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The Distorting Arm's Length Principle

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  • Devereux, Michael P.
  • Keuschnigg, Christian

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 C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7375.

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Date of creation: Jul 2009
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Handle: RePEc:cpr:ceprdp:7375

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

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References

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Citations

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Cited by:
  1. Michael P Devereux, 2008. "Taxation of Outbound Direct Investment: Economic Principles and Tax Policy Considerations," Working Papers 0824, Oxford University Centre for Business Taxation.
  2. Choe, Chongwoo & Matsushima, Noriaki, 2011. "The Arm's Length Principle and Tacit Collusion," MPRA Paper 37295, University Library of Munich, Germany, revised 12 Mar 2012.
  3. Søren Bo Nielsen, 2014. "Transfer Pricing: Roles and Regimes," CESifo Working Paper Series 4694, CESifo Group Munich.

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