Title

Production location of multinational firms undertransfer pricing: the impact of the arm’s
length principle

Author(s)Kato, Hayato; Okoshi, Hirofumi

CitationInternational Tax and Public Finance. 26(4)P.835-P.871

Issue Date 2019-08-15
Text Version author
URL

http://hdl.handle.net/11094/81779

DOI

10.1007/s10797-018-9523-2

rights© 2018, Springer Science+Business Media, LLC,
part of Springer Nature.

Note

Osaka University Knowledge Archive : OUKA
https://ir.library.osaka-u.ac.jp/
Osaka University

Production Location of Multinational Firms underTransfer Pricing: The Impact of the Arm’s Length
Principle ∗Hayato Kato †Hirofumi Okoshi ‡October 2018

Abstract
When multinational enterprises (MNEs) separate the geographical location of affiliates, they can shift profits between the affiliates by manipulating intra-firm prices
of inputs. We show that if the international tax difference between the parent andthe host countries is large, MNEs choose to separately locate their affiliates in the twocountries. We also investigate the impact of the arm’s length principle (ALP) on thelocation choice, which requires that the intra-firm price of inputs should be set equal
to the price of similar inputs for the independent downstream firms. The ALP maychange the location choice of MNEs, bringing smaller tax revenues to the host country,
but greater revenues globally.

Keywords: Multinational enterprises (MNEs); Transfer pricing; Production location choice;Intra-firm trade; Arm’s length principle (ALP)
JEL classifications: F12; F23; H25; H26∗ We wish to acknowledge the valuable comments from two anonymous referees and the editor, Ronald

Davies. Thanks are also to David Agrawal, Jay Pil Choi, Dave Donaldson, Taiji Furusawa, Makoto Hasegawa,Andreas Haufler, Jota Ishikawa, Michael Keen, Kozo Kiyota, Yoshimasa Komoriya, Christopher Ludwig, Yasusada Murata, Ben Lockwood, Yukihiro Nishimura, Hikaru Ogawa, Toshihiro Okubo, Pascalis Raimondos,
Yasuhiro Sato, Nicolas Schmitt, Yoichi Sugita, Kimiko Terai, Eiichi Tomiura, and Lorenzo Trimarchi for
helpful suggestions. This paper was presented at HITS-MJT (Kanazawa Seiryo U), Hitotsubashi-Sogang
Trade Workshop (Hitotsubashi U), Public Economics Workshop (U of Tokyo), Study Group on Spatial Economics (Kyushu Sangyo U), JSIE Kanto Meeting (Nihon U), International Symposium of Urban Economics
and Public Economics (Osaka U), Applied Economics Workshop (Keio U), Australasian Trade Workshop(U of Auckland), 17th GEP/CEPR Annual Postgraduate Conference (U of Nottingham), Public Economics
Seminar (LMU), and International Institute of Public Finance (U of Tampere). Financial supports from theJapan Society for the Promotion of Science (Grant Number: JP16J01228), the MEXT-Supported Program
for the Strategic Research Foundation at Private Universities (Grant Number: JPS1391003), the Obayashi
Foundation, the Japan Legislatic Society Foundation, and the German Research Foundation through GRK
are gratefully acknowledged. All remaining errors are our responsibility.
† Corresponding author. Faculty of Economics, Keio University, 2-15-45 Mita, Minato-ku, Tokyo, 108-8345,
Japan. E-mail address: hayato.kato2@gmail.com‡ Munich Graduate School of Economics, University of Munich, Seminar for Economic Policy, Akademiestr.
1/II, D-80799 Munich, Germany. E-mail address: hirofumi.okoshi1@gmail.com

1

1.

Introduction

The manner in which multinational enterprises (MNEs) organize their production structureis essential for their international strategy. As MNEs can substantially benefit from theopportunity to locate their affiliates in several countries, their location decisions dependon country-specific characteristics, such as the extent of competition and policies in hostcountries. Considerable research has been undertaken to investigate the determinants of
MNEs’ locations from both theoretical and empirical standpoints. 1 Among other factors
affecting the location choice, the corporate taxation prevalent in both the host and parent
countries is known to have a significant impact. 2
When considering a firm with a single plant, the consequence of corporate taxation isstraightforward; the firm locates its production in a country with a lower tax rate to savetaxes. However, the impact of taxation on MNEs’ location choice is not this simple. The
striking difference between MNEs with multiple plants and single-plant firms is that MNEs’transactions may take place within their organization across borders. This means that MNEs
can partly control prices of intermediate goods for foreign affiliates, which are known astransfer prices, through intra-firm trade in order to reduce global tax payments. Thus, it
is possible that using such a transfer pricing strategy, MNEs locate their production in ahigh-tax country, while exporting inputs to their affiliates located in a low-tax country.
The relationship between corporate tax rates and the location choice of MNEs using transfer pricing is not just a theoretical curiosity, but is of great importance to the modern
economy. Along with the progress of economic integration, intra-firm trade has grown dramatically in recent years, which provides MNEs room for tax manipulations through transfer
1 For comprehensive surveys, see Markusen (2004); Navaretti and Venables (2004); and Blonigen (2005).
2 Hebous et al. (2011) show that lower corporate tax induces inflows of foreign capital irrespective of thetype of investment, such as greenfield foreign direct investment and cross-border mergers and acquisitions.
Voget (2011) finds that one percentage point decline in foreign effective tax rate augments the likelihood of
headquarters’ relocation by 0.22 percentage point. Karkinsky and Riedel (2012) and Griffith et al. (2014)
investigate the link between corporate taxation and patent location.

