International Transfer Pricing: Income Shifting and Tax Avoidance

Foundations and Trends
R
in Accounting
Vol. 9, No. 1 (2014) 1–57

c 2014 R. Sansing
DOI: 10.1561/1400000037
International Transfer Pricing
Richard Sansing
Tuck School of Business at Dartmouth
Hanover, USA
and
CentER, Tilburg University
The Netherlands
richard.c.sansing@tuck.dartmouth.edu
Contents
1 Introduction 2
2 Historical Perspective 7
3 Evidence of Income Shifting 12

3.1 Aggregate data . . . . . . . . . . . . . . . . . . . . . . . 12
3.2 Intangible assets . . . . . . . . . . . . . . . . . . . . . . . 13
3.3 Product level data . . . . . . . . . . . . . . . . . . . . . . 14
4 Transfer Pricing Fundamentals 16

4.1 Price or profit? . . . . . . . . . . . . . . . . . . . . . . . . 16
4.2 Economic profits or accounting profits? . . . . . . . . . . . 17
4.3 Economic costs or accounting costs? . . . . . . . . . . . . 19
5 Optimization Models 21
5.1 Transfer price discretion . . . . . . . . . . . . . . . . . . . 21
5.2 Two sets of books . . . . . . . . . . . . . . . . . . . . . . 24
5.3 Endogeneity of comparable uncontrolled prices . . . . . . . 29
5.4 Transfer pricing and investment incentives . . . . . . . . . 31
6 Transaction Cost Economics 34

6.1 Endogeneity of organizational structure . . . . . . . . . . . 34
ii
iii
6.2 Intangible assets . . . . . . . . . . . . . . . . . . . . . . . 35

6.3 Returns to internalization . . . . . . . . . . . . . . . . . . 37
7 Tax Compliance Models 42

7.1 Transfer price inconsistency . . . . . . . . . . . . . . . . . 42
7.2 Advance pricing agreements . . . . . . . . . . . . . . . . . 43
8 Formulary Apportionment 45
9 Future Research 48
9.1 Methods of shifting income from intangible assets . . . . . 48
9.2 Allocating the returns to organizational capital . . . . . . . 49
10 Conclusions 50
Acknowlegements 52
References 53
Abstract
International transfer pricing determines how the worldwide income of

a multinational enterprise is divided among countries for income tax
purposes when transactions occur within the firm. This review exam-
ines economics, accounting, legal research, and tax practitioner litera-
tures on international transfer pricing.
The empirical literature documents the ability of multinational
enterprises to shift income attributable to intangible assets and orga-
nizational capital from high-tax to low-tax countries. The theoretical
literature reflects many different perspectives, but a recurring theme is
that the current system that evolved in a world in which value was cre-
ated by tangible assets with clear physical locations is not well suited
for a world in which value is created by firms that develop intangible
assets and choose organizational structures that economize on transac-
tion costs.
R. Sansing. International Transfer Pricing. Foundations and Trends

R
in
Accounting, vol. 9, no. 1, pp. 1–57, 2014.
DOI: 10.1561/1400000037.
1
Introduction
This monograph reviews international transfer pricing. Taxable income

for a multinational enterprise (MNE) is determined on the basis of sep-
arate accounting, in which the incomes of a United States (U.S.) parent
and its foreign subsidiaries are determined separately. When goods or
services are transferred between related entities the transfer price, i.e.,
the price at which the good or service is transferred, determines how
the income of the two entities is divided between the U.S. and the
foreign country for income tax purposes. If a U.S. manufacturing firm
produce a widget at a cost of $20 and transfers it to its Dutch sub-
sidiary, and the Dutch retailer in turn sells it to an unrelated party
for $30, how the $10 profit is divided between the U.S. parent and the
Dutch subsidiary depends on the transfer price. If the transfer price is
$27, the U.S. parent has taxable income of $7 and the Dutch subsidiary
has taxable income of $3. A particularly important type of service is
the use of intellectual property that is developed in one country and
used in another.
The rapid increase in globalization has increased both trade and
foreign direct investment. Much of the increase has been in the form
of intrafirm trade. Eden [1998, p. 70] argues that intrafirm trade is
2
3
the sine qua non of the MNE. About 40% of U.S. international trade
occurs between a U.S. firm and a related party in a foreign country
[Clausing, 2003]. The Organization for Economic Co-operation and
Development (OECD) estimates that more than 60% of world trade
takes place between related parties in MNEs [Wittendorf, 2010, p. 5].
For some pairs of countries, 75% of cross-boarder trade occurs within
MNEs [Brem, 2004]. The increase in intrafirm trade means that transfer
pricing has become much more important over time.
If the MNE could pick any price in an unconstrained fashion, it
could shift all of its taxable income to the country with the lower
income tax rate.1 Therefore, tax authorities have coordinated on the
arm’s length standard for determining whether the resulting allocation
of taxable income is valid for tax purposes. The arm’s length standard
involves a thought experiment, in which one asks what allocation would
have arisen had the parties been unrelated, each striving to maximize
its own income. This approach raises serious conceptual difficulties,
as the economic theory of the firm indicates that two related entities
within a vertically integrated firm will interact quite differently than
will independent firms.
The research on international transfer pricing is found in journals
that reflect very different research traditions. Leading papers can be
found in economics journals, accounting journals, law reviews, and
tax practitioner journals. This monograph puts more weight on the
accounting and tax practitioner literatures, while striving to incorpo-
rate the most important contributions from the economics and legal
research literatures. Eden [1998] and Wittendorf [2010] provide more
comprehensive surveys of the economics and legal research literatures,
respectively. Transfer pricing is just one part of how MNEs are taxed;
Blouin [2011] provides a review of the larger literature on the taxation
of MNEs.
It is important to understand and appreciate the history of a field
of study in order to put current disputes into perspective. Section 2
1
Transfer prices are not the only way to shift income from a high-tax rate country
to a low-tax rate country. For example, an MNE can reduce taxable income in a
high-tax country by having high-tax rate affiliates do all of the borrowing or making
all of the tax-favored R&D investments.
4 Introduction
briefly summarizes the development of the international tax regime

from the post-World War I era through the most recent revision in the
U.S. transfer pricing regulations, with particular emphasis on the areas
of disagreement between the U.S. Treasury Regulations and the OECD
Transfer Pricing Guidelines (hereafter, OECD Guidelines).
Section 3 summarizes the empirical evidence that shows that firms
successfully shift income from high-tax to low-tax countries. Most of
this evidence is based on firm-level data. Firms owning valuable intan-
gible assets are particularly adept at shifting income attributable to
intangible assets to low-tax jurisdictions. Other studies use product-
level data rather than firm-level data. Both types of studies paint a
compelling picture that shows that shifting income via transfer pricing
is pervasive.
Section 4 examines some fundamental transfer pricing issues.
I emphasize that the tax authorities define the arm’s length standard in
terms of the profit one would expect unrelated parties to earn, not the
price at which unrelated parties would transact. I also analyze the dif-
ference between economic profits and accounting profits. Models in the
economics literature often treat the cost of equity capital as if it were
deductible for tax purposes. This approach is analytically convenient
but substantively mistaken.
Section 5 reviews the literature in which the transfer price is
viewed as an optimal choice of the MNE. One set of papers focuses
on the extent to which firms have discretion over the transfer price
itself. In these studies, the firm can choose any price from a specified
range. Not surprisingly, the firm chooses an endpoint of the range, as
it strives to allocate as much income as possible to the country with
the lower tax rate.
Another set of papers examines the dual roles played by transfer
prices. One role is determining the allocation of taxable income within
an MNE. The other role is a mechanism by which division within a
vertically integrated firm with decentralized decision rights coordinate
their actions. These papers model the tradeoff between using a transfer
price for tax purposes and internal decision-making purposes. I argue,
however, that the evidence supporting the existence of this alleged
tradeoff in practice is quite weak.
5
A third set of papers examines the endogeneity of a comparable

transaction with an unrelated party, in which the price from a transac-
tion with an unrelated party is used to allocate income between related
parties. The final set of papers examines the effect of the transfer price
on investment incentives. In each case, the tax incentives distort invest-
ment choices, with ambiguous effects on economic efficiency.
Section 6 examines the issue of transfer pricing through the lens
of transaction cost economics, in which firms vertically integrate in
order to economize on transaction costs. The transactions costs asso-
ciated with valuable intangible assets are particularly severe, so firms
holding valuable intangibles tend to vertically integrate. This makes
it difficult to identify comparable transactions between unrelated par-
ties that can be used in order to implement the arm’s length standard.
One particularly difficult issue arises when the organizational structure
itself creates value. As the transfer pricing rules tend to focus on the
location of tangible capital, the question of which political jurisdiction
should tax the returns to organizational capital is difficult to resolve.
The papers that take a transaction cost economics perspective find that
using an arm’s length price often does not yield an arm’s length alloca-
tion of taxable income, reflecting the fact that related parties interact
in fundamentally different ways than do unrelated parties.
Section 7 addresses the issue of tax compliance. In practice, many
firms are taxed by multiple political jurisdictions on the same income
due to inconsistent transfer pricing rules. The prospect of double taxa-
tion has led to the use of institutional arrangements in which the MNE
and one or more tax authorities agree upon transfer prices before the
tax return is filed. These arrangements are known as advance pricing
agreements, or bilateral advance pricing agreements in the case of agree-
ments with two tax authorities. These agreements can make all three
parties to be better off; even though taxes are zero-sum wealth trans-
fers, the deadweight loss associated with audit costs can be reduced.
The difficulty that the U.S. government has taxing the income
earned by U.S. MNEs, particularly those using valuable intangible
assets, has led some to advocate changing to a system of formulary
apportionment to replace the current system of separate accounting.
6 Introduction
Section 8 describes formulary apportionment, with particular emphasis

