VoxEU Column Taxation

Transfer pricing of intangible assets with the arm’s length principle

It is well known that multinational enterprises take advantage of corporate tax systems worldwide to avoid taxation. Transfer pricing is one common method used for profit-shifting, as intra-firm transactions are shielded from the market mechanism. Numerous guidelines and regulations have been implemented to tackle such profit-shifting, but challenges remain. This column theoretically explores how one such regulation, the ‘arm’s length principle’, affects the licensing strategies of multinationals in the presence of a tax haven. It shows that the mere existence of this principle may lead to further profit-shifting and may worsen the welfare of high-tax countries. 

Multinational enterprises (MNEs) have a strong presence in the world economy. For example, according to Tørsløv et al. (2020), the share of global corporate profits made by MNEs was about 15% in 2015. It is well known that MNEs take advantage of differences in corporate tax rates and preferential tax measures provided by various countries. Specifically, it has been reported that MNEs often artificially shift their profits across countries to avoid taxation (Huizinga and Laeven 2008, Egger et al. 2010, Bauer and Langenmayr 2013, Zucman 2014, Davies et al. 2018). For example, according to the estimation of Tørsløv et al. (2020), more than $600 billion, which was close to 40% of multinational profits, was shifted to tax havens in 2015. These tax havens include Ireland, the Netherlands, Luxembourg, Switzerland, Singapore, the Bahamas, Barbados, Bermuda, and the Cayman Islands, among others.

This kind of profit-shifting is often conducted via so-called transfer pricing of intra-firm transactions. With respect to the prices of goods and services within a firm (i.e. transfer prices), there is no market mechanism. Thus, MNEs have an incentive to manipulate transfer prices for tax planning. This is called ‘transfer pricing’. In reality, profit-shifting is executed using highly complex methods. Well known methods of profit-shifting include transfer pricing of both tangible and intangible assets, internal debt, and interest payments. One of the most famous examples of profit shifting through intangible assets is the ‘Double Irish with a Dutch Sandwich’ conducted by Apple, Google, and Facebook, among others. It was reported that Google saved at least $3.7 billion in taxes in 2016 using this method.1   

Transfer pricing with intangible assets and the arm's length principle

The member countries of the Organisation for Economic Co-operation and Development (OECD) have cooperated in efforts to tackle artificial profit-shifting by setting guidelines for transfer pricing, in which the arm's length principle (ALP) was specifically proposed. As a method of exercising the ALP, the comparable uncontrolled price (CUP) method is considered ideal. It suggests that tax authorities audit tax-avoidance behaviours by comparing the prices used in intra-firm transactions with those of similarly uncontrolled transactions between independent parties (i.e. arm's length prices).

Reality, unfortunately, is not as simple. In particular, it is very difficult to audit intra-firm transfers of intangible assets because of the following ambiguous nature of intangible assets. First, it is easy to transfer intangible assets across countries without accompanying production. Thus, MNEs tend to locate their intangible assets in tax havens to minimise tax payments. For instance, profits shifted to Ireland via royalties accounted for approximately 23% of Ireland’s annual GDP between 2010 and 2015.2 Second and more importantly, finding appropriate fees or royalties of intangible assets is difficult, because there is often no comparable transaction for intangible assets. As pointed out by the OECD guidelines, "[t]ax administrations should not automatically assume that associated enterprises have sought to manipulate their profits. There may be a genuine difficulty in accurately determining a market price in the absence of market forces or when adopting a particular commercial strategy” (Chapter I: 33).

In the case of transactions of intangible assets, therefore, it is difficult to apply the CUP method. The OECD proposes four different additional methods of exercising the ALP: the cost plus method, the resale price method, the transactional net margin (TNM) method, and the transactional profit split method. In practice, practitioners heavily rely on the TNM method because of its ease of use. For example, according to the Internal Revenue Service, the most frequently used transfer pricing method for both tangible and intangible property in 2016 was the comparable profits method or the TNM method, which accounted for 89% of transactions.3 The method examines the profit-level indicator (PLI), defined as net profits relative to an appropriate base (e.g. sales) that a taxpayer realises from a controlled transaction. With the TNM method, the PLI of the taxpayer from the controlled transaction should be equal to the PLI obtained in a comparable transaction by an independent enterprise (i.e. a reference firm). The selection criteria of the reference firm are based upon an evaluation of the functional risks of the taxpayer and the reference firm (e.g. R&D risk and credit risk). This implies that the reference firm may not operate in the same industry. Moreover, even if a particular taxpayer chooses a reference firm for the TNM method, the tax authority often proposes a different reference firm.

