Palgrave Macmillan Journals Journal of International Business Studies

Transfer Pricing Determinants of U.S.
Multinationals
Author(s): Mohammad F. Al-Eryani, Pervaiz Alam and Syed H. Akhter
Source: Journal of International Business Studies, Vol. 21, No. 3 (3rd Qtr., 1990), pp. 409-
425
Published by: Palgrave Macmillan Journals
Stable URL: https://www.jstor.org/stable/154953
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TRANSFER PRICING DETERMINANTS
OF U.S. MULTINATIONALS
Mohammad F. Al-Eryani*
Sana'a University, Yemen
Pervaiz Alam**
Kent State University
Syed H. Akhter***
Marquette University
Abstract. This paper examines the influence of environmental

and firm-specific variables on the selection of international
transfer pricing strategies. The primary data were obtained
from 164 multinational enterprises by means of a question-
naire. Responses were analyzed by performing factor analysis
and constructing a probit model. The findings suggest that
legal constraints and firm size are significant determinants in
the selection of international transfer pricing strategies by U.S.
multinationals.
In order to successfully compete in the global market, U.S. multinationals

use control and evaluation systems for monitoring the performance of their
divisions abroad. A multinational corporation also deals with the complex-
ities of cultural and political differences, tax regulations, import-export
restrictions, controls on the transfer of funds, and various other restrictions
designed by host countries to protect their national economic interests. The
*Mohamed F Al-Eryani is an Assistant Professor of Accounting at Sana'a University,

Yemen. He obtained his Ph.D. degree in business administration from Kent State
University. His Ph.D. dissertation was on multinational transfer pricing practices.
**Pervaiz Alam is an Assistant Professor of Accounting at Kent State University.
His research interests include multinational capital structure and international
product pricing strategies. His most recent publications are in Decision Sciences
and Journal of Industrial Mathematics.
***Syed H. Akhter is an Assistant Professor of Marketing at Marquette University.
His research interests include foreign market entry strategies, political risks, and
schematic information processing. Dr. Akhter has published in various journals
including the European Journal of Marketing, Advances in International
Marketing, and the Journal of Global Marketing.
Comments on an earlier draft of this paper by Richard Hoffman, David Jarjoura, Kent McMath,
Rosemerry Rudesal, and three anonymous referees are gratefully acknowledged. We are also indebted
to the participant firms and to discussants of an earlier version of this paper presented at the Research
Workshop, Graduate School of Management, Kent State University. Partial funding for this study was
received from the Department of Accounting, College of Business Administration, Kent State University.
Received: April 1988; Revised: February, September & November 1989; Accepted: November 1989.
409
410 JOURNAL OF INTERNATIONAL BUSINESS STUDIES, THIRD QUARTER 1990
challenge for multinationals is to design a transfer pricing strategy which

appropriately rewards the management of the unit(s) abroad and also
addresses the various legal, cultural, and economic restrictions of the host
countries.
International transfer pricing strategies can be classified into two groups:
market based and nonmarket based. Market-based transfer pricing uses the
prevailing market price for exchanging products within the corporate
family. As these prices are market determined, they are considered to be
objective and not subject to manipulation by the selling unit. Consequently,
the use of a market-based transfer pricing strategy encourages the selling
unit(s) to be efficient in order to sell at market prices and also minimizes
conflict between divisions over the selection of a fair transfer price.
Nonmarket-based pricing includes a wide array of transfer pricing
methods, including negotiated prices, cost-based prices, mathematically
programmed prices, and dual prices. Arguments for using nonmarket-based
transfer pricing strategies by multinationals are based on tax differentials
among countries, restrictions on repatriation of funds, import duties, price
controls, and political instability (see Shulman [1967, 1969]; Burns [1980]).
The purpose of this study is to examine the influence of environmental and
firm-specific variables on the selection of international transfer pricing strat-
egies by U.S. multinationals. To determine the factors influencing the selec-
tion of transfer pricing strategies, the analysis was conducted in two stages.
First, thirty-four environmental variables relevant to international transfer
pricing were factor analyzed to determine factor scores. Second, the factor
scores were used as input to a probit model.'
REVIEW OF THE RELEVANT LITERATURE
Theoretical Research
Three different theoretical frameworks (economic, mathematical program-

ming, and behavioral) have been developed to explain transfer pricing strat-
egies. Hirshleifer [1956], in a study of the economic model, argued that if
the intermediate market is competitive, the transfer price should be the
market price. If the intermediate market is imperfectly competitive, he
argued, then the transfer price should be the marginal manufacturing cost.
The mathematical programming model, however, posits that the transfer
price of the intermediate product should be equal to the opportunity cost
of producing the product [Abdel-khalik and Lusk 1974].
Both the economic and mathematical programming approaches place high
priority on production efficiency, cost minimization, and profit maximiza-
tion. However, they tend to ignore the human dimension in transfer pricing
decisions. Behavioral models have been developed to incorporate the
human dimension in the transfer pricing model. Rather than relying on co
structures and market forces for determining transfer price, the behavior
model recommends the use of negotiated transfer pricing for achieving
TRANSFER PRICING DETERMINANTS 411
organizational goals. Watson and Baumler [1975] demonstrated that

