DP7375 The Distorting Arm's Length Principle

Author(s): Michael P. Devereux, Christian Keuschnigg
Publication Date: July 2009
Keyword(s): arm's length principle, corporate finance, Corporate tax, foreign direct investment, outsourcing, transfer prices
JEL(s): D23, F23, H25
Programme Areas: Public Economics, International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7375

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.