Trade-off between license revenue and tax saving

In a recent paper (Choi et al. 2019), we theoretically explore the relationship between the ALP and MNEs’ technology transfers through cross-border licensing within the framework of oligopoly. Specifically, we investigate how the ALP affects MNEs’ licensing strategies and welfare in the presence of a tax haven. The headquarters of an MNE transfers its technology patent to its shell company in a tax haven to license the technology to the MNE’s subsidiary in the third country. On one hand, if the MNE decides to license its technology to unrelated local firms in the third country, a comparable transaction appears, and the CUP method becomes applicable. Thus, the MNE needs to set the same royalty for both related and unrelated parties. On the other hand, if the MNE transfers its technology only internally, there is no comparable transaction, and the tax authority relies on the TNM method. When making a licensing decision, the MNE faces a trade-off between the license revenue from the unrelated parties and the greater opportunity for profit-shifting via transfer pricing. Thus, the very presence of the ALP may affect the MNE's licensing decisions and welfare.

Our study contributes to transfer-pricing literature by capturing the nature of profit-shifting using intangible assets. In particular, most papers have dealt with intra-firm transactions through physical products, internal debt, and interest payments. The analysis of profit-shifting via intangible assets has to date been limited to only a few studies, including those of Hopland et al. (2018), Juranek et al. (2018a), and Juranek et al. (2018b). They incorporated royalty payments in their analysis but they did not consider licensing to external firms. Moreover, despite the fact that licensing improves production costs, the interaction between licensing and the market has been largely overlooked, because extant literature has often only considered perfectly competitive markets.

MNE’s licensing strategies and economic welfare

Our findings in the basic model, in which a potential licensee is unrelated to the MNE’s subsidiary, provide two insights. First, the ALP may distort the MNE licensing strategy. In the absence of the ALP, the MNE is willing to offer a licensing contract to an unrelated firm regardless of the existence of a tax haven. In the presence of the ALP, however, the MNE may refrain from offering the contract. Thus, the comparable licensing transaction may vanish, enabling the MNE to enjoy further profit-shifting opportunities from its subsidiary.

Second and more importantly, the disincentivisation of licensing may worsen the welfare of high-tax countries. One may expect that anti-tax-avoidance policies such as the OECD’s Base Erosion and Profit Shifting (BEPS) Actions prevent MNEs from profit-shifting and contribute to welfare improvement through an increase in the tax revenue. Our model, however, has shown that such a positive aspect may appear at the expense of consumers, because the MNEs may stop licensing to remove comparable transactions.4 

We also investigated the case in which the goods produced by a potential licensee and the MNE’s subsidiary are substitutes as an extension to our basic model. In this case, consumers may lose even if the licensing still occurs with the ALP. This is because the MNE strategically decreases the output of its subsidiary to take more advantage of the licensing revenue from the local firm. As a result, the ALP harms consumers. 

Simply put, the avoidance of licensing in the presence of the ALP may worsen domestic welfare if the licensee and the MNE's subsidiary do not compete in the local market, but may improve welfare if they compete.

Editor's note: The main research on which this column is based first appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan here.


Bauer, C J and D Langenmayr (2013), “Sorting into outsourcing: Are profits taxed at a gorilla's arm's length?”, Journal of International Economics 90: 326-336.

Choi, J P, T Furusawa and J Ishikawa (2020), “Transfer pricing regulation and tax competition”, Journal of International Economics, forthcoming.

Choi, J P, J Ishikawa and H Okoshi (2019), “Tax Havens and Cross-border Licensing”, RIETI Discussion Paper Series 19-E-105.

Davies, R, J Martin, M Parenti and F Toubal (2018), “Knocking on tax haven's door: multinational firms and transfer pricing”, Review of Economics and Statistics 100: 120-134.

Egger, P, W Eggert and H Winner (2010), “Saving taxes through foreign plant ownership”, Journal of International Economics 81: 99-108.

Hopland, A O, P Lisowsky, M Mardan and D Schindler (2018), “Theory and implications of flexibility in income shifting under losses”, Unpublished manuscript.

Huizinga, H and L Laeven (2008), “International profit shifting within multinationals: A multi-country perspective”, Journal of Public Economics 92: 1164-1182.

Juranek, S, D Schindler and G Schjelderup (2018a), “Transfer pricing regulation and taxation of royalty payments”, Journal of Public Economic Theory 20: 67-84.

Juranek, S, D Schindler and A Schneider (2018b), “Royalty taxation under tax competition and profit shifting”, CESifo Working Paper No. 7227.

Tørsløv, T R, L S Wier and G Zucman (2020), “The missing profits of nations”, NBER Working Paper No. 24701.

Zucman, G (2014), “Taxing across borders: Tracking personal wealth and corporate profits”, Journal of Economic Perspectives 28: 121-48.



2 See

3 For details, see The comparable profits method is mainly used in the US to calculate appropriate transfer prices. Basically, these two methods are the same, with the only difference being that the TNM method deals with investigations based on transaction units, whereas the comparable profits method investigates firm-level transactions.

4 Choi et al. (2020) also show that transfer-pricing regulations may harm consumers in a different context.

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