This paper examines transfer pricing in multinational firms when individual divisions face different income tax rates. Assuming that a firm decouples its internal transfer price from the arm's length price used for tax purposes, we analyze the effectiveness of alternative pricing rules under both cost‐ and market‐based transfer pricing. In a tax‐free world, Hirshleifer (1956) advocated that the internal transfer price be set equal to the marginal cost of the supplying division. Extending this solution, we argue that the optimal internal transfer price should be a weighted average of the pre‐tax marginal cost and the most favorable arm's length price. When the supplying division also sells the intermediate product in question to outside parties, the external price becomes a natural candidate for the arm's length price. We argue that for internal performance evaluation purposes firms should generally not value internal transactions at the prevailing market price if the supplying division has monopoly power in the external market. By imposing intracompany discounts, firms can alleviate attendant double marginalization problems and, at the same time, realize tax savings due to differences in income tax rates. Our analysis characterizes optimal intracompany discounts as a function of the market parameters and the divisional tax rates.