successful firms handle intra-departmental conflicts through negotiated
transfer prices. Acklesburg and Yukl [1979] suggested that negotiated transfer
prices can result in better relations and cooperation among divisions.
Empirical Research
Empirical research on international transfer pricing has focused on the

following issues: (1) the determination of transfer prices, (2) the transfer
pricing behavior of multinationals in different countries, and (3) the exam-
ination of the influence of different factors, both at home and in the host
country, on the selection of transfer pricing strategies.
With respect to the determination of transfer prices, Business International
Corporation [1965] reported that U.S. multinationals mostly determined
transfer prices based either on local production cost plus fixed markup, or
production cost of the most efficient manufacturing unit in the corporate
group plus fixed markup, regardless of individual plant costs. Greene and
Duerr [1970], however, found that most U.S. corporations established
transfer prices based either on a cost plus or on a negotiated basis.
With regard to the transfer pricing behavior of corporations from different
countries, Arpan [1971] found that non-U.S. multinationals mostly used
market pricing to price intra-company transfers. Tang [1979], however,
found that production cost plus markup was the most popular international
transfer pricing method among both U.S. and Japanese companies.
With reference to the examination of the influence of different factors on
the selection of transfer pricing strategies, a considerable body of literature
exists. Shulman [1969], when discussing the influence of different environ-
mental variables on transfer pricing strategies, suggested that companies
could circumvent profit repatriation restrictions by charging a higher price
for imports from the parent or related companies. Similarly, lower prices
could be charged to circumvent high import duties in host countries.
Lecraw [1985] reported that multinationals systematically used nonmarket-
based transfer prices to reduce custom duties and taxes, and to circumvent
government price and capital-profit remittance controls.
Recently, Benvignati [1985] found that advertising expenditures, the magni-
tude of a company's foreign transfers, and the number of countries where
a multinational operates were significant determinants of a nonmarket-
based transfer pricing strategy. However, she also found that large firms
and those with a large number of foreign subsidiaries showed a greater pref-
erence for market-based transfer pricing.
Prior research also suggests that governmental policies and regulations
encourage multinationals to engage in transfer pricing manipulation more
often in less developed countries than in more developed countries. For
example, Plasschaert [1985] noted that transfer pricing manipulation is more
widespread in less developed countries (LDCs) than in more developed
countries (MDCs) because the governments of LDCs are poorly equipped,