on the destination sales formulary apportionment system, and describes
the advantages and disadvantages of formulary apportionment com-
pared to separate accounting. In Section 9, I offer my thoughts regard-
ing promising unexplored research questions. Section 10 concludes.
2
Historical Perspective
Although mechanisms to prevent double taxation by different political

jurisdictions existed in the nineteenth century, serious efforts to devise
a system to prevent double taxation of international commerce began
after World War I. The International Chamber of Commerce and the
League of Nations took the lead [Wittendorf, 2010, p. 85]. The Carroll
Report [Carroll, 1933] put forth recommendations regarding the taxa-
tion of business income, embracing the method of separate accounting
and the arm’s length standard. Paragraph 677 of the Carroll Report
stated, in part:
The fairest and most generally practical criterion is that of
what would be earned within the country by an indepen-
dent enterprise engaged in similar activities under similar
conditions, such conditions including capital invested, vol-
ume of business or services rendered, costs and risk.
Langbein [1986] critically describes the historical development of the
arm’s length standard, arguing that Carroll was biased against the use
of formulary apportionment to allocate income among countries.
The Draft Convention on the Allocation of Business Income
reflected the recommendations of the Carroll Report [Wittendorf, 2010,
7
8 Historical Perspective
p. 92]. After World War II, the Organization for European Co-operation
(OECC), which became the OECD in 1961, continued to embrace this
approach.
In the U.S., the arm’s length standard was included in §45-1(b) of
the 1935 U.S. Treasury Regulations. §45 was renumbered as §482 in
1954. Treasury Regulations interpreting §482 were finalized in 1968.
The regulations provided a hierarchy of methods, in which the compa-
rable uncontrolled price method had the highest priority, followed by
resale price, cost plus, and other methods in that order. The compa-
rable uncontrolled price (CUP) method uses the price of a compara-
ble good or service in a transaction between unrelated taxpayers as a
benchmark for evaluating whether the transfer price satisfies the arm’s
length standard. The resale price method uses the gross profit expressed
as a percentage of the sales price of an unrelated seller of goods as
a benchmark. An arm’s length transfer price results in the related
party seller of goods having the same gross profit percentage as the
unrelated seller. The cost plus method uses the gross profit expressed
as a percentage of cost of an unrelated manufacturer of goods as a
benchmark. An arm’s length transfer price results in the related party
manufacturer having the same gross profit percentage as the unrelated
manufacturer.
The most contentious issues that arose after the 1968 regulations
were issued dealt with intangible assets. U.S. firms could transfer intan-
gible assets to foreign subsidiaries in low-tax jurisdictions as tax-free
contributions to capital under IRC §351. Because the foreign subsidiary
is then the owner of the intangible asset, the taxable income from the
intangible asset would be allocated to the foreign subsidiary rather
than the U.S. parent, even if the U.S. parent had deducted research
and development costs while developing the asset.
Congress responded in 1976 by denying tax-free treatment to
the transfer of intangible assets to foreign subsidiaries. In addition,
Congress amended IRC §482 in 1986 by mandating that income from
transferred or licensed intangible assets must be commensurate with
the income (CWI) attributable to the intangible asset. The Treasury
Department then published a White Paper, A Study of Intercompany
9
Pricing [U.S. Department of the Treasury, 1988] describing methods

by which it could implement the CWI standard.
One of the controversial aspects of the CWI standard is that it is
based on the realized profitability of the intangible asset, as opposed
to its expected profitability at the time of the transfer. The difference
between the two is known as a super royalty. Other governments argued
that the super royalty provision is not consistent with the arm’s length
standard [Eden, 1998, p. 415].
The OECD questioned whether the CWI standard was consistent
with the arm’s length standard, saying:
To the extent that a commensurate-with-income approach
involves the application of hindsight, there is a danger of a
fundamental contradiction between the arm’s-length stan-
dard, which depends on evaluating bargains at the time
they take place, and the commensurate-with-income con-
cept to the extent in involves a year-by-year retrospective
reappraisal based on profits. [OECD, 1993]
In this environment, the U.S. Treasury Department proposed new
regulations in 1992. The Proposed Regulations were replaced with Tem-
porary Regulations in 1993 and Final Regulations in 1994. One of the
important differences between the 1968 Regulations and the 1994 Reg-
ulations is that the hierarchy of transfer pricing methods was replaced
with the “best method rule,” in which no method is assumed to be
more or less reliable than any other method [Treas. Reg. §1.482-1(c)].
Another is the periodic adjustment provision relating to the transfer of
intangible assets [Treas. Reg. §1.482-4(f)(2)]. The most important inno-
vation was the comparable profit method (CPM) [Treas. Reg. §1.482-5].
The CPM uses a profit level indicator, such as the rate of return on cap-
ital, of a comparable unrelated firm as a benchmark when evaluating
whether the transfer price satisfies the arm’s length standard.
The OECD expressed considerable skepticism regarding CPM when
the revised Treasury Regulations were issued, questioning whether it
was consistent with the arm’s length standard [OECD, 1993]. On the
other hand, the OECD guidelines do allow the transactional net margin
method (TNMM), which compares the net profit from a transaction to
10 Historical Perspective
some base. Paragraph 2.97 of the OECD transfer pricing guidelines

permits return on sales, return on assets, or return on capital as one
of the appropriate bases against which to compare the profit from a
transaction. In practice, it appears that CPM is the most widely used
method in the U.S. and TNMM is the most used method in Europe
[Wittendorf, 2010, p. 737].
The difference, if any, between CPM and TNMM as described in
the OECD guidelines appears to be one of degree rather than kind.
On the other hand, the difference in degree seems clear. Paragraph
2.77 of the OECD guidelines states:
As a matter of principle, only those items that (a) directly

or indirectly relate to the controlled transaction at hand
and (b) are of an operating nature should be taken into
account in the determination of the net profit indicator for
the application of the transactional net margin method.
Treasury Regulation §1.482-5(b)(1) states, in part, that:
Comparable operating profit is calculated by determining a

profit level indicator for an uncontrolled comparable, and
applying the profit level indicator to the financial data
related to the tested party’s most narrowly identifiable busi-
ness activity for data incorporating the controlled transac-
tion is available (relevant business activity). To the extent
possible, profit level indicators should be applied solely to
the tested party’s financial data that is related to controlled
transactions. (emphasis added)
The difference between the two arises when a profit level indicator
includes, but is not limited to, the profit from the controlled transac-
tion. The OECD guidelines would appear to not allow the use of such
a profit indicator; the Treasury Regulations would.
In addition, the OECD guidelines express a preference for the tradi-
tional transaction methods (CUP method, resale price, and cost plus)
over the TNMM method or profit-split methods, with CUP being
favored among the traditional transaction methods. Paragraph 2.3 of
11
the OECD Guidelines states:
As a result, where, taking account of the criteria described

at paragraph 2.2, a traditional transaction method and a
transactional profit method can be applied in an equally
reliable manner, the traditional transaction method is
preferable to the transactional profit method. Moreover,
where, taking account of the criteria described at paragraph
2.2, the comparable uncontrolled price method (CUP) and
another transfer pricing method can be applied in an
equally reliable manner, the CUP method is to be preferred.
Cheng [1995] and Levy and Wright [1995] compare the U.S. regu-
lations to the OECD guidelines. Although the Final Regulations are
more similar to the OECD guidelines than were the Proposed Regula-
tions, important differences remain. The most important differences are
between the comparable profit method and the transactional net mar-
gin method, the possibility of periodic adjustments to implement the
commensurate-with-income standard, and the OECD’s preferences for
particular methods as opposed to the best method rule in the Treasury
Regulations.
3
Evidence of Income Shifting
3.1 Aggregate data
There is strong empirical evidence in favor of the proposition that firms

choose transfer pricing strategies that shift taxable income from coun-
tries with higher tax rates to countries with lower tax rates. Grubert
and Mutti [1991] study 1982 data of U.S. MNEs operating in 33 coun-
tries. They find that return on sales has a strong negative correlation
with both statutory and effective tax rates.
Grubert et al. [1993] study 1987 data of U.S. firms. They find that
foreign-owned U.S. firms are much less profitable than domestically
owned U.S. firms, and that only about half of the difference can be
explained by characteristics of foreign controlled companies unrelated
to transfer pricing.
Klassen et al. [1993] examine income-shifting incentives due to cor-
porate tax rate changes in the U.S., Canada, United Kingdom (U.K.),
and France. They find evidence of income shifting from Canada to the
U.S. and from the U.S. to the U.K. and France in 1985 and 1986.
The Canadian corporate income tax rate increased during those years,
whereas the U.K. and French corporate income tax rates decreased
12
3.2. Intangible assets 13
during these years. Firms shifted income to the U.S. in 1987, a year in
which the U.S. corporate income tax rate decreased.
Bartelsman and Beetsma [2003] examine income shifting by
manufacturing firms within 16 OECD countries from 1979 to 1997.
They find evidence of income shifting among OECD countries that is
both statistically and economically significant. The authors estimate
that at least 65% of the additional tax revenue that a government
would expect to receive due to a unilateral tax rate increase is lost due
to income shifting.
Clausing [2009] examines firm responses to tax rate differences for
U.S. MNEs from 1982 to 2004. The study looks at both account-
ing responses, such as using transfer prices to shift income, and real
responses, such increasing investment or employment in foreign coun-
tries. A one percentage point decrease in the foreign tax rate is asso-
ciated with a 0.5 percentage point increase in the foreign affiliate’s
return on sales. A one percentage point decrease in the foreign tax rate
is associated with a 1.6% increase in foreign employment, 2.9% increase
in foreign sales, and a 4.8% increase in foreign assets.
Huizinga and Laeven [2008] examine parent companies and sub-
sidiaries of European MNEs using 1999 data. They find evidence of
income shifting by European MNEs away from high-tax countries,
notably Germany, and toward European countries with lower tax rates.
3.2 Intangible assets
Income from intangible assets is easier to shift to low-tax jurisdictions

