April 24, 2014

One Book or Two?

The link between tax liability and internal pricing.

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In large multinational firms with many divisions, tax planning and internal supply chain pricing are usually treated as distinct issues that address two different problems: how to minimize tax liability and how to ensure efficient internal pricing. The corresponding conventional wisdom is that firms need keep two sets of books, one for tax reporting and another for internal accounting, reflecting the transfer prices different divisions within a firm charge for their internal supply chain goods.

Decoupling, as the practice is known, usually means that transfer prices reflected on a firm’s tax return are different from the transfer prices the firm uses to set the right internal incentives and evaluate its business performance, including how costly and profitable its intra-division transfers are.

But treating the two as separate can be a warning sign for many nations’ tax authorities, who may want to know why a multinational firm is using tax reporting numbers that don’t reflect its true internal pricing and overall economic and financial condition. Even in less stringent tax jurisdictions, where two sets of books won’t set off alarms, internal transfer pricing has to account for tax rate differences among jurisdictions. Complicating internal price setting is that most countries require firms to charge a reasonable arms-length price — a price comparable to what the firm would pay for the same goods or services on the open market.

“Tax expenses are part of the cost of doing business,” says Professor Moritz Hiemann, a specialist in managerial and financial accounting. “So if you have different tax rates between jurisdictions in which you’re doing business, and you have different divisions in different countries, and a range of acceptable arms-length prices, then differences in those tax rates will also affect your optimal production choices, including internal pricing.”

Hiemann worked with Stefan Reichelstein of Stanford University, a renowned economist and expert in managerial accounting, to analyze different tax and internal pricing scenarios for a range of large multinationals. Their analysis shows how internal pricing should relate to allowable arms-length prices and suggests that firms treat the two as related, interdependent issues. “Decoupling can be beneficial because it provides flexibility to differentiate internal transfer prices from those allowed by tax rules,” Hiemann says. “But the optimal transfer prices are dependent on the various applicable tax rules, because they contribute to the cost of doing business, and affect the optimal amounts of goods to be transferred and sold.”

Consider a firm that wants to minimize its tax liability and produces an intermediate product in North America that gets transferred to a parent company in Europe for use in an end product. The amount of product transferred to Europe becomes a cost to the European firm. The higher tax rate in most European countries provides a high benefit because that cost can be deducted on each tax return. “For tax purposes, a higher transfer price is desirable,” Hiemann says. “But the optimal internal transfer price is determined jointly by the tax benefits and by other economic factors, such as the production cost the North American subsidiary incurs. The higher the allowable tax transfer price and the larger the difference in tax rates between the two jurisdictions, the lower the after-tax cost of the product to the company. So, all else constant, an increase in either means the firm should transfer more product to Europe.” Internal pricing issues are especially sensitive when it comes to intangible assets like copyrights, patents, and other intellectual property, he says, because intangibles are so easy to transfer across borders but so difficult to value.

Firms that choose to incur the added expense of decoupling, says Hiemann, must recognize that their transfer prices and reported arms-length prices are not independent. “In each set of books,” Hiemann says, “the internal transfer price will be a function of the transfer price allowable under the tax system.”

Moritz Hiemann is Assistant Professor of Business in the Accounting Division at Columbia Business School.

Read the Research

Hiemann, Moritz, and Stefan Reichelstein. “The Dual Role of Transfer Prices in Multinational Firms: Divisional Performance Measurement and Tax Optimization.” European Financial Review, October, 2013.