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The Distorting Arm’s Length Principle

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  • Michael P. Devereux

    ()
    (Oxford University Centre for Business Taxation)

  • Christian Keuschnigg

    ()
    (University of St. Gallen, IFF-HSG)

Abstract

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 heterogeneous firms subject to financing frictions and offshoring of intermediate inputs. We find that arm’s length prices systematically differ from independent party prices. Application of the principle thus distorts multinational activity by reducing debt capacity and investment of foreign affiliates, and by distorting organizational choice between direct investment and outsourcing. Although it raises tax revenue and welfare in the headquarter country, welfare losses are larger in the subsidiary location, leading to a first order loss in world welfare.

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Bibliographic Info

Paper provided by Oxford University Centre for Business Taxation in its series Working Papers with number 0910.

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Date of creation: 2009
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Handle: RePEc:btx:wpaper:0910

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Keywords: Corporate tax; transfer prices; arm’s length principle; outsourcing; foreign direct investment; corporate finance;

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References

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  1. Nielsen, Soren Bo & Raimondos-Møller, Pascalis & Schjelderup, Guttorm, 2006. "Taxes and Decision Rights in Multinationals," CEPR Discussion Papers 5952, C.E.P.R. Discussion Papers.
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  18. Harry Huizinga & Luc Laeven, 2006. "International profit shifting within multinationals: a multi-country perspective," European Economy - Economic Papers 260, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission.
  19. Jack M. Mintz & Michael Smart, 2001. "Income Shifting, Investment, and Tax Competition: Theory and Evidence from Provincial Taxation in Canada," International Tax Program Papers 0402, International Tax Program, Institute for International Business, Joseph L. Rotman School of Management, University of Toronto, revised Apr 2003.
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Cited by:
  1. Søren Bo Nielsen, 2014. "Transfer Pricing: Roles and Regimes," CESifo Working Paper Series 4694, CESifo Group Munich.
  2. Michael P Devereux, 2008. "Taxation of Outbound Direct Investment: Economic Principles and Tax Policy Considerations," Working Papers 0824, Oxford University Centre for Business Taxation.
  3. Choe, Chongwoo & Matsushima, Noriaki, 2013. "The arm's length principle and tacit collusion," International Journal of Industrial Organization, Elsevier, vol. 31(1), pages 119-130.

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