than is income from tangible assets because tangible assets have an
easily verifiable physical location. Harris [1993] examines 1984–1990
data to investigate the effect of the decrease in the U.S. corporate
income tax rate from 46% to 34% on reported U.S. taxable income. He
finds that firms with high levels of “flexible” expenses such as interest,
R&D, and advertising reported significantly more U.S. taxable income
following the tax rate decrease.
Harris et al. [1993] examine manufacturing firms from 1984 to 1988.
They find evidence consistent with U.S. MNEs shifting income into
14 Evidence of Income Shifting
low-tax countries and out of the U.S., and shifting income out of high-
tax countries and into the U.S. As in Harris [1993], firms with high levels
of intangible assets and debt financing were more likely to engage in
income shifting.
Grubert and Slemrod [1998] use 1987 data to investigate the joint
decision to invest in Puerto Rico and shift income from the U.S. to
Puerto Rico. They find that a large fraction of U.S. investment into
Puerto Rico is attributable to the ability to engage in income shifting.
Firms with high levels of intangible assets are more likely to invest in
Puerto Rico, consistent with the income-shifting hypothesis.
Grubert [2003] extends this research to examine the relations among
intangible assets, production location, and income shifting in 60 loca-
tions that account for virtually all investment by U.S. MNEs. The study
finds that about half of the difference in profitability between low-tax
rate and high-tax rate countries is attributable to income shifting asso-
ciated with R&D investments. Furthermore, MNEs with high levels of
R&D are more likely to invest in countries with very high and very low
statutory tax rates, consistent with the strong income shifting benefits
associated with intangible assets.
3.3 Product level data
Some studies examine data at the product level rather than the firm
level to investigate tax-motivated income shifting. Swenson [2001]
examines U.S. imports from Canada, France, Germany, Japan, and
the U.K. from 1981 to 1988 using product-level data. The study finds a
statistically significant albeit economically small relation between tax
rate changes and price changes; a 5% decline in the foreign tax rate is
associated with a 0.024% price increase.
Using international trade price data from 1997 to 1999, Clausing
[2003] finds that intrafirm trade with low-tax countries is associated
with lower export prices and higher import prices, both of which have
the effect of shifting taxable income to the lower tax rate country. A
one percentage point lower tax rate is associated with export prices
3.3. Product level data 15
that are 0.94% lower and import prices that are 0.64% higher, both
relative to non-intrafirm transactions.
Using Census Bureau and Customs Bureau data, Bernard et al.
[2006] find that the arm’s length price of undifferentiated exported
goods is 8.8% higher when sold to an unrelated buyer compared to a
foreign related party. The difference is 66.7% for differentiated goods.
The difference is negatively associated with the income tax rate in the
foreign country; a one percentage point decrease in the foreign tax rate
is associated with a price increase of about 0.6%.
4
Transfer Pricing Fundamentals
4.1 Price or profit?
Although much of the accounting and economics literature focuses on

the price at which goods and services are transferred between affiliated
entities in an MNE, the tax authorities make it clear that the focus
should be on the taxable income of the affiliated entities. The transfer
price is simply a means to the end of determining an allocation of
taxable income that satisfies the arm’s length standard.
Treas. Reg. §1.482-1(a)(1) states:
Section 482 places a controlled taxpayer on a tax parity with

an uncontrolled taxpayer by determining the true taxable
income of the controlled taxpayer (emphasis added).
Treas. Reg. §1.482-1(b)(1) states:
In determining the true taxable income of a controlled tax-

payer, the standard to be applied in every case is that of
a taxpayer dealing at arm’s length with an uncontrolled
taxpayer. A controlled transaction meets the arm’s length
standard if the results of the transaction are consistent with
16
4.2. Economic profits or accounting profits? 17
the results that would have been realized if uncontrolled

taxpayers had engaged in the same transaction under the
same circumstances (arm’s length result).1
Similarly, Section 1.6 of the OECD Transfer Pricing Guidelines hold
that when two associated enterprises operate under conditions that
differ from those under which independent enterprises operate, then:
[Any] profits which would, but for those conditions, have
accrued to one of the enterprises, but, by reason of those
conditions, have not so accrued, may be included in the
profits of that enterprise and taxed accordingly.
Section 1.7 of the OECD Transfer Pricing Guidelines refers to:
A determination of the profits which would have accrued
at arm’s length, in order to determine the quantum of any
re-writing of accounts.
The distinction between an arm’s length price and an arm’s length
allocation of profit is an important one. A pair of unrelated firms will
likely interact in fundamentally different ways than will two related
parties. Given those differences, one should not assume that a market
price that arises between two unrelated parties that yields a market
return to these parties will yield an economically meaningful division
of profits between two related parties.
4.2 Economic profits or accounting profits?
Income taxes are levied on accounting measures of revenue and costs.

One common characteristic of economists’ models of transfer pricing
[e.g., Horst, 1971, Samuelson, 1982, Diewert, 1985] is the way they
define costs. Suppose a firm produces q units at a cost C(q) that it
transfers to a related party in a different country at a transfer price
of p per unit. If the tax rate is τ , these models represent the after-tax
income as
(1 − τ )[pq − C(q)]. (4.1)
1
It is worth emphasizing that the arm’s length standard is fundamentally incon-
sistent with the commensurate with income standard.
18 Transfer Pricing Fundamentals
This formulation implies that pq − C(q) is the firm’s pretax profit.

But economists and accountants mean different things by the word
“profit.” The normal return to capital is a cost to an economist. There-
fore, economists think of pq − C(q) as the abnormal return, the return
that exceeds the cost of capital. To an accountant, profit includes both
the normal and abnormal return to equity capital. However, it does not
include interest expense, as interest paid goes to creditors rather than
shareholders. Economists do understand this, of course; see Sandmo
[1974]. But as Sandmo acknowledges, it is “usually neglected in discus-
sions of the corporate income tax.”
This dichotomy between debt capital and equity capital is reflected
in the tax law. Interest expense is deductible when computing taxable
income; dividends and other returns to equity holders, such as stock
repurchases, are not. Therefore, although the representation in (4.1) is
analytically convenient, it is wrong to the extent the normal return to
equity capital is part of the cost function C(q). This is true even if the
investment in question is funded entirely with debt, because increasing
the amount of debt in the capital structure also increases the cost of
equity. To see why, consider an all equity firm with $400 million of assets
with a cost of capital of 12% that reflects the risk-free rate of 4% and a
risk premium of 8%. Now consider a new $100 million project with the
same riskiness of the existing asset that is funded with 4% bonds. The
risk premium of 8% associated with the $500 million of assets is borne
entirely by the equity holders, so the cost of equity has increased to
14%; the 4% risk-free rate plus a 10% risk premium. The risk premium
has increased from 8% to 10% because the risk associated with $500
million of assets is being borne by $400 million of equity. In absence of
the tax deductibility of interest, the weighted average cost of capital
would not change as the firm’s capital structure changed [Modigliani
and Miller, 1958]. The weighted average cost of capital r would be:
400 100
r = 14% × + 4% × (1 − τ ) × . (4.2)
500 500
Typically, a scale-enhancing project would likely be funded with
the same mix of debt and equity as the rest of the firm. If the costs
of manufacturing q units, exclusive of the cost of capital, is m(q), and
4.3. Economic costs or accounting costs? 19
the cost of capital associated with producing q units is r(q), then the
correct representation of (4.1) should be:
(1 − τ )[pq − m(q)] − r(q). (4.3)
4.3 Economic costs or accounting costs?
The fact that the normal return to equity capital is an economic cost
but not an accounting cost is important when analyzing transfer pric-
ing methods based on “costs.” In a competitive equilibrium, abnormal
returns are zero, and thus expression (4.1) is equal to zero. But when
applying the cost-plus method, “cost” simply refers to accounting costs;
the markup on accounting costs provides the normal return to capital.
Treas. Reg. §1.482-3(d)(3)(ii)(A) makes this clear:
A producer’s gross profit provides compensation for the per-
formance of the production functions related to the product
or products under review, including an operating profit for
the producer’s investment of capital and assumption of risk.
The difference between economic costs and accounting costs is easily
forgotten, however. Berry [1989] discusses the economic underpinnings
of the various transfer pricing methods. He discusses a hypothetical
competitive button-making industry:
At arm’s length, no manufacturer would long produce these
buttons for returns less than those available from using
the injection-molding facilities for some other purpose, and
since the buttons are not (by assumption) patented or
trademarked, no manufacturer will long be able to sell such
buttons at an usual profit without attracting the entry of a
competitor. The manufacturing price, therefore, that would
be expected to prevail at arm’s length can be estimated
by adding the profit margin generally realized by indepen-
dent manufacturers of similar molded plastic products to
the actual costs of the captive manufacturer.
Consider this claim in light of expression (4.3). Expression (4.3)
will equal zero for all manufacturers in a competitive equilibrium.
20 Transfer Pricing Fundamentals
The cost-plus method determines an arm’s length price by adding

the appropriate gross profit to the cost of production [Treas. Reg.
§1.482-3(d)(2)(i)]. The appropriate gross profit is the gross profit
markup from a comparable uncontrolled transaction, expressed as
a percentage of cost [Treas. Reg. §1.482-3(d)(2)(ii)]. Let the cost
functions of the controlled manufacturer be mc (q) and rc (q), and
the corresponding cost functions of the uncontrolled manufacturer be
mu (q) and ru (q). Using the cost-plus method, the arm’s length price
of the controlled transaction must be:
pq − mu (q)

mc (q) 1 + . (4.4)
mu (q)
But this only corresponds to the revenue earned by the uncon-
trolled manufacturer, pq, in the special case in which mc (q) = mu (q),
i.e., when the manufacturing accounting costs for the controlled and
uncontrolled manufacturers are the same. As I will discuss in Section 6,
this is unlikely to occur because vertically integrated groups and pairs
of independent firms make systematically different operating the invest-
ment decisions.
5
Optimization Models
5.1 Transfer price discretion
Many transfer pricing models view the transfer price as a strategic

