Production Location of Multinational Firms under Transfer Pricing: The Impact of the Arm's Length Principle
In what situation does a vertically-integrated multinational enterprise (MNE) establish an upstream affiliate in a different country from its downstream affiliate? When MNEs separate the location of two affiliates, they can shift prots between affiliates by manipulating intra-firm prices. The location choice of the MNE depends on the difference in corporate taxes between the parent and the host countries. This paper shows that if the international tax difference is small, the upstream affiliate is located in the same country as the downstream affiliate. It also investigates the impact of the arm's length principle (ALP) on the location choice, which requires that the intra-firm price of inputs should be set equal to that of similar inputs for the independent downstream firms. The imposition of the ALP may change the location choice of MNEs. This location change brings smaller tax revenues to the host country, but generally greater revenues globally.