Using Bilateral Advance Pricing Agreements to Resolve Tax Transfer Pricing Disputes

We investigate the use of bilateral advance pricing agreements (BAPAs) to resolve transfer pricing disputes between a taxpayer and two tax authorities. BAPAs are designed to protect firms from double taxation while reducing expected compliance costs (audits costs plus BAPA implementation costs). We identify settings in which we expect BAPAs to arise and investigate the effect of the program on compliance costs. We show that a reduction in expected compliance costs is a necessary but not sufficient condition for an agreement to be reached. Agreements are more likely to arise when the amount of income potentially subject to double taxation is low and the difference in tax rates between the two countries is high. We also show that the existence of the BAPA program can increase tax compliance costs in settings in which the absence of a BAPA conveys information to the tax authorities, inducing them to audit a taxpayer without a BAPA more intensively than they would have had the BAPA program not existed. Although this outcome is socially inefficient, it increases the expected net payoff (taxes collected less tax compliance costs) of the country with the higher tax rate