compared to MDCs, to understand or to monitor the intricacies of inter-
national transfer pricing. Brean [1979] also argued that LDCs are more
vulnerable to transfer pricing manipulation because of the greater ignorance
of LDCs on matters of international transfer pricing and the inadequacy of
LDCs' institutions when dealing with multinationals on various inter-
national transfer pricing issues.
The examination of the existing literature shows that, except for Benvignati
[1985] and Lecraw [1985], none of the prior studies has directly addressed
the issue of the determinants of market-based versus nonmarket-based
transfer pricing in a multivariate framework. Using mainly firm-specific
variables, Benvignati reported a fairly high multicollinearity among some
of the independent variables used for regression analysis and obtained an
R-square of only 0.077. Lecraw's sample was confined to subsidiaries of
multinationals in only four Asian countries. The present study improves on
the Benvignati and Lecraw studies by using (1) both environmental and firm-
specific variables, and (2) a sample which includes multinationals oper-
ating in MDCs and LDCs.
RESEARCH METHOD
Research Hypotheses
Legal Hypothesis
The laws and regulations of host countries-for example, antitrust and anti-
dumping legislation, tax and custom regulations, and financial reporting
requirements-influence the pricing of intra-company shipments. For
instance, multinationals may underprice the intra-company sale of inter-
mediate products to foreign affiliates to drive their competition out of the
market. To thwart the attempts of multinationals to lessen competition, anti-
trust authorities in host countries enact antitrust legislation to make price
discrimination, predatory pricing, and dumping practices illegal. For
example, in Canada, Section 32 of the Combines Investigation Act
prohibits agreements between related firms which unreasonably increase
prices. Transfer prices are controlled in the Federal Republic of Germany
under Section 22 of the 1957 Act Against Restraints of Competition; in
Brazil, under Law No. 4137 of September, 1962; and in Pakistan, by the
Monopolies and Restrictive Trade Practices Ordinance No. V of 1970 (see
Greenhill & Herbolzheimer [1981]).
The use of market-based transfer pricing prevents the accusation of transfer
pricing manipulation and avoids legal complications. Therefore, the
following hypothesis is proposed:
The Legal Hypothesis
The more important the legal variable to multinationals, the greater
the use of market-based transfer pricing by multinationals.
Size Hypothesis
Most existing research on the transfer pricing practices of large firms indi-
cates that large firms use different pricing strategies for intra-company
exchanges. Earlier research [Robbins and Stobaugh 1973] presented
evidence that big companies normally use standard markups to achieve
uniform policies. Similarly, Arpan [1972-1973] argued that the larger the
parent firm, the more likely it is to use a cost-oriented (nonmarket) pricing
system.
In contrast to these earlier studies, more recent research indicates that
larger firms use market-based transfer pricing strategies. For example,
Yunker [1982] claimed that large firms tend to use market-based transfer
pricing because of environmental variability and worldwide sales. The
use of market-based transfer pricing by large firms is also supported by
Benvignati [1985] who argued that larger companies are more likely to use
market-based transfer pricing methods because their size makes them more
visible to government authorities. Thus, the following hypothesis is proposed:
The Size Hypothesis
The larger the multinational, the more likely it is that it will use
a market-based transfer pricing strategy.
Political-Social Hypothesis
Political factors (e.g., expropriation, nationalization, civil wars, political
turmoil) and social factors (e.g., class conflicts, ethnic conflict) may play a
crucial role in motivating multinationals to practice transfer pricing manipu-
lations. Shulman [1967] argued that U.S. multinationals operating in countries
with unstable political environments place greater importance on the polit-
ical and social environment in the host countries. Therefore, we argue that
multinationals in such environments will be less likely to employ market-
based transfer pricing methods in order to hedge against political and social
uncertainties. The following hypothesis is proposed:
The Political-Social Hypothesis
The more unstable the political and social environment, the less
likely it is that multinationals will use market-based transfer
pricing strategies.
External Economic Hypothesis

Incentives to use nonmarket-based transfer pricing may arise from market
imperfections caused by government regulations. These imperfections may
occur because of exchange controls, price controls, import restrictions,
import quotas, and inflation. Exchange controls make the repatriation of
profits from the subsidiaries to the home office difficult; price controls
prevent market mechanisms from determining the transfer price; import
restrictions in host countries artifically raise prices; and inflation erodes
real profit. All these restrictions may encourage the use of nonmarket-
based pricing. For instance, if inflation in host countries is higher than in
multinational's home country, the multinational may be tempted to overpr
so that its share of real profit from foreign subsidiaries is maintained.

Hence, we argue that the more stringent the economic restrictions imposed
by host governments, the more likely it is that U.S. multinationals will use
nonmarket-based transfer prices to circumvent these restrictions. Thus, the
following hypothesis is proposed:
The External Economic Hypothesis
The stricter the external economic restrictions, the less likely it is
that a multinational will use a market-based transfer pricing strategy
Internal Economic Hypothesis
The internal economic variable relates to firm-specific conditions. These
include conditions such as market share of foreign affiliates, competitive
position of foreign affiliates, and performance evaluation of foreign affili-
ates. We argue that all these internal economic conditions affect intra-
company transfers. However, the direction of the sign of the internal
economic variable is indeterminable because there may be competing prac-
tices involved. For example, some multinationals may underprice (or use a
nonmarket method) to enlarge the market share of a foreign subsidiary and
others may want to use market-based pricing to fairly assess the perfor-
mance of foreign affiliates. Therefore, we propose the following hypothesis:
The Internal Economic Hypothesis
Multinational firms are less likely to use market-based transfer
pricing when internal economic conditions require underpricing.
LDC Hypothesis
Prior research [Brean 1979; Plasschaert 1985] demonstrates that LDCs are
more vulnerable to transfer pricing manipulation than MDCs. Furthermore,
as LDCs typically do not have well-developed financial or product
markets, there are fewer suppliers of foreign made, better quality pro
Often, in such markets, multinationals do not face much competition f
local producers or other foreign suppliers, resulting in an oligopolistic
a monopolistic position for the multinationals. Thus, market forces
not be the driving factor in establishing transfer prices.
Other reasons why multinationals may use nonmarket pricing in LDCs are
(1) to show lower profits in order to resist trade union pressures, and (2) to
assist local affiliates in their early stages of operations through under-
invoicing. Hence, the following hypothesis is proposed:
The LDC Hypothesis
The larger the number of affiliates of a U.S. multinational oper-
ating in less developed countries, the less likely it is that a market-
based transfer pricing strategy will be employed.
Data Collection
The present study is limited to U.S.-based multinationals having affiliat