2

pricing. 3, 4 Recently, the OECD launched a project involving over 80 countries to address
the tax avoidance behavior of MNEs, including transfer pricing. 5 According to the OECD,
revenue losses from tax avoidance by MNEs are estimated to be between 4% and 10% of
global corporate income tax revenues. 6 Despite the growing concern globally, limited work
has been done on the interaction between MNEs’ location choice and their transfer pricing strategy. The first aim of this paper is to examine how corporate tax rates affect the
production location decision of MNEs using transfer pricing.
From the government’s perspective, there is no doubt that steps preventing MNEs fromtax manipulations are indispensable for collecting tax revenues. Many countries adopt atransfer pricing tax system to infer whether MNEs avoid tax payments. The key idea toappropriate the transaction price for related affiliates is the arm’s length principle (ALP)
which is set out in Article Nine of the OECD Model Tax Convention. The principle points
out that conditions (e.g., price, markup or profit) of controlled transactions between related
firms should be similar to those of independent transactions.
Among several methods the application of the ALP follows in practice, we focus on thecomparable uncontrolled price (CUP) method, which compares the price charged for goods
in a controlled transaction with the price charged for comparable goods in an uncontrolled
transaction, called the arm’s length price. 7, 8 According to the OECD guideline on transfer
pricing, the CUP method is to be preferred if this and other methods can be applied in
3 Bernard et al. (2010) show that over 46 percent of U.S. imports composed of intra-firm transactions in

2000. Lanz and Miroudot (2011) report that U.S. imports of intermediate products score around 50 percent
in 2009. See also Slaughter (2000) and Hanson et al. (2005) for the importance of intra-firm trade.
4 For (in)direct evidence on transfer pricing, see Swenson (2001); Bartelsman and Beetsma (2003); Clausing(2003); Bernard et al. (2006); Cristea and Nguyen (2016); Gumpert et al. (2016); Guvenen et al. (2017); andDavies et al. (2018).
5 The project is called “Base Erosion and Profit Shifting.”
Further details can be found at https://www.oecd.org/g20/topics/taxation/beps.htm, accessed on 17 March 2017.
6 See
http://www.oecd.org/ctp/oecd-presents-outputs-of-oecd-g20-beps-project-for-discussion-at-g20finance-ministers-meeting.htm, accessed on 17 March 2017.
7 The CUP method is applied to tangible assets. The corresponding method for intangible assets is called
the comparable uncontrolled transaction (CUT) method. There are other methods such as cost-plus method,resale price method, and profit split method. See OECD (2017, ch.2) for details.
8 The uncontrolled transaction includes both a transaction of an MNE with an independent firm (”internal
comparables”) and a transaction between other independent firms (”external comparables”). Our framework
captures the internal comparable transaction.

3

an equally reliable manner (OECD, 2017, para. 2.3). The second aim of this paper is toinvestigate the impact of the ALP on MNEs’ tax avoidance and production location choice.
We present a simple two-country model with a vertically-related MNE and a local downstream firm. The MNE has a headquarters in the parent country and a downstream affiliate
in the host country. It locates an upstream affiliate in either the parent or the host, which
provides inputs to both the two downstream firms in the host. The headquarters makes
exogenous profits from different business in the parent. Corporate tax rates are exogenous
and the parent’s tax rate is assumed to be higher than the host’s.
We analyze the location pattern of upstream production under the cases with and without
the ALP. If the ALP is imposed, the upstream affiliate must set equal prices to the two
downstream firms. 9 We show that without the ALP, the MNE may locate an upstream
affiliate in the high-tax parent country. With the ALP, however, the MNE simply locates
it in the low-tax host country. There exist tax rates for which the imposition of the ALPchanges the location pattern. This location change leads to smaller tax revenues in the hostcountry, but greater revenues globally.
At first glance, it seems surprising that the upstream affiliate may be located in the hightax country. The key is that the transfer price can be used as a profit shifting device if the
upstream and downstream affiliates are separately located. The upstream affiliate located in
9 In

our setting, the arm’s length price is the price that the upstream affiliate charged to the local downstream firm. As MNEs are usually not price takers, the AL price in an internal comparable
transaction is more or less an MNEs’ choice variable and thus is subject to manipulation (Cristea andNguyen (2016)). Although tax authorities recognize this possibility of manipulation (see e.g., IRS§1.482–1(d)(4)(iii)), they have to refer to internal comparable transactions in some cases due to limited information available. One recent example of such case is the transfer pricing case of Medtronic, a medical device company based in the US, v. the Internal Revenue Service (IRS) (see for details Global Tax Alert(News from Transfer Pricing), 21 June 2016: http://www.ey.com/gl/en/services/tax/international-tax/
alert--us-tax-court-imposes-a-proper-arms-length-allocation-method-for-transfer-pricing, accessed on 2
June 2018). Medtronic US gave license to its Puerto Rican affiliate for production. The affiliate purchased
components from Medtronic US, manufactured finished medical devices, and sold them to the Puerto Rican
market. Whereas the IRS accused Medtronic US of profit shifting for the years at issue, 2005-06, Medtronic
US argued that the royalty rates charged to the Puerto Rican affiliate, which are a sort of transfer price of
inputs, were the AL royalty rates in light of the CUT method. The AL royalty rates calculated by Medtronic
US came from several internal comparable transactions, including a license agreement between Medtronic
US and Siemens (German conglomerate company). In 2016, the US Tax Court accepted the royalty rates
proposed by Medtronic US with small adjustments. See Avi-Yonah (2007) for other applications of the
CUP/CUT method.

4the high-tax parent may set the transfer price low so as to shift the headquarters’ exogenous
profits to the low-tax host. The larger international tax difference gives more room for profit
shifting, likely leading to geographical separation of affiliates. The introduction of the ALP
limits the ability to manipulate the transfer price, so that the MNE simply prefers to locate
its upstream affiliate in the low-tax host.
It is not surprising that the imposition of the ALP removes the opportunity of profit
shifting and thus increases global tax revenues. However, even though the ALP encourages
the co-location of affiliates in the host country, the host’s tax revenues decrease. The ALP
makes the transfer price of inputs higher, leading the downstream affiliate to produce less.
The reduction in the downstream affiliate’s profits is so huge that the host country earns lesstax revenues. Our result indicates that the ALP is certainly an effective measure against
worldwide profit shifting, but may cause a conflict of interest between countries.
Our contribution is to examine the location choice of MNEs using transfer pricing, to whichmost of the studies in the literature have provided limited attention. Their main interest is
in how transfer prices are affected by international differences in, e.g., corporate tax rates,
tax systems, and trade barriers. 10 Nielsen et al. (2003) examine how different corporate tax
systems, separate accounting and formula apportionment, affect transfer prices differently.
Kind et al. (2005) ask the same question in a tax competition framework and also look at the
impact of a reduction in trade barriers. However, the production location choice of MNEs is
outside the scope of these papers.
There are a few papers that address the choice of organization structure of MNEs withprofit shifting motives. Nielsen et al. (2008) analyze the impact of different decision structures
on transfer prices; i.e., the decision on production is made either by the headquarters of MNEs
(centralization) or by the local affiliate (decentralization). Unlike our model, their model fixes
the location of affiliates. Using the property-rights approach, Bauer and Langenmayr (2013)
10 Earlier contributions include Copithorne (1971); Horst (1971); Samuelson (1982); and Kant (1988).

