Abstract This paper examines the economic distortions caused by the use of the arm's-length standard when determining transfer prices for tax purposes. It focuses on the Comparable Uncontrolled Price (CUP) method. The fact that the vertically integrated form of business is selected to make sales in one country and not in another suggests that key factors relevant to the organizational form choice differ between the two countries. Thus, independent and affiliated organizations will operate under inherently different conditions because the variations in economic conditions, themselves, cause the same manufacturers to use both independent and related sellers for different countries at the same time. The analysis of the consequences of using the CUP method for tax purposes within the vertically integrated group, given double marginaliization between independent parties, shows that the CUP method allocates to the manufacturer a higher proportion of the gross margin per unit than that earned by the manufacturer when it deals with an unrelated seller.
A Wed, study studied this question.