Intra-firm trade is becoming an increasingly important component of world trade; and the dominant market position which is held by transnational corporations in certain clusters of industries provides substantial scope for differential pricing policies which may result in an abuse of such a position.
Transnational corporations tend to fix prices of goods and services traded between the corporation and its affiliates located in different countries. Intracorporate transfer pricing by a multiregional company within a country may matter little to a national government, unless it is a restrictive business practice, since all the benefits of the transaction are retained domestically. When engaged in by transnational corporations, however, it affects the distribution of the benefits of their activities between countries, and may stifle local competition.
Moreover, such abuses in transfer prices for intra-firm trade may also be reflected in the prices charged subsequently to third parties by the selling unit of the corporation, and occur in respect both of the prices of goods for resale without further transformation and of goods which are further manufactured using inputs supplied on an intra-firm basis. Manipulations of transfer prices are in consequence likely to have an adverse effect on market and industrial structures and on the balance of payments of either the home or the host countries in which transnational corporations operate.
The use of transfer pricing by transnational corporations is particularly problematic for developing countries since they are most often the host country. The particular conditions in developing countries inducive to high transfer prices (ie above arm's length prices) for flows from parents to foreign subsidiaries include the following: corporate income tax higher than in parent's country; political pressures to nationalize or expropriate high-profit foreign firms; political instability; high inflation rate; currency fluctuations; exchange controls; and import/export price controls, tariffs and subsidies.
Transfer prices may be distorted for internal motives: the varying degree of ownership in its subsidiaries may induce the parent company to make profits appear where its ownership is relatively large; there may be an incentive to reduce the apparent profits in a particular affiliate for purposes of wage bargaining; transfer pricing may be an indirect way of allocating markets if, for instance, the prices charged to an affiliate are such as to make its exports non-competitive. The manipulation of prices may also respond to external factors: the diversity among countries in the rates of taxation or in the rules of assessment; the difference in taxation even in the same country on the various forms of remuneration of capital, dividends, interests and royalties, and the ensuing tendency to transform taxable income into non-taxable costs; the varying rules of exchange control by some host countries regarding the remittance of those various types of remuneration; the risk of changes in exchange rates; and finally, the risk of nationalization or expropriation.
A 1990 UN report stated that between 30% to 40% of the trade of several major developed nations is intra-firm, that is, it occurs within the affiliate networks of transnational corporations. Research has shown that, although intracorporate trade in goods within transnational corporations is concentrated within certain industries, such as motor vehicles and chemicals, more than one quarter of the value of all international trade in goods appears to be of an intragroup character. In addition, although much less well-documented, there is the provision of intracorporate services, for example: research and development, rentals of equipment, administration and loans. The scope for price manipulation is therefore quite extensive.