How Multinationals’ Tax and Tariff Planning Can Be More Effective

After a turbulent few years, trade has bounced back. In 2022, global trade was calculated to be 10% higher than pre-pandemic levels. Trade within multinational enterprises is estimated to account for over a third of this.

In current periods of high inflation and sharply rising energy and transportation costs, it’s important for companies to make effective trade decisions. One area where efficiencies can be made, particularly for MNEs, is tax and tariff planning.

To provide goods and services around the globe, MNEs rely upon transfer prices charged for intra-firm trades, which allows them to shift profits across countries. These not only determine the allocation of profit between the two local business units involved in the trade, and thereby the income taxation in those countries, but are also the basis for tariff payments levied on cross-border shipments of goods.

Setting transfer prices to effectively plan taxes and tariffs is challenging because of the scale and variety of an MNE’s operations. The last minute and trade-specific information required makes it impossible for a head office to make effective decisions in advance. In contrast, companies’ local business units have a clearer, more precise picture of regional legalities. When understood correctly, these not only guide a company in optimizing its operations accordingly and save money, but also can help a company set transfer prices to plan tax and tariff payments.

However, while business units have superior information to realize the benefits of making certain adjustments, their incentives may be at odds with those of head office. They have to optimize individual business unit profits, whereas the head office aims to minimize taxes and tariffs overall.

MNE Case Study

To understand how the most effective decisions could be made, we investigated how the different elements of transfer prices set by the head office and business units reflected income tax and tariff planning. Our study analyzed an MNE’s confidential internal and external transfer prices and the separate price elements set by the head office and business units for all goods exported from EU countries to any other country in the world.

The MNE we analyzed is based in Germany, sources products from 52 countries, and exports both within the EU and to 110 countries outside.

The MNE uses a cost-plus pricing method, which implies that it sets transfer prices such that a product’s unit cost is determined first, after which markups are set relative to these unit costs. These elements of the transfer price are distinguished: the unit cost per product (which is set by the head office based on business unit input); markups set by the head office; and business units’ subsequent discretionary price adjustments.

For each trade, the “incoterm” is given. Known as the “world’s essential terms of trade for the sale of goods,” incoterms are the International Chamber of Commerce’s commercial terms that determine whether the buyer or the seller bears the costs of transportation, shipment, insurance, and tariff payments. Knowing the incoterms allowed us to investigate whether business units choose these terms to allocate trade costs to the high-tax country’s business unit, without charging this business unit through adjusting the transfer price.

Our analysis shows that the unit cost per product already reflects tariff planning. The head office markups reveal income tax but not tariff planning. The business units’ price adjustments lower both income taxes and tariff payments. The information advantage of the business units likely explains the difference between the head office and business unit markups.

While head office markups are set at an early stage based on aggregated expected product trade levels, the subsequent price adjustments of the business unit are made per trade when all relevant tax variables are known. Overall, our analysis shows that business units’ price adjustments generate more tax savings than markups set by the head office.

Additionally, the MNE engages in less tax planning in competitive markets than in those where it’s a product market leader and can set stable prices. Tax planning in competitive markets primarily occurs via business unit price adjustments rather than already being present in the unit cost. This may be due to competitive pressure, which limits opportunities for tax planning early in the price-setting process, requiring MNEs to rely on the business units’ superior information.

We also observe that head office markups take conflicts with tax authorities into account while the business units’ price adjustments reflect the risk of conflicts with customs authorities—because the head office primarily deals with tax disputes in the focal MNE, whereas business units address conflicts with customs authorities.

Finally, in countries where the head office indicated difficulties in motivating business units to act in the MNE’s interest, tax planning is greater in the head office markups, with business units engaging less in tax planning.

We find that business units use incoterms to strategically allocate trade costs to lower the income tax burden. Incoterms define which trade costs arise in the importing country with the buyer and which in the exporting country with the seller. Our analysis shows that for internal trades, the business units allocate more trade costs to the country with higher tax rates to reduce the income tax burden.

When an exporting business unit in a high tax country bears more trade costs, it doesn’t increase the transfer price so that these costs are deducted in the high-tax country. However, when an external trading partner prefers these terms of trade, the exporting business unit increases the transfer price to cover these additional costs. These costs can be economically very significant.

What Are the Takeaways?

What can companies take from this study? Aside from providing clarity on tax and tariff planning through transfer prices and allocating trade costs to higher taxed business units, our study challenges conventional thinking of how such planning should take place and shows that greater control by individual business units can help to reduce the MNE’s overall tax burden.

Our study shows that transfer price decision making at the business unit level can align with the wider firm’s objectives, even when explicit incentives to do so are absent. The finding that business units contribute positively to tariff planning supports a case for greater delegating if the head office has limited information.

In competitive markets, or when facing customs risks, MNEs may even need to fully rely on the local business units to realize tax savings. However, when the conflict of interest between the business unit and head office becomes greater, communication between the head office and business unit is preferred over delegation.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Saskia Kohlhase is an assistant professor with Rotterdam School of Management, Erasmus University. Her research focuses on consequences of taxing cross-border economic activities, tax incentives of loss-making firms, and ESG reporting of public and private companies.

Jacco L. Wielhouwer is professor of economics of accounting and tax at the Vrije Universiteit Amsterdam. His research focuses on taxation and investments, disclosure, and compliance and enforcement of regulations.

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