The Arm’s Length Principle, Transfer Pricing and Foreclosure under Imperfect Competition

Abstract: This paper studies a multinational firm’s transfer price decisions in imperfectly competitive market settings. It investigates whether the firm’s optimal transfer price coincides with the arm’s length price and examines how the firm might respond if it is compelled to follow the arm’s length principle. The main findings are: (1) in the absence of tax transfer incentives, the firm’s optimal transfer price does not coincide with the arm’s length price. If the firm is compelled to follow the arm’s length principle, it has an incentive to circumvent the arm’s length principle by keeping two sets of books, one for internal management, and another for tax reporting purposes; (2) the arm’s length principle can affect the MNF’s decision on whether or not to foreclose its competitor. Absent profit shifting incentives, the firm will foreclose its downstream competitor. Imposing the arm’s length principle induces the firm to supply its competitor, but the firm can revert to its foreclosure decision by keeping two sets of books. If the firm’s upstream and downstream divisions face different tax rates, the firm’s foreclosure decision will be reversed if the arm’s length principle is enforced.