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The arm's length principle and distortions to multinational firm organization

Type of publication Peer-reviewed
Publikationsform Original article (peer-reviewed)
Publication date 2013
Author Keuschnigg Christian, Devreux Michael,
Project Corporate Finance, Taxation and Economic Performance
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Original article (peer-reviewed)

Journal Journal of International Economics
Volume (Issue) 89
Page(s) 432 - 440
Title of proceedings Journal of International Economics


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.