choice of the MNE, chosen subject to constraints imposed by the tax
authorities. Horst [1971] studies the production and selling strategies
of a monopolist operating in two countries. That study examines the
optimal transfer price in a setting with a remarkably lax set of transfer
pricing rules, described this way.
If customs and tax authorities on both sides were reason-
ably diligent, a firm would probably not try to declare the
value of its exports to be less than their marginal cost of
production or greater than their market price in the export-
ing country. But any value the firm wished to declare within
these broad limits would probably go unchallenged. (empha-
sis added)
Not surprisingly, the firm responds to these generous rules by setting
transfer prices at either the lower bound (marginal production cost) or
the upper bound (final selling price). In the absence of tariffs, the choice
depends on which country has the higher tax rate. If the importing
21
22 Optimization Models
country imposes a tariff, the choice depends joint on the tariff rate and
the income tax rate.
Samuelson [1982] follows the general approach in Horst [1971], but
notes that if either the output market in the selling country is imper-
fectly competitive or marginal production costs are not constant, the
firm’s choices of production quantities will affect the ultimate selling
price, the marginal cost of production, or both. Because the assumption
that the tax authorities will accept any transfer price within that range
implies that the transfer price will be one of those two endpoints, the
transfer price becomes endogenous to the firm’s choices. Horst acknowl-
edges this possibility, but dismisses it as small, asserting: “In words,
the firm can ignore the way an increase in sales or production would
affect the upper and lower limits on the export transfer price, π.”
Because the firm always uses either the upper or lower bound of the
range of transfer prices, the choice of output quantity affects not only
the firm’s pretax income but also the transfer price used to allocate
taxable income between the two countries. As a result, the firm will
not produce so as to equate marginal revenue and marginal cost, as it
does when the range of transfer prices is exogenous to the firm’s choices.
The comparative statics, showing the effects of a tax rate change on
output quantity, are different in the exogenous and endogenous cases
when the firm prefers a high transfer price.
Diewert [1985] adopts a slightly different approach to the modeling
of transfer price rules. In that study, the firm can choose its transfer
price from any element in the interval [w1 , w2 ]. As in Horst [1971], the
firm always chooses one of the endpoints as its transfer price for tax pur-
poses. As in Horst, the endpoints are exogenous. However, the interval
itself could be completely disconnected from the underlying economics
of the model, whereas Horst’s range was from a low of marginal pro-
duction cost to a high of output price.
Diewert’s study focuses on the efficiency consequences of transfer
prices. He first characterizes the production decisions that maximize
firm income in a setting without taxes. The key feature in the model is
the existence of an intermediate good that a division operating in one
country produces and transfers to a division operating in a different
5.1. Transfer price discretion 23
country. He then examines the effect of taxes. Although the model

incorporates both income taxes and trade taxes, much of the focus is
on the special case in which trade taxes are zero [t1 = t2 = τ1 = τ2 = 0];
I will focus on this case as well. Even in the presence of different income
tax rates there exists a transfer price λ∗ at which the production choices
that were optimal in the setting without taxes are also optimal in the
presence of taxes, where λ∗ is the marginal cost of producing the good
that is transferred between divisions. Therefore, the tax authorities
could induce an efficient outcome in the context of Diewert’s model
if they were able to set w1 = w2 = λ∗ . If the transfer price differs
from λ∗ , the production plan that maximizes firm income in the setting
with taxes will not be the plan that maximized firm income without
taxes. Diewert correctly points out that tax authorities do not have the
information needed to determine marginal cost. Therefore, this result is
only useful as a benchmark case against which implementable transfer
pricing rules can be evaluated.
Diewert then considers the price at which (a) each division would
maximize profits independently and (b) supply would equal demand
for the intermediate good transferred between divisions in the absence
of trade taxes but in the presence of different income tax rates, which
Hirshleifer [1956] calls an arm’s length price. The arm’s length price will
not necessarily achieve the efficient outcome, however. The production
choices that maximize firm income must satisfy a second-order condi-
tion for the firm. If one of the divisions exhibits increasing returns to
scale, for example, a transfer price of λ∗ would satisfy each division’s
first-order condition, but would violate one of the divisions’ second-
order condition. If both divisions face convex technology sets, however,
the arm’s length transfer price will yield the efficient outcome.
Smith [2002a] also considers an interval of transfer prices, but one
in which the midpoint of the interval corresponds to one of the transfer
pricing methods (CUP or CPM). The firm can deviate from the mid-
point by φ ∈ [−Φ, Φ]; Smith refers to this ability to deviate as ex post
discretion. As in the Horst and Diewert models, the firm will always
choose one of the endpoints of the range in order to shift as much
income as possible to the country with the lower tax rate. Although Φ
is exogenous, the midpoint itself is influenced by the firm’s investment

in relationship-specific investments, which Smith calls ex ante discre-
tion. As in Diewert’s model, this implies that the transfer price is
endogenous, even though the degree of discretion is exogenous. This
is a much more compelling way to model firm discretion over transfer
prices, because the midpoint of the range has a meaningful connection
to the underlying economic features of the model. Furthermore, it per-
mits, but does not require, a much smaller degree of discretion than
that implied by the Horst and Diewert models.
De Waegenaere et al. [2012] take a similar approach to Smith. In
that study, value is generated by a tangible investment made by a
foreign subsidiary and an intangible investment made by a domestic
parent; the domestic parent faces a higher tax rate than does the foreign
subsidiary. If CPM is implemented perfectly, the subsidiary is allocated
enough income so that it earns an after-tax rate of return equal to
its cost of capital; the rest of the income should be allocated to the
U.S. parent. The parameter π measures the degree of compliance with
CPM, where π = 1 reflects complete compliance and π = 0 reflects
zero compliance. Zero compliance means the foreign country taxes all
income associated with the domestic intangible asset.
5.2 Two sets of books
Many studies in this literature examine the dual roles played by transfer
prices. One role is determining the allocation of taxable income within
an MNE. The other role is a mechanism by which divisions within
a vertically integrated firm with decentralized decision rights coordi-
nate their actions. These studies are of two types. One type constrains
the firm to using one transfer price for both external tax and internal
coordination purposes. The other type permits the firm to use differ-
ent transfer prices for external tax and internal coordination purposes.
I first review the leading papers in which firms are constrained to use
the same price for both purposes. I then review the leading papers in
which the prices are decoupled. Finally, I discuss the arguments for
both approaches.
5.2. Two sets of books 25
At one extreme is the approach that assumes that the price used
for external tax and internal coordination purposes must be identical.
This approach is adopted in Narayanan and Smith [2000]. In their set-
ting, the head office located in one country manufactures a product
and transfers it to a sales office in another country. The head office has
private information regarding production costs, whereas the sales office
has private information regarding demand for the product. Communi-
cation regarding private information is exogenously precluded. In one
setting, the firm is a monopolist; in a second setting, the firm engages
in Bertrand duopolistic competition with differentiated products.
The firm can choose whether to act in a centralized fashion or a
decentralized fashion. In a centralized firm, the head office chooses the
output price, the transfer price, and produces to meet demand. The
transfer price can be any value greater than the manufacturing cost and
less than the output price, as in Horst [1971]. The sales office makes no
decisions. Centralization implies that output price is chosen based on
expected demand, uninformed by the private information of the sales
office. In a decentralized firm, the head office chooses the transfer price,
but delegates the choice of output price to the sales office. The sales
office is evaluated on its own profits, and chooses the output price after
observing the transfer price and its private signal regarding demand
for the product.
When the firm is a monopolist and the tax rate in the manufactur-
ing country is weakly greater than the tax rate in the selling country,
operating in a decentralized fashion dominates operating in a central-
ized fashion and the transfer price is equal to the manufacturing cost. In
this case, the transfer price both signals marginal cost to the sales office
and allocates all taxable income to the country with the lower tax rate.
When the tax rate in the selling country is strictly greater than the tax
rate in the manufacturing country, the optimal transfer price for the
decentralized firm exceeds marginal cost, reflecting a tradeoff between
increasing pretax profits and trying to shift income to the manufactur-
ing country. In contrast, the centralized firm uses a transfer price equal
to the selling price, shifting all income to the manufacturing country.
It is optimal for the firm to centralize in that case if the uncertainty
of demand is sufficiently low, because the benefit of decentralization

arises because the sales office can base the output price on the actual
demand parameter as opposed to its expected value.
The tensions are similar in the duopoly setting, but are complicated
by the fact that the choice of transfer price also influences competition
in the product market. The authors analyze both the case in which
the rival can observe the organizational form and transfer price and
the case in which the rival can only make a conjecture regarding these
choices.
The opposite extreme approach is one in which external tax and
internal coordination transfer prices are decoupled. Baldenius et al.
[2004] consider a benchmark case in which the two transfer prices
are chosen independently. In their model, an upstream division in a
foreign country with a tax rate t transfers an intermediate good to
a downstream domestic division that faces a tax rate t + h, h > 0.
The domestic division chooses quantity q, the sale of which generates
revenue for the downstream division R(q) and cost for the upstream
division of C(q). The tax transfer price p is chosen from a range that
can depend on q, [ p(q), p(q)]. As in Diewert [1985], there is no func-
tional relation between the range of transfer prices and the underlying
economics of the setting. The domestic division is assumed to maxi-
mize after-tax divisional income. The internal transfer price TP(q) for
which the choice of q that maximizes divisional after-tax income also
maximizes the after-tax income of the firm as a whole is:
TP(q) = (1 − t)C(q) + tp(q). (5.1)
If instead the domestic division is evaluated on pretax income, the
internal transfer price is
1
TP(q) = [(1 − t)(q) − hp(q)]. (5.2)
1−t−h
The authors then compare the optimal decoupled transfer price to
the one that would be optimal if the two prices were constrained to
be the same. Conformity typically yields a lower transfer price than
the tax minimizing transfer price p(q), as the firm finds the optimal
compromise between maximizing pretax profits and striving to allocate
income to the low tax rate foreign country.
5.2. Two sets of books 27
Between these two polar opposites of complete conformity and

