The arm's length principle and distortions to multinational firm organization

To prevent profit shifting by manipulation of transfer prices, tax authorities typically apply the arm's length principle in corporate taxation and use comparable market prices to ‘correctly’ assess the value of intracompany trade and royalty income of multinationals. We develop a model of firm...

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Bibliographic Details
Published in:Journal of international economics 2013-03, Vol.89 (2), p.432-440
Main Authors: Keuschnigg, Christian, Devereux, Michael P.
Format: Article
Language:English
Subjects:
Arm's length principle
Arms length transactions
Corporate finance
Corporate profits
Corporate tax
Market prices
Multinational corporations
Studies
Transfer prices
Transfer pricing
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Summary:To prevent profit shifting by manipulation of transfer prices, tax authorities typically apply the arm's length principle in corporate taxation and use comparable market prices to ‘correctly’ assess the value of intracompany trade and royalty income of multinationals. We develop a model of firms subject to financing frictions and offshoring of intermediate inputs. We find that arm's length prices systematically differ from prices set by independent agents. Application of the principle distorts multinational activity by reducing debt capacity and investment of foreign affiliates. Although it raises tax revenue and welfare in the headquarter country, welfare losses may be larger in the subsidiary location, leading to a loss in world welfare. ► Multinational firms set transfer prices to efficiently organize production. ► Arm's length prices differ from independent party prices. ► The arm's length principle reduces profit shifting and distorts firm organization.
ISSN:0022-1996
1873-0353
DOI:10.1016/j.jinteco.2012.08.007