The Distorting Arm’s Length Principle

Michael P. Devereux (Oxford University Centre for Business Taxation)
Christian Keuschnigg (University of St. Gallen (IFF-HSG), CEPR and CESifo)

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  intra-company trade and royalty income of multinationals. We develop a model of heterogeneous firms subject to financing frictions and off-shoring 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.

Download WP09/10 >