Tariff Elimination versus Tax Avoidance: Free Trade Agreements and Transfer Pricing

This study explores the new roles of rules of origin (ROO) when multinational enterprises (MNEs) manipulate their transfer prices to avoid a high corporate tax. ROO of a free trade agreement (FTA) require exporters to identify the origin of exports to be eligible for a preferential tariff rate. The results suggest that a value-added criterion of ROO restricts MNEs’ abusive transfer pricing. Interestingly, an FTA with ROO can induce MNEs to shift profits from a low-tax country to a high-tax country. Because ROO augment tax revenues inside FTA countries, they can transform a welfare-reducing FTA into a welfare-improving FTA

Attractive target for tax avoidance: trade liberalization and entry mode

Growing foreign direct investments (FDIs) have been observed in parallel to the development of tax avoidance by multinational enterprises; however, empirical evidence indicates the asymmetric effects of trade costs on a firm’s entry decision. To give a new rationale and insights into the impacts of transfer pricing and trade liberalization on a firm’s global activities, this study incorporates transfer pricing and investigates a foreign firm’s entry decision: exports, greenfield FDI (GFDI), or cross-border mergers and acquisitions (CM&As). We show that CM&A is the equilibrium entry mode when transfer pricing regulation is loose, whereas the choice between exports and GFDI depends on the fixed costs of GFDI. Moreover, trade liberalization increases the likelihood of CM&A but decreases that of exports because a reduction in trade costs enhances tax-avoidance efficiency due to more intrafirm trade, implying that tax avoidance in the form of CM&A becomes crucial as globalization progresses. Our welfare analysis shows that regulating CM&A based on consumers’ benefits may result in welfare reduction because profit shifting is most effective under CM&A and a host country’s tax revenue from the foreign firm increases. The results imply the importance of considering the link between international tax and antitrust policies

Production location of multinational firms under transfer pricing: the impact of the arm’s length principle

When multinational enterprises (MNEs) separate the geographical location of affiliates, they can shift profits between the affiliates by manipulating intra-firm prices of inputs. We show that if the international tax difference between the parent and the host countries is large, MNEs choose to separately locate their affiliates in the two countries. We also investigate 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 the price of similar inputs for the independent downstream firms. The ALP may change the location choice of MNEs, bringing smaller tax revenues to the host country, but greater revenues globally.This is a post-peer-review, pre-copyedit version of an article published in Int. Tax Public Finance. The final authenticated version is available online at: https://doi.org/10.1007/s10797-018-9523-2

Economic Integration and Agglomeration of Multinational Production with Transfer Pricing

Do low corporate taxes always favor multinational production in the course of eco- nomic integration? To investigate this, we propose a two-country model in which multi- nationals choose the locations of production plants and foreign distribution affiliates and shift profits between home plants and foreign affiliates by manipulating transfer prices in intra-firm trade. We show that when trade costs are high, plants are concentrated in the low-tax country; surprisingly, this location pattern reverses when they are low. Unlike existing models with single-plant firms, the impact of economic integration is non-monotonic: a fall in trade costs first decreases and then increases the share of plants in the high-tax country, which we empirically confirm. We also analyze tax competition and find that allowing for transfer pricing makes competition tougher. This indicates that international coordination on transfer-pricing regulation can potentially make the world better off