Review of Accounting Studies, 4, 119–134 (1999)
1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Relationship-Speciﬁc Investments and the
Transfer Pricing Paradox
Tuck School of Business at Dartmouth, 100 Tuck Hall, Hanover, NH 03755
Abstract. The revised Treasury Regulations interpreting Internal Revenue Code §482 allow the use of proﬁt-
based transfer pricing methods, as well as the older methods based on prices from comparable transactions between
independent parties. This paper compares the effects of price-based and proﬁt-based transfer pricing methods
on the allocation of taxable income in a model in which organization structure affects the level of relationship-
speciﬁc investments made by vertically integrated groups and comparable independent ﬁrms. Analysis of the
model shows that the price-based methods systematically allocates more taxable income to foreign subsidiaries
and less to domestic parents than does the proﬁt-based method.
Using a model in which differences in organization structure induce different investment
choices, I show that transfer pricing methods based on the price charged by independent
ﬁrms results in controlled foreign subsidiaries being allocated a greater amount of income
(relative to its assets) than its domestic parent. The model implies that the current dispute
between the Internal Revenue Service (IRS) and its foreign counterparts regarding the
acceptability of the comparable proﬁt method of determining transfer prices is consistent
with the desire of each tax authority to maximize its own tax revenues in transfer pricing
disputes involving U.S. parents and foreign subsidiaries.
Much international trade occurs between related parties. U.S. parent ﬁrms exported $86
billion of merchandise to foreign afﬁliates in 1989, which accounted for 24 percent of
total U.S. exports for that year. These U.S. parent ﬁrms imported $72 billion from foreign
afﬁliatesin1989, accounting for 15 percent of all U.S.imports. Trade between U.S. afﬁliates
of foreign parents is also large, accounting for $40 billion of U.S. exports and $133 billion
of U.S. imports for 1989 (Hufbauer, 1992).
The allocation of income between a parent corporation and its subsidiary depends on
the prices at which intermediate goods are transferred between the producer (the upstream
ﬁrm) and the user (downstream ﬁrm) of the intermediate goods. When the entities operate
in different countries, the transfer price determines how much of the income earned by the
joint efforts of the two entities is taxed in each country.
Previous theoretical research on international transfer pricing has focused on questions
of efﬁciency. Papers in this tradition include Copithorne (1971), Horst (1971), Diewert
(1985), Eden (1985), Halperin and Srinhidi (1987, 1996), Sansing (1996), and Harris and
Sansing (1998). In contrast, this paper focuses on the distributional effects of transfer pric-
ing rules instead of their efﬁciency effects. I ask how taxable income is divided between the
United States and a foreign country given certain transfer pricing rules. The transfer pricing
rules have no efﬁciency effects in this model because I assume that (i) each government