International Transfer Pricing and Subsidiary PerformanceThe Role of Organizational Justice

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International Transfer Pricing and Subsidiary Performance: The Role of Organizational Justice
By Ramn Paz-Vega
International intrafirm trade is increasingly important in the global economy. Intrafirm transactions are governed by transfer-pricing policies mandated by parent companies. Economic and accounting theories have long prescribed policies that maximize the parent companys short-term profits but may have other, unintended outcomes. These outcomes are explored in a single-case study. Based on this case study and organizational justice theory, a theoretical framework is developed to show how frequently used transfer-pricing policies, through their impact on subsidiary managers perceptions of justice, can significantly affect the subsidiarys strategic performance. First, the conditions under which transfer-pricing policies can be perceived as procedurally, interactionally, or distributively unfair are presented. Second, it is proposed that those justice perceptions have an impact on subsidiary managers commitment, trust in the parent company, neglect, ethical behavior, productivity, work quality, and compliance, and that the magnitude of this impact is moderated by the quality of relations between the parent company and subsidiary managers. Finally, it is predicted that such attitudes and behaviors may generate important agency and transaction costs that jeopardize the expected outcomes of international strategies of vertical integration. 2009 Wiley Periodicals, Inc.
Correspondence to: Dr. Ramn Paz-Vega, Plaza Montero #4, Ciudad Satelite, Monterrey, N.L. 64960 Mexico, 52 81 8103 7135 (phone/fax), ramonpaz@ prodigy.net.mx
Published online in Wiley InterScience (www.interscience.wiley.com). 2009 Wiley Periodicals, Inc. DOI: 10.1002/tie.20261
220 f e at ur e aR T I C L E
conomic globalization involves an increasing scale of international trade and foreign direct investment flows on the part of multinational companies (United Nations Conference on Trade and Development [UNCTAD], 2006). A simplified view of this trend shows multinational companies producing in countries where costs are lower and/or selling in countries where demand and prices are higher (Abdallah, 1989). It is estimated that in 2005 there were around 770,000 international subsidiaries of 77,000 multinational companies, which accounted for 10% of the worlds gross domestic product (GDP; UNCTAD, 2006). The resulting crossborder trade between multinational companies and their affiliates, often referred to as intrafirm or sometimes related-party trade, accounts for a large share of international trade. For example, intrafirm trade accounts for one third of exports of goods from both Japan and the United States (Organization for Economic Co-operation and Development [OECD], 2002). In sum, it has been estimated that 60% of international trade takes place within multinational enterprises (Neighbour, 2002; UNCTAD, 2004). Intrafirm transactions commonly involve exporting goods to or importing them from one or more subsidiaries in a foreign country. Less evident is the fact that they also include transfers of services, transfers or uses of intangible property, tangible property loans, intrafirm financing, and cost-sharing arrangements. All these transactions must be valuated at transfer prices, which may accordingly be called prices of goods, service charges, management fees, royalties, licensing fees, rents, interests, or allocated costs (Tang, 1993). In intrafirm transactions, subsidiaries usually buy or sell at prices mandated by headquarters (Eccles, 1985a; Kogut, 1985). Transfer pricing has long been seen as a problem of finding the right transfer price in order to maximize parent-company profits (Abdallah, 1989; Eccles, 1985a; Hirshleifer, 1956; Knowles & Mathur, 1985). In the international scenario, this view has been narrowed to a problem of tax minimization (Choe & Hyde, 2004; Feinschreiber, 1993a; Kogut, 1985; Rosenblum & Martel, 2002; Smith, 2002). Consistent with this logic, transfer prices can be discretionally altered to make a subsidiary appear either highly profitable or grossly unprofitable (Milgrom & Roberts, 1992, p. 80). These perspectives are limited ethically, scientifically, and practically. Transfer-pricing problems are much more complex and multidimensional than what short-term profit maximization suggests. If corporate profit maximization is the sole objective, incentives emerge to abuse transfer pricing, mainly in terms of failures of justice and
unsatisfactory corporate social performance (e.g., Arpan, 1972, cited by Tang, 1993; Knowles & Mathur, 1985; Mehafdi, 2000; Paul, Pak, Zdanowicz, & Curwen, 1994). Many companies have faced serious problems as a consequence of their adoption of transfer-pricing policies that ignore normative or behavioral consequences. Consider, for instance, the case of Dow Chemicals operations in South Korea in the 1970s and early 1980s:
In 1974, Dow Chemical entered into a 50 percentowned joint venture with the Korean Pacific Chemical Corporation (KPCC) to produce vinyl chloride monomer in that Asian country. Dow Chemical imposed the purchase of chlorine, a raw material for the joint venture, from a Dow wholly-owned subsidiary. Some time later, KPCC found out that it could obtain chlorine of similar quality from local suppliers, at lower prices. Dow neither changed its position nor its transfer price. By 1982, amid sharp conflicts, the joint venture stopped buying chlorine from Dows subsidiary. Faced with both substantial losses from its chlorine-producing subsidiary and escalating conflict in its joint venture affiliate, Dow attempted to buy the majority of the joint venture shares. KPCC rejected the proposal. After considerable pressure by both parties and by local chlorine producers, the Korean government supported the local parties. As a result of the scandal, Dow had to sell, not only its shares of the joint venture, but all its chemical interests in South Korea to a consortium of local firms, taking significant losses. (Dymsza, 2002, p. 421)
Transfer pricing is a key component of the implementation phase of vertical integration strategies (Eccles, 1985a). The role of transfer pricing as a control mechanism is to achieve goal congruence (Anthony & Govindarajan, 2004)that is, to align the activities of the subsidiary to the strategic goals of the parent company. In this article I suggest that some frequently used international transferpricing policies and practices are having the opposite effect: by ignoring fairness dimensions, they are producing a strategic misalignment between the subsidiary and the parent company. Consequently, multinational corporations should pay renewed attention to enhancing the perceptions of justice by subsidiary managers when designing and implementing international transfer-pricing policies. I argue that their failure to do so may seriously harm the strategic performance and viability of subsidiaries. To the best of my knowledge, the role of transfer-pricing policy as a determinant of subsidiary managers perceptions of fairness has not been addressed in the literature. Thus, the objective of this article is to develop a theoretical framework to show how frequently used interna-
Thunderbird International Business Review Vol. 51, No. 3 May/June 2009
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International Transfer Pricing and Subsidiary Performance 221
tional transfer-pricing policies, through their impact on subsidiary managers perceptions of justice, can significantly affect the subsidiarys long-term performance. Since the overwhelming majority of multinational companies are based in highly industrialized countries (Abdallah, 1989; UNCTAD, 2006), I focus my analysis in a setting in which intrafirm trade takes place between one parent company, located in its home, industrialized country, and one subsidiary, located in any host country. The framework can easily be extended to operations between two or more subsidiaries in any country. The article is organized as follows: in the next section I introduce the transfer-pricing problem. Next, I briefly present a case in which transfer pricing was manipulated. Afterwards, based on organizational justice theory, I build my arguments in three steps. First, I present the conditions under which some transfer-pricing policies and practices can be perceived as procedurally, interactionally, or distributively unfair by subsidiary managers, and possibly by other subsidiary stakeholders such as hostcountry shareholders. Second, I predict that perceptions of fairness in transfer-pricing policy have an impact on several attitudes and behaviors of subsidiary managers namely, their organizational commitment, trust in the parent company, neglect, ethical behavior, compliance, productivity, and work qualityand that the magnitude of that impact is moderated by the quality of the relations between the parent company and subsidiary managers. Finally, applying the work of Husted and Folger (2004), I propose that unfair transfer-pricing policies and practices generate important agency and transaction costs that jeopardize the expected outcomes of international strategies of vertical integration.
