Review of Quantitative Finance and Accounting, 11 (1998): 139–164
© 1998 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Transfer Pricing, Incentive Compensation and Tax
Avoidance in a Multi-Division Firm
YOON K. CHOI
Dept. of Finance, University of Central Florida
THEODORE E. DAY
School of Management, University of Texas at Dallas, Richardson, Texas 75083-0688.
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 of the 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 of the division with
the most production uncertainty.
Key words: Incentive compensation, tax arbitrage, transfer pricing
Transfer pricing decisions in vertically integrated organizations may have a signiﬁcant
impact on the incentive compensation received by the division managers. This will be the
case whenever the fraction of divisional sales or purchases resulting from intraﬁrm trans-
actions is sufﬁciently large that the transfer price has a signiﬁcant impact on divisional
proﬁts. To the extent that the unconsolidated proﬁts of the division are used to determine
a manager’s incentive compensation, transfer pricing decisions may therefore create con-
ﬂict between division managers concerning the appropriate transfer price.
This conﬂict becomes more complicated when the components of the ﬁrm’s ﬁnal
output are produced in different tax jurisdictions. If divisional proﬁts are taxed at different
marginal rates, the impact of the transfer pricing decision on the ﬁrm’s after-tax proﬁts
implies that the transfer price plays a dual role within the organization. On the one hand,
the transfer price is used to create the incentives required to motivate the division man-
agers to supply unobservable effort to the production process. Just as important, however,
the transfer price can be used to shift divisional proﬁts from the high tax jurisdiction to the
@ats-ss2/data11/kluwer/journals/requ/v11n2art2 COMPOSED: 07/01/98 2:41 pm. PG.POS. 1 SESSION: 72