engaged in the manufacturing and marketing of consumer and industrial
goods. For the purpose of this study, MDCs and LDCs are those countries
that fit the classification adopted by the United Nations [1985]. Specifi-
cally, MDCs include Australia, Canada, Japan, New Zealand, South
Africa, U.S.A., and countries in Southern Europe and Western Europe
(excluding Cyprus, Malta, and Yugoslavia). LDCs include countries in
Latin America and the Caribbean, Africa (other than South Africa), Asia
(excluding Japan), Cyprus, Malta, and Yugoslavia.
Data regarding transfer pricing policies were obtained from U.S. multi-
nationals by means of a questionnaire. The first mailing and the follow-up
mailing were sent to participating corporations on March 30 and April 15,
1987, respectively.2 Both Fortune directories of the 500 largest and the
second 500 largest U.S. companies were used to select a sample of U.S.
multinationals. Large companies were used to ensure an adequate number
of companies doing business either in MDCs or LDCs, or both. Angel's
Directory, which provides information on whether or not U.S multi-
nationals own affiliates in MDCs and/or LDCs, was utilized to classify the
1,000 companies listed in the Fortune directories into groups operating
primarily in MDCs or primarily in LDCs. A company which owned affil-
iates in both MDCs and LDCs was included in the MDCs group if more
than 50% of its affiliates were located in MDCs. Similarly, if more than
50o of its affiliates were located in LDCs, it was included in the LDCs
group.3 Using this approach, 791 U.S. multinationals were selected to
comprise the sample. Of these, 417 were classified as operating primarily
in MDCs and 374 as operating primarily in LDCs. Dun and Bradstreet's
Billion Dollar Directory was used to identify the names and addresses of
controllers, treasurers, financial vice presidents, and vice presidents for
international operations responsible for international transfer pricing
policies. The data collection instrument was pretested on a sample of 30
companies from each of the MDCs and LDCs groups before the general
mal ing.
The overall response rate was 210/o on 791 questionnaires mailed. Of the
417 U.S. multinationals operating primarily in MDCs, 76 usable responses
were received, a response rate of 180/o. Of the 374 U.S. multinationals oper-
ating primarily in LDCs, 88 usable responses were received, yielding a
response rate of 24%.4 We thus had a sample of 164 firms for analysis and
interpretation. Table 1 gives the distribution of the sample size by world-
wide sales. The table indicates that about 40% of the firms operating in
MDCs have worldwide sales of over a billion dollars; for firms operating
in LDCs, 47% of the corporations had sales of over a billion dollars.
Thus, over 4007o of the firms in our sample were relatively large firms
worldwide sales of over a billion dollars.
Questionnaire and Measurement Issues
The primary data concerning general company characteristics, environment

determinants, and transfer pricing methods were obtained by means of a
questionnaire. Since there are no universally acceptable set of transfer
TABLE 1
U.S. Multinational Corporations Classified by Value
of Worldwide Sales in 1986 for the Sample Firms
Worldwide Sales Corporations Corporations

(in millions) Operating in MDCs Operating in LDCs Total
Less than $50 0 (0.0%) 6 (6.9%) 6 (3.7%)
$50-$100 4 (5.5%) 7 (8.0%) 11 (6.7%)
100-200 7 (9.2%) 9 (10.3%) 16 (9.8%)
200-300 12 (15.8%) 5 (5.7%) 17 (10.4%)
300-500 5 (6.6%) 14 (16.1%) 19 (11.7%)
500-1000 17 (22.4%) 5 (5.7%) 22 (13.5%)
More than $1000 31 (40.8%) 41 (47.1%) 72 (44.2%)
Valid responses 76 (100.0%) 87 (100.0%) 163 (100.0%)

No response 0 1 1
Total responses 76 88 164

MDCs= more developed countries
LDCs=less developed countries
pricing determinants, multiple indicators were used to capture the key

factors. Based on prior research, 34 environmental determinants were
selected in designing the data collection instrument. A 5-point scale was
used by the responding U.S. multinationals to rate the 34 economic, beha-
vioral, legal, political, and social environmental determinants of inter-
national transfer pricing and the 15 transfer pricing methods identified from
prior research.5 The presence of bias from responses received from the
first mailing versus responses received from the second mailing was tested
using Kendall's tau and Pearson correlation. Results show that the initial
and follow up responses were significantly correlated (Tau=0.8610,
P'<0.0001; Pearson=0.9626, P<0.0001).
Factor Analysis
Factor analysis was used to identify the key determinants of transfer

