Strategic incentives for keeping one set of books under the Arm’s Length Principle

The OECD’s recommendation that transfer prices between multinational enterprises and their subsidiaries be consistent with the Arm’s Length Principle (ALP) for tax purposes does not restrict internal pricing policies. However, we show that under imperfect competition firms may choose to keep one set of books (i.e., to set transfer prices consistent with the ALP), as a way of softening competition in the external market. As a result, firms’ profits are greater, and the surplus is smaller, than under vertical integration. In contrast, when firms keep two sets of books (i.e., their transfer prices differ from those used for tax purposes), competition intensifies in both markets relative to vertical integration.