Keeping Two Sets of Books : The Relationship between Tax & Incentive Transfer Prices

This paper studies two distinct roles that transfer prices play within multinational enterprises operating in two tax jurisdictions. Assuming that the multinational enterprise chooses one transfer price for tax purpose and another for providing incentives to its subsidiary's manager, we analyze the relationship between these two transfer prices. The two transfer prices are independent if taxable income is assessed based on the formula apportionment approach in both jurisdictions. Under the separate entity approach, however, they are interdependent: they both decrease as the expected penalty for noncompliance with the arm's length principle increases; the tax transfer price decreases and the incentive transfer price increases as the marginal cost of production increases. We also study how the relationship changes depending on whether the incentive transfer price is negotiated or dictated by the parent company. Our results are shown to be robust to different market and tax environments