In
addition to the profit-shifting motive of transfer pricing mentioned in the text, studies such as Elitzur and
Mintz (1996); Schjelderup and Sørgard (1997); and Zhao (2000) point out a strategic motive. The strategic
motive comes from MNEs’ incentive to make their downstream affiliates competitive against rival firms. See
Section 4.4. for more on this point.

5and Egger and Seidel (2013) investigate the organization decision on whether to integrate local
suppliers or import inputs from independent foreign suppliers. Keuschnigg and Devereux(2013) ask the same question in a model with financial frictions. While they focus on sourcing
decisions across the boundaries of MNEs (”make or buy” inputs), we emphasize production
location decisions within the boundaries of MNEs. 11 Closer to the interests of our study, Yao(2013) analyzes the impact of the ALP on MNEs’ location choice in a spatial competition
model à la Hotelling. In his model, MNEs choose where to locate within a host country, thatis, they choose a point on the ”linear-city,” whereas in our model an MNE chooses whether
to locate in a host or parent country. 12
Although the location choice of internationally-mobile firms is at the core of the literature
on tax competition, 13 the role of the transfer pricing and/or the ALP has not been addressed
there. Haufler and Wooton (1999) consider tax competition between potential host countries
for a single MNE (or its affiliate) without profit shifting motives. 14 Based on their framework,
Ma and Raimondos (2015) allow the MNE to use transfer pricing and examine the effect ofthe market size of potential host countries. They simplify the vertical structure within the
MNE, and are thus unable to analyze the impact of the ALP. In contrast, we take corporate
taxes as given, and describe the vertical structure more precisely to address the ALP issue.
The rest of the paper is organized as follows. Section 2 describes the setup of the model.
The main analysis is presented in Sections 3 and 4 where the equilibrium outcomes in thebenchmark (no-ALP) and the ALP cases are derived. Section 5 analyzes the impact of the
ALP on tax revenues. Section 6 concludes the paper.

11 In a related context, Choi et al. (2018) find a possibility of dual sourcing where an MNE buys inputs

from both independent suppliers and related subsidiaries.
12 The role of the ALP on transfer prices is also studied by Gresik and Osmundsen (2008); Bauer andLangenmayr (2013); Choe and Matsushima (2013); and Keuschnigg and Devereux (2013). However, they do
not consider the location choice of MNEs.
13 See Keen and Konrad (2013) for a comprehensive survey.
14 For subsequent development in the literature on bidding for a firm, see, e.g., Bjorvatn and Eckel (2006);
Haufler and Wooton (2006); Ferrett and Wooton (2010); and Furusawa et al. (2015).

6

2.

Basic Setting

The economy consists of two countries, a host and a parent, with two vertically-linked industries, an upstream industry (intermediate input) and a downstream industry (final good).
Our focus is on the host country, where the consumption and production of final goods takeplace. The headquarters of the MNE is located in the parent country and makes exogenous
profits π. In the host country, there are a downstream affiliate of the MNE and a local
downstream firm. The two firms produce totally differentiated goods.
The MNE locates an upstream affiliate in either the parent country with tax rate T or
the host country with tax rate t (< T ). If the upstream affiliate is established in the host
together with the downstream affiliate, termed as a co-location scheme, it produces and sells
inputs to both the related and unrelated downstream firms. The price for the related affiliate
is called an internal price and the price for the independent local firm is called an arm’s
length price. By contrast, if the upstream affiliate is established in the parent separate fromthe downstream affiliate, termed as a separate-location scheme, it produces in the parent andexports to the two downstream firms. The internal price under this scheme can also be calleda transfer price due to the cross-border transactions. The two schemes are illustrated in Fig.
1.

7

Fig. 1.

Model structure: (a) co-location scheme; (b) separate-location scheme

The timing of the game is as follows. First, the MNE chooses the location of upstream
production (Fig. 1.(a) or (b)). Second, it sets input prices to maximize the total posttax profit, which is the sum of the post-tax profits of the upstream and the downstream
affiliates. Third, the downstream affiliate and the local firm choose outputs to maximize
their own profits. 15 We proceed by analyzing in turn the case where the MNE is free fromthe arm’s length principle (ALP) and the case where it obeys the ALP.

3.

Benchmark Case

We first consider the case where the ALP is not imposed: the upstream affiliate can sell tothe related downstream affiliate and the independent firm at different prices. The equilibriumoutcomes are derived in both the co-location and the separate-location schemes. Comparing
the equilibrium profits under the two schemes, we analyze in which country the MNE locates
15 We consider a decentralized decision structure where the MNE leaves quantity choice to the downstream

affiliate.

8the upstream affiliate, given the tax rates of the host and the parent countries.

3.1.

Co-location Scheme

Given the location of upstream production, the MNE first chooses input prices and then
the two downstream firms source the inputs to produce final goods. We solve the problem
backward.
The two downstream firms choose quantities to maximize their own pre-tax profits. Let π
and π∗ be respectively the pre-tax profits of the downstream affiliate and the local firm; themaximization problems are formulated as
max π = (p − g)q,q

max π∗ = (p∗ − g∗ )q∗ ,q∗where p = 1 − q,p∗ = 1 − q∗ .
p (p∗ ) is the final good’s price of the downstream affiliate (the local firm) and q (q∗ ) is thequantity produced by the downstream affiliate (the local firm). The downstream firms use
linear production technology, resulting in a one-to-one transformation from intermediate to
final goods. g is the price of the intermediate inputs for the downstream affiliate, called theinternal price, and g∗ is the price for the local firm, called the arm’s length price. Solving
the maximization problems gives
1−g,
2
1 − g∗
q∗ =
.
2
q=

(1)
(2)

Taking into account these demand schedules, the MNE sets input prices for the two downstream firms. Letting πu be the pre-tax profits of the upstream affiliate and Π be the total
9

post-tax profit of the MNE, the MNE faces the following problem:max Π = (1 − T )π̄ + (1 − t)(πu + π)g,g∗

