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The Distorting Arm's Length Principle

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  • Christian Keuschnigg

    ()

  • Michael P. Devereux

    ()

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 Department of Economics, University of St. Gallen in its series University of St. Gallen Department of Economics working paper series 2009 with number 2009-20.

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Length: 39 pages
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:usg:dp2009:2009-20

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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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Citations

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Cited by:
  1. 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.
  2. Chongwoo Choe & Noriaki Matsushima, 2012. "The Arm’s Length Principle and Tacit Collusion," Monash Economics Working Papers 02-12, Monash University, Department of Economics.
  3. Søren Bo Nielsen, 2014. "Transfer Pricing: Roles and Regimes," CESifo Working Paper Series 4694, CESifo Group Munich.

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