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Int e r n a t i o n a l T r a n s f e r - P r i c i n g Pol ic ie s a n d P r a c t i c e s : A n O v e rview

A transfer price is defined as the price charged by a selling department, division, or subsidiary of a multinational enterprise for a product or service supplied to a buying department, division, or subsidiary of the same multinational enterprise (Abdallah, 1989, p. 7). In turn, transfer pricing is the process of designing and implementing policies that determine those prices (Tang, 1993) that internationally, involve transactions between units located in different countries. In general terms, two approaches to the transferpricing problem can be distinguished (Rosanas, 1991). On the one hand, there is a body of prescriptive literature, not strongly supported by theory, that recommends the use of transfer pricing based on equivalent market
prices, or transfer pricing freely negotiated by the related parties (e.g., Anthony & Govindarajan, 2004; Dean, 1955; OECD, 2001). These prescriptions seek to achieve goal congruence between parent company and subsidiaries, fairness in evaluating subsidiary managers, and/or fair tax payments to host countries. On the other hand, there has been substantial theoretical development by economists and academic accountants. For them, transfer prices are a purely internal cost matter that internal selling and buying cancel out, with a resultant nil effect on corporate profits and cash flows. Thus, since long ago, economic theory has approached transfer-pricing decisions as a problem in marginal analysis. The solution that maximizes corporate profits is to transfer between units at marginal cost (Hirshleifer, 1956; Pindyck & Rubinfeld, 1998). Consistent with this economic perspective, Solomons (1965) outlined the basic, and still prevalent, accounting criteria to define transfer prices; he advocated the use of standard variable costs as a gross estimate of marginal costs. Nevertheless, the practical application of this knowledge has been almost impossible. Marginal costs are not easily measurable in the short term (Rosanas, 1991), and their estimation through accounting variable costs has been demonstrated to be grossly inadequate (Slof, 1994). In practice, most intrafirm transactions are governed by policies mandated by the parent company, which usually adopts the criterion of profit maximization. As Kogut (1985, p. 33) points out, Given the tremendous contribution that transfer pricing can make to after-tax income, the administration of intrafirm prices is invariably centralized.
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Eccles (1985a) identified three transfer-pricing policies used in practice: 1. Mandated cost-based policies, in which the selling unit receives a mandated price based on either variable or full cost, actual or standard (this policy means that the subsidiary receives no profits on internally traded goods); 2. Market-based policies, in which either the internal mandated transactions are based on market prices or actual negotiation takes place between both parties; and 3. Dual pricing, in which a double accounting system is established, using two sets of prices; the selling party receives a market-based sales price, while the buying party pays standard variable costs. Corporate headquarters assume the difference in an account used to consolidate financial statements. Most transfer-pricing theory and practice was initially developed for the case of parent companies and subsidiaries located within one domestic jurisdiction. Upon the advent of globalization, these theory and practices were extended to international subsidiaries without much refinement. The literature has been silent for many years on transfer pricing in international settings. Nowadays, international transfer-pricing decisions are strongly influenced by a number of environmental variables. In particular, tax minimization has become the driving force in international transfer-pricing policy (Clausing, 1998; Wrappe, Milani, & Joy, 1999). A related problem is double taxation. Most industrialized countries require their multinational companies to aggregate the loss or income of foreign branches with the loss or income of the parent corporation and pay the home-country income tax. Many governments have enacted bilateral tax treaties to eliminate double taxation, but the problem often does not disappear (Abdallah, 1989). Whenever there are no tax treaties, multinational companies have a strong and often legitimate incentive to shift as much income as possible to their home country. Besides tax considerations, a subsidiary in a foreign country may be mandated to transfer at cost or at very low prices to the parent company, and/or to take high prices in transfers from the parent company for other purposes such as moving cash, profits, or dividends outside the host country; enhancing the appearance of profitability and increasing the credit status of the parent company; or shifting income to countries where economic, social, and political conditions (inflation, exchange-rate volatility, property rights, etc.) are more stable (Tang, 1993).
Multinational corporations have many alternatives for maneuvering transfer prices in order to shift income (Kogut, 1985; Oyerle & Emmanuel, 1998; Smith, 2002). In addition to transfers of goods, they can sell services, rights of use, and related concepts to their subsidiaries, and transfer the corresponding royalties, licensing or management fees, and so on (Tang, 1993), which are the so-called invisible transactions of the balance of payments (Rivera-Batiz & Rivera-Batiz, 1994). Another related practice is known as thin capitalization (Mehafdi, 2000; OECD, 2001); it refers to the practice of financing the assets and operations of subsidiaries with debt capital from the parent company, or providing loans of machinery and other fixed assets to the subsidiary. In other words, instead of investing in the equity of subsidiaries, parent companies frequently lend money or rent assets to their subsidiaries, charging interests or rents under transfer-pricing policies. These types of transactions are generally less subject to tax regulations by the host country (Oyerle & Emmanuel, 1998), and their value is difficult to appraise, which allows for a more discretional valuation by managers (Tang, 1993). The many alternatives to shift income between subsidiaries and countries led to the establishment of regulations and international conventions. Many industrialized countries have enacted rules to prevent tax evasion through transfer pricing, most of which are compatible with the Arms Length principle recommended by the OECD. This principle defines the standard to compare transfer pricing as that of an independent taxpayer dealing at arms length with another independent taxpayer. In this way, international intrafirm transactions should be priced as if they take place between independent parties transacting in the open market (OECD, 2001). Transfer-pricing policy decisions may have two different outcomes (Eccles, 1985a). On one hand, they have a clear effect on subsidiary financial performance and on whole-company profitability. As previously discussed, this avenue has been widely studied in economics and accounting and is the dominant perspective on the subject. On the other hand, there are behavioral and ethical implications. The transfer-pricing problem is mainly related to interpersonal relationships (Rosanas, 1991, p. 135), among which the issue of fairness is of particular interest (Slof, 1994, p. 121). In fact, Eccles (1985b) postulated an effect of transfer pricing on justice perceptions, particularly for subsidiary managers. However, he did not conduct research to further study this avenue. Organizational and behavioral implications of international transfer pricing remain largely unexplored at the theoretical level. This research builds on these early in-
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sights and, for the first time, it gives serious consideration to the relationship between international transfer pricing and justice perceptions. In the next section, I introduce the case of a parent company/subsidiary dyad in which transfer pricing was manipulated. This case will be helpful to gain insight on the conditions under which managers perceive transfer-pricing policy as fair or unfair, and the relations between fairness perceptions and the performance of subsidiaries.
A C a s e S t u d y o f Tr a n s f e r - P r i c e M a n i p u la ti o n
In order to explore the behavioral effects of transferpricing policy, particularly when it is manipulated to shift income out of the subsidiary, I conducted a single-case study (Yin, 1994), in which the main unit of analysis is the subsidiary organization. Data collection involved interviewing local managers, as well as access to many documents and archival records of the focal subsidiary. Examples of such documents are: financial statements, tax declarations, audit reports, minutes of shareholder assemblies, minutes of management team meetings, accounting procedures and policies, internal communications, letters, and electronic mail messages. Collected data included the identification of transferpricing policy and the quantification of its operation, particularly in terms of income shifted out of the subsidiary. It also included the observation and interpretation (through discourse analysis) of subsidiary managers perceptions of procedural, interactional, and distributive justice; their behaviors and attitudes, such as job satisfaction, trust in parent company, compliance with parent
company decisions, organizational commitment, and work productivity; and costs associated with these behaviors and attitudes. The case is Mexfruco,1 a Mexican firm established in 1997 as a subsidiary of Interfruco, a U.S. corporation. Its main activity is sourcing, packing, shipping, and exporting fresh fruits, mainly avocados. The final products of the subsidiary (different presentations of fresh fruits) are sold internationally by the parent company without any further processing. Mexfruco is a medium-sized company in the context of its industry, with sales in the range of 15 to 20 million dollars per year during the period of study (19972001), and with 200 full-time employees. This subsidiary began operating in July 1997, with the participation of two local entrepreneurs as minority shareholders, who also acted as managers of the firm for some time. Table 1 presents some indicators of Mexfrucos strategic performance through time. Since the beginning, all international sales were formally managed by Interfruco. However, Interfrucos staff conducted actual sales and client communications only in the case of some customers, while Mexfrucos staff performed these functions with several other customers. Driven by market prices, and before accepting orders, Interfruco and Mexfruco agreed every week on selling and buying prices. On that basis, Mexfruco purchased fruit in Mexico and sold it to Interfruco, which in turn invoiced international customers, adding a commission of at least 8%. Physical fruit flows were direct from Mexfruco to international receivers. Internal transactions between Mexfruco and Interfruco were governed by a transfer price, which was also agreed upon on a weekly basis. This price was set according to Mexfrucos costs, plus a markup for Mexfruco that varied from 3 to 5%.
