The Armâ€™s Length Principle, Transfer Pricing and Foreclosure under Imperfect Competition
Abstract: This paper studies a multinational firmâ€™s transfer price decisions in imperfectly competitive market settings. It investigates whether the firmâ€™s optimal transfer price coincides with the armâ€™s length price and examines how the firm might respond if it is compelled to follow the armâ€™s length principle. The main findings are: (1) in the absence of tax transfer incentives, the firmâ€™s optimal transfer price does not coincide with the armâ€™s length price. If the firm is compelled to follow the armâ€™s length principle, it has an incentive to circumvent the armâ€™s length principle by keeping two sets of books, one for internal management, and another for tax reporting purposes; (2) the armâ€™s length principle can affect the MNFâ€™s decision on whether or not to foreclose its competitor. Absent profit shifting incentives, the firm will foreclose its downstream competitor. Imposing the armâ€™s length principle induces the firm to supply its competitor, but the firm can revert to its foreclosure decision by keeping two sets of books. If the firmâ€™s upstream and downstream divisions face different tax rates, the firmâ€™s foreclosure decision will be reversed if the armâ€™s length principle is enforced.
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