pricing. Principal axis analysis with varimax rotation was used to extract
factors. This method of factor analysis is appropriate for exploring the
underlying dimensions of a construct. It is based on the conservative
method of estimating communality by using the squared multiple correla-
tion in the diagonal of the correlation matrix (see Harman [1976]). Prior
to the analysis, two factoring criteria were established: (1) to define a factor
as having at least three items with loadings of 0.50 or greater, and (2) to
select the minimum number of independent factors which explain as much
of the common variance as possible in the final solution. Reliabilities of
the items defining the final factor solution were estimated using Cronbach's
alpha coefficient (see Nunnally [1967]). Table 2 gives the four significant
factors and the items with loadings of 0.50 or greater. These four factors
explain 54Wo of the variance and are labeled as the political and social
factor, the external economic factor, the internal economic factor, and the
legal factor.
Probit Model
In addition to the four factors extracted through factor analysis, two other
variables were added to the probit model: the country variable and the size
of the company. The country variable is a dummy variable, assigned a
value of one ("1") if the majority of the firm's foreign affiliates were
located in LDCs and zero ("0") if the majority were in MDCs. The size
variable is based on worldwide sales of multinationals in U.S. dollars. The
dichotomous dependent variable was coded one ("1") for companies
employing market-based methods and a zero ("0") for companies using
nonmarket methods.6
Following Vancil [1979), Table 3 was prepared portraying the number and
percent of firms using nonmarket- versus market-based methods of transfer
pricing classified by MDCs versus LDCs. Note that, among nonmarket-
based methods, actual unit full cost plus fixed markup, standard unit full
cost plus fixed markup, and negotiated pricing techniques were most
widely used in both MDCs and LDCs. Also, none of the respondent firms
used actual unit variable cost or marginal costs in transferring goods to
either MDCs or LDCs. Our findings are consistent with Vancil's results.
He also found that negotiated pricing is widely used but variable or
marginal costing is used on a limited basis. Table 3 shows that 650Wo of
respondents used nonmarket-based transfer pricing methods and 35%o used
market-based methods for the combined groups; approximately similar
values are noted for MDCs and LDCs groups, separately.
Most respondents in our study indicated that they used both market- and
nonmarket-based transfer pricing methods. However, the frequency of use
varied. Firms which used market-based transfer pricing methods more
frequently than nonmarket-based methods were classified into a market-
based transfer pricing group. Similarly, firms with greater use of nonmarke
based methods were grouped into a nonmarket-based transfer pricing cate-
gory. Twenty-two cases could not be classified into either of these groups
and were excluded from the probit model. This reduced our sample from
164 to 148 firms, with 60 cases in the market-based group and 88 cases
in the nonmarket-based group.
The probit model was developed using maximum likelihood estimation
technique. Maximum likelihood estimators are consistent, asymptotically
efficient, and have a known sampling distribution. The model used in this
study is expressed as follows:
TPM= 0% + 3 1LEGAL + J2SIZE+ 3POLS+ 34EXECON+ 5INTECON+ 6LDC
where:
TPM =Transfer pricing method; "1" if prices are market
based, "0" if nonmarket based;
LEGAL = Legal factor as described in Table 2;

SIZE =Worldwide sales in U.S. dollars provided by respon-
dent firms;
POLS = Political-social factor as described in Table 2;
EXECON = External economic factor as described in Table 2;
INTECON= Internal economic factor as described in Table 2; and
LDC = A dummy variable where a value of "1" is assigned
for LDCs and of "0" for MDCs.
ANALYSIS AND INTERPRETATION
The results of the probit model are summarized in Table 4.7 The table
shows that the model has an R-square of 0.506 and an overall predictive
accuracy of 65.5%/0.8 Further, the model classified market-based transfer
pricing methods with 75.9% accuracy and nonmarket-based transfer pricing
methods with 56.2% accuracy.9 Of the six variables used in the probit
model, the legal variable and the size variable are statistically significant.
This suggests that the legal environment and the size of the firm are the
most important variables in determining which international transfer pricing
strategy will be employed by U.S. multinationals. Although the remaining
variables were statistically insignificant, the direction of each relationship
was as predicted.
Test of Legal Hypothesis
Table 2 shows that the following items loaded on the legal factor (arranged
in descending order of factor loading): (i) compliance with U.S. tax regu-
lations; (ii) compliance with tax and customs regulations of host countries;
(iii) compliance with financial reporting rules and requirements; and
(iv) compliance with antitrust and antidumping legislation of host countrie
Generally, the factor loadings for these items are strong, ranging from 0.
to 0.89. Further, Table 4 shows that the LEGAL variable is statistically
significant at the 0.05 level and positively related to market-based transfer
prices. This implies that multinationals use market-based transfer pricing to
comply with the laws and regulations of their home as well as host
countries. The use of nonmarket-based pricing is avoided because it may
lead to charges of price fixing, tax avoidance, and other similar violations.
Test of Size Hypothesis
Table 4 shows that the SIZE variable,1 0 as predicted, is positively and signi
icantly (at the 0.025 level) related to market-based transfer pricing. This
indicates that the larger the size of a firm the more likely it is to use
market-based transfer pricing.
Our results differ from early research [Arpan 1972-1973; Robbins and
Stobaugh 1973] which presented evidence that larger multinationals tend to
use nonmarket-based transfer pricing methods. Rather, our results support
Yunker's [1982] arguments that large firms use market-based transfer
pricing because of environmental variability and worldwide sales and
TABLE 2
Rotated Factor Loadings
Environmental Factors and Their Determinants
Environmental Factors Factor**

