential value with corporate taxes based on R(s) and e2(s); ta = 0.30 and tb is the corporate tax rate in host country. The bold values indicate local maxims.

the model is operational and can easily be put to practice by the managers of the multinationals.

6. Conclusion
Multinationals have long used transfer pricing mechanisms to circumvent market imperfections brought about by government authorities such as taris, duties, exchange controls and blocked funds. Another well-known use of transfer price schemes is to exploit tax arbitrage opportunities. The previous arguments on the benets of moving income from one jurisdiction to another using transfer prices were based on prot-seeking incentives and implied that the taxable income in a high tax rate country should be minimized to minimize global tax
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liability. Minimization of global tax liability would be achieved by charging high transfer prices in the countries with high tax rates. However, this type of tax arbitrage benet disappears whenever dividends are fully repatriated, there is no tax deferral and full tax credit is allowed by home tax authorities. This article presents a value-seeking framework under risk neutrality where transfer prices are used to exploit tax arbitrage as well as nancial arbitrage opportunities that are present in segmented international capital markets. By shifting the focus from prot seeking to valueseeking approach, the paper oers a new framework for setting transfer prices based on the impact on value of nancial and tax arbitrage. However, for a parent to use transfer pricing schemes as a strategic tool, it has to have a market valuation that would support its ownership of the aliate. In other words, nancial and/or tax arbitrage may lead to ownership arbitrage for the rm. This article also develops a cost structure for transfer pricing schemes where prots on intra-rm trade and fund ows are allowed along with a penalty for transfer prices charged above a trigger level. This value gain is treated independently of any nancial or tax arbitrage eects. This value gain will exist even if there is no tax arbitrage opportunity and capital markets are totally integrated. Subsequently, an optimization framework is obtained where a value-maximizing level of transfer price can be determined that takes into account favorable and unfavorable impacts of nancial and tax arbitrage along with prot opportunities from transfer of any products, services or funds. First, in a base case where taxes are assumed away, it argues that in the presence of nancial arbitrage alone, and in a case where cash ows of the subsidiary are positively correlated to exchange rates as in import-based aliates, the parent should own the aliate and set transfer prices at a level higher than its expected trigger price to maximize value. This is not true for export-based aliates where cash ows and exchange rates are strongly negatively correlated. It is best to carve o these aliates and sell them to host country investors after charging them C for the funds and services already transferred. Exploring the extended model with tax dierentials between the parent and the host country reveals some surprising reversals to the implications of the prot-seeking rule and to the conventional practice. The maxim that whenever the tax rate in the host country is lower/higher than that of the parent transfer prices should be set low/high is no longer valid because the framework of this article allows for full tax
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credit and total repatriation of dividends with no deferral. However, another form of tax arbitrage emerges where the level of transfer prices determine the present value of tax shields based on transfer prices in each country. The tax advantage of transfer prices depend on the size of tax dierences and how they interact with nancial arbitrage opportunities in the market. When tax dierences are large enough and tax arbitrage eect is dominant, higher taxes in the host country becomes a factor that increases the present value of tax shields. This gain is due to tax code allowances that allow excess tax credits earned from one aliate to be applied against tax decits from another aliate. This impact may interact with that of nancial arbitrage and make it possible for the parent to own the aliate in cases where nancial arbitrage alone would have prohibited it to happen. The optimal levels of transfer prices dier from that of the base case and are lower/higher for unfavorable/favorable tax arbitrage. A set of testable propositions emerge from the ndings of this study. First, with segmented capital markets where UIRP holds for risk-free assets, parent ownership tends to be more prevalent for aliates whose cash ows are strongly positively correlated by exchange rates and/or when host country tax rates are signicantly higher than home. Second, multinationals that set their transfer price higher than the expected trigger price should have higher values compared to their peers that do not. Accordingly, transfer prices should be set higher for industries that have higher prot margins and lower penalties. The third proposition of this article is that transfer prices should be higher/ lower than the expected trigger price for aliates in countries with higher/lower tax rates. This proposition stands in sharp contrast to predictions of conventional prot maximization dictum that says the parent has an incentive to charge high transfer prices in high tax environments to shift prots to low tax locations. A couple of caveats are in order while testing the above hypothesis. The predictions of this article are valid for aliates that are wholly owned and that operate in environments where import duties are insignicant. Moreover, the parent transfers 100 per cent of dividends and full tax credit is allowed for foreign tax liability with no deferral. This kind of environment may not exactly describe the institutional practices at present but recent tax proposals by the U.S. administration is a step in that direction.13 Even if tax dierences matter in the conventional sense, this article shows that there is a mitigating factor that should be balanced against the predictions of the well-known tax
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minimization rule. Also, the empirical investigation should show evidence of the eect on rm value of the choice of transfer pricing policy. Empirical results that show correlations between the level of transfer prices and tax rates will not be conclusive. Those correlations would simply show evidence of the practices followed by the decision makers in rms but would fail to show if those practices are value enhancing. Another restriction in testing the propositions of this article is that the model overlooks agency costs.14 While the direct eect of choosing low/high transfer prices is to increase the after-tax value of the parent, these eects may be potentially oset in poorly governed rms by increased opportunities for managers to manipulate income. Therefore, the results should be tested for rms with highquality governance. In summary, this article develops a value-seeking framework to analyze the benets of transfer price schemes in the presence of nancial arbitrage and tax arbitrage in segmented international capital markets that lead to ownership arbitrage. The model is exible enough and can easily be expanded to include the eects of import duties, partial ownership, variable dividend payout ratios, deferral of income repatriation, and agency costs that may also aect the value of a multinational. Furthermore, more complex nancing structures like borrowing at home or in the foreign country or hedging can also be handled by the model. However, it is important to note that any of these new elements that may be included in the model should be viewed in terms of their eects on value. The optimization model to be used by any particular company to set their optimal transfer price should modify the present model to t their business practices to allow them to draw their own conclusions.

