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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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  14. Keuschnigg, Christian & Ribi, Evelyn, 2009. "Outsourcing, unemployment and welfare policy," Journal of International Economics, Elsevier, vol. 78(1), pages 168-176, June.
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Cited by:
  1. Chongwoo Choe & Noriaki Matsushima, 2012. "The Arm’s Length Principle and Tacit Collusion," Development Research Unit Working Paper Series 02-12, Monash University, Department of Economics.
  2. Michael P. Devereux, 2008. "Taxation of outbound direct investment: economic principles and tax policy considerations," Oxford Review of Economic Policy, Oxford University Press, vol. 24(4), pages 698-719, winter.
  3. Søren Bo Nielsen, 2014. "Transfer Pricing: Roles and Regimes," CESifo Working Paper Series 4694, CESifo Group Munich.

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