decoupling is a third approach in which the external and internal trans-
fer prices can differ, but deviating from the internal price is not permit-
ted under the tax law and, if detected upon audit by the tax authority,
will increase the firm’s taxes and incur penalties. Smith [2002b] consid-
ers a setting in which the internal transfer price is set so as to provide
the manager of a foreign subsidiary incentives to incur personally costly
effort so as to increase output. If the probability q of audit is sufficiently
high, the firm uses a single transfer price that reflects a tradeoff between
a desire to allocate taxable income to the country with the lower tax
rate and avoid a penalty. For lower values of q, the firm chooses either
the highest or lowest permissible external transfer price, but adjusts
its choice of the internal transfer price to decrease the probability that
a penalty will be levied for using different transfer prices. Therefore,
the main effect of transfer pricing regulation in this model is to impose
efficiency costs by deterring the firm from using the optimal internal
transfer price.
Hyde and Choe [2005] study a setting in which an upstream parent
in a low-tax country sells to a downstream subsidiary in a high tax
country, which then sells to consumers in the foreign country. The
parent chooses both the incentive (s) and tax (t) transfer prices. The
subsidiary chooses the quantity to purchase from the parent, and
is exogenously assumed to maximize its own after-tax profit, which
reflects both transfer prices. The subsidiary chooses the quantity to
purchase from the parent, and is exogenously assumed to maximize
its own after-tax profit, which reflects both transfer prices. The tax
law specifies an arm’s length price, a. The more by which the tax
transfer price deviates from the arm’s length price, the greater the
probability that the tax authority will penalize the firm. Given some
mild assumptions regarding the consequences of deviating from the
arm’s length price, the optimal tax transfer price lies on the interior of
the interval [a, a], where choosing the tax transfer price t = a ensures
that no penalty will be incurred and choosing t = a ensures that the
penalty will be incurred for certain. As penalty for deviating from
the arm’s length price increases, both transfer prices s and t decrease.
Therefore, a change in the tax environment affects both incentive and
tax transfer prices, and in the same way. In contrast, an increase in

the parent’s manufacturing costs causes the internal price s to increase
but the tax transfer price t to decrease.
This substantial body of academic research on transfer price con-
formity notwithstanding, the case supporting the claim that firms
face real costs from using different transfer prices for internal and
tax purposes is quite weak. First, neither the U.S. Treasury Regula-
tions nor the OECD Guidelines suggest that the transfer prices that
MNEs use for internal purposes have any effect at all on the determi-
nation of whether a transfer price used for tax purposes satisfies the
arm’s length standard. Second, survey evidence described by Spring-
steel [1999] states that 77% of companies with annual revenues in excess
of $2 billion use separate systems for tax and internal transfer pricing.
Third, Wilson’s [1993] field study looked specifically for evidence of fric-
tions between tax and incentive considerations in the area of transfer
pricing.
When the coordination frictions associated with transfer
pricing become large, firms have an incentive to develop
alternative mechanisms to motivate managers. To this end,
they can establish separate transfer prices for tax or man-
agerial purposes or use performance measures that do not
depend on transfer prices. All of the sample firms use one
of these alternatives. (emphasis added)
Mills [1998] finds that items that generate book-tax differences are
more likely to be associated with proposed IRS audit adjustments.
Some authors [e.g., Smith, 2002b] suggest that this is a cost of using
different transfer prices for tax and financial reporting purposes. How-
ever, Mills and Sansing [2000] show that in a game-theoretic tax com-
pliance model, although a positive correlation should exist between
proposed audit adjustments and book-tax differences, a positive corre-
lation should not exist between retained audit adjustments and book-
tax differences. The empirical evidence is consistent with both of these
predictions.
In short, the costs of using different transfer prices for internal
and tax purposes appear to be small. In fact, the use of multiple
5.3. Endogeneity of comparable uncontrolled prices 29
accounting systems in contexts other than transfer pricing is pervasive.

There are different depreciation rules for financial reporting, regular
tax, and alternative minimum tax purposes. Firms routinely deviate
from generally accepted accounting rules when measuring divisional
performance. For example, AT&T, Best Buy, Coca-Cola Company,
Directv, Kaiser Aluminum, and Whirpool Corporation use a modified
form of accounting earnings, economic value added (EVAr ) for perfor-
mance measurement [Zimmerman, 2014, p. 172]. EVAr , a registered
trademark of Stern Stewart & Co., deviates from generally accepted
accounting principles (GAAP) in that it capitalizes and amortizes inter-
nally developed intangible assets such as those created by research and
development, brand promotion, and employee training. It also measures
certain costs (bad debt expense, income tax expense) on a cash basis
rather than an accrual basis.
5.3 Endogeneity of comparable uncontrolled prices
Transaction based transfer pricing methods use prices, or profit indica-

tors derived from prices, arising from transactions between unrelated
parties to divide income earned by related parties. Example 1 in Treas.
Reg. §1.482-4(c)(4) describes a pharmaceutical company, USpharm,
licensing the right to sell a drug to a subsidiary in country X and to an
unrelated firm in country Y. Countries X and Y are quite similar, and
the licensing agreements are identical. Consequently, the royalty rate
between USpharm and the unrelated party in country Y is used when
allocating income between USpharm and its subsidiary in country X.
Halperin and Srinidhi [1996] consider a setting in which the opti-
mal royalty rate between USpharm and the unrelated firm operating in
country Y affects the licensee’s subsequent production decisions, and
thus reflects a tradeoff between the royalty per unit and the units pro-
duced. When the royalty rate is also used to allocate income between
USpharm and it subsidiary in country X, the optimal royalty changes.
In this setting, the allocation of income between USpharm and its for-
eign subsidiary is an endogenous choice variable, constrained only by
the fact that the same royalty rate must be used in each country.
An objection to this approach is that Treas. Reg. §1.482-

(1)(d)(4)(iii)(A)(2) provides that a transaction will not be considered
a reliable measure of an arm’s length result if one of the principal
purposes of the transaction is to establish an allocation of income for
a controlled transaction. Harris and Sansing [1998] invoke this regula-
tion when deriving the transfer price under the CUP method, explicitly
not allowing the manufacturing firm to consider how its choice of price
when transacting with an independent seller might affect the allocation
of income between the manufacturer and a related seller.
The example in the Treasury Regulations is of little help when
choosing between these two ways of modeling the transfer pricing rules.
In the example, 95% of sales are made to a controlled foreign subsidiary,
and only 5% of sales are made to an uncontrolled firm in a different
(albeit similar) country. In this extreme case, the price at which only 5%
of inventory is sold cannot be used to determine a transfer price for the
sale to the controlled foreign subsidiary. Whether that would continue
to hold if half the sales were made to each country is an open question.
Endogeneity is also a concern when applying the resale price and
cost-plus methods. Halperin and Srinidhi [1987] consider a setting
in which the gross profit margin from a comparable uncontrolled
transaction is derived from transactions that the MNE engages in with
unrelated parties. They analyze the case of a U.S. MNE in which the
U.S. tax rate exceeds the foreign tax rate. The U.S. parent firm buys a
product that is manufactured by its foreign subsidiary and resells it in
the U.S. The MNE faces decreasing marginal revenue and increasing
marginal costs. When the resale price method is used, the MNE
produces more than it would in the absence of taxes in order to reduce
the sales price to unrelated parties, and thus lower the gross profit
percentage and thereby increase transfer price on its purchases from
its foreign subsidiary. Similarly, when the cost-plus method is used,
the foreign subsidiary reduces its output to increase its gross profit
percentage and thus increase the transfer price on its sales to the U.S.
parent.
Schjelderup and Weichenrieder [1999] compare the CUP method
and CPM in a setting in which an upstream subsidiary operating in
5.4. Transfer pricing and investment incentives 31
a low tax rate country exports to a downstream parent operating in

a high tax rate country. Both transfer prices are endogenous. In their
model, demand for the downstream parent’s output is downward slop-
ing and the upstream subsidiary average costs are non-decreasing. They
assume that the comparable uncontrolled price equals marginal cost,
whereas the comparable uncontrolled profit method satisfies an average
profitability condition. These conditions imply that the transfer price
under the comparable profit method will be higher, and the quantity
transferred will be lower, relative to the comparable uncontrolled price
method. The authors suggest that basing transfer prices on average
profits rather than marginal costs is a instrument for a protectionist
trade policy rather than simply a mechanism for allocating taxable
income between countries.
5.4 Transfer pricing and investment incentives
Smith [2002a] studies the effect of transfer pricing rules on investment

incentives. A firm includes two affiliates, called the upstream and down-
stream divisions. One division is incorporated in and operates in the
U.S., whereas the other division is incorporated in and operates in a
foreign country. Each division can make a capital investment on date
zero that reduces its subsequent variable costs per unit, but only if it
transacts with its affiliate in the other country.
When the upstream and downstream divisions determine the trans-
fer price in accordance with the comparable profit method, whether
taxes distort the date zero capital investment decision depends jointly
on the difference in tax rates between the upstream and downstream
countries and whether tax depreciation is more or less generous than
economic depreciation. When tax and economic depreciation are the
same, the key condition (1 − tu )R∗ = ∆ is satisfied, where R∗ reflects
the cost of capital and D reflects depreciation.
To see that tax and economic depreciation are the same when this
condition is satisfied, consider an investment of $1100 on date zero that
generates pretax cash flows of $720 on dates one and two. Let the tax
rate of the upstream firm be 25% and the cost of capital be 15%. If the
depreciation expense on date one is $500 and the depreciation expense

on date two is $600, the project has zero net present value because:
$720 − 25%($720 − $500) $720 − 25%($720 − $600)
$1100 = + (5.3)
1.15 1.152
Furthermore, tax depreciation is the same as economic depreciation
because:
$720 − 25%($720 − $500)
$1100 − $500 = (5.4)
1.15
The pretax rate of return is 20% on each date, so:
20% 6 20% 1492