= (1 − T )π̄ + (1 − t)[(g − c)q + (g∗ − c)q∗ + (p − g)q],
where T and t are respectively the parent’s corporate tax rate and the host’s. It is assumed
that t < T throughout the analysis. 16 c ∈ [0, 1) is the constant marginal cost of the upstream
production. π̄ is constant profits earned (from different business) in the parent market. 17
Deriving the two first-order conditions (FOCs) from the MNE’s problem (dΠ/dg = 0;dΠ/dg∗ = 0) and solving the system of equations for (g, g∗ ), we obtaing = c,
g∗ =

1+c
,
2

(3)
(4)

where the second-order conditions (SOCs) trivially hold. The equilibrium input prices are
independent of tax rates because both the upstream and downstream firms co-locate in thehost country and face the same tax rate. The MNE exercises monopoly power against the
local firm by setting g∗ greater than the marginal cost c. By contrast, it adopts marginal
cost pricing for the downstream affiliate to avoid losses from inefficient markups.
Using equilibrium choices, the total post-tax profit Π is re-expressed as
Π = (1 − T )π̄ +3(1 − t)(1 − c)2
.
8

(5)

16 If t ≥ T , the upstream affiliate is always located in the low-tax parent country (separate location) in

both the benchmark and ALP cases. Thus, our focus is on the range of t < T , where the imposition of the
ALP may change the location pattern.
17 It is common in the literature to assume exogenous profits or profits independent of transfer price(Schjelderup and Sørgard, 1997; Nielsen et al., 2003, 2008; Haufler and Mardan, 2014). In these studies,
the tax-manipulation effect, which we will define shortly, is so strong that the price-cost margin (and thus
profits) can be negative as in our analysis. To isolate the tax-manipulation effect as clearly as possible, we
follow the convention of the literature. In Appendix 8, we endogneize it by introducing a local downstream
firm in the parent country.

10

3.2.

Separate-location Scheme

In the separate-location scheme, where the upstream affiliate is located in the parent country,
the two downstream firms behave similarly to the co-location scheme. Suppose the superscript
S denotes variables in the separate-location scheme. From Eqs. (1) and (2), the outputs offinal goods can be written as
1 − gS,2
1 − g∗S
q∗S =
,
2

qS =

where g and g∗ have been replaced with g S and g∗S in Eqs. (1) and (2), respectively.
Given these demand schedules, the MNE chooses input prices to maximize the following
total post-tax profit:max ΠS = (1 − T )(π̄ + πuS ) + (1 − t)π S
g S ,g∗S= (1 − T )[π̄ + (g S − c)q S + (g∗S − c)q∗S ] + (1 − t)(pS − g S )q S .
Our focus is on a certain range of tax rates where the maximization problem has a uniqueinterior solution:t > t ≡ max{0, ta , tb },(A1)

where ta ≡ 2T − 1,tb ≡ [(3 + c)T − (1 + c)]/2.
If t and T satisfy (A1): t > t, equilibrium outputs and prices of intermediate and final
goods are positive, and the SOCs hold in all cases of the following analysis. 18 The regularity
18 More precisely, q S > 0 requires t > ta , while pS > 0 does t > tb .

11

condition (A1) is assumed throughout the analysis.
The equilibrium input prices are given by
gS = c +(1 − c)(t − T ),| t − 2T{z + 1 }(6)

Tax-manipulation effect

g∗S =

1+c
,
2

(7)

where the SOCs are satisfied and t − 2T + 1 > 0 holds under (A1). The second term of g S
involves the tax difference, which is termed as a tax-manipulation effect of transfer price. Its
sign depends on the tax difference. If both countries had the same tax rate (t = T ), it would
hold that g S = c (= g), meaning no room for tax manipulation. Under our assumption thatt < T , the second term of g S is negative and g S < c holds. By making upstream profit
negative, the MNE shifts exogenous profits from the high-tax parent to the low-tax hostcountry. A larger tax difference (t << T ) brings more room for profit shifting and thus
lowers g S more. 19
It is also noted that the arm’s length price g∗S is equal to the one in the co-location scheme,
and does not depend on tax rates. This is again because g∗S is used solely for exploiting
market power against the local firm.
The total post-tax profit evaluated at the equilibrium choices is given by(1 − c)2 (t − 4T + 3)
Π = (1 − T ) π̄ +,8(t − 2T + 1)
S



(8)

where the second term in the square bracket is positive under (A1): t > t.

19 Clausing (2003) empirically supports this result: she finds that MNEs in the U.S. tend to set lower export

prices, as tax rates in the trading partners are lower.

12

3.3.

Location Choice

Comparing the total post-tax profits in the two schemes, the MNE chooses a location for
upstream production. From Eqs. (5) and (8), the profit difference can be calculated asΠ − ΠS =(1 − c)2 (3t − 4T + 1)(T − t),8(t − 2T + 1)

where t − 2T + 1 > 0 holds under (A1). As the denominator is positive, the sign of thedifference is determined by the numerator.
It can be seen that Π − ΠS = 0 holds at t ∈ {t∗ , T }, where t∗ is defined byt∗ ≡ (4T − 1)/3 (< T ).

(9)t∗ is positive if the parent’s tax rate is sufficiently high, i.e., T > T ≡ 1/4.
The profits under the two schemes are illustrated in Fig. 2. 20 If the parent’s tax rate islow (T ≤ T : Fig. 2.(b)), t∗ becomes negative and Π − ΠS > 0 holds for t < T . The MNE
always co-locates the upstream affiliate with the downstream affiliate in the host country.
If the parent’s tax rate is high (T > T : Fig. 2.(a)), the location choice is more complex.
Π − ΠS > 0 holds if t is close to T (i.e., t ∈ (t∗ , T )), while Π − ΠS ≤ 0 holds if t is far below
T (i.e., t ∈ (t = 0, t∗ ]). The MNE chooses the co-location scheme, if the two countries have
similar tax rates. Otherwise, it prefers the separate-location scheme.
20 These figures are derived using the following parameter values: c = 0.3; π̄ = 3; (a)T = 0.35; (b)T = 0.2.

In this numerical example, t = 0 holds. We note that the qualitative results stated in Proposition 1 do notdepend on these particular parameter values.

13Fig. 2.

