UN Manual on Transfer Pricing (2017)

A.2. Theory of the Firm and Development of Multinational Enterprises

A.2. Theory of the Firm and Development of Multinational Enterprises

A.2.1.                 In economic theory, firms are organizations that arrange the production of goods and the provision of services. The aim of a firm is to produce goods and provide services to maximize profits. In the absence of MNEs, production would be carried out through a series of arm’s length transactions between independent parties.7 These transactions would require contracts between the independent producers but a significant part of these resources would be used in the process of making contracts.

A.2.2.                 The expenses of making contracts are called “transaction costs” since expenses are incurred by individuals in finding other persons with whom to contract, as well as in negotiating and finalizing the contracts. As contracts cannot cover every possible issue that may arise between the contracting parties, there is a risk of disputes being created by unforeseen contingencies. When disputes occur between contracting parties they may incur considerable costs in resolving these disputes including negotiation costs, legal expenses, and litigation and mediation expenses. As transactions and associated costs would be significant in an economy without firms, it is rational for firms to be created to produce goods and services, provided that the firms’ costs of production are less than the costs of outsourcing the production.

A.2.3.                 Within a firm, contracts between the various factors of production are eliminated and replaced with administrative arrangements. Usually, the administrative costs of organizing production within a firm are less than the cost of the alternative, which is outsourcing market transactions. The theoretical limit to the expansion of a firm is the point at which its costs of organizing transactions are equal to the costs of carrying out the transactions through the market.

A.2.4.                A firm will internalize the costs of production to the extent that it can achieve economies of scale in production and distribution and establish coordination economies. The United Nations Conference on Trade and Development (UNCTAD) in its 1993 World Investment Report: Transnational Corporations and Integrated Production noted that in many industries the expansion of internalized activities within multinational enterprises indicates that there are significant efficiency gains that may be achieved.

A.2.5.                 A firm’s functions in providing goods and services are collectively called its supply chain, through which the firm converts inputs into goods and services. Most firms begin by operating in their home market and rely on their competitive advantages to enter markets abroad. The term “supply chain” is defined as “the chain of processes involved in the production and distribution of a commodity.” In this chapter the term “supply chain” is used for the provision of both goods and services by MNEs. The term “value chain” is defined in this Manual as “the process or activities by which a company adds value to an article, including production, marketing, and the provision of after-sales service.”

A.2.6.                 MNEs create organizational structures and develop strategies to arrange the cross-border production of goods and services in locations around the world and to determine the level of intra-entity or intra-group integration. UNCTAD considered that there was a trend in many MNEs across a broad range of industries to use structures and strategies with high levels of integration in their operations. The integration included structures giving an associated enterprise control over a group-wide function or the sharing of group-wide functions between two or more enterprises.

A.2.7.                Successful MNEs use their location and internalization advantages to maximize their share of global markets and growth opportunities. Thus, multinational enterprises are able to minimize their costs through their integration economies, which are not available to domestic firms.

A.2.8.                 The key feature of MNEs is that they are integrated (global) businesses. Globalization has made it possible for an MNE to achieve high levels of integration and the ability to have control centralized in one location. Modern information and communications systems also provide increased horizontal communications across geographic and functional business lines. This has resulted in many MNEs providing services such as advisory, research and development (R&D), legal, accounting, financial management, and data processing from one or several regional centres to group companies. Also, management teams of an MNE can be based in different locations, leading the MNE from several locations.

A.2.9.                 In order to optimize the value chain, MNEs may establish new business operations in a developing country. These investments often happen in stages, with the initial stage involving the establishment of infrastructure, improvement of the education of individuals and accordingly, provision of economic benefits to the country.

A.2.10.               MNEs have common control, common goals and common resources, and the units of the enterprise — parent company, subsidiaries and branches — are located in more than one country. Thus, many MNEs are fully integrated businesses that plan and implement global strategies. UNCTAD has noted that integration of production by MNEs creates challenges for policy-makers in adapting the methods for allocating the income and costs of MNEs between jurisdictions for tax purposes.

A.2.11.               In Multinational Enterprises and the Global Economy (2008) the authors argue that the history of MNEs was shaped by political, social and cultural events that influenced the ownership, organization and location of international production of their goods and services. The authors claim that MNE groups integrated their operations until the late 1980s and then more recently chose to outsource some activities in which they do not have competitive advantages.

A.2.12.               For most of the twentieth century, MNE groups and international enterprises operating through branches or subsidiaries tended to expand the range of their value adding activities and by the late 1980s firms had integrated their production and marketing functions. Up to the 1960s and 1970s, MNEs had engaged in limited or no outsourcing of operations and they became large integrated conglomerates. But the authors argue that from the late 1980s MNEs began outsourcing many activities that were previously performed by the firms themselves. From the early 1990s, MNEs began restructuring to specialize in the areas in which they had competitive advantages, such as unique firm-specific assets, in particular high value intangible assets, and the capabilities that provided the firms with their market position and competitive edge.

A.2.13.               MNEs examined their value chains to identify the functions in which they had no advantage over other firms. They then began deciding on which functions they would perform themselves and which functions would be outsourced to independent firms, a process called value chain optimization. For in-house services, MNEs might decide to provide some services through centralized service centres. While the initial functions that were outsourced were non-core activities such as payroll, billing and maintenance services, outsourcing has expanded to cover core activities. The core activities may involve producing goods or providing services. For example, many firms outsource call centre activities or certain administrative functions to independent firms in countries which have educated workforces and relatively low-cost labour. Consequently, modern MNE groups organize their cross-border operations through a network of contractual arrangements with independent enterprises and cooperative in-house relationships.

A.2.14.              MNEs vary in size and include some small and medium sized enterprises (SMEs). When SMEs commence operating in other jurisdictions through locally incorporated subsidiaries they will usually incur the additional requirement of complying with transfer pricing rules. Some SMEs may face challenges in complying with transfer pricing rules because of their lack of expertise with international tax issues in general and limited compliance resources that may hinder them from expanding their operations abroad. Consequently, domestic transfer pricing rules which apply to SMEs should reflect the capacity of SMEs to comply and the capacity of the tax authorities to administer them. Some countries may have special simplified rules for SMEs, such as simplified documentation requirements, and may use flexible approaches in handling transfer pricing issues involving SMEs. This creates the need to define an SME. Although there is no universal definition, an SME may be defined on the basis of criteria including: turnover; balance sheet value; number of employees; and transaction values.