Transfer pricing rules, OECD guidelines,and market distortions

We study the impact of transfer pricing rules on sales prices, firms’ organizational structure, andconsumers’ utility within a two-country monopolistic competition model featuring source-basedprofit taxes that differ across countries. Firms can either become multinationals, i.e., they serve theforeign market through a fully controlled affiliate; or they can become exporters, i.e., they serve theforeign market by contracting with an independent distributor. Compared to the benchmark cases,where tax authorities are either unable to audit firms or where they are able to audit them perfectly,the use of the OECD’s Comparable Uncontrolled Price (CUP) or Cost-Plus (CP) rule distorts firms’output and pricing decisions. The reason is that the comparable arm’s length transactions betweenexporters and distributors, which serve as benchmarks, are not efficient. We show thatimplementing the CUP or CP rules is detrimental to consumers in the low tax country, yet benefitsconsumers in the high tax country....