Production location choice in the benchmark case: (a) high T and (b) low T

If the two countries had equal tax rates, the tax manipulation effect would disappear sothat the location choice would not matter, i.e., Π = ΠS at t = T . Consider then a marginal
decrease in the host’s tax rate from t = T . The MNE naturally benefits from this reduction,
but the degree of benefit varies from scheme to scheme. Indeed, we can confirm
−

dΠ
dΠS
>−
.
dt t=Tdt t=T

The marginal profit in the co-location scheme is higher than that in the separate-location
scheme. Having an upstream affiliate in the parent is beneficial to the MNE trying to14

manipulate tax payments, but it comes at a cost of the higher tax rate in the parent. Under
small international tax differences, there is little room for manipulating tax payments. Thus,
the low-tax host becomes more profitable for upstream production than the high-tax parent.
Under fairly large tax differences, however, this is not necessarily the case. Let us assume
T > T and look at the marginal effects of taxes on the total post-tax profit at t = t∗ > 0,
where Π = ΠS holds. We can confirm
−

dΠ
dΠS
<−
.
dt t=t∗dt t=t∗In contrast to the previous case of t = T , a reduction in t increases total post-tax profit in
the separate-location scheme more than in the co-location scheme. A larger tax difference
strengthens the tax-manipulation effect and thus allows more profit shifting. To exploit the
profit-shifting opportunity, the upstream affiliate is separately located from the downstream
affiliate for t ≤ t∗ .
These results are summarized as follows.

Proposition 1 (No-ALP case).

Suppose the MNE can set different input prices for its

downstream affiliate and the local firm, and assume t < T and the regularity condition (A1):t > t. Two cases may arise:(i) Suppose the parent country’s tax rate is sufficiently high (T > T ). If the host country’s
tax rate is not low enough (t ∈ (t∗ , T )), the MNE locates an upstream affiliate in the
low-tax host country (”co-location”). On the other hand, if it is low enough (t ∈ (t, t∗ ]),the upstream affiliate is located in the high-tax parent country (”separate location”).
(ii) Suppose the parent country’s tax rate is not sufficiently high (T ≤ T ). For any host’s
tax rate (t ∈ (t, T )), the MNE always locates an upstream affiliate in the low-tax hostcountry (”co-location”).

15

4.

Arm’s Length Principle (ALP) CaseLet us turn to the case where the MNE follows the ALP. It now sets equal prices to both thedownstream affiliate and independent local firm. 21

4.1.

Co-location Scheme

We first solve the third stage game, where the downstream firms choose quantities, and thensolve the second stage game, where the MNE chooses input prices. Maximization problems
facing the downstream firms are exactly the same as in the benchmark (no-ALP) case, exceptthat both the affiliate and the local firm source inputs at the same price, g̃, where the tilde(˜) represents the variable in the ALP case. Replacing g and g∗ with g̃ in Eqs. (1) and (2)givesq̃ = q̃∗ =1 − g̃
.
2

Noting the MNE is unable to discriminate prices, its maximization problem is formulatedase = (1 − T )π̄ + (1 − t)(π̃u + π̃)
max Π
g̃

= (1 − T )π̄ + (1 − t)[2(g̃ − c)q̃ + (p̃ − g̃)q̃].
The profits from selling inputs, 2(g̃ − c)q̃, are doubled because prices and quantities for thetwo downstream firms are the same.
21 We assume that the ALP applies to both cross-border transactions (i.e., separate location) and domestictransactions (i.e., co-location). Article Nine and the OECD guidelines are fully or partly applicable todomestic transfer pricing in some member countries of the OECD such as the U.K., Norway and Canada(Wittendorff, 2012).

16

From the FOC with respect to g̃, the following optimal input price is obtained:g̃ =1 + 2c,3(10)where the SOC trivially holds. Comparing this with the input prices under the co-location
scheme in the benchmark case, g and g∗ defined in Eqs. (3) and (4), we find g < g̃ < g∗ .
In the benchmark case, the MNE exercises market power against the local firm and sets thearm’s length price higher than the marginal cost (g∗ > c). For the downstream affiliate, the
MNE sets the internal price to the marginal cost (g = c) so as to avoid inefficient markups
between affiliates. The ALP, however, does not allow for price discrimination so that theunique price reflects the two opposing motives. Therefore, the input price in the ALP casefalls between the two prices in the benchmark case.
The total post-tax profit in equilibrium is given by2

e = (1 − T )π̄ + (1 − t)(1 − c) .
Π
3

4.2.

(11)

Separate-location Scheme

The quantities that the downstream firms choose are the same as in the co-location scheme:q̃ S = q̃∗S =1 − g̃ S,
2

where the superscript S represents the separate-location scheme as before. Given thesedemand schedules, the MNE chooses an input price to maximize the total post-tax profit:e S = (1 − T )[π̄ + 2(g̃ S − c)q̃ S ] + (1 − t)(p̃S − g̃ S )q̃ S .
max Π
g̃ S

17

Solving the FOC yields the equilibrium input price:g̃ S =

2(1 − c)(t − T )1 + 2c+,33(t − 4T + 3)
|
{z
}

(12)

Tax-manipulation effectwhere the SOC is satisfied and t − 4T + 3 > 0 holds under the regularity condition (A1):t > t. The second term of g̃ S captures the tax-manipulation effect as seen in g S defined in
Eq. (6). Its sign depends only on the tax difference. The above input price can be reduced
to the one under the co-location scheme (g̃ S = g̃) at t = T . For t < T , the second term
becomes negative, implying that the MNE reduces the input price to bring more profits tothe downstream affiliate in the low-tax host country. Comparing g̃ S with g S reveals thatthe tax-manipulation effect is smaller in g̃ S than in g S . 22 The input price is no longer an
effective device for shifting profits. As in the co-location scheme, the input price in the ALP
case falls between the transfer price and the arm’s length price in the benchmark case, i.e.,g S < g̃ S < g∗S .
The equilibrium total post-tax profit is calculated as(1 − c)2 (1 − T )SeΠ = (1 − T ) π̄ +.
t − 4T + 3(13)

22 To see this formally, we calculate the difference between the coefficient of t − T in g̃ S and that in g S :

∂g̃ S
∂g S
2(1 − c)1−c−=−∂(t − T ) ∂(t − T )3(t − 4T + 3) 2(t − 2T + 1)
(t − 8T + 7)(1 − c)=−
< 0.
12(t − 4T + 3)(t − 2T + 1)

18

4.3.