table
1 Some Indicators of Mexfrucos Strategic Performance

Market Share of Mexican Avocado Exports 14.7% 13.7% 16.9% 11.9% 9.5% 12.3% 7.6% 8.4%
Year 1997 1998 1999 2000 2001 2002 2003 2004
Total Sales (Mexican Pesos) 15,315,868 109,462,663 213,312,438 199,791,222 176,982,762 132,357,567 201,498,244 132,273,521
Market Share in Japan 21.0% 27.0% 42.7% 26.8% 23.6% 20.7% 10.4% 7.5%
Market Share in the United Kingdom 44.5% 30.7% 46.8% 35.7% 24.7% 32.1% 0.0% 0.0%
Market Share in the United States 47.2% 10.4% 12.2% 9.3% 14.2% 12.3% 10.1% 6.9%
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Interfruco used to pay Mexfruco seven days after fruit shipping. From its startup, and until late 2000, Mexfruco grew and operated very successfully. Mexfruco was a pioneer in quality control and food safety systems in the Mexican avocado industry. Its protocols and expertise became a key factor to differentiate itself from competitors and constituted one of Mexfrucos most important sources of competitive advantage. On these bases, Mexfruco became the largest exporter of Mexican avocados both in terms of volume and market diversity in 1999. Between 1997 and 2000, the subsidiary had substantial autonomy for most of its operating decisions, and it also exerted great influence on Interfrucos sales and marketing programs and policies in international markets. The transactions between Mexfruco and Interfruco, at first glance, continued as usual: avocados were sold to Interfruco at Mexfrucos cost plus a little markup. Occasionally, as is normal in the fresh fruit business, a shipment could have problems. Failures in the transportation system, high maturity of the fruit, excessive rains in groves, and several other problems might cause the fruit to arrive in poor condition to the market. In those cases, Mexfruco used to absorb most of the losses, granting the corresponding discount to Interfruco by issuing credit notes; in these cases, Interfruco lost only its commission. This mechanism of credit note issuing was used (as shown in Table 2), and seemingly abused, to shift income out of Mexfruco without any technical justification. At the end of the first year (1997), Interfrucos CEO, John Reed, and Mexfrucos managing director, Jos Prez, agreed to shift 68% of Mexfrucos profits to Interfruco. During those initial months, Interfruco had very low profits. Reed convinced Prez of the need to improve the financial
structure of Interfruco in preparation for the expected growth of the company. Prez agreed, after negotiating some bonus for Mexfrucos workers, equivalent to the legal profit-sharing mandate.2 Prez also considered that, since Mexfruco was exempt from income tax during its first year of operation, the move did not constitute any tax evasion (and no personal risk for him). The interests of the two local minority shareholders were also considered. Since they were managing the subsidiary, the losses they were facing were compensated by a substantial salary increase for the next year. Paradoxically, it was Prez who suggested the mechanism for this income shifting: Mexfruco would issue a number of credit notes to Interfruco, granting it discounts on the basis of price adjustments. At the end of the second year (1998), Reed decided to repeat the procedure. Mexfrucos books showed an attractive profit. Reed decided to shift 85% of that profit through the mechanism of price adjustments. According to Mexfrucos assistant manager at that time, Reed explained that Interfruco needed a stronger balance sheet in order to be able to finance future growth and promised not to use the mechanism in 1999. This time there were neither bonuses to replace workers profit sharing nor compensation to local shareholders. And there was tax evasion in the host country: Mexfrucos auditor reported violations to tax norms regulating transfer prices in related-party transactions. Prez never fully agreed with the move but trusted Reed would compensate Mexfruco in the future. In fact, price adjustment discounts diminished in the next fiscal year (1999). Because of this, and the expansion of its sales, Mexfruco reported one of the largest profits of its history in 1999. However, the practice of issuing price-adjustment discounts was extensively applied throughout the 2000
table
2 Income Shifted From Mexfruco Through Price-Adjustment Discounts (Current Mexican Pesos)
After-Discount (Remaining) Profits 96,032 78,829 1,765,862 408,828 2,416,550 1,563,226 2,054,968 3,057,353 Discounts as Percentage of Earned Profits 68.0% 84.9% 7.3% 89.0% 8.3% 13.9% 16.1% 7.4%
Fiscal Year 1997 1998 1999 2000 2001 2002 2003 2004
Prediscount (Earned) Profits 299,858 522,039 1,904,360 3,701,877 2,231,284 1,816,605 2,448,783 2,845,807
Price-Adjustment Discounts 203,826 443,210 138,498 3,293,049 185,266 253,379 393,815 211,546
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fiscal year. Mexfruco was on the path of having another record-breaking season in both sales and profits. When interviewed, Mexfrucos general accountant indicated that, throughout that year, Interfrucos CFO regularly and unilaterally mandated such price adjustments with the only purpose of reducing Mexfrucos profits. Often, these discounts were not announced but just deducted from weekly payments to Mexfruco (G. Morales, interview, January 2, 2006). In an e-mail message to Interfrucos CFO, Prez emphasized:
The point that I would like to stress here is the same that I have been asking for once and again and again . . . lets talk before you deduct, let us know what you plan to deduct, lets play like the team we are supposed to be . . . (J. Prez, e-mail message, February 2, 2000)
This state of affairs was unacceptable for Mexfrucos managers. They traveled several times to Interfrucos headquarters in California to express their disagreement, but their voices were not heard. The discussions always focused on profitability analysis and Interfrucos request for higher margins both at Interfruco and Mexfruco. During those meetings, parent-company managers systematically refused to talk of any issue not connected to short-term financial performance. There is a body of evidence showing that the new situation was increasingly being seen as unfair by Mexfruco managers. Consider, for instance, some of their expressions:
I am getting very tired of our impossibility (yours and mine) to talk about serious problems without your extreme reactions and attacks. (J. Prez, letter to John Reed, November 25, 2000) We argued all the time [for prices], and at the end they anyway paid us whatever they wanted. (S. Medina, interview, June 9, 2005) We had to source, pack, and ship fruit, at the will of [Interfruco], and at the prices they mandated . . . (L. Espinoza, interview, June 11, 2005) I am offended by acts from [the parent company] such as unannounced discounts, unjustified withholding and delays in payments . . . jokes about our complaints, serious lack of respect. . . . We have often been not well treated by [parent company] staff. (J. Prez, letter to John Reed, August 7, 2001)
At the end of 2000, Interfruco had shifted 89% of Mexfrucos profits out of the subsidiary. External auditors again declared tax evasion problems. Mexfruco began to have some cash constraints and, consequently, it extended its payment terms to growers. In the extremely competitive environment of the Mexican avocado industry, Mexfruco began to lose bargaining power. However, Interfrucos managers kept on claiming that Mexfrucos profits were not sufficient. They pushed for cost cutting, particularly on Mexfrucos social programs such as food safety, workers training and development, and workers health programs. There was a piece of U.S. legislation that had an important impact in the relations between Mexfruco and Interfruco. It is the Foreign Sales Corporation Act of 1984, which was replaced in 2000 by the Extraterritorial Income Exclusion Act. These laws granted tax incentives of up to 100% of the income taxes caused by foreign transactions to U.S.-based firms trading between third countries (Feinschreiber, 1993b). Although both acts were repeatedly ruled illegal by the World Trade Organization and the latter was finally repealed by the U.S. Senate in 2004, they provided an effective incentive for income-shifting practices. Interfrucos income shifting affected Mexfrucos ability to comply with Mexican tax obligations. Formally speaking, auditors only considered that Mexfruco was not in compliance in the 1998 and 2000 fiscal years. However, its accounting records show that, by reducing its taxable income, Mexfruco was not legally but morally and socially irresponsible with respect to its tax duties. The situation of minority shareholders or workers was not different. They lost share value and profit-sharing income, respectively, which was considered to be socially irresponsible by Mexfruco managers.
