
countries now have explicit transfer pricing penalty
legislation modeled on the US legislation.
How important an issue is transfer pricing? In
Ernst & Young’s (2003, 7) most recent global
transfer pricing survey, 86% of MNE parent and
93% of subsidiary respondents stated that transfer
pricing was the most important international tax
issue they currently face. The respondents noted
that almost half their MNEs had been audited since
1999, and two-thirds expected to be audited within
the next 2 years (Ernst & Young, 2003, 10). Of the
MNEs that had been audited, one-third of the
audits concluded with an adjustment (that is, the
MNE owed more tax to the national tax authority).
Tax penalties were threatened in one-third of these
cases and actually imposed in one-sixth of them
(Ernst & Young, 2003, 7). To quote Ernst & Young
(2003, 15): ‘If an MNE is subject to an adjustment as
the result of a transfer pricing examination, there is
almost a one-in-three chance of being threatened
with a penalty, and a one-in-seven chance of
actually having one imposed.’
Global dollar estimates for TPM are hard to come
by. The US Department of the Treasury (1999, 3)
estimated the annual loss in US income tax revenue
due to TPM at $2.8 billion. Manufacturing
accounted for one-half the estimated tax loss,
followed by wholesale and retail trade; over half
the estimated loss came, not surprisingly, from
large corporations (US Department of the Treasury,
1999, 13). In terms of actual, not estimated, tax
dollars, in fiscal year 2002, the US Internal Revenue
Service (IRS) recommended $5.56 billion in transfer
pricing adjustments (that is, additional income tax
owed by the MNEs) and spent $15 million on direct
examination costs (US Department of the Treasury,
2003, 10). Estimates of the impacts of the transfer
pricing penalty are not available, but a recent IRS
survey revealed that 31% of US MNEs were spend-
ing between $100,000 and $1 million dollars
annually preparing the contemporaneous transfer
pricing documentation required as a precondition
to avoid being hit by the y6662 penalty (US
Department of the Treasury, 2003). Moreover, even
the threat of transfer pricing adjustments and
penalties can affect a multinational’s market valua-
tion. Swatch, for example, saw its stock price drop
by 11% on the Zurich stock exchange when two
employees claimed to the US Labor Department
that the Swiss MNE had used transfer price
manipulation through its British Virgin Islands
subsidiary to evade millions of dollars in taxes
(Lopez, 2004).
These numbers suggest that both the threat and
the reality of transfer pricing penalties should
affect the strategies and market valuation of
MNEs. The purpose of our paper is to address
exactly that question: How do transfer pricing
penalties affect the behavior and profits of multi-
nationals? We develop a theoretical model analyz-
ing the penalty’s impact on MNE after-tax profits.
We hypothesize that MNEs that engage in TPM
should respond to the transfer pricing penalty
either by continuing their existing pricing policies
(and therefore risking being hit with the penalty),
or by setting government-approved arm’s length
prices (and therefore paying more income taxes).
We outline the circumstances under which MNEs
would choose one or the other of these alternatives.
In either case, the MNE’s cash flows should fall,
having a negative impact on the firm’s stock market
valuation.
We test our model using an event study of the
stock market prices of American Depository
Receipts (ADRs) of all Japanese multinationals with
US subsidiaries over the 1990s. A brief history of the
US transfer pricing penalty legislative process from
1989 to the present is used to isolate the critical
dates for our event study. We follow the rigorous
research methodology design for event studies laid
out in MacKinlay (1997), McWilliams and Siegel
(1997) and McWilliams et al. (1999).
Our results show a strong negative reaction to the
penalty for Japanese stock market returns in the US,
providing support for our theoretical model, even
though there has been only one major penalty case
to date. We estimate the impact of the y6662
legislation on the market value of the Japanese
ADRs between 1990 and 1997 to be a cumulative
loss of $56.1 billion (an average $7 billion dollars
per year), which is 12.6% of the ADRs’ market value
at the end of the period. This drop in market value
can be compared with US Treasury estimates,
mentioned above, of $2.8 billion in annual forgone
tax revenues due to TPM and $5.56 billion in
recommended tax adjustments in 2002. Thus, the
market value impact – on Japanese MNEs alone –
appears to be larger than the US Treasury’s esti-
mates of forgone tax revenues.
We therefore conclude that the transfer pricing
penalty – and even the threat of the penalty – can
be punitive for targeted firms. The penalty dis-
courages transfer price manipulation and reduces
the MNEs’ market value. Talking softly but carrying
a big stick does encourage tax compliance, albeit at
a very high cost in terms of lost market value.
Talk softly but carry a big stick Lorraine Eden et al
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Journal of International Business Studies