Location Choice

From Eqs. (11) and (13), the profit difference is given by2e −Π
e S = (1 − c) (t − 3T + 2)(T − t) ,Π3(t − 4T + 3)
where t − 3T + 2 > 0 and t − 4T + 3 > 0 hold under (A1). The profits under the two schemes
are illustrated in Fig. 3. 23 The sign of the profit difference depends only on T − t. Undere −Πe S ≥ 0 and thus the MNE always prefers the
our assumption that t < T , it holds that Π
co-location scheme. In contrast to the benchmark case, the separate-location scheme is never
optimal even if T is much higher than t. The input prices can neither be effectively used toexercise market power against the local firm, nor to shift profits, thereby reducing the benefitof choosing the separate-location scheme.

Fig. 3.

Production location choice in the ALP case

Proposition 2 (ALP case).

Suppose the MNE sets equal input prices for its downstream

affiliate and the local firm, and assume t ≤ T and the regularity condition (A1): t > t. For
23 The parameter values are the same as those in Fig. 1(a): c = 0.3; π = 3; T = 0.35. We note that thequalitative results stated in Proposition 1 do not depend on these particular parameter values.

19any host’s tax rate (t ∈ (t, T )), the MNE always locates an upstream affiliate in the low-tax
host country (”co-location”).

4.4.

Extensions and Robustness

We have seen that the upstream affiliate may be located in the parent country (separate
location) even if the parent’s tax rate is higher than the host’s (Proposition 1), and theimposition of the ALP may change the separate-location scheme to the co-location scheme(Proposition 2). One may wonder these results crucially depend on our simplified structure,
where the intermediate inputs are supplied only by the upstream affiliate, and there is only
one local firm in the downstream market. We briefly discuss the robustness of the results
against three extensions: (i) imperfect substitutability between the two final goods, (ii) a
local upstream firm, and (iii) many downstream firms.

Substitutability of the Final Goods.

We allow for the two final goods to be substitutable.

The transfer price has then a strategic effect as well as the tax-manipulation effect. As thestrategic effect reduces the transfer price to make the downstream affiliate competitive, itworks in the same direction as the tax-manipulation effect.
Let b ∈ (0, 1) denote the degree of substitutability of the goods. If b is so high thatcompetition in the downstream industry is tough, the MNE prevents the local firm fromdoing business by stopping selling inputs to it. Unless such input foreclosure occurs, we
obtain the qualitatively same results as in Propositions 1 and 2. See our working paper(Kato and Okoshi, 2017) for details.

A Local Firm in the Upstream Industry.

We add a local upstream firm in the host country.

The upstream firm has the same marginal cost of c, supplies the same type of intermediate
inputs as the upstream affiliate, and competes with it in prices. Bertrand competition withhomogeneous products leads both the two upstream firms to set their prices equal to or lower

20than their marginal cost. The upstream firm cannot set its price lower than the marginal costin order to earn non-negative profits. On the other hand, the upstream affiliate, if located in
the parent country, can do so because its negative profits are compensated by the profits fromdifferent business π̄. Thus, the MNE locates the upstream affiliate in the high-tax parent
country as in Proposition 1.
In the ALP case, if the MNE were to set the input price lower than the marginal costfor the downstream affiliate, the price would also be applied to the local firm and thus leadto negative profits from it. The introduction of ALP makes the separate-location scheme
less profitable than before and may change the location pattern as in Proposition 2. See
Appendix 3 for details.
As we assume the two upstream firms produce the same type of inputs and have thesame marginal cost, the arm’s length price is uniquely identified. In practice, however,tax authorities may observe multiple uncontrolled comparable prices. The OECD guideline
suggests that the arm’s length price might be pinned down by statistical tools to narrow the
price range such as the interquartile range or other percentiles (OECD, 2017, para. 3.57). In
Appendix 7, we allow for the differentiation of inputs and analyze the case where the arm’s
length price takes a range of values.

Many Local Firms in the Downstream Industry. We allow for many local downstream firms,
each of which produces a differentiated variety of products. A greater number of downstream
firms yields more input sales. This implies that the downstream affiliate’s profits relative to
profits from local downstream firms become less important in the MNE’s total profits. The
MNE now lays less emphasis on the role of transfer prices and relies more on input sales
from many local firms. Thus, it tends to prefer the co-location scheme simply for the low
tax rate of the host country. However, if the number of downstream firms is not too large,
Propositions 1 and 2 still hold. See Appendix 4 for details.

Furthermore, we extend our analysis to include (iv) extra costs of international trade, (v)extra costs of transfer pricing, and (vi) endogenous profits in the parent market. In these21generalized settings, we obtain the qualitatively similar results to those of Propositions 1 and2. The detailed analysis can be found in the Appendix.

5.

The Impact of the ALP on Tax Revenues

It has been shown that the imposition of the ALP may change the location of upstream
production from the parent to the host country. At first glance, this location change seems
to enhance production in the host and bring larger tax revenues. However, this is not true.
It can be verified that for t ∈ (t, t∗ ), tax revenues under the separate-location scheme in
the benchmark case, denoted by T RH , are greater than those under the co-location schemegin the ALP case, denoted by T
RH : 24g
T
RH < T RH ,gwhere T
RH = t(π̃u + π̃ + π̃∗ )= t · 2(p̃ − c)q̃,
T RH = t(π S + π∗S )= t[(pS − g S )q S + (pS∗ − g∗S )q∗S ],where it is noted that p̃ = p̃∗ and q̃ = q̃∗ . The tax base in the benchmark case consistsof the profits of the two downstream firms (π S + π∗S ), while in the ALP case the tax baseincludes the profits of the upstream affiliate (π̃u ) as well as the two profits (π̃ + π̃∗ ). In thebenchmark case, the transfer price is set lower than the true marginal cost. As a result, thedownstream affiliate significantly expands and more goods are produced than in the ALP
case, i.e., q S + q∗S > 2q̃. 25 In fact, the imposition of the ALP helps the local firm expand
24 For t∗ (defined in Eq. (9)) to be positive, we assume a sufficiently high T such that T > T = 1/4.
25 To see this formally, we haveq S + q∗S − 2q̃ = [2g̃ − (g S + g∗S )]/2 > 0,
→ t < (4T + 1)/5 ≡ tq .