Mexfruco managers, who were used to having a significant degree of autonomy, were confronting an increasingly centralized management of transfer prices. Consequently they complained about the impossibility of expressing opinions, providing input for decision making, or challenging parent-company decisions or evaluations. They also felt they were treated inappropriately, without respect. Moreover, these feelings were likely aggravated by Mexfruco managers perception that Interfruco was not providing any explanations for decisions affecting them. Mexfruco managers were not satisfied with the results of their activity either. Consider these excerpts from the letter, already cited, that Prez wrote to Reed in early August 2001:
The profits from our endeavors stay in [Interfruco], while many of the risks have stayed with [Mexfruco] . . . I believe that a fair share of the profits must go to where most of the value is added . . .
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If the business fails, local people will look for me, not for you or for the company . . . I also have the tax risk of illegally transferring profits out of the country . . . [which] is a criminal fraud . . . . . . economically I do not have a better position now . . . . . . after 4 years of working for the company . . . I do not see myself as a better person. (J. Prez, letter to John Reed, August 7, 2001)
Based on the previous case, and recurring to organizational justice theory, in the following section I discuss the conditions under which managers perceive transferpricing policy as fair or unfair, and study the relations between fairness perceptions and subsidiary performance. Figure 1 synthesizes the argument.
It was clear that, to a very large extent, income-shifting practices were causing these perceptions, as reflected by both the concern with the subsidiarys seemingly purposeful low profitability and the concern, as minority shareholder, with personal income. But there appeared to be other criteria of unfairness. On the one hand, several kinds of risk at the personal level are mentioned, like the risk of business failure and a corresponding risk of damage to professional and social relations, and legal risks derived from tax avoidance. On the other hand, there is a normative concern for not having become a better person after years of working for the company, although this is not directly linked to transfer-pricing policy. On August 21, 2001, at a formal assembly of Mexfruco shareholders, the two top subsidiary managers (and minority shareholders) decided to rescind their contracts and sell their shares to the parent company (Minutes of the Asamblea General Ordinaria de Accionistas de [Mexfruco], August 21, 2001). From that point on, Mexfruco has been a wholly owned subsidiary of Interfruco and, as can be seen in Table 2, income shifting was importantly reduced afterward. Nevertheless, the company has had many problems and has lost market share, although it remains in operation.
figure
The Perception of Fairness and Subsidiary Performance

Drawing from organizational justice theory and the insight gained in the case study, in this section I analyze how the ethical and behavioral dimensions of transferpricing policy can affect the managers job satisfaction and performance. In particular, I address, on one hand, the effect of transfer-pricing policy formulation, implementation, and outcomes on subsidiary managers perceptions of fairness. On the other hand, I study the role of fairness perceptions as a determinant of managers behavior and performance. Organizational justice theory, as developed in social psychology, focuses on the perceptions of justice that organizational players have (Tyler, 2001). Organizational justice is a field that has experienced an important development, mainly because it has been very useful to explain and predict diverse behaviors found in organizations (Colquitt, Wesson, Porter, Conlon, & Ng, 2001; Greenberg, 1987, 1990a). In broad terms, it sees organizational actions as a sequence of events in which a procedure generates a process of interaction through which an outcome is achieved and allocated to someone (Bies & Moag, 1986). Each part of the sequence is subject to particular fairness considerations: the procedure to procedural
1 International Transfer Pricing and Subsidiary Performance: The Role of Organizational Justice
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justice; the interaction to interactional justice; and the allocation of outcomes to distributive justice. The perception of fairness in international transfer pricing is important, if not for any other reason, because it is the demand for fairness in an exchange that generates transaction costs (Husted & Folger, 2004), and minimizing transaction costs is the main objective of transaction governance mechanisms (Williamson, 1981). When transfer pricing is conceptualized as a problem of agency, fairness in such a contractual context may be an important factor to reduce agency costs (Eccles, 1985b). Thus, creating the perception of fairness can be considered a central problem in managing transfer pricing. Building on the work of Ouchi (1980), Husted and Folger (2004) have proposed that the perceptions of fairness in exchanges are influenced by (a) the design of the governance mechanism; (b) its implementation; and (c) its outcomes. Consistent with this perspective, I propose that perceptions of justice in transfer pricing are influenced by (a) the strategic process of transfer-pricing policy decision making, which is a hybrid that incorporates market and hierarchy mechanisms to various degrees (Rosanas, 1991), and by which mandated intrafirm transactions and specific transfer pricing criteria are decided upon; (b) the administrative process of policy implementation and actual transfer price setting, which includes aspects such as who are the persons involved in the process, which is the level of information sharing, how do actual interactions take place, how are conflicts managed, and the like; and (c) the outcomes of transfer pricing, which include but are not limited to performance measurement and evaluation. The influence of these types of factors on managers perceptions of fairness can be better explained by the notions of procedural, interactional, and distributive justice, respectively.
Procedural justice theory offers one way to explain the link between transfer-pricing policy and the perception of fairness of the processes by which it is decided upon.
Perceptions of Fairness as Outcome of TransferPricing Policy

Based on the sequence proposed by Bies and Moag (1986), according to which an organizational decision consists of a procedure that generates a process of interaction through which an outcome is achieved and allocated to someone, in this section I first explore perceptions of fairness in transfer pricing from the perspective of procedural justice; next, from the perspective of interactional justice; and finally from that of distributive justice.
Procedural Justice Perceptions Procedural justice theory offers one way to explain the link between transfer-pricing policy and the perception of fairness of the processes by which it is decided upon.
Procedural justice theory stems from the legal tradition and focuses on the fairness of the processes used to resolve disputes. It predicts that decisions resulting from a process perceived as fair are better accepted, even if they are unfavorable, than those resulting from unfair processes, and assumes that fair processes will lead to fair outcomes (Thibaut & Walker, 1975, 1978). One of the key determinants of procedural justice perceptions is voice, which is the possibility of expressing opinions and feelings during the process of decision making, the opportunity to provide inputs to the decision maker prior to the decision, and the ability to challenge or rebut evaluations (Bies & Shapiro, 1988; Greenberg, 1990a). In the specific context of international intrafirm transactions, Kim and Mauborgne define procedural justice as the extent to which the dynamics of a multinational corporations decision-making process are judged to be fair by the managers of its subsidiaries (1993, p. 503). These authors found that the key factors that lead to judgments of process fairness by subsidiary managers are: (a) the management of the parent company is knowledgeable about local situations of the subsidiary; (b) two-way communication exists in the multinationals decision-making process; (c) the parent company is fairly consistent in making decisions across subsidiaries; (d) subsidiary managers can legitimately challenge the strategic views of the parent company; and (e) subsidiaries receive an account of the multinationals final decisions. Fairness perceptions in transfer-pricing policy decision making are strongly influenced by the degree of
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centralization of the process. Some authors (e.g., Kogut, 1985) argue that the strategy of vertical integration inherently implies mandated transfer prices and the centralization of all major decisions on the topic. In fact, empirical studies (e.g., Eccles, 1985a) have shown this to be the case in most U.S. multidivisional companies. Under these conditions, the decision rights of subsidiary managers (i.e., the distribution of authority and responsibility that derives from strategy) are limited. An often-voiced complaint by managers is that their responsibility exceeds their authority in a way that they are held accountable for outcomes that they cannot control. As a consequence, fairness perceptions can be expected to be negatively affected. It has been shown, however, that such degree of centralization is not universal. For example, while the transfer-pricing policy formulating process is highly centralized among U.S. firms, Japanese companies follow a more decentralized process, decisions are made through negotiation and consensus, and the interests of local partners and managers receive greater emphasis, independent of the transfer-price method that is chosen (Tang, Walter, & Raymond, 1979). This is evidence that the process of transfer-pricing policy decision making can be performed in a way in which voice is exercised and local interests are considered, even within a strategy of international vertical integration. There is empirical evidence that participation and the exercise of voice increase fairness perceptions in processes such as budgeting (Libby, 1999; Lindquist, 1995), which may resemble transfer-pricing decisions.
