Transfer Pricing in Vertically Integrated Industries

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 (non-independent) 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