Abstract
The conference paper by Johnson (2006, Review of Accounting Studies, forthcoming) develops an incomplete-contracting transfer pricing model with a number of novel features: taxation, sequential investments, and intangible assets being transferred. This discussion aims to disentangle these features so as to highlight those that are the key drivers of the results. Moreover, I show that some of the results can be generalized to settings involving a greater level of technological interdependency between the divisions.
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Notes
See for instance Price Waterhouse (1984). There is a need for new survey studies on transfer pricing practice, as the most comprehensive surveys date back to the 1980s.
The same problem of course applies to the I.R.S.’s use of the royalty method for taxation.
Chwolka and Simons (2003) study royalty based transfer pricing in a setting where only one of the parties, the supplier, makes a (cooperative) investment.
Let subscripts denote partial derivatives, e.g., \(M_{12}=(\partial^2 / \partial I_1\partial I_2)M(I)\).
Johnson argues that the zero opportunity cost assumption follows directly from the intangible nature of the asset. Note however that even if the asset were tangible, \(M^{\rm o}(I_1)\equiv 0\) would continue to hold provided the upstream division has no alternative selling opportunities for the asset and the investment \(I_1\) leaves subsequent relevant cost for the upstream division unaffected.
In earlier incomplete contracting studies (e.g., Baldenius et al., 1999), the choice of transfer quantity was nontrivial. By investing more, a division increases its eagerness to trade which results in a greater transfer quantity. As a consequence of economies of scale, the other division then also has a greater incentive to invest in fixed assets. Even without direct production externalities, therefore, investments along the value chain are linked through the ensuing quantity choices. In Johnson’s model, this effect is absent because the transfer decision is discrete and trivial.
Solving the problem in (7) yields first-best investments of \( I_1^*=\{(1-t)[1+(1-k_2)z]-(1-t-h)k_1-\hat{\alpha} h (1+z)\}/X \) and \( I_2^*=\{(1-t)[1+(1-k_1)z]+h k_1 z-(1-t)k_2-\hat{\alpha} h (1+z)\}/X,\) for \(X\equiv (1-t-\hat{\alpha} h)(1-z^2)\).
References
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Acknowledgment
I am grateful to Mingcherng Deng, Nicole Bastian Johnson and Bugra Ozel for helpful discussions.
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Baldenius, T. Discussion of “Divisional performance measurement and transfer pricing for intangible assets”. Rev Acc Stud 11, 367–376 (2006). https://doi.org/10.1007/s11142-006-9000-5
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DOI: https://doi.org/10.1007/s11142-006-9000-5