Notes
1. In this article, transfer prices are used synonymously with internal prices used within a corporation that diers from arms length. 2. Horst (1971), Arpan (1972), Fowler (1978), Collins and Frankel (1985), and Kant (1988), for example. 3. A recent article by Curtis (2008) argues that transfer pricing has been often framed as a tax issue but it has repercussions much beyond that for a multinational treasurer. As noted by Curtis, transfer pricing is closely knitted with the eciency of many nancial management functions in the multinational. This article is a step into that kind of inquiry. 4. Stulz (1981), Eun and Janakiramanan (1986), Hietala (1989), Bonser-Neal et al. (1990), and Nishiotis (2004).
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5. This framework was developed in Thomadakis and Usmen (1991) and Usmen (1994). 6. Desai et al. (2004) show empirical evidence from the past twenty years that there is a trend away from joint ventures to majority and whole ownership of the aliates by U.S. MNCs. They argue that this trend can be explained by the increased burden of joint ventures for the MNC who would like to make decisions freely about selling and nancing to minimize worldwide costs. Especially, when the local partners have a stake in local prots alone, the MNC cannot set transfer prices in a way that would minimize global tax liability. 7. The cost of the resources transferred to the subsidiary could also be charged in domestic currency units. In that case, cash ows of the foreign subsidiary would have a cost of C/e(s) and the impact of exchange rate uncertainty still be captured in the model. However, the present model charges C in foreign currency for reasons of natural hedging. 8. This type of modeling is also used in Thomadakis and Usmen (1991) and Usmen (1994). The hypothetical valuation of the cash ows in the host country are relevant because the parent should remain the owner if it can create a value beyond the alternative of selling the aliate upfront to host country investors after charging them C for the products, services and funds already transferred. One should not be confused by thinking that there are no foreign owners to value the cash ows that diers from the parent and therefore this value dierential is contradictory. 9. We thank an anonymous referee for pointing this to us. 10. See for example, Clausing (2003). 11. Based on (16), the optimal C is obtained where 1 tb Ees 1 ta aED es. Again, the covariance between tax shields and exchange rates come into play. It is the nonlinearity with respect to exchange rates on value that explains why the tax dierential matters. 12. For example, the U.S. tax code allows foreign tax credits derived from one source against foreign tax liabilities from another source provided they are based on same type of income. This practice is known as tax averaging. However, total tax creditable in any 1 year is limited by a formula based on foreign versus total taxable income of the multinational. 13. Financial Times, Wednesday, May 6, 2009 issue reported that Obama Administration is cracking down on tax avoidance loopholes that allow U.S. multinationals to report disproportionately high prots in low tax countries and to delay paying U.S. taxes by deferring repatriation of these prots. 14. Value-maximization runs into obstacles in the presence of agency costs. See, for example, Jensen (2001).

References
Arpan, J.S., International Intracorporate Pricing (New York: Praeger, 1972). Bonser-Neal, G., G. Brauer, R. Neal and S. Wheatley, International Investment Restriction and Closed-End Country Fund Prices, Journal of Finance 45 (1990), pp. 523548. Clausing, K.A., Tax-Motivated Transfer Pricing and US Intrarm Trade Prices, Journal of Public Economics 87 (2003), pp. 20072223. Collins, J.M. and A. Frankel, International Cash Management Practices of Large U.S. Firms, Journal of Cash Management 5 (1985), pp. 4248.

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Curtis, S.L., Transfer Pricing for Corporate Treasury in the Multinational Enterprise, Journal of Applied Corporate Finance 20 (2008), pp. 97112. Desai, M.A., C.F. Foley and J.R. Hines Jr., The Costs of Shared Ownership: Evidence from International Joint Ventures, Journal of Financial Economics 73 (2004), pp. 323 374. Eun, C.S. and S. Janakiramanan, A Model of International Asset Pricing with a Constraint on the Foreign Equity Ownership, Journal of Finance 41 (1986), pp. 897914. Financial Times, Wednesday, May 6, (2009), pgs 3, 8 and 9. Fowler, D.J., Transfer Prices and Prot Maximization in Multinational Enterprise Organizations, Journal of International Business Studies 9 (1978), pp. 926. Hietala, P., Asset Pricing in Partially Segmented Markets: Evidence from the Finish Market, Journal of Finance 41 (1989), pp. 603613. Horst, T., The Theory of the Multinational Firm: Optimal Behavior Under Dierent Tari and Tax Rates, Journal of Political Economy 79 (1971), pp. 10591072. Jensen, M.C., Value Maximization, Stakeholder Theory, and the Corporate Objective Function, European Financial Management 7 (2001), pp. 297317. Kant, C., Foreign Subsidiary, Transfer Pricing and Taris, Southern Economic Journal 55 (1988), pp. 162170. Nishiotis, G.P., Do Indirect Investment Barriers Contribute to Capital Market Segmentation?, Journal of Financial and Quantitative Analysis 39 (2004), pp. 613630. Stulz, R.M., On the Eects of Barriers to International Investment, Journal of Finance 36 (1981), pp. 923934. Thomadakis, S.B. and N. Usmen, Foreign Project Financing in Segmented Capital Markets: Equity Versus Debt, Financial Management 20 (1991), pp. 4253. Usmen, N., Currency Swaps, Financial Arbitrage, and Default Risk, Financial Management 23 (1994), pp. 4357.

2012 Blackwell Publishing Ltd.