Transfer-pricing policy is one way to establish the responsibility of subsidiary managers, in terms of the criteria by which a managers performance is measured.
Thus, since voice and participation are recognized as criteria of procedural fairness in many different cultures (Greenberg, 2001; Morris & Leung, 2000), it can be expected that participative processes of transfer-pricing policy decision making will achieve enhanced perceptions of procedural fairness. In any event, unfairness will be perceived whenever voice and participation cannot be exercised. For instance, in the Mexfruco case, subsidiary managers were not able to present the needs and conditions of their unit with respect to taxation, its workers rights to profit sharing, or its diminished bargaining power, all caused by income shifting. Mexfruco managers could not challenge parent-company views either. They did not receive explanations of parent-company decisions. Consequently, as predicted by Kim and Mauborgne (1993), perceptions of procedural unfairness emerged from these factors. Among the processes linked to transfer-pricing policy formulation and implementation, performance measurement and evaluation, which is usually the basis for defining managers rewards, is likely to be the most influential on managers perception of fairness. Transfer-pricing policy is one way to establish the responsibility of subsidiary managers, in terms of the criteria by which a managers performance is measured. Profitability is one of the most important criteria (Eccles, 1985a). Fairness in using transfer pricing for performance evaluation is difficult to achieve because, as discussed above, transfer-pricing policies are, in practice, strongly focused on shifting income toward the parent company. For instance, when a mandated cost-based policy is used, the general manager of the selling party should not be held responsible for the profits and losses on his/her units product; receiving no profits on internally traded goods transferred at cost will likely be a major source of concern for managers if profitability is a means of performance evaluation, as it was in the case of Mexfruco. Although this does not necessarily mean that corporate performance will suffer, it does create the possibility that managers will believe that their contributions to the company are not fairly evaluated. To the extent that fairness is a concern, the importance of nonfinancial measures to evaluate performance should not be overlooked (Eccles, 1985a). A process of performance evaluation perceived as fair by subsidiary managers will rest on the ability of the parent company to exercise subjective judgment to take into account the contributions of managers to total company performance even at the expense of the financial results of the subsidiary (Eccles, 1985b). Therefore, these procedural justice considerations lead to the following proposition:
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Proposition 1a: International transfer-pricing policy will be considered as fair by subsidiary managers to the extent to which: 1. It takes into consideration the local situation and interests of the subsidiary; 2. Subsidiary managers can exert voice (i.e., they can express opinions and challenge parent company views); 3. There is agreement between parent-company management and subsidiary managers on the criteria and procedure for measuring and evaluating performance; and 4. Subsidiary managers have the necessary decision rights to affect outcomes.
Interactional Justice Perceptions Research has shown that perceptions of justice are influenced by factors that go beyond the formal procedures used to make decisions. These factors are related to the quality of the interaction that people have with decision makers. As Bies and Moag (1986, p. 44) note, People are sensitive to the interpersonal treatment they receive during the enactment of organizational procedures. Although some authors consider this dimension just as the interpersonal aspect of procedural justice (Greenberg, 1990a, p. 411), most scholars agree that this is a different concept, known as interactional justice. According to Bies (2001; Bies & Moag, 1986), the criteria of fairness from the interactional point of view are: (a) truthfulness, which refers to the expectation of open and honest communication; (b) respect, which implies the avoidance of deliberate rudeness or attacking behaviors; (c) propriety of questions (i.e., seeking or requiring information that does not constitute, or may not lead, to discrimination or to the formulation of prejudicial statements); and (d) justification, which is the explanation that a decision maker offers so that the action or decision might be understood and found acceptable, or in other words, the explanation about either the propriety of a decision or the mitigating circumstances that led to an unfavorable outcome (Bies & Shapiro, 1988). Once a transfer-pricing policy has been chosen, parent-company and subsidiary managers interact to various degrees to implement the policy and set actual transfer prices (Eccles, 1985a). Transfer-price setting will be considered interactionally fair if it can be done through processes of communication in which parent-company managers respect their subsidiary counterparts, provide justification for proposals and decisions, request adequate information and share it appropriately, and so on. By the same token, the way in which conflicts are managed and resolved will also be subject to fairness judgments. Several of these conditions were missing in the case of Mexfruco,
which led to perceptions of interactional injustice. For instance, there was neither justification about Interfrucos aggressive income-shifting practices nor open and honest communication on the topic. In addition, Mexfruco managers complained of jokes, attacks, and, in general, disrespect by Interfruco managers. At the empirical level, justification or explanation is the factor of interactional justice that has received more attention. For instance, in a budgeting setting, Libby (1999) has shown that fairness perceptions are improved when subordinates receive the communication of a rationale for their lack of influence over the final budget target set by their superior. The similitude between budgeting and transfer-pricing decision-making processes suggests that justification can likely have the same type of effect in international transfer-pricing settings. The following proposition can be offered from the previous discussion: Proposition 1b: International transfer-pricing policy will be considered as fair by subsidiary managers to the extent to which: 1. They receive adequate justification or explanation for proposals and decisions; 2. They can truthfully, respectfully, and unrestrictedly communicate with parent-company managers; 3. They consider the amount and quality of questions and shared information as appropriate; and 4. Conflicts are resolved in a satisfactory fashion.
