Distortions Caused by the use of Arm's-Length Transfer Prices.

This paper examines the effects of using an arm's-length transfer price, such as the Comparable Uncontrolled Price (CUP) method, to allocate income for tax purposes between a manufacturing entity and a selling entity within a multinational enterprise (MNE). The CUP method allocates disproportionately high levels of income earned. by the MNE to the manufacturer In our model. This result Is consistent with . the anomaly identified in Grubert et al. (1993) and Collins et al. (1997), in which U.S. subsidiaries of foreign MNEs frequently report zero, or near-zero, taxable income. In addition, the CUP method distorts decisions regarding production and organizational structure when the tax rates In the two countries differ.