Multinationals and Transfer Pricing

Alan M. Rugman, University of Reading

Prepared for "Prospects and Possibilities for the 2013 G8 Lough Erne Summit:
Trade, Transparency, Tax and Terrorism"

June 14, 2013, Belfast
Organized by the School of Politics, International Studies and Philosophy, Queen's University Belfast
and the G8 Research Group, University of Toronto
with the support of the United Kingdom's Department for Employment and Learning, Newsdesk Media
and the Balsillie School of International Affairs
This conference was streamed live here. Watch the video here.
To find out more, please click here.


The public policy concern that multinational enterprises (MNEs) use transfer pricing (and other internal market mechanisms) to avoid paying their fair share of taxation is analysed using basic principles of international business theory. The following international business (IB) principles are used:

  1. MNEs exist to create value in a world of market imperfections. Internalisation theory explains why MNEs create internal markets (using a network of wholly owned subsidiaries) to overcome imperfections (transaction costs) in goods and factor markets.
  2. Any imperfections in capital (financial) markets, due to country level regulations and heterogeneity in effective tax notes similarly leads to internalisation by MNEs through the creation of efficient internal capital markets.
  3. As a result of 1 and 2, the use of transfer pricing by MNEs needs to be analysed as an efficient response to exogenous market imperfections; in other words, MNEs attempt to bypass government imposed distortions in capital markets through internalisation activities.
  4. If governments wish to reduce transfer pricing activity by MNEs, then country level variations in effective tax rates need to be eliminated. This can be achieved through a policy of unitary taxation.
  5. Unfortunately, unitary taxation requires that capital markets be fully integrated. In particular, country level differences in effective tax rates need to be eliminated such that tax policies are harmonised. There is little empirical evidence that this can be achieved.
  6. For example, although the EU has achieved considerable economic integration, it is clearly not an optimum currency area. Thus, the euro has failed to achieve financial market integration and macroeconomic stabilisation. The reason is that governments still control fiscal policy through independent tax regimes.
  7. This analysis implies that there are two ways forward. First, the EU can seek complete internal market harmonisation of monetary and fiscal policy. This requires that all countries join the euro and that sovereign country governments surrender tax policy and budgets to a centralised EU bureaucracy. This will signal the end of the nation state but make it easier for MNEs to operate within the EU according to a unitary tax method. Second, governments can retain sovereignty over fiscal policy (and for non-euro members over monetary policy) but then governments need to accept that the market imperfections they create will lead to the national use of transfer pricing and similar methods by MNEs.
  8. In summary, analysis of MNEs and transfer pricing requires an understanding of the distinction made by Edith Penrose between value creation and value appropriation. All of the above analysis uses internalisation theory and the creation of internal capital markets in the sense of value creation. This is the reason that MNEs exist, to overcome exogenous (country level) market imperfections and thereby create internal (firm level) markets. Essentially this is an efficiency driven (and moral) activity.
  9. In contrast, sovereign governments are often influenced by coalitions of self-interested groups seeking to redistribute wealth through value appropriation. Such value appropriation activities may create distortions which may actually reduce value creation. The current imbroglio about MNEs and transfer pricing is a vivid example of the lack of understanding of basic IB principles exhibited by UK politicians.

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Examples of MNEs creating internal capital markets.

Current UK government policy criticises MNEs for not paying sufficient tax on their UK operations, for example, Google, Amazon and Starbucks are all said to minimise their tax payments in the UK (although their policies are entirely legal). Margaret Hodge, MP, states that their activities may be legal but immoral. This is false reasoning.

The three MNEs are legally permitted to declare their EU regional head office in any one member state. Google runs its EU operations from Ireland; Amazon from Luxembourg; and Starbucks from Holland. They are required to declare profits across their EU subsidiaries to be consolidated at their regional head office. Thus there is no legal reason for the UK to demand disclosure of their UK operations. This would only be applicable if the UK were to withdraw from the EU.

A similar nonsensical argument, advanced by Oxfam, suggests that UK owned firms do not pay enough tax in developing economies in Africa and Asia. This is the logical reverse of the Margaret Hodge "MNEs are immoral" argument. The foreign subsidiaries of UK MNEs pay the appropriate legal taxes required by host governments. It is the failure of host governments to harmonise their tax policies (thereby creating capital market imperfections) which leads MNEs to create their own efficient internal capital markets. For example, Nguyen (2013) demonstrates that UK MNEs in South East Asia promote host country economic development through the use of internal funds in the face of chronic host country capital market imperfections.

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Penrose, E.T. 1959. The Theory of the Growth of the Firm. Oxford University Press: Oxford.

Penrose, E.T. 1995. The Theory of the Growth of the Firm, 3rd edition. Oxford University Press: Oxford.

Rugman, A.M. and Verbeke, A. 2002. Edith Penrose's Contribution to the Resource-based View of Strategic Management. Strategic Management Journal 23(8): 769-780.

Nguyen, Q. T. K. 2013. Can British multinational enterprises finance economic development in South East Asia? Multinational Business Review, forthcoming (2013).

Rugman, A.M and Eden L. 1985. Multinationals and Transfer Pricing. Croom Helm Limited: Kent.

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