The Distorting Arm's Length Principle

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The Distorting Arm's Length Principle

Author Info

Christian Keuschnigg ()
Michael P. Devereux ()

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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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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
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Handle: RePEc:usg:dp2009:2009-20

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Paper
- Michael P. Devereux & Christian Keuschnigg, 2009. "The Distorting Arm’s Length Principle," Working Papers 0910, Oxford University Centre for Business Taxation. [Downloadable!]

Find related papers by JEL classification:
D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies
F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business

This paper has been announced in the following NEP Reports:

NEP-ALL-2009-08-16 (All new papers)

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