Transfer Pricing

Transfer pricing is an accounting practice employed by multinational companies to minimize their global tax obligation (see discussion of this topic in Virtual Organization). A company can book profits in low tax countries and claim expenses in high tax countries. Suppose, for example, a car manufacturer has plants in the US and Mexico and that the US tax rate is higher than that of Mexico. The US plant could buy some components from its sister plant in Mexico, paying a price (set by accountants at headquarters) above its own cost of production. This ploy would have the effect of reducing profits in the US (a high tax venue) and raising them in Mexico (a low tax venue) without changing the overall revenue of the company. The benefit is a lower tax bill. Thus, the company gets the best of both tax worlds with a simple accounting trick.

This practice is not new. Barnet and Muller documented it in Global Reach, nearly forty years ago. The current financial crisis is responsible for renewed interest in transfer pricing, because governments are desperately seeking to increase tax revenues. The New York Times reports that “the charity Christian Aid, which is concerned with the effect [of transfer pricing] on developing countries, estimated that governments lose $160 billion a year when companies working across borders misapply the rules” (NYT, Jan. 4, 2010). According to Bloomberg news “Transfer pricing lets companies such as Forest, Oracle Corp., Eli Lilly & Co. and Pfizer Inc., legally avoid some income taxes by converting sales in one country to profits in another — on paper only, and often in places where they have few employees or actual sales” (bloomberg.com, May 13, 2010).

Disputes over transfer pricing are symptomatic of intensifying conflict between national governments and global companies. Indeed, these disputes reflect a struggle for economic and political dominance. Just as kings gained the upper hand over landed aristocracies with the progress of industrialization in the early modern period, global firms are gaining political power at the expense of existing national governments. The reasons are similar: kings won out because wealth shifted from possessors of land to possessors of factories; multinationals will eventually win the game because wealth is shifting from static resources to dynamic resources, i.e., wealth is becoming increasingly global in scope. The shift in power will be a slow process; governments are not yet toothless tigers, and can fight back against the multinationals. But the ultimate outcome is not in doubt – a new political economy resembling the pre-modern feudal system is in the making (see Virtual Organization, chapter 8).

One of the great ironies in history is the inability of entrenched power to anticipate basic change in the conditions of economic and political life. The Bourbon kings’ proverbial failure to forget and their inability to learn led to the French Revolution in which at least one of them lost a head. The Maginot Line, erected by the French to deter German aggression after World War I, has become symbolic of the failure to anticipate altered conditions of warfare. French strategic military thinking in the 1920s was guided by the experience of the static confrontations of massed forces characteristic of the First World War, and failed utterly to take account of the innovations in mobile, lightning warfare perfected by the Germans in the period between the world wars.

Contemporary governments are making the same kinds of fatal errors in dealing with global companies. Based on past experience, governments are trying to control the activities of multinationals through fiscal and monetary policy. But these companies are more agile and innovative than governments and are able to circumvent control measures. Occasionally they are excessively clever and carry things too far as did Enron by using virtual organization to obfuscate their financial condition. Such excesses bring down the wrath of government on particular firms but do not alter the basic shift of power to global business.

Transfer pricing is a powerful element in a global company’s bag of tricks, and like sophisticated financial instruments it can be modified to overcome restrictions that governments might impose. The current furor triggered by the recent precipitous decline in government revenues will run its course and transfer pricing will continue to serve the interests of global business.