∗
(1 − 0.25)R = (1 − 0.25) + × = ≈ 0.1923 (5.5)
1.15 11 1.15 5819
and
5 6
11 11 1492
∆=1− − = ≈ 0.1923. (5.6)
1.15 1.152 5819
If tax depreciation exceeds economic depreciation, the upstream
division invests more on date zero if the upstream tax rate exceeds the
downstream tax rate, and invests less if the upstream tax rate is less
than the downstream tax rate. The reverse holds when tax depreci-
ation is less than economic depreciation. Similar results hold for the
downstream division.
The CUP method has qualitatively different effects on investment
than does the CPM in Smith’s model. Because the investments on date
zero are relationship specific, the benefits are assumed to be divided
evenly, irrespective of which party made the investment. This is an
instance of why the comparable uncontrolled price method need not
yield an arm’s length result.
Because the division that makes the investment will get all of
the depreciation deductions but only half of the benefits from the
investment, the CUP method induces more investment in the high
tax country and less investment in the low tax country, relative to the
benchmark case in which tax rate differences do not affect investment
decisions. Unlike CPM, the investment incentives are unaffected by
whether tax depreciation is more or less generous than economic
depreciation.
5.4. Transfer pricing and investment incentives 33
The preceding analysis assumes that the firm has no ability to devi-
ate from the transfer price implied by either the comparable profit
method or the comparable uncontrolled price method. If instead the
firm has some ex post discretion, it will use that discretion to shift
income to the lower-tax country. This in turn can either exacerbate or
mitigate investment distortions relative to the benchmark case with no
tax rate differentials.
De Waegenaere et al. [2012] study the effects of transfer prices on
investments in tangible and intangible assets. In their model, a large
number of firms make investments in research and development to
engage in a patent race. One of the firms wins the race, and subse-
quently makes a tangible investment that uses the patented technol-
ogy. Making the tangible investment in a low-tax rate foreign country
makes it possible for the MNE to shift income attributable to an intan-
gible asset developed in the high-tax rate domestic country unless the
domestic country can perfectly enforce the arm’s length allocation of
income implied by CPM. The greater the ability to deviate from the
arm’s length standard, the greater the incentive the firm has to locate
tangible investment in the foreign country.
The present value of taxes collected by the domestic country on
intangible investments depends on whether one looks at the winner
of the patent race or all firms that entered the race. Taxes collected
by the domestic country from the winner are positive. However, if one
considers all the firms that entered the race, the present value of the
domestic country’s tax collections is zero if the domestic country can
perfectly enforce the arm’s standard, and negative if the winner can
shift income attributable to the patent to the low-tax country.
In addition, deviating from the arm’s length standard increases
investment in research and development. This could increase or
decrease efficiency, because the privately optimal level of research and
development investments in a patent race could be either higher or
lower than the socially optimal level.
6
Transaction Cost Economics
6.1 Endogeneity of organizational structure
Transfers between affiliates of an MNE rarely involve standard com-

modity products. Coase [1937] argues that activities occur within firms
when the cost of coordinating economic activity via a market mecha-
nism exceeds the cost of coordinating economic activity within a firm.
As the transaction costs of transferring standardized commodity prod-
ucts is quite low, such a transaction is unlikely to occur within an
MNE in the first place. Buckley and Casson [1976] argue that vertically
integrated MNEs arise because the benefits of organizing transactions
within a firm outweigh the higher costs of production, communication,
and governance associated with vertical integration.
Williamson [1975, 1985] elaborated upon Coase’s insight and
contributed to the theory of transaction cost economics. One of
Williamson’s key contributions to this theory is the idea of relationship-
specific investments, which are those that create significantly more
value in the context of a specific trading partner. For example, a down-
stream manufacturer could make investments in assets with characteris-
tics that add value only when transacting with a specific upstream man-
ufacturer. In such settings, it makes sense for the two manufacturers to
34
6.2. Intangible assets 35
vertically integrate to guard against the upstream manufacturer obtain-

ing some of the quasi-rents associated with the downstream manufac-
turer’s relationship-specific investment.
6.2 Intangible assets
MNEs often own valuable intangible assets, because it is often difficult

to efficiently make use of intangible assets by transacting with indepen-
dent firms [Caves, 1982, pp. 3–6]. Dunning [1993] refers to this as the
O Factor in his OLI (ownership, location, internalization) paradigm.
For example, the transfer of a new, hard-to-patent technology to a
subsidiary would not have occurred with an unrelated party, because
unrelated firms do not engage in such transactions on competitive mar-
kets. So the hypothetical question, ‘At what price would related parties
agree if they had been unrelated?’ simply has no answer [Eden, 1998,
p.593].
Owning valuable intangible assets enables the firm to earn a rate of
return on its tangible assets that exceeds its cost of capital. Berry [1989]
argues that the owner of the valuable intangible property would retain
the entire economic benefit of the intangible. If the manufacturer owns
the intangible asset, competition among potential distributors would
drive their after-tax returns down to the cost of capital, leaving the
residual value in the hands of the manufacturer. This implies that man-
ufacturer’s gross profit percentage would reflect the value created by
the intangible asset, whereas the retailer’s gross profit percentage would
not. In this case, the resale price method, but not the cost-plus method,
should yield an arm’s length allocation of taxable income. Similarly, if
the distributor owns the intangible asset, competition among potential
manufacturers would drive their after-tax returns down to the cost of
capital, leaving the residual value in the hands of the distributor. In
this case, the cost-plus method, but not the resale price method, should
yield an arm’s length allocation of taxable income.
However, the owner of the intangible asset may not be able to cap-
ture all of its benefits. Consider a manufacturer whose valuable intangi-
ble property makes it a monopolist. If the manufacturing and retailing
36 Transaction Cost Economics
activities are carried out within a single firm, the production and pric-
ing strategy that maximizes firm income equates marginal revenue and
marginal cost. Now suppose instead that the manufacturer sells to an
unrelated retailer. Then the manufacturer will choose the wholesale
price that equates the manufacturer’s marginal revenue and marginal
cost, and the retailer will in turn choose the retail price that equates
the retailer’s marginal revenue and marginal cost, a process known
as double marginalization [Tirole, 1990, p. 174]. Double marginaliza-
tion yields a lower output and higher price relative to case in which a
vertically integrated firm performs both the manufacturing and retail-
ing functions. There are alternative arrangements that avoid double
marginalization (e.g., the manufacturer charges the retailer a fixed fran-
chise fee), but they have drawbacks of their own, such as inefficient risk
sharing. This is a simple illustration of how the effort to put “a con-
trolled taxpayer on a tax parity with an uncontrolled taxpayer” can
break down; the two affiliated entities are in a fundamentally different
economic relationship than are two independent firms. Establishing tax
parity between a controlled taxpayer and a corresponding independent
firm becomes impossible because the aggregate taxable incomes of the
two pairs of firms will likely differ, perhaps substantially.
Harris and Sansing [1998] explore this issue. In their study, a ver-
tically integrated group can avoid the double marginalization problem
that arises when both the manufacturing firm and selling firm can
exercise market power. However, they also consider the case in which a
local independent selling firm has private information regarding market
demand, and thus can base its output strategy on the realization of the
stochastic demand parameter. In contrast, the MNE can only base its
decision on expected demand.
The authors first investigate the distributional effects of using the
price that the independent manufacturer charges the independent seller
to allocate taxable income between members of the vertically integrated
group when tax rates are equal. They find that the manufacturer in the
vertically integrated group is allocated a higher gross margin per unit
than what its independent counterpart earns. In the special case of a lin-
ear demand curve, 100% of the profits are allocated to the manufacturer
within the vertically integrated group. This illustrates why using an
6.3. Returns to internalization 37
arm’s length price that would arise in a transaction between unrelated

parties need not yield an arm’s length allocation of profit when used
to allocate income between related parties.
The authors then consider the efficiency consequences of using the
CUP method when the tax rate that the manufacturer faces, tm ,
differs from the tax rate that the seller faces, ts . When tm > ts ,
using the CUP method can deter vertical integration because allo-
cating more income to the manufacturer makes vertical integration
more costly. When tm < ts , using the CUP method can induce vertical
integration.
6.3 Returns to internalization
Langbein [1989] argues that the benefits of vertical integration arise

due to the organizational form itself, and not any particular factor of
production that has a physical location. Because the Treasury Regula-
tions interpreting §482 have a production cost orientation as opposed
to a transaction cost orientation, the framework underlying the trans-
fer price rules is poorly suited to allocating income within a verti-
cally integrated group designed to economize on transaction costs. In a
production cost framework, the allocation of income is determined by
identifying the location of a firm’s factors of production and assigning
value to them. But if economizing on transaction costs creates value,
the resale price method effectively allocates all synergies attributable
to vertical integration to the upstream manufacturer, as the down-
stream retailer is assigned a profit margin that unrelated parties that
do not benefit from vertical integration receive. Similarly, the cost-plus
method assigns all synergies to the downstream retailer.
Brem [2004] makes a similar argument. Value is created in a ver-
tically integrated MNE by coordinating transactions more efficiently
than what independent firms accomplish. The arm’s length approach
simply cannot capture this difference. He says:
Looking at transfer pricing through the lens of eco-

nomic and industrial organization theory shows that the
arm’s-length approach neglects fundamental insights from
transaction cost economics (TCE). . . TCE is built on the

notion that the coordination and exchange of transac-
tions. . . is not cost-free but related to transaction costs.
The theory of transaction cost economics is that transactions are

