Negotiation for Transfer Prices under the Arm's Length Principle

Determining whether MNEs are engaged in tax avoidance by analyzing their transfer pricing practices is difficult due to the presence of firm-specific products or technologies; additionally, disputes about MNE transfer pricing activities sometimes arise. Because resolving such disputes formally is time consuming, an MNE and a tax authority may agree on a transfer price level in an informal negotiation. This study investigates how MNE transfer price is determined in informal negotiations processes by interlinking MNE investment in product quality and negotiation power, and how a longer period for resolving a dispute in a formal process affects the equilibrium transfer price. We find that a longer time for a formal process induces firm investment, but its effect on the equilibrium transfer price depends on each MNE's negotiation power against its tax authority. In addition, our analysis shows that tax revenues in a high-tax country may increase due to MNE tax avoidance activity, because increases in firms' investments boost their operating profits. Furthermore, a fixed subsidy for investments in quality may be more likely to reduce welfare during a prolonged dispute resolution when a high-tax country places extra weight on tax revenue.