A Negotiation-Based Model of Tax-Induced Transfer Pricing

We present a new model of tax induced transfer pricing as an alternative to the oft-used concealment model. Inspired by interviews with practitioners, we consider a large multinational firm which is audited by the tax
authority in the high-tax location. When this country adjusts the transfer
prices proposed by the firm, the low-tax location may dispute this decision
and initiate negotiations. Since negotiations are costly, the high-tax location sets a transfer price that prevents the low-tax location from entering
negotiations. We compare this model's predictions to those of the concealment model. The negotiation model replicates the predictions on the tax
rate effects on transfer pricing, while adding new predictions. Profit shifting
is expected to fall in the high-tax country's bargaining power and to rise
in firm profits and domestic firm ownership in both countries. Most importantly, profit shifting occurs even if tax enforcement is perfect. We analyze
the effects of an introduction of a common consolidated corporate tax base
with formula apportionment and conclude that the negotiation model may
change the perspective on such a policy. Specifically, strong countries with
large bargaining power may find this reform unappealing.