organized within firms in order to economize on transaction costs.
These costs include the concern that unrelated parties will act oppor-
tunistically, and that the costs of opportunism can be mitigated when
both parties are part of the same firm. Dunning [1993] refers to this as
the ‘I’ (internalization) factor that explains the existence of vertically
integrated MNEs. Independent firms will underinvest in relationship-
specific assets, because some of the benefits from such investments will
accrue to the other party unless the parties can credibly commit to their
future actions. For example, it may be efficient for an upstream supplier
to invest in production technologies that benefit a specific downstream
user. But if the two firms cannot write a contract that specifies all
future contingencies, the supplier will be in a weak negotiating posi-
tion to the extent the investments are only worthwhile to this specific
downstream user, which is called the hold-up problem. This induces
under-investment in relationship-specific assets.
Vertical integration mitigates the hold-up problem. But the fact
that the choice of organizational form itself creates value creates con-
ceptual difficulties for a production cost orientation. To which taxing
jurisdiction should one assign the value attributable to organizational
form? Langbein [1989] argues that separate ownership of components
of a vertically integrated group would threaten appropriation or other
hazards to the business, which would destroy value. The value is pre-
served via the organizational structure itself. Lev [2001, p. 6] mentions
“organizational capital” as a type of valuable intangible asset. But how
should the returns to organizational capital be allocated among politi-
cal jurisdictions for tax purposes?
This question is addressed at length in Wittendorf [2010] in Section
9.1.2 (for the U.S. tax law), 9.2.2 (for the OECD Guidelines), and 18.2.2
(relating to the definition of intangible assets). The Supreme Court
discusses the issue when upholding the use of formulary apportionment
in Container Corp. of America v. Franchise Tax Board.
[Whenever] a unitary business exists, separate accounting,

while it purports to isolate portions of income received in
various States, may fail to account for contributions to
income resulting from functional integration, centralization
of management, and economies of scale. Because these fac-
tors of profitability arise from the operation of the business
as a whole, it becomes misleading to characterize the income
of the business as having a single identifiable “source.”
As Langbein [1986] points out, the ‘production cost’ orientation in the

U.S. Treasury Regulations does not deal well with income that arises
because of ‘transaction cost’ efficiencies. The Court of Claims made
clear in Merck & Co. v. United States that value created via organiza-
tional structure does not represent an intangible asset.
Organizational structure is not listed in the regulation as a

recognized, independent item of intangible property. Orga-
nizational structure, without more, is not included in the
concept of an enforceable property right that would sup-
port arm’s length license agreement. . . The ‘methods’ ‘pro-
grams,’ and ‘procedures’ involved in such organizations are
not recognized as embodying rights to property so as to
qualify under the regulation as intangible property with
independent value.
Paragraph 2.113 of the OECD Guidelines mentions the division of

returns from organizational structure as being a reason for favoring the
profit-split method, acknowledging the inherent arbitrariness involved
when dividing the returns to organizational structure.
A further strength of the transactional profit split method is

that it is less likely that either party to the controlled trans-
action will be left with an extreme and improbable profit
result, since both parties to the transaction are evaluated.
This aspect can be particularly important when analyzing
the contributions by the parties in respect of the intangi-

ble property employed in the controlled transactions. This
two-sided approach may also be used to achieve a division of
the profits from economies of scale or other joint efficiencies
that satisfies both the taxpayer and tax administrations.
Eden [1998, p. 621] refers to profit-split methods as the “ugly duckling”

of transfer pricing methods, “ignored and scorned by the tax author-
ities.” Nevertheless, judges often use profit-split method to resolve
transfer price cases according to Wittendorf [2010, p. 39].
Both U.S. Treasury Regulations [§1.482-6(c)] and the OECD Guide-
lines [Paragraph 2.121] describe the profit-split method as a two-stage
process. In the first stage, income is allocated to each party to the trans-
action to compensate it for “routine contributions.” The U.S. Treasury
Regulations then indicate that any profit in excess of the compensa-
tion for routine contributions should be allocated on the basis of the
parties’ contributions of non-routine intangible property [Treas Reg.
§1.482-6(c)(B)]. The OECD Guidelines suggest the division of residual
profit on the basis of relative contributions of assets, capital, or costs
[Paragraph 2.135].
Sansing [1999] examines the implications of using the price at which
two independent firms transfer goods to divide the income between the
domestic parent and foreign subsidiary of a U.S. MNE. That study
examines the special case in which the tax rates of the two countries
are equal, so as to focus on distributional issues rather than efficiency
issues. The benefits of vertical integration are in the form of higher
relationship-specific investments. The costs are in the form of informa-
tion rents that accrue to the manager of the subsidiary in an Antle and
Eppen [1985] capital rationing model.
In Sansing’s model, each member of the controlled group makes
higher investments in relationship-specific investments than does its
independent counterpart. CPM allocates more taxable income to the
parent and less to the subsidiary relative to the CUP method because
the parent bears the larger share of the cost of making relationship-
specific investments.
This study demonstrates that using a price that arises from an

interaction between two independent firms need not yield an allocation
of taxable income that satisfies the arm’s length standard, because
the members of the controlled group make different investments in
relationship-specific assets that do independent firms.
7
Tax Compliance Models
7.1 Transfer price inconsistency
Most transfer pricing models assume that the transfer price used, how-
ever it is derived, will be the same for calculating the income of each
related party. In practice, however, double taxation due to different
countries using different transfer prices is common. Although govern-
ments are supposed to use competent authority procedures when cases
of double taxation arise, there is no requirement that the governments
arrive at a compromise that prevents double taxation. Survey evidence
indicates that 47% of parent firms have had transfer price adjustments
that result in double taxation since 2009 [Ernst and Young, 2013].
According to the 2007 Ernst & Young survey [Ernst and Young, 2007,
p. 3]:
Inconsistencies in the interpretation and application of

information, as well as the underlying transfer pricing rules
themselves, continue to cause incompatible compliance bur-
dens and risk of double taxation. U.S. taxpayers, for exam-
ple, are required to include stock-based compensation in
the cost base when applying cost- or profit-based methods,
42
7.2. Advance pricing agreements 43
but many other countries do not accept this treatment

of stock-based compensation as being consistent with the
arm’s-length standard.
Two studies have analyzed transfer price inconsistency. De Waegenaere

et al. [2006] include the possibility that two countries will assert the
right to tax the same income in their strategic tax compliance model.
Although in many cases the possibility of double taxation increases the
firm’s expected tax liability, it is possible for the firm’s expected tax
liability to decrease as the probability p of double taxation increases.
This occurs because an increase in p can induce the firm to report
more aggressively, i.e., increase the probability of incorrectly reporting
income to the low-tax country. The tax savings from successfully engag-
ing in income shifting more than offsets the tax losses when double tax-
ation does occur. It is also possible for an increase in p to decrease the
expected audit costs incurred by governments. Because an increase in
p can both increase expected government tax collections and decrease
expected audit costs, we would not expect governments to coordinate
their transfer pricing rules closely in those cases.
De Waegenaere and Sansing [2010] examine the effect of transfer
price inconsistency on firm investment decisions. In that model, pro-
ductive efficiency is attained when the tax rate on domestic investment
is equal to the combined domestic and foreign tax rate on foreign invest-
ment. Transfer price inconsistency could either move the combined tax
rate on foreign investment closer to or further away from the domes-
tic tax rate, and thus the presence of inconsistent transfer prices could
either increase or decrease productive efficiency. Transfer price inconsis-
tency can arise endogenously in their model when each country chooses
its transfer prices non-cooperatively in an attempt to maximize its own
welfare, even if this effort decreases aggregate social welfare.
7.2 Advance pricing agreements
An institutional arrangement that has arisen recently to prevent dou-

ble taxation is the bilateral advance pricing agreement (BAPA). In a
BAPA, the MNE and all governments with taxing jurisdiction with
44 Tax Compliance Models
respect to a transaction agree upon a method by which the income

from the transaction will be taxed before the transaction takes place.
This prevents costly audits and double taxation.
Tomohara [2004] claims that BAPAs induce inefficient production
outcomes. This model features a MNE that produces an intermediate
good in its home country and sells it to an affiliate in a foreign country.
The affiliate is a monopolist in the foreign country. The study concludes
that a BAPA is inefficient because unless the tax rates in the two
countries are equal or if the intermediate good is transferred at its
production cost, because otherwise the equilibrium output quantity is
different from the quantity that would maximize pretax profits. This
conclusion is puzzling in two respects. First, maximizing pretax profits
need not be economically efficient, because efficiency should include
consumer surplus; pretax profits just includes producer surplus and
tax collections. Second, comparing output under a BAPA to output in
absence of taxation is not the right comparison; the relevant comparison
is output under a BAPA to output under MNE taxation in absence of
a BAPA, which the author does not model.
De Waegenaere et al. [2007] study BAPAs in the context of a strate-
gic tax compliance game. In the absence of a BAPA, the MNE reports
its income to two countries, each of which can engage in a costly audit
of the taxpayer’s report. Alternatively, the taxpayer can approach the
two governments and propose a BAPA which, if adopted, prevents the
taxpayer from being subjected to double taxation and reduces audit
costs. The study finds that a decrease in expected tax compliance costs
is a necessary but not sufficient condition for a BAPA to arise. It also
finds that a BAPA is less likely to occur when the tax rates of the
two countries are close, because the audit probability by the high-tax
country is increasing in the difference between tax rates. The study also
predicts that high-tax rate countries will most aggressively promote the
use of BAPAs because if a firm could propose a BAPA but does not do
so, this failure to propose a BAPA provides useful information to the
high-tax country regarding the firm’s private information.
8
Formulary Apportionment
The difficulties in applying the arm’s length standard in a system of

separate accounting has led some to advocate an alternative based on
formulary apportionment, in which an MNE’s income is apportioned
among countries on the basis of a formula. Before the system of separate
accounting became established, systems involving formulary apportion-
ment were in use. For example, Austria, Hungary, and Czechoslovakia
used formulary apportionment to allocate income among those three
countries Langbein [1986, p. 632]. Formulary apportionment has long
been used to tax business income that crosses sub-national borders,
such as the U.S. states and the Canadian provinces. More recently,
European firms that elect to use the Common Consolidated Corporate
Tax Base (CCCTB) system allocate income among European countries
using formulary apportionment.
Avi-Yonah and Clausing [2008] propose that the U.S. unilaterally
adopt a system of formulary apportionment, using the destination of
sales to allocate income. Avi-Yonah et al. [2009] proposed a variation in
which each entity is assigned a normal market return on its expenses
incurred in a country, with only the residual profit allocated on the
basis of the destination of sales.
45
46 Formulary Apportionment
They argue that a system of separate accounting based on arm’s

length pricing cannot yield sensible results, in part because of the prob-
lem of allocating income attributable to organizational capital.
Theories of MNEs emphasize that they arise in part due

to organizational and internalization advantages relative to
purely domestic firms. Such advantages imply that profit
is generated in part by internalizing transactions within
the firm. Thus, with firms that are truly integrated across
borders, holding related entities to an arm’s length stan-
dard for the pricing of intracompany transactions does not
make sense, nor does allocating income and expenses on a
country-by-country basis.
The authors favor destination sales formulary apportionment

