Profit shifting under the arm's length principle

TL;DR

This paper models how firms shift profits across borders under the arm's length principle, considering internal sales and debt, and examines how anti-shifting rules influence this behavior.

Contribution

It introduces a comprehensive model combining internal sales and debt for profit shifting under arm's length and thin capitalization rules, highlighting conditions enabling profit shifting.

Findings

Firms can shift profits to low-tax countries while complying with arm's length rules.

Internal sales and debt act as either complementary or substitute channels for profit shifting.

Cross-effects between channels facilitate profit shifting through transfer prices and interest rates.

Abstract

This study analyses the tax-induced profit shifting behaviour of firms and the impact of governments' anti-shifting rules. We derive a model of a firm that combines internal sales and internal debt in a full profit shifting strategy, and which is required to apply the arm's length principle and a general thin capitalisation rule. We find several cases where the firm may shift profits to low-tax countries while satisfying the usual arm's length conditions in all countries. Internal sales and internal debt may be regarded either as complementary or as substitute shifting channels, depending on how the implicit concealment costs vary after changes in all transactions. We show that the cross-effect between the shifting channels facilitates profit shifting by means of accepted transfer prices and interest rates.