Title

Transfer pricing, incentive compensation and tax avoidance in a multi-division firm

Keywords

Incentive compensation; Tax arbitrage; Transfer pricing

Abstract

This article examines the relation between transfer pricing and production incentives using a model of a vertically integrated firm with divisions located in different tax jurisdictions. We show that if divisional profits are taxed at the same marginal rate, the transfer price should be set to minimize the compensation risk faced by the manager ofthe buying division. For the case where divisional profits are taxed at different marginal rates, we are able to characterize the trade-off between the tax savings from setting transfer prices to reduce profitability in the high tax jurisdication and the loss of effort attributable to the impact of tax avoidance on the incentive compensation system. Further, we show that if it is feasible to compensate the division managers using multiple performance measures, the transfer price should be used to minimize the firm's overall tax liability. Finally, we show that when authority to determine the transfer price must be delegated to one of the division managers, it is optimal to assign responsibility for setting the transfer price to the manager ofthe division with the most production uncertainty. © 1998 Kluwer Academic Publishers.

Publication Date

1-1-1998

Publication Title

Review of Quantitative Finance and Accounting

Volume

11

Issue

2

Number of Pages

139-164

Document Type

Article

Personal Identifier

scopus

DOI Link

https://doi.org/10.1023/A:1008216216943

Socpus ID

54649084466 (Scopus)

Source API URL

https://api.elsevier.com/content/abstract/scopus_id/54649084466

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