and their Determinants Loading Communality Eigenvalue
1. Legal Factor 1.679
(0.860)*
1. Compliance with U.S. tax
regulations 0.890 0.799
2. Compliance with tax and customs
regulations of host countries 0.846 0.744
3. Compliance with financial reporting
rules and requirements 0.638 0.439
4. Compliance with antitrust and
anti-dumping legislation of host
countries 0.631 0.467
II. Political & Social Factor 11.164

(0.951 )
1. Racial policies of host countries 0.892 0.836
2. Civil wars in host countries 0.863 0.851
3. Religious conflicts in host countries 0.854 0.810
4. Human rights violations by host
governments 0.852 0.793
Ill. External Economic Factor 3.406

(0.859)*
1. Existence of exchange controls 0.750 0.675
2. Existence of price controls 0.714 0.603
3. Restrictions on imports imposed by
host governments 0.653 0.545
4. Minimization of adverse impact of
inflation in host countries 0.579 0.444
IV. Internal Economic Factor 2.026

(0.799)*
1. Increased market share of foreign
affiliates 0.805 0.691
2. Strengthened competitive position
of foreign affiliates 0.798 0.673
3. Performance evaluation of foreign
affiliates 0.697 0.536
*Reliability coefficient
**Factor loadings greater than ? 0.50 are considered significant. See Hair, et al. [1979
p. 234.
Benvignati's [1985] conclusions that large firms use market-based transfer

pricing because they are more visible.
Test of Political-Social Hypothesis
Table 2 shows that the following four items loaded most heavily on the
POLS factor (arranged in descending order of factor loading): (i) racial
policies of host countries; (ii) civil wars in host countries; (iii) religious
conflicts in host countries; and (iv) human rights violations by host govern-
ments. The factor loading for all these items are very strong, ranging from
TABLE 3
Frequency of Use of International Transfer
Pricing Methods by Respondent Firms
MDCs LDCs TOTAL
# % # %# %
Nonmarket Based Methods
Actual unit full cost 4 4 4 5 8 5
Actual unit full cost plus fixed
markup 15 15 11 15 26 15
Actual unit variable cost 0 0 0 0 0 0
Standard unit variable cost
plus fixed markup 3 3 2 3 5 3
Standard unit full cost plus
fixed markup 15 16 10 13 25 15
Standard unit full cost 5 5 0 0 5 3
Standard unit variable cost 1 1 0 0 1 0
Standard unit variable cost
plus fixed markup 5 5 4 5 9 5
Marginal cost 0 0 0 0 0 0
Opportunity cost 2 2 0 0 2 1
Negotiated price 13 13 12 16 25 15
Mathematical programming 1 1 3 4 4 2
Dual pricing 1 1 1 1 2 1
Total nonmarket based 65 66 47 62 112 65
Market Based Methods

Prevailing market price 17 18 12 16 29 17
Adjusted market price 15 16 16 22 31 18
Total market based 32 34 28 38 60 35
Total number of firms 97 100 75 100 172 100
Note: Total number of responses exceeds 76 firms in the MDC group because some
firms identified the use of more than one transfer pricing method. On the other
hand, the total number of responses for the LDC group is less than 88 because
some firms did not identify the transfer pricing method they used for multinational
transfers.
MDCs=more developed countries
LDCs= less developed countries
0.85 to 0.89. When the POLS factor is used in the probit model, it is found
to be negative as predicted (see Table 4) but statistically insignificant.
Thus, we cannot conclude that adverse political and social conditions in
host countries require multinational firms to rely on nonmarket-based
transfer prices.
Test of External Economic Hypothesis
Table 2 shows that the following four items loaded most heavily on
the EXECON factor (arranged in descending order of factor loading):
(i) existence of exchange controls; (ii) existence of price controls;
(iii) restrictions on imports imposed by host governments; and
(iv) minimization of adverse impact of inflation in host countries. Tab
indicates that the EXECON variable, while statistically insignificant, was
negatively related, as predicted. Therefore, although multinationals may
TABLE 4
Probit Estimates of the Relationship between Transfer Pricing
Strategies and Environmental and Firm-Specific Variables
(TPM= So + f31LEGAL+ 32SIZE+ 33POLS+ 34EXECON+ 35/NTECON+ 36LDC)
Regression Standard Asymptotic Predicted

