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International Tax and Public Finance

, Volume 15, Issue 3, pp 231–255 | Cite as

Transfer pricing in vertically integrated industries

  • Thomas A. GresikEmail author
  • Petter Osmundsen
Article

Abstract

Tax officials judge whether a multinational’s transfer price is consistent with the arm’s-length standard, the price at which two independent firms would carry out a similar transaction, by using data from comparable but independent transactions. In vertically integrated industries, the only source of comparable data may be from controlled (nonindependent) transactions. Conventional wisdom asserts that standard arm’s-length methods cannot perform well in such markets because the comparability rules encourage the integrated firms to collude tacitly on transfer prices in a way that amplifies tax-differential incentives. In this paper, we show that strategic linkages between vertically integrated firms operating in the same final good market moderate, and can possibly reverse, tax-differential incentives if the correct comparison method is used. The Cost-Plus method turns out to be the most effective in limiting the equilibrium amount of profit-shifting out of the high-tax country and it yields the highest tax revenues for the high-tax country. These benefits are shown to strengthen when the firms have private cost information.

Keywords

Transfer pricing Vertical integration Incentive comparability 

JEL

F23 H26 

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Copyright information

© Springer Science+Business Media, LLC 2007

Authors and Affiliations

  1. 1.Department of Economics and EconometricsUniversity of Notre DameNotre DameUSA
  2. 2.Department of Industrial EconomicsUniversity of StavangerStavangerNorway

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