Transfer Pricing Rules, OECD Guidelines, and Market Distortions

• DOI: http://doi.org/10.1111/jpet.12075
• Author: SUSANA PERALT,KRISTIAN BEHRENS,PIERRE M. PICARD
• Published date: 01 August 2014
• Date: 01 August 2014

TRANSFER PRICING RULES,OECDGUIDELINES,AND

MARKET DISTORTIONS

KRISTIAN BEHRENS

Universit´

eduQu

´

ebec `

a Montr´

eal (UQAM), CIRP ´

EECEPR

SUSANA PERALT

Nova School of Business and Economics, Universit´

e catholique de Louvain, CEPR

PIERRE M. PICARD

Universit´

e du Luxembourg, Universit´

e catholique de Louvain

Abstract

We study the impact of transfer pricing rules on prices,

firms’ organizational structure, and consumers’ utility in a

two-country monopolistic competition model with source-

based profit taxes. Firms can either be multinationals and

serve the foreign market through a fully controlled affiliate,

or be exporters and serve the foreign market by contract-

ing with an independent distributor. The use of the OECD’s

comparable uncontrolled transfer price (CUP) rule dis-

torts firms’ output and pricing decisions, because the com-

parable arm’s length transactions between exporters and

Kristian Behrens, Canada Research Chair, Department of Economics, Universit´

e

du Qu´

ebec `

aMontr

´

eal(UQAM),Canada;CIRP´

EE, Canada; and CEPR, UK

(behrens.kristian@uqam.ca). Susana Peralta, Nova School of Business and Economics,

Portugal; CORE, Universit´

e catholique de Louvain, Belgium; and CEPR, UK (per-

alta@novasbe.pt). Pierre M. Picard, CREA, Universit´

e du Luxembourg, Luxembourg; and

CORE, Universit´

e catholique de Louvain, Belgium (pierre.picard@uni.lu).

We thank the editor John Conley, Thierry Brechet, Gianmarco Ottaviano; confer-

ence and seminar participants at the International Workshop in Economic Geography

(Barcelona, June 2008); and two anonymous referees for helpful comments and sugges-

tions. Behrens is holder of the Canada Research Chair in Regional Impacts of Globalization.

Financial support from the CRC Program of the Social Sciences and Humanities Research

Council (SSHRC) of Canada is gratefully acknowledged. Behrens also gratefully acknowl-

edges previous financial support from the European Commission under the Marie Curie

Fellowship MEIF-CT-2005-024266, and from FQRSC Qu´

ebec (Grant NP-127178). Peralta

gratefully acknowledges financial support from the Fundac¸˜

ao para a Ciˆ

encia e Tecnologia

under the Project “Technology and Institutions” and from the Nova Forum scholarship

program. Picard gratefully acknowledges the financial support of the University of Lux-

embourg (F2R-CRE-PUL-10EGQH).

Received June 1, 2011; Accepted September 9, 2012.

C2013 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 16 (4), 2014, pp. 650–680.

650

Transfer Pricing Rules, OECD Guidelines, and Market Distortions651

distributors—which serve as the benchmark—are not effi-

cient. We show that the CUP rule is detrimental to con-

sumers in the low-tax country, yet benefits consumers in the

high-tax country when compared to the benchmark of un-

constrained profit shifting. Using the OECD rule increases

tax revenue at the expense of consumer surplus. Those re-

sults also hold under the alternative cost-plus transfer pric-

ing rule.

1. Introduction

Multinationals manipulate transfer prices to minimize their tax liabilities.

High transfer prices for sales of goods to affiliates in high-tax countries are

used to repatriate profits to low-tax countries, thereby reducing the over-

all tax burden. When firms face no restrictions, transfer prices may become

pure tax-evasion devices with no economic meaning. Obvious examples in-

clude firms that “sold toothbrushes between subsidiaries for $5,655 each,” or

that were “buying plastic buckets for $973 each and tweezers for $4,896.”1

Tax authorities thus have a strong incentive to recover tax revenue by audit-

ing multinationals, restricting their freedom to set transfer prices, contesting

their tax declarations, and negotiating possible settlements.

When tax authorities interfere with transfer prices they may, however,

generate inefficiencies that distort consumer prices and firms’ organiza-

tional choices.

Furthermore, “a system that forces on multinational firms similar prices

to those faced by unrelated firms misses the point of multinationals: to cut

costs by locating their activities more efficiently around the world.”2To cope

with these conflicting problems, the OECD has suggested a set of guidelines

to alleviate market distortions while helping tax authorities and multination-

als to reach mutually satisfying agreements (OECD 2001). These guidelines

are based on the notion of arm’s length price, i.e., “the price two unrelated par-

ties would reach through bargaining in a competitive market” (Eden 1998, p.

602). However, as most multinationals operate in imperfectly competitive

markets, the OECD guidelines are likely to be affected by market distortions

arising between unrelated parties.

This paper studies the market distortions arising under the two mostly

frequently used transfer pricing rules in the OECD guidelines, namely,

the comparable uncontrolled price (henceforth CUP) and the cost-plus

(henceforth CP) rules (see Ernst & Young 2002). To do so, we develop

a two-country trade model in the wake of Krugman (1980) that features

1The Economist, “A taxing battle,” 1/31/2004, Vol. 370, Issue 8360, 71–72; Op cit.,“Discord

over harmony,” 11/12/2005, Vol.377, Issue 8452, 82–82.

2The Economist, “Taxing questions,” 5/22/93, Vol. 327, Issue 7812, 73.