Transfer Pricing Rules, OECD Guidelines, and Market Distortions

We study the impact of transfer pricing rules on prices, firms' organizational structure, and consumers' utility in a two-country monopolistic competition model with source-based profit taxes. Firms can either be multinationals and serve the foreign market through a fully controlled affiliate, or be exporters and serve the foreign market by contracting with an independent distributor. The use of the OECD's comparable uncontrolled transfer price (CUP) rule distorts firms' output and pricing decisions, because the comparable arm's length transactions between exporters and distributors—which serve as the benchmark—are not efficient. We show that the CUP rule is detrimental to consumers in the low-tax country, yet benefits consumers in the high-tax country when compared to the benchmark of unconstrained profit shifting. Using the OECD rule increases tax revenue at the expense of consumer surplus. Those results also hold under the alternative cost-plus transfer pricing rule.