Distributive Justice Perceptions Independently from the processes by which transfer-pricing policy is decided upon and the interactions by which they are implemented, the outcomes of transfer pricing may have a direct effect on managers perceptions of justice. There exists the potential for perceptions of unfairness to arise after the transfer-pricing policy has begun to operate (i.e., once the outcomes are clearly visible to managers; Husted & Folger, 2004). Distributive justice theory provides a framework to explain this effect. Social exchange theory (Homans, 1961) constitutes the seminal work in distributive justice. Homans postulated that the distribution of a reward is said to be fair when the ratio of rewards is equal, as perceived by all the parties, to the ratio of contributions. Equity theory (Adams, 1965) extended the concept to organizational settings. Adams argued that people compare the ratios of their own perceived outcomes to their own perceived inputs to the corresponding ratios of comparison to others in the organization. For him, outcomes in the job situation for a person are all factors perceived to be returns on
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the individuals job investments, such as rewards, status, and the intrinsic interest of the job. Inputs include all factors perceived by a person as relevant for getting some return, such as effort, age, education, qualifications for the job, and the like. Equity is determined by a particular input-outcome balance, defined by the individuals perception of what he/she is giving and receiving (Campbell & Pritchard, 1976; Lawler, 1968). Unfairness is perceived if the ratios are unequal. More recent research has emphasized other criteria for distributive justice beyond self-interested criteria such as equity. While these criteria are seemingly prevalent in Western cultures, there are other, moral criteria, such as equality or need, which are preferred in other cultures (Folger, Cropanzano, & Goldman, 2005; Leung, 2005; Turillo, Folger, Lavelle, Umphress, & Gee, 2002). There are many outcomes of transfer-pricing policies and practices that may be perceived as inequitable, and/or may be judged as morally unfair. First of all, if cost-based transfer prices and invisible transactions are used, reward systems based on subsidiary profits such as bonuses or subsidiarys stock ownership will provide little or no economic benefits for managers, as it happened in the Mexfruco case. Even if they follow from a fair process of performance evaluation, such rewards will be clearly perceived as unfair. In addition, subsidiary managers may eventually judge some of their job conditions as unfair, even if performance evaluations reasonably underweight the subsidiarys financial results. Those conditions can be, for instance, the lack of autonomy or the perception of reduced status. When cost-based transfer pricing is in place, and attempting to have consistent systems of performance evaluation and reward, subsidiaries are frequently managed as cost centers, not as profit centers (Abdallah, 1989). It has been shown that in many organizations, cost-center managers have less prestige for several reasons: they are not responsible for the bottom line, they may be less sure that they are recognized, and there is an implied subservience to the relevant profit center (Eccles, 1985b). Another outcome perceived as unfair may be the practical impossibility for subsidiary managers to allocate resources for growing and improving their units. Subsidiary managers may often consider, with reason or without it, that a significant share of the value of corporate final products is added by the subsidiary, where all the hard work is done. If transfer pricing significantly shifts income out of the subsidiary (i.e., the parent company takes all the profits), local managers may show a perception of inequity or relative deprivation, particularly
if those resources are perceived to be used to spur the growth and improvement of other subsidiaries or to acquire conspicuous signs of parent-company wealth. There are more subtle outcomes that may be perceived as unfair. When subsidiaries have no profits, there may be risks for their managers at the personal level. This was clear in the case of Mexfruco. On the one hand, some transfer-pricing policies may weaken the financial structure of the subsidiary; as a consequence, managers will perceive financial harm for their business units (Mehafdi, 2000). These managers, and eventually local shareholders, will develop a sense of financial exposure to local creditors. If events varying from delays in payments to creditors to lawsuits and bankruptcy occur, they will cause a loss of personal reputation and will damage managers relationships in their professional and business environment. On the other hand, transfer pricing that shifts income out of the subsidiary and the host country will cause the subsidiary to pay no income taxes. Those firms have more possibilities to be audited. Responding to tax audits may also be perceived as an unfair outcome of transfer-pricing policy. Furthermore, if the host-country authorities find out that the transfer-pricing policy has been designed to avoid taxes, local subsidiaries may face penalties and, eventually, subsidiary managers may be charged with perpetrating tax fraud, or at least with complicity. This type of outcome will undoubtedly be perceived as unfair. By the same token, as illustrated by the Mexfruco case, the outcomes of the subsidiary may be perceived as unfair by ethically minded managers when multinational corporations misuse their transfer-pricing systems (Mehafdi, 2000). Aguilera, Rupp, Williams, and Ganapathi (2007) argue that the perceptions of corporate socially responsible behavior are one aspect of employees general justice perceptions. Transfer-pricing policies may limit the desirable social performance of subsidiaries in their host countries (Paz-Vega, 2005) and, therefore, they may be judged as unfair. This may occur, for example, when transfer pricing is used to reduce the share of profits to local partners or the legal or contractual share of profits to workers (Arpan, 1972, cited by Tang, 1993; Knowles & Mathur, 1985) or when transfer prices are used for illegal actions such as tax avoidance, money laundering, or capital flight (Paul et al., 1994). In addition to the unfairness of these outcomes, and as a consequence of them, subsidiary managers may face a real or perceived loss of personal reputation in their local communities and a deterioration of their social relations, which are by themselves other unfair outcomes.
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The previous discussion on distributive justice leads to the following proposition: Proposition 1c: International transfer-pricing policy will be considered as fair by subsidiary managers to the extent to which: 1. The transfer-pricing policy is consistent with the criteria by which rewards or punishments are granted; 2. Job conditions for subsidiary managers (status, degree of autonomy, possibility to allocate resources, etc.), as derived from transfer-pricing policy, are considered as appropriate; 3. Subsidiary results, as influenced by transfer prices, do not lead managers to situations of financial or tax exposure at the personal level; and 4. Transfer pricing is not a cause of poor corporate social performance at the local level.
Interaction Between Different Types of Justice Perceptions Distributive, procedural, and interactional justice perceptions tend to be correlated (Colquitt et al., 2001). For instance, research shows that people care less about the fairness of procedures when they lead to positive outcomes (Brockner & Siegel, 1996; Greenberg, 1990a). Some authors argue that distributive, procedural, and interactional perceptions are three dimensions or components of overall fairness (Cropanzano, Slaughter, & Bachiochi, 2005). Accordingly, perceptions of injustice along one dimension can be at least partially mitigated by perceptions of justice along another of the dimensions (Cropanzano, Bowen, & Gilliland, 2007). By the same token, perceptions of one type of injustice increase the likelihood of perceiving other types of injustice (Shapiro & Kirkman, 2001). The case of Mexfruco exhibits perceptions of injustice with respect to transfer-pricing policy along all three dimensions, which supports Shapiro and Kirkmans (2001) notion of simultaneous perception of multiple types of unfairness, as well as the idea of Cropanzano and colleagues (2005) about the existence of an overall concept of fairness. The Moderating Effect of Culture Organizational justice theory has been mainly developed in an Anglo-American cultural context, and therefore, some caution must be exercised regarding its crosscultural generalizability. In general terms, research shows that concerns about justice are universal, but that what is considered to be distributively, procedurally, or interactionally fair shows substantial variation across cultures (Beugr, 2007). Thus, the constructs of organizational justice do not seem to be universal in its causes (Greenberg, 2001; Leung, 2005; Morris & Leung, 2000).
Organizational justice theory has been mainly developed in an Anglo-American cultural context, and therefore, some caution must be exercised regarding its crosscultural generalizability.
For example, with respect to distributive justice and consistent with mainstream organizational justice theory (e.g., Adams, 1965), individualistic cultures prefer equity as the rule of distribution. However, collectivistic cultures may prefer equality, particularly for within-group distributions (Leung, 2005; Morris & Leung, 2000). Accordingly, the equity criteria would lead to a transferpricing policy that allocates profits according to the value added by each of the subsidiaries, which is close to the Arms Length principle, universally accepted as criteria of fairness for transfer-pricing decisions (OECD, 2001). Criteria of equality would lead to transfer-pricing policy that equally distributes income among participant units, something that, to the best of my knowledge, has never been proposed in the international business literature. In any event, shifting income out of the subsidiary, as in the Mexfruco case, does not follow any of these criteria and, most likely, would be considered distributively unfair. Procedural justice seems to be more universal (i.e., voice is recognized as fair in different cultures; Greenberg, 2001; Morris & Leung, 2000). However, there are diverse modalities of voice. Collectivistic cultures prefer procedural rules based on mediation, compromise, and negotiation, in order to maintain social relations (to which fairness is subordinated). In contrast, individualistic cultures prefer straightforward procedural methods, such as persuasion and bargaining (Leung, 2005). Without doubt, the impossibility of exercising any voice modality or participating in decision making, as it occurred to Mexfruco managers with respect to transfer-pricing policy, leads to judgments of unfairness.
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Interactional justice is highly sensitive to cultural differences, because what constitutes appropriate interpersonal interactions in one culture may be considered totally unacceptable in another culture (Greenberg, 2001; Li & Cropanzano, 2005). However, explanation or justification seems to be universal criteria of interactional fairness. In the case of Mexfruco, subsidiary managers complained about unjustified and unannounced discounts, which reflects perceptions of interactional unfairness. In addition, they complained about interpersonal treatment, disrespect, and the like, which may reflect cultural conditioning. In short, perceptions of distributive unfairness in transfer pricing seem to arise from failures to the equity criteria; perceptions of procedural unfairness initially emerge from the impossibility of exercising voice, in any of its cultural modalities; and most perceptions of interactional unfairness seem to arise from the lack of explanation or justification. Therefore, although perceptions of fairness can be influenced by cultural factors such as collectivism or individualism, it seems that the fairness of transfer-pricing decisions and implementation is judged according to the typical self-interest model of organizational justice, perhaps because managers consider them to be predominantly business (i.e., instrumentally rational) issues.
