Tuesday, March 30, 2010

Multinational Corporations practice transfer pricing: lets try to fit that into a Solver/Excel network optimization model

The foundation of this Solver model is a classical operations research problem on network optimization. There is a certain capacity in the three “producing” countries, which can’t be exceeded; and the demand sets the upper boundary for all product flows into the four “consuming” countries. We know the production costs as well as the selling prices across the countries. All that in a classical model would help us establish the maximal profit. Regarding the MNC’s, though, we also take into account the corporate income taxes and the fact that an MNC has, either sales or production, subsidiaries in all countries.

If an MNC plans to produce in country 1 and sell in country 4, it would check which one has a lower corporate tax. If the consuming country is more competitive, the subsidiary of country 1 will sell the product to the subsidiary of country 4 at zero profit margin. The subsidiary of country 4 will make the sale to the customer at market prices, thus obtaining all profits. The profits are thus paid in the country with lower taxes.

If, on the other hand, the producing country has lower corporate income taxes, the producing subsidiary sells the product to the sales subsidiary – at full market value. The sales subsidiary sells the product to the final customer at market price as well, making no profit. All the profit is accrued in the producing country – with the MNC once again being able to choose the lower tax rate. This transfer pricing model was created for my optimization modeling class.

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