(DSFA) on the grounds that customers are less mobile than inputs
such as assets or employees. They acknowledge the arbitrariness of this
approach. For example, if a country produces in country X and sells in
country Y, country Y would tax all of the income even though most
or all of the value is created in country X. However, allocating income
based on the destination of sales may well be less arbitrary than the dis-
proportionate allocation of income to low-tax rate countries observed
in practice under separate accounting. Finally, the authors conjecture
that other countries would find it to be in their economic self-interest
to also adopt a destination sales formulary apportionment system.
Morse [2010] offers several arguments against DSFA. One important
issue is that the measurement of the sales factor is easy to manipulate,
as it depends on where the goods are delivered or where title passes.
This is particularly important in the case of business-to-business sales,
where again the location of the “customer” depends on the endoge-
nously chosen organizational structure of the firm. If a U.S. MNE sells
all of its output to an independent distributor located in Ireland, all of
its income would be taxed in Ireland even if the distributor then sells
to customers throughout the world. Klassen and Shackelford [1998]
highlight the importance of understanding the institutional details of
formulary apportionment systems that use the sales factor.
47
It is also not clear that other countries will follow the U.S. lead.
Anand and Sansing [2000] show that U.S. states with high levels of
natural resource income have not increased the weight on the sales
factor in their apportionment formulas, even though other states have.
Finally, the OECD [2010] is strongly opposed to formulary appor-
tionment. Paragraph 1.25 of the OECD Guidelines states:
One such concern is that predetermined formulae are arbi-

trary and disregard market conditions, the particular cir-
cumstances of the individual enterprises, and management’s
own allocation of resources, thus producing an allocation of
profits that may bear no sound relationship to the specific
facts surrounding the transaction.
Paragraph 1.32 offers an unequivocal rejection of formulary apportion-

ment.
For the foregoing reasons, OECD member countries reiter-

ate their support for the consensus on the use of the arm’s
length standard that has emerged over the years among
member and non-member countries and agree that the the-
oretical alternative to the arm’s length principle represented
by global formulary apportionment should be rejected.
9
Future Research
In this section, I discuss two promising but yet unexplored avenues for
future research. Both relate to the transaction cost economics perspec-
tives discussed in Section 6 of this monograph.
9.1 Methods of shifting income from intangible assets
Section 3.2 of this monograph summarizes the empirical research that

suggests MNEs with high levels of intangible assets are the most suc-
cessful at shifting taxable income to lower tax rate jurisdictions. A
rich area for future research is the set of techniques that MNEs use to
shift intangible income. For example, MNEs sometimes use cost sharing
arrangements (CSAs), in which both the costs and benefits of devel-
oping intangible assets are shared between affiliated firms operating in
different countries. The regulations governing CSAs are quite extensive
[Treas. Reg. §1.482-7]. Chapter 8 of the OECD Guidelines covers these
arrangements, which the OECD calls cost contribution arrangements
(CCAs).
MNEs also use complicated structures such as “Double Irish”
and “Dutch Sandwich” structures to reduce the tax on income from
48
9.2. Allocating the returns to organizational capital 49
intangible property [Sokatch, 2011]. Incorporating institutional fea-

tures such as CSAs or complicated ownership structures into models
of international taxation may yield important insights both into the
behavior of MNEs and the merits of alternatives to separate account-
ing, such as formulary apportionment.
9.2 Allocating the returns to organizational capital
As is discussed in Section 6.3, organizational capital is an important

source of value for MNEs, as it helps reduce transaction costs. The
U.S. Treasury Regulations and the OECD Guidelines adopt a produc-
tion cost perspective, which is poorly suited to allocate the income
attributable to lower transaction costs. What is needed is a way to
incorporate returns to organizational capital into the existing concep-
tual framework of the arm’s length standard.
An alternative is to conclude that it is simply not possible to fit
returns to organizational capital into the existing framework. To the
extent that such returns should be allocated under the profit-split
method, as the OECD Guidelines suggest, the arm’s length standard
is really a hybrid system in which returns to organizational capital
are in effect allocated on the basis of formula apportionment, with the
basis for dividing residual profit (e.g., assets or costs) representing the
formula weights.
10
Conclusions
The empirical work on transfer pricing strongly suggests that firms

are able to shift taxable income from countries with high tax rates to
countries with low tax rates. Firms with valuable intangible assets are
particularly adept at shifting income to low-tax countries.
The theoretical literature reflects many different approaches and
perspectives. Two key insights stand out. First, the use of separate
accounting with transfer prices based on the arm’s length standard
works well in an environment in which value is created by investing in
tangible capital with a clear physical location. The modern MNE cre-
ates value by investing in intangible assets and economizing on trans-
actions costs, and neither intangible assets nor organizational capital
has a clear physical location. Therefore, the traditional method of allo-
cating taxable among countries is poorly suited to the economics of the
modern MNE.
Second, using a price that arises in a transaction between unre-
lated parties to allocate income within a vertically integrated group
can yield an allocation of taxable income that is not consistent with the
arm’s length standard. This occurs because the different organizational
structures induce the two sets of firms to make different investment
50
51
and operating decisions. Because the arm’s length standard is properly

understood as being defined in terms of profit rather than price, the
price used by unrelated parties may not yield an allocation of taxable
income that satisfies the arm’s length standard.
Two approaches often seen in the theoretical literature are partic-
ularly hard to justify. First, models in the economics literature often
treat the cost of equity capital as a tax-deductible cost. These models
only tax an equity investment’s abnormal return instead of both the
normal and abnormal returns. Although this approach is analytically
tractable, it is substantively misleading. Second, a large literature is
based on the premise that it is costly for a firm to use one transfer
price for tax purposes and another transfer price for internal decision-
making purposes. The empirical work in this area does not support this
premise.
Acknowledgements
I thank Lisa De Simone for helpful comments.
52
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International Transfer Pricing: Income Shifting and Tax Avoidance

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Foundations and Trends

International Transfer Pricing

3 Evidence of Income Shifting 12

4 Transfer Pricing Fundamentals 16

6 Transaction Cost Economics 34

6.2 Intangible assets . . . . . . . . . . . . . . . . . . . . . . . 35

7 Tax Compliance Models 42

International transfer pricing determines how the worldwide income of

R. Sansing. International Transfer Pricing. Foundations and Trends

This monograph reviews international transfer pricing. Taxable income

briefly summarizes the development of the international tax regime

A third set of papers examines the endogeneity of a comparable

Section 8 describes formulary apportionment, with particular emphasis

Although mechanisms to prevent double taxation by different political

Pricing [U.S. Department of the Treasury, 1988] describing methods

some base. Paragraph 2.97 of the OECD transfer pricing guidelines

As a matter of principle, only those items that (a) directly

Treasury Regulation §1.482-5(b)(1) states, in part, that:

Comparable operating profit is calculated by determining a

the OECD Guidelines states:

As a result, where, taking account of the criteria described

3.1 Aggregate data

There is strong empirical evidence in favor of the proposition that firms

3.2 Intangible assets

Income from intangible assets is easier to shift to low-tax jurisdictions

3.3 Product level data

4.1 Price or profit?

Although much of the accounting and economics literature focuses on

Section 482 places a controlled taxpayer on a tax parity with

Treas. Reg. §1.482-1(b)(1) states:

In determining the true taxable income of a controlled tax-

the results that would have been realized if uncontrolled

4.2 Economic profits or accounting profits?

Income taxes are levied on accounting measures of revenue and costs.

This formulation implies that pq − C(q) is the firm’s pretax profit.

4.3 Economic costs or accounting costs?

The cost-plus method determines an arm’s length price by adding

5.1 Transfer price discretion

Many transfer pricing models view the transfer price as a strategic

country. He then examines the effect of taxes. Although the model

is exogenous, the midpoint itself is influenced by the firm’s investment

5.2 Two sets of books

of demand is sufficiently low, because the benefit of decentralization

Between these two polar opposites of complete conformity and

tax transfer prices, and in the same way. In contrast, an increase in

accounting systems in contexts other than transfer pricing is pervasive.

5.3 Endogeneity of comparable uncontrolled prices

Transaction based transfer pricing methods use prices, or profit indica-

An objection to this approach is that Treas. Reg. §1.482-

a low tax rate country exports to a downstream parent operating in

5.4 Transfer pricing and investment incentives

Smith [2002a] studies the effect of transfer pricing rules on investment

depreciation expense on date one is $500 and the depreciation expense

6.1 Endogeneity of organizational structure

Transfers between affiliates of an MNE rarely involve standard com-

vertically integrate to guard against the upstream manufacturer obtain-

6.2 Intangible assets

MNEs often own valuable intangible assets, because it is often difficult

arm’s length price that would arise in a transaction between unrelated

6.3 Returns to internalization

Langbein [1989] argues that the benefits of vertical integration arise

Looking at transfer pricing through the lens of eco-

transaction cost economics (TCE). . . TCE is built on the