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The Arm’s Length Principle and Distortions to Multinational Firm Organization

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 firms subject to financing frictions and offshoring of intermediate inputs. We find that arm's length prices systematically differ from prices set by independent agents. Application of the principle distorts multinational activity by reducing debt capacity and investment of foreign affiliates. Although it raises tax revenue and welfare in the headquarter country, welfare losses may be larger in the subsidiary location, leading to a loss in world welfare.
   
type journal paper
   
keywords Transfer prices, Arm's length principle, Corporate finance
   
language English
kind of paper journal article
date of appearance 1-3-2013
journal Journal of International Economics
publisher Elsevier (Amsterdam)
ISSN 0022-1996
ISSN (online) 1873-0353
DOI 10.1016/j.jinteco.2012.08.007
volume of journal 89
number of issue 2
page(s) 432-440
review double-blind review
   
citation Keuschnigg, C., & Devereux, M. P. (2013). The Arm’s Length Principle and Distortions to Multinational Firm Organization. Journal of International Economics, 89(2), 432-440, DOI:10.1016/j.jinteco.2012.08.007.