22

(q̃∗ = q̃ > q∗S ), but discourages the production of the downstream affiliate (q̃ < q S ) andreduces the price-cost margin (p̃ − g̃ < pS − g S ). 26 The contraction of host production
combined with the narrower price-cost margin results in smaller tax revenues.
In contrast, it can be verified that in most cases, the location change induced by the ALP
increases tax revenues globally:g
T
RW > T RW ,gwhere T
RW = T π̄ + t(π̃u + π̃ + π̃∗ )= T π̄ + t · 2[(p̃ − g̃) + (g̃ − c)]q̃,
T RW = T (π̄ + πuS ) + t(π S + π∗S )= T [π̄ + (g S − c)q S + (g∗S − c)q∗S ] + t[(pS − g S )q S + (pS∗ − g∗S )q∗S ].
where tax revenues in the parent country are now included. In the benchmark case, theupstream affiliate sets the transfer price lower than the marginal cost (g S < c), and earns
negative profits. The host country benefits from larger tax revenues at the expense of theparent country, but the benefit of the host does not exceed the loss of the parent. By imposing
the ALP, the internal price is set higher than the marginal cost (g̃ > c), which brings positive
profits to the upstream affiliate in the host country and leads to greater tax revenues globally.
These results are summarized as follows (see Appendix 2 for the proof).

Proposition 3 (Tax revenues).

The imposition of the ALP changes the location of

upstream production from the parent to the host country (from ”separate location” to ”coThere exists t satisfying the above inequality because it holds that ta < tq < t∗ and t > t ≡ max{0, ta , tb }from (A1): t > t.
26 Noting that g S < g S and g̃ > g S , we have∗∗q̃ − q∗S = (g∗S − g̃)/2 > (g∗S − g)/2 > 0.
Combining this result with q S + q∗S > 2q̃ gives q̃ < q S . This also implies that the price-cost margin is smallerin the ALP case than in the benchmark case: q̃ = p̃ − g̃ < pS − g S = q S .

23

location”) if the international tax difference is large (t ∈ (t, t∗ )). This location change decreases tax revenues in the host country, but increases those globally.

Considering the fact that countries adopt transfer pricing taxation to raise their tax revenues, the implementation of the ALP may give rise to an unintended consequence for countries with low corporate tax rates. Proposition 3 also suggests a conflict of interest in the
ALP between low-tax and high-tax countries. 27 In Appendix 9, we show that the results
generally apply to social welfare. The ALP limits the use of transfer price and thereby leads
to higher prices of final goods, which reduces consumer surplus in the host country. Thus
the location change caused by the ALP would lower not only tax revenues, but also social
welfare (consumer surplus and profits as well as tax revenues) in the host country. For afull analysis on welfare in a related model but without location choice, we refer independentworks by Choi et al. (2018); and Ishikawa et al. (2017).

6.

Conclusion

We have analyzed how corporate tax rates affect the production location choice of MNEs. One
may think that internationally-mobile firms locate their production in low-tax countries, but
this simple reasoning may not hold true for MNEs with multiple affiliates. MNEs attempt toreduce tax payments globally by manipulating transfer prices for intra-firm trade. Thus, they
have an incentive to locate their upstream and downstream affiliates separately to exploit
international tax differences. Contrary to the conventional wisdom, this paper shows thatthe upstream affiliate is likely to be located in the high-tax parent country, if its tax rate ismuch higher than that of the host country where the downstream affiliate is located.
With a view to preventing tax manipulation, the transfer pricing tax system requires
MNEs to follow the ALP, where MNEs should not set different prices for related affiliates
27 Similar results can be found in Yao (2013) in a different setting mentioned in the Introduction.

24

and unrelated firms. We have also analyzed the impact of the ALP on the location choiceof MNEs. With the ALP, MNEs are unable to fully utilize intra-firm transactions acrossborders for profit shifting. The ALP makes the transfer pricing strategy less effective, andthus may change the location pattern from a separate-location to a co-location of upstream
and downstream affiliates. This location change seems to bring greater tax revenues to thecountry hosting the two affiliates, but we have demonstrated that this is not true. In contrast
to a separate location, a co-location in the host country does not provide the scope of profit
shifting from the parent country, which leads to the loss of tax base in the host. Owing tothis, the host government may hesitate to implement the ALP strictly, although the ALP
may increase global tax revenues.
We conclude by proposing possible extensions worth investigating. One extension is toallow taxes to be endogenously chosen by governments. In addition, one can think of manyother policies to attract MNEs such as production and entry subsidies. Considering theimportance of international tax planning, further analysis on different national tax systems
is also needed such as the impact of a change from the separate accounting system to theformula apportionment system, or the role of the advance pricing agreement. These issues
are left to future research.

25

Appendix
A.1.

List of Key Variables
BenchmarkInternal price of the input
Arm’s length price of the input
Price of the affiliate’s final good
Price of the local firm’s final good
Quantity of the affiliate’s final good
Quantity of the local firm’s final good
Pre-tax profit of the upstream affiliate
Pre-tax profit of the downstream affiliate
Pre-tax profit of the local firm
Total post-tax profit of the MNE

Co-location Separate locationgg S (transfer price)
g∗
g∗S
p
pS
p∗
pS∗
q
qS
q∗
q∗S
πu
πuS
π
πS
π∗
π∗S
Π
ΠS

Arm’s Length Principle (ALP)
Arm’s length price of the input
Price of the affiliate’s final good
Price of the local firm’s final good
Quantity of the affiliate’s final good
Quantity of the local firm’s final good
Pre-tax profi of the upstream affiliate
Pre-tax profit of the downstream affiliate
Pre-tax profit of the local firm
Total post-tax profit of the MNE

Co-location
g̃
p̃
p̃∗
q̃
q̃∗
π̃u
π̃
π̃∗
e
Π

Separate location
g̃ S
p̃S
p̃S∗
q̃ S
q̃∗S
π̃uS
π̃ S
π̃∗S
eS
Π

We note that (i) in the ALP case, the internal price is equal to the arm’s length price, (ii)the downstream firms produce one unit of final goods using one unit of intermediate inputs,and (iii) the pre-tax profits from the parent country π̄ are always constant.

A.2.