The Perception of Fairness as a Determinant of Subsidiary Managers Performance

There is a significant body of literature that shows that people respond to perceptions of fairness by translating them into attitudes and behavior. Thus, assessments of organizational justice can be used to explain a wide variety of organizational phenomena and as predictors of organizational behavior. It has been shown that fairness perceptions affect several organizational variables such as organizational commitment, intention to turnover, organizational citizenship behaviors, trust in management, productivity, and job satisfaction (Cohen-Charash & Spector, 2001; Colquitt et al., 2001; Greenberg, 1990a; Viswesvaran & Ones, 2002). Meta-analytic studies of these variables show that they are closely linked to one another, which suggests that there is a general morale factor in organizations (i.e., a basic psychological state related to the goodness of the workplace; Viswesvaran & Ones, 2002). Accordingly, in this section I propose that subsidiary managers perception of the fairness or unfairness of transfer-pricing policies and practices impact several organizational goodness variables and, in this way, the long-term performance of the subsidiary. According to equity theory, individuals perceiving an unfair state may react behaviorally to reduce or avoid inequity (Greenberg, 1987). Adams (1965) argued that individuals can change the ratio of inputs to outcomes by (a) cognitively distorting inputs or outcomes (i.e., attempting to justify the outcomes received); (b) acting on the organization to get it to change inputs or outcomes; (c) actually changing the individuals own inputs or outcomes; (d) changing the standard of comparisons; and (e) leaving the particular relationship. Adamss predictions can be applied to the context of transfer-pricing policy outcomes. For instance, in order to reestablish equity, managers may distort the way in which inputs and outcomes are perceived (i.e., they convince themselves or are convinced by othersfor instance, by explanation or justification) that the balance between their efforts and their rewards is appropriate. By the same token, acting on the organization to change the ratio of inputs to outcomes frequently implies the exercise of voice (Bies & Shapiro, 1988). On the other hand, exiting (i.e., leaving the relationship), as in the Mexfruco case, is a costly alternative to both the manager and the subsidiary; the subsidiary would lose all the training, experience, relationships, and knowledge of the departing manager; in the case of international subsidiaries, such knowledge and experience of local managers is frequently of paramount importance.
It has been shown that fairness perceptions affect several organizational variables such as organizational commitment, intention to turnover, organizational citizenship behaviors, trust in management, productivity, and job satisfaction.
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Lawler (1968) postulated that, among their several alternatives, individuals that perceive unfairness will first attempt to actually change their inputs or outcomes. In other words, justice perceptions will likely lead people to alter their performance levels by increasing or decreasing productivity and work quality, in order to reduce the inequity. This suggests that, in a situation in which outcomes to the subsidiary are perceived as unfair, work quality and productivity will be decreased to reduce the inequity. Neglect is another response to unfairness that attempts to diminish the individuals inputs; neglect is characterized by passiveness, reduced interest or effort, lateness or absences, use of company time for personal business, and so on (Withey & Cooper, 1989). Furthermore, it is important to note that a situation of unfairness may lead to opportunistic or unethical behavior on the part of subsidiary managers (Greenberg, 1990b; Mehafdi, 2000). As a way to reduce the inequity, managers may engage in questionable practices such as developing conflicting sources of personal income, extorting suppliers and bribing customers, stealing, and the like. In the specific setting of multinational companies, Kim and Mauborgne (1993) have demonstrated that perceptions of fair decision making have a positive influence on subsidiary top managers compliance. Kim and Mauborgne define subsidiary top managers compliance as the extent to which subsidiary managers carry out corporate strategic decisions made for their national units (1993, p. 503). They found that the effect of justice judgments on compliance is both direct and indirect; the later is mediated by organizational commitment and trust. In other words, trust and commitment decline whenever unfairness is perceived by subsidiary managers. In the context of multinational companies and their subsidiaries, commitment inspires subsidiary managers to identify with the strategic objectives of the parent company and to exert effort on behalf of the achievement of those objectives. Trust fosters the cooperative actions necessary to carry out the multinationals strategic decisions. Both commitment and trust encourage subsidiary managers to comply with their parent companys decisions and to engage in desirable behavior, and discourage subsidiary managers from exercising managerial discretion and from behaving opportunistically. The preceding discussion leads to the following proposition: Proposition 2a: To the extent to which subsidiary managers perceive unfairness in transfer-pricing policy and its implementation, 1. Subsidiary managers job commitment will likely decrease;
2. Trust in parent company will likely decrease; 3. Strategic compliance will likely decrease; 4. Neglect will likely increase; 5. Turnover will likely increase; and 6. Unethical behavior will likely increase.
The Moderating Effect of Culture and Relational Quality Transfer-pricing policy decision making and implementation are not isolated events. They take place in a broader social, cultural, and organizational context that has been shaped by different historical developments and social relations. This context involves parent-company and subsidiary managers, with their own cultural identities. There is evidence that attitudinal and behavioral responses to perceptions of fairness or unfairness tend to be general across cultures, converging around responses such as withdrawal of resources (including effort or commitment); exiting the relationship; voicing or activism against the unfair/illegitimate agent; and the like (Withey & Cooper, 1989). However, the degree and modality of the response may vary in different countries. These reactions tend to be less intense in high-power-distance and collectivistic cultures (Leung, 2005), apparently because, in the former, culture legitimizes the dominance of some groups over others and the corresponding existence of a certain degree of unfairness; and in the latter, because people prefer to maintain social harmony over fairness (Beugr, 2007; Greenberg, 2001). Therefore,
Proposition 2b: The responses of subsidiary managers to perceptions of unfairness in transfer-pricing policy will be moderated by cultural factors in the following ways: 1. Managers responses will be less intense in collectivistic cultures, as compared to those in individualistic cultures. 2. Managers responses will be less intense in high-power-distance cultures, as compared to those in low-power-distance cultures. In addition, Granovetter (1985) has argued that economic behavior is shaped by the structure of social relations. He underlines that the specific characteristics of these relations play a crucial role in generating trust and discouraging malfeasance. As discussed above, subsidiary managers respond to unfairness in transfer-pricing policy by translating their perceptions into actual, usually undesirable attitudes and behaviors. However, Granovetters ideas suggest that the magnitude of that response can vary according to the concrete details and strength of the relations between parentcompany and subsidiary managers. The background of these relations, the relative power of each manager, their status and position in the intrafirm network, the initial
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level of trust between them, and the like are variables that characterize the relationship between managers. The construct of relational quality (Ario & De La Torre, 1998) captures most of these dimensions. It is defined as the sum of three terms: The first is the initial state of trust that exists between the parties, as a result of the parties status, reputation, and previous experiences between them. The second term derives from the parties cumulative experiences during their work together, as each observes the behavior of its counterpart, both in steady states and during times of environmental change. The third term refers to external events, unrelated to the work relation between the parties but that affect their credibility and reputation. Granovetter (1985) also argues that social influence is not a one-time phenomenon. It is an ongoing process, continuously constructed and reconstructed during interaction. He affirms that the stability of the relation is a key characteristic in trust creation and relation strengthening. This suggests that, through time, the repeated interactions between parent company and subsidiary, the perceived fairness of those interactions, and the resulting attitudes and behaviors can modify and reconstruct the structure of relations between the parties. Consistent with this view, Ario and De La Torre (1998) explain that learning-action-reaction loops contribute more or less to the building of relational quality on a cumulative basis. An analysis of the dynamics and influence of social relations, fairness perceptions, and attitudes and behaviors on relational quality is beyond the scope of this article. However, it is important to realize that at any given point in time, the response of subsidiary managers to the perceived fairness or unfairness of transfer-pricing policy takes place in the context of a particular structure and quality of social relations. On the basis of this knowledge, I offer the following proposition: Proposition 2c: The higher the relational quality between subsidiary and parent company managers, the less intense the (undesirable) response of subsidiary managers to perceptions of unfairness in transfer-pricing policy.
volve unfairness (Mehafdi, 2000). As discussed above, this situation naturally triggers inefficiency, executive turnover, managerial discretion and suboptimal decision making, opportunism, and/or unethical behavior. Husted and Folger (2004) point out that these responses to injustice constitute additional transaction costs, which they call fairnessresponse transaction costs. Similarly, Eccles (1985b) argues that unfairness perceptions by subsidiary managers will likely increase agency costs. The objectives sought after, and the benefits expected from, international vertical integration can significantly be undermined by these costs. If this is the case, those objectives and benefits will not be fully achieved (i.e., the strategic performance and long-term value of the subsidiary will be poor). As a consequence, parent-company management may eventually consider abandoning the strategy of vertical integration. In summary, I propose: Proposition 3a: The greater the perceived unfairness of international transfer-pricing policy, the greater the fairnessresponse costs created by that transfer-pricing policy. Proposition 3b: The greater the fairness-response costs created by transfer-pricing policy, the lower the strategic performance exhibited by the subsidiary.
