Duopolistic Competition, Taxes and the Arm'S-Length Principle

Numerous (high-tax) countries presume that multinational firms use their transfer-pricing policies to shift profits into countries with lower tax rates. To avoid the corresponding loss in tax revenues, tax authorities develop constantly tightening rules which limit the scope of transfer-price distortions. Affected firms include the decision of compliance to these rules into their strategic considerations. Within a game-theoretic model we show that firms' transfer-pricing policies are driven by three issues: interaction with competitors, minimization of tax burden, and avoidance of punishments. It shows that tighter transfer-pricing rules may help firms to defuse competition and to increase their profits and that non-compliance to the arm's length principle is part of their equilibrium strategy