Proof of Proposition 3

Tax Revenues in the Host Country. Assuming T > T = 1/4, we show that when t ∈ (t, t∗ ),g
tax revenues in the benchmark case, T RH , are greater than those in the ALP case, T
RH . Itsuffices to check the difference of taxable profits:gT
RH − T RH = t[π̃u + π̃ + π̃∗ − (π S + π∗S )] < 0,→ π̃u + π̃ + π̃∗ − (π S + π∗S ) ≡ Γ < 0.

26

If it is shown that (i) Γ < 0 holds at t = t∗ and (ii) Γ is increasing in t, we can conclude
that Γ is negative for t ∈ (t, t∗ ). First we check (i):Γ|t=t∗ = −13(1 − c)2< 0.
72(ii) requires the following condition:∂(π S + π∗S ) dg S
dΓ
=−
> 0,
dt
∂g S
dt
dg S
2(1 − c)(1 − T )
where
=
> 0,
dt
t − 2T + 1
noting that profits earned in the host under the ALP, π̃u + π̃ + π̃∗ , are independent of transfer
price and thus of tax rates. We only need to check that profits in the host in the benchmark
case, π S + π∗S , are decreasing in transfer price, g S :∂(π S + π∗S )5g S − 4
=
∂g S
8
S
g −1
< 0,
< ∗
2
where we make use of g S < g∗S and g∗S < 1. Both (i) and (ii) are proved to be true and thus
we complete the proof.
Tax Revenues in the World. We first show g S < c for t ∈ (t, t∗ ) while assuming T > T = 1/4.
g S < c requires the following condition:gS − c =(1 − c)(t − T )< 0,t − 2T + 1

which obviously holds under our assumption.
We then show the following:gT
RW − T RW = −T πuS + t[π̃u + π̃ + π̃∗ − (π S + π∗S )]= −T πuS + tΓ ≡ ∆ > 0,gwhere T RW and T
RW are world tax revenues in the benchmark and the ALP cases, respectively.
Analogous to the previous case, if it is shown that (i) ∆ is positive at t = t∗ and (ii) ∆ isdecreasing in t, we can conclude that ∆ > 0 holds for t ∈ (t, t∗ ). First we see (i):∆|t=t∗ =(13 − 2T )(1 − c)2
> 0.
216

27

To prove (ii), it suffices to show
d∆
dπ S
dΓ
= −T u + Γ + t
dt
 dt
 dt
S
dΓ dπu
<t
−
+Γ
dt
dt
∂(π S + π∗S − πuS ) dg S
+ Γ < 0,=t
∂g S
dt
where from the first to the second line we make use of t < t∗ < T . As we have seen dg S /dt > 0
and Γ < 0, we only need to check∂(π S + π∗S − πuS )c + 2 − 3g S
=
−
∂g S
2
c + 2 − 3c<−2
= −(1 − c) < 0,noting that g S < c from the first to the second line. We complete the proof.

A.3.

A Local Firm in the Upstream Industry

In the text, the upstream affiliate is the only supplier of inputs. One may wonder thissetting is crucial for the results, but it is not the case. We see that the upstream affiliate
may be located in the high-tax parent country (“separate location”) in the benchmark case
(Proposition 1) and the imposition of the ALP may change this location pattern (Proposition2). We introduce a local upstream firm in the host country. The local upstream firm has
the same marginal cost c as the MNE’s upstream affiliate and competes with the affiliate
in a Bertrand fashion. The timing proceeds in the same manner as in the text. First, the
MNE chooses a location for upstream production. Then the MNE and the local upstream
firm set input prices. Finally the downstream affiliate and the local firm source the inputs
and produce final goods.
As inputs produced by the two upstream firms are homogeneous, the downstream firms buy
inputs from the lowest price supplier. Hence, the dominant strategy for the local upstream
is to set its input price equal to the marginal cost c. Considering this strategy of the local
upstream, the MNE sets input prices equal or lower than c. We need to modify the MNE’s
maximization problem so as to include inequality constraints on input prices.
Benchmark Case.

Let us first look at the separate-location scheme. The maximization28

problem for the MNE is modified as 28
max ΠS = (1 − T )[π̄ + (g S − c)q S + (g∗S − c)q∗S ] + (1 − t)(pS − g S )q S ,g S ,g∗Ss.t. g S ≤ c, g∗S ≤ c,where the final good’s price pS and quantities (q S , q∗S ) are defined in Section 3 and we assume
that the MNE upstream affiliate takes all the input demand if its prices are equal to the onesof the local upstream.
Letting λ and µ be the Lagrange multipliers for the constraints of g S ≤ c and g∗S ≤ crespectively, we solve the above problem to get
gS = c +(1 − c)(t − T )< c,t − 2T + 1

λ = 0,g∗S = c,µ = (1 − c)(1 − T )/2 > 0,
where we maintain the assumptions (A1): t > t and t < T . As the multipliers are all
non-negative, the equilibrium prices satisfy the Kuhn-Tucker conditions for optimization. g S
allows a similar interpretation to the one for the unconstrained optimal transfer price definedin Eq. (6). The first term is the base price equal to the arm’s length price. The second term
represents the tax-manipulation effect.
The associated post-tax profits are then given by(1 − T )(1 − c)2S
Π = (1 − T ) π̄ +.
4(t − 2T + 1)
Under the co-location scheme in the benchmark case as discussed in Section 3, the MNE
sets input prices higher than c in the unconstrained maximization problem, i.e., g > c andg∗ > c. Hence, in the constrained problem here, it can be confirmed that the MNE sets input
prices equal to c, i.e., g = c and g∗ = c, and obtains the following post-tax profits:Π = (1 − T )π̄ +(1 − t)(1 − c)2.
4

As easily seen, Π is smaller than ΠS at t ∈ (t, T ). In other words, the MNE’s optimal choice isthat the upstream affiliate is always located in the parent country (separate location). Even
when considering the local upstream, our conclusion still holds; the upstream production
may be located in the high-tax country for the tax-manipulation purpose.
28 We do not distinguish the notation of variables between the unconstrained problem in the text and theconstrained problem here.

29

ALP Case.
In the ALP case, the optimal input prices in the unconstrained problem
discussed in Section 4 are never below the marginal cost c under the two schemes, i.e., g̃ > c
and g̃ S > c. By the same reasoning as before, it can be confirmed that the constrained
problem gives the input prices equal to the marginal cost, i.e., g̃ = c and g̃ S = c. Hence, theassociated profits are identical with the one under the co-location scheme in the benchmark
e =