The Distorting Arm's Length Principle

Christian Keuschnigg and Michael Devereux

University of St. Gallen Department of Economics working paper series 2009 from Department of Economics, University of St. Gallen

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 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.

Keywords: Corporate tax; transfer prices; arm's length principle; outsourcing; foreign direct investment; corporate finance (search for similar items in EconPapers)
JEL-codes: D23 F23 H25 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2009-08
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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http://ux-tauri.unisg.ch/RePEc/usg/dp2009/DP-0920-Ke.pdf (application/pdf)

Related works:
Working Paper: The Distorting Arm’s Length Principle (2009)
Working Paper: The Distorting Arm's Length Principle (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:usg:dp2009:2009-20

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