Variable Coefficient Error t-value Sign
Intercept 4.4442 0.2481 17.9134***

Legal 0.1841 0.1144 1.6093* +
Size 0.0006 0.0003 1.9726** +
Political & Social
(POLS) -0.0024 0.1084 -0.0218 -
External economic
(EXECON) -0.0624 0.1148 -0.5441 -
Internal economic
(INTECON) 0.0049 0.1166 0.0419 ?
LDC -0.0482 0.2115 -0.2276 -
Pearson goodness-of-fit chi square= 145.422

Degrees of freedom = 141.000
Probability = 0.382
R-square = 0.506
Percent Correctly Classified:
Market based method 75.9%
Nonmarket based method 56.2%
Overall 65.5%
*Significant at the 0.05 level

**Significant at the 0.025 level
***Significant at the 0.0001 level
rely more on nonmarket-based transfer pricing strategies in order to circu

vent stringent economic restrictions which hinder the free flow of funds
between countries, we could not find statistical support for this contention.
Test of Internal Economic Hypothesis
Table 2 shows that the following three items loaded most heavily on the
INTECON factor (arranged in descending order of factor loading):
i) increased market share of foreign affiliates; ii) strengthened competitive
position of foreign affiliates; and iii) performance evaluation of foreign affil-
iates. As discussed previously in the hypothesis section, we could not
predict the sign of the INTECON coefficient because of competing impli-
cations on transfer pricing of the INTECON variable. Table 4 shows that
the INTECON variable is statistically insignificant and the sign of the coeff
cient is positive. Thus, neither can we conclude that multinationals use
market-based transfer pricing for performance evaluation of foreign affili-
ates nor could we argue that they use nonmarket-based transfer pricing to
enlarge the market share of foreign affiliates.
Test of LDC Hypothesis
Less developed countries impose various restrictions on multinationals out
of concern that multinationals manipulate transfer prices. Brean [1979]
argued that such restrictions result from ignorance of the LDCs with resp
to transfer pricing methods. Further, the less developed product markets in

such economies do not provide opportunities for market forces to establish
transfer prices. Thus, we expected that U.S. multinationals would employ
nonmarket-based transfer pricing strategies on intra-company shipments.
Table 4 shows that the LDC variable, as predicted, is negatively associated
with market-based transfer pricing methods; however, it is statistically insig-
nificant. Therefore, we cannot conclude that the level of development of a
country in which a foreign affiliate is located is a significant factor in a
multinational's decision to use a market-based transfer pricing strategy.
SUMMARY AND CONCLUSIONS
The purpose of this study was to find the determinants of the international
transfer pricing strategies of U.S.-based multinationals. The findings show
that the legal and size variables are significantly associated with the use of
market-based transfer pricing strategies. These results suggest that legal
considerations such as compliance with tax and custom regulations, anti-
dumping and antitrust legislations, and financial reporting rules of host
countries are influential in the use of market-based transfer pricing.
However, the economic restrictions such as exchange controls, price
controls, and restrictions on imports, political-social conditions, and the
extent of economic development in host countries are either unimportant or
are secondary determinants of a market-based transfer pricing strategy.
The results also suggest that U.S. multinationals closely abide by U.S. tax
regulations. Treasury Regulation 1.482 prescribes the following transfer
pricing methods: the uncontrolled price method, the resale method, the
cost plus method, and some other appropriate method when none of the
methods described above are applicable. The evidence of this study shows
that cost plus and market-based pricing were the most popular methods
used both in MDCs and LDCs.
Furthermore, our findings are consistent with prior studies. For instance, our
analysis supports one of Arpan's [1972-1973] conclusions "that there is no
universally optimal system of international intra-corporate pricing" (p. 11
We found that most firms in our sample were using both market-based and
nonmarket-based pricing. We find that, similar to Yunker's [1982] results,
there is no strong positive and significant association between performance
evaluation and market-based transfer pricing. It appears that multinationals
adjust their performance evaluation policies to the transfer pricing method
used.
This study also sheds some light on transfer pricing theories. Our analysis
supports the economic theory of transfer pricing which argues that, in
imperfectly competitive markets, management will use nonmarket-based
transfer prices. Perfect competition is not commonly seen in practice and,
therefore, it is not surprising to see that many of the respondent firms
reported the use of nonmarket-based transfer pricing. We also found support
for the behavioral theory of transfer pricing. The data suggests that nearly
15'0o of our sample firms used negotiated transfer pricing methods.