Conclusions
More than 50 years ago, Dean reached the conclusion that the chances are strong that an unsound system of transfer pricing will cause harm (1955, p. 74). Since that time, economists and academic accountants have developed a substantial body of theory on the matter. Nevertheless, particularly with the advent of globalization and its concomitant increase in foreign investment flows and international intrafirm trade, such theory has proven to be insufficient to explain and predict the diverse implications of transfer-pricing policy decisions. In this article, I have assumed that transfer-pricing problems are more complex and multidimensional than what mere corporate profit maximization implies. I have argued that their study and application crucially require the consideration of ethical and behavioral dimensions within a strategic perspective. Drawing from organizational justice theory, I have offered a theoretical explanation of the importance of such considerations on several subsidiary variables, which, in turn, may affect the strategic performance of the subsidiary. I acknowledge that transfer-pricing policy and practices are not the only determinants of the subsidiarys performance or of a managers perceptions of justice. The parent company may find alternative ways to allocate resources and invest in the development and maintenance
The Cost of Unfairness

The previous analyses show that, to the extent to which transfer-pricing policies and practices are decided upon and implemented through just processes, and to the extent to which the outcomes are fair, commitment, trust, compliance, productivity, and work quality will increase. However, it has to be noted that, as several studies report, subsidiary managers overtly express dissatisfaction or conflict with prevalent transfer-pricing policies, because they may in-
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of competitive advantages, including the growth and improvement of the subsidiary. Also, the parent-company management may be involved enough with the local conditions of the subsidiary and the goals and aspirations of its managers. It is clear to me that if parent-company management shares these concerns, it may use ways different from transfer pricing to achieve an adequate support for the aspirations and goals of local managers, and to reduce their eventual anxiety for the lack of good financial results. The eventual demonstration of the truth of my propositions requires further research, which can build on and expand the findings of the exploratory case study presented in this article. This can be done, in a first stage, using a multiple-case-study strategy. The complexity and multidimensionality of the problem require greater insight into the phenomena of transfer-pricing management and its consequences, particularly with respect to the formation of fairness judgments in different cultures. Whereas the case strategy is appropriate to test my theoretical propositions, it is equally well suited to explore whether there are alternative, more relevant explanations. The selected cases should ideally belong to the same industry and show contrasting transfer-pricing policies. They must include parent companies and subsidiaries operating in countries between which there exist treaties to avoid double taxation, in order to control for this factor that often leads companies to shift income to the parent company. In a second stage, a survey strategy can be used to confirm the propositions presented in this article, as modified by the case-study research. Survey results would add to the generalizability and external validity of the case-study findings. Assuming that future research does not prove my propositions to be false, and consistent with the findings of this articles case study, there seems to be a frequent and serious misalignment between the strategic perspective, which determines transfer pricing in the first place, and the short-term profit maximization view that prevails in most international transfer-pricing practices. The strategic perspective has an implicit long-term orientation: it seeks to develop a long-lasting competitive advantage. This would firstly be an advantage of the subsidiary, and it is predominantly the subsidiarys responsibility to develop, maintain, and enhance it. Porter (1996) has highlighted the importance of strategic consistency among company activities. His arguments suggest that the inconsistency between a strategy of vertical integration on one hand and a short-term profit-maximizing transfer-pricing policy on the other, erodes the competitive advantage of the firm. The case study of this article illustrates, and my theoretical framework explains, how this erosion may occur. The short-term profit-maximization objec-
The international vertical integration strategies of multinational companies can be made more successful by giving justice dimensions the importance that they deserve in strategy formulation, implementation, and evaluation.
tive, supported by traditional economic transfer-pricing theory, can cause perceptions of unfairness on the part of subsidiary managers and other constituencies such as local shareholders, which may lead to a counterproductive outcome: the inability of the subsidiary to reach the objectives for which it was created (i.e., poor strategic performance of the subsidiary). My argument proposes that justice factors are necessary, although not sufficient, to achieve strategic objectives. In order to develop and maintain its competitive advantage, the subsidiary needs the commitment, productivity, compliance, and so on of its managers. The international vertical integration strategies of multinational companies can be made more successful by giving justice dimensions the importance that they deserve in strategy formulation, implementation, and evaluation. Since transfer-pricing policies, processes, and practices govern the international intrafirm transactions of such companies, incorporating criteria of fairness into them will serve the objectives of maximizing shareholder long-term value and improving the job satisfaction of subsidiary managers. For all these reasons, transfer-price manipulation should be minimized, and if practiced, it should take into account its ethical and behavioral implications. Furthermore, in agreement with Abdallah (1989); Gatti, Grinnell, and Jensen (1997); and the OECD (2001), I argue in favor of discontinuing the use of cost-based international transfer-pricing policies and generalizing the use of
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market-based criteria as a first important step in improving fairness perceptions. Although cost-based transfer pricing and invisible transfer transactions maximize the shortterm profit of the parent company, market-based transfer pricing is more compatible with the ethical and behavioral dimensions of the problem and the long-term perspective implicit in a strategy of international vertical integration. Gatti et al. demonstrated that a market-based approach to transfer pricing may sacrifice some short-term profits, but it obtains superior measures of subsidiary performance, reduces the transaction costs associated with cost-based pricing, is more likely to lead to the maximization of longrun profits, and, thus, improves the chances of maximizing shareholder wealth in the long term. The empirical verification of my propositions may eventually contribute to the theoretical understanding
and practical application of transfer-pricing policy and its ethical and behavioral dimensions as key determinants of the success of international vertically integrated ventures. In addition, such findings would offer new applications of organizational justice theory to international organizational phenomena and would support the importance of distributive justice. In my framework, distributive justice regains a predominant role in organizational justice theory because, on the one hand, it incorporates moral criteria in addition to self-interest and on the other hand, it offers an ex-post, definite evaluation of procedural and interactional justice rules. Finally, if my propositions are demonstrated to be true, they will provide empirical support for Husted and Folgers (2004) model that postulates transaction costs to be affected by fairness perceptions in exchange.
Dr. Ramn Paz-Vega is a lecturer in the Graduate School of Management (EGADE) of the Instituto Tecnologico
de Monterrey (ITESM) in Monterrey, Mexico. He obtained his PhD from EGADE in 2008. His research focuses on business ethics and corporate social responsibility in international settings, particularly from the perspective of subsidiary organizations. He is also managing partner of Paz Mendoza y Asociados, S.C., a consulting firm in the international fruit trade.
N o te s
1. The firm identified as Mexfruco throughout this article, and its parent company Interfruco, are pseudonymous. Any similarities between the fictitious Mexfruco and Interfruco and any real companies bearing these names are coincidental and unintentional. All personal names have been disguised too. 2. Mexican Labor Law mandates companies to share with their workers 10% of their taxable income every year.
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Int e r n a t i o n a l T r a n s f e r - P r i c i n g Pol ic ie s a n d P r a c t i c e s : A n O v e rview

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1 Some Indicators of Mexfrucos Strategic Performance

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The Perception of Fairness and Subsidiary Performance

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Perceptions of Fairness as Outcome of TransferPricing Policy

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The Perception of Fairness as a Determinant of Subsidiary Managers Performance

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The Cost of Unfairness

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