However, the results do not show the popular use of mathematical program-
ming models.
Finally, the findings of this study are useful for practitioners who may be
interested in identifying critical variables for designing a transfer pricing
strategy. The significance of the legal and size variables rather than other
factors in determining the choice of a market-based transfer pricing
strategy suggests that legal rather than economic or social constraints play
an important role in the selection of transfer pricing strategies. Future
research could examine whether industry and product differences result in
different transfer pricing strategies, and the reasons for such differences
which do exist. One could also examine reasons why U.S.-based multi-
nationals tend to use nonmarket-based transfer pricing more frequently
market-based transfer pricing as compared to multinationals based in
foreign countries.
NOTES
1. Probit analysis was used because of the dichotomous dependent variable (market- versus nonmarket-
based transfer pricing). Probit utilizes the ordinality of the dependent variable which may not be the
case for logit when the dependent variable is dichotomous. However, logit was also used to test whether
the results were sensitive to the statistical procedure. The signs and the significance levels of all coef-
ficients were quite similar to the probit results.
2. A pilot study was conducted in early February 1987 on a sample of thirty corporations. Results indi-
cated that respondents did not have any difficulty in completing the questionnaire.
3. Firms were categorized as operating primarily in MDCs versus LDCs based on the number of affil-
iates because of the nonavailability of data on total assets or total revenues by country of operation.
Consequently, we could not test our model at different levels of involvement (measured by total assets
or total revenues) of a multinational in a host country.
4. The overall response rate was not the desirable 30%; however, we believe it is not so low as to
be a cause of serious concern. Prior studies have also reported response rates below 30%. For example,
Imhoff [1988] had a response rate of 9.4%70 and Eichenseher and Shields [1983] reported a response rate
of 24%7o.
5. A copy of the questionnaire is available from the second author upon request.
6. We first attempted to use ordinary least squares regression (OLS) with "percent of times market
based methods used" as the dependent variable However, this variable could not be used as a depen-
dent variable because it was bimodal, suggesting that OLS would be inappropriate. Therefore, we
decided to use the probit model.
7. With any set of related data, there is a possibility that the independent variables are correlated to
the point that they cause significant multicollinearity. Multicollinearity can affect the signs of probit coef
ficients; however, unlike regression analysis, multicollinearity has no effect on testing the significance
of individual variables in probit equations. In probit analysis, the standard errors of coefficients are not
used to perform the likelihood tests [Grablowsky and Talley 1981]. The correlations between the inde-
pendent variables of the model used in this study were generally low.
8. McKelvey and Zavonia [1975] describe the probit generated R-square as an indication of how well
the data fit the underlying theoretical distribution. However, they caution that this measure is not
strictly similar to the OLS generated R-square.
9. Classification rate is affected to some extent by the measurement error in dependent and independent
variables.
10. The size variable was treated as a continuous variable because of the nonavailability of data on
assets or sales by country of operation. Therefore, we could not test the association of the transfer
pricing methods with the size of operation in each of the host countries.
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Transfer Pricing Determinants of U.S.

Abstract. This paper examines the influence of environmental

In order to successfully compete in the global market, U.S. multinationals

*Mohamed F Al-Eryani is an Assistant Professor of Accounting at Sana'a University,

challenge for multinationals is to design a transfer pricing strategy which

REVIEW OF THE RELEVANT LITERATURE

Three different theoretical frameworks (economic, mathematical program-

organizational goals. Watson and Baumler [1975] demonstrated that

Empirical research on international transfer pricing has focused on the

countries (MDCs) because the governments of LDCs are poorly equipped,

External Economic Hypothesis

so that its share of real profit from foreign subsidiaries is maintained.

The present study is limited to U.S.-based multinationals having affiliat

Questionnaire and Measurement Issues

The primary data concerning general company characteristics, environment

Worldwide Sales Corporations Corporations

Valid responses 76 (100.0%) 87 (100.0%) 163 (100.0%)

Total responses 76 88 164

pricing determinants, multiple indicators were used to capture the key

Factor analysis was used to identify the key determinants of transfer

TPM= 0% + 3 1LEGAL + J2SIZE+ 3POLS+ 34EXECON+ 5INTECON+ 6LDC

LEGAL = Legal factor as described in Table 2;

ANALYSIS AND INTERPRETATION

Environmental Factors Factor**

II. Political & Social Factor 11.164

Ill. External Economic Factor 3.406

IV. Internal Economic Factor 2.026

Benvignati's [1985] conclusions that large firms use market-based transfer

MDCs LDCs TOTAL

Market Based Methods

Regression Standard Asymptotic Predicted

Intercept 4.4442 0.2481 17.9134***

Pearson goodness-of-fit chi square= 145.422

*Significant at the 0.05 level

rely more on nonmarket-based transfer pricing strategies in order to circu

to transfer pricing methods. Further, the less developed product markets in

SUMMARY AND CONCLUSIONS

15'0o of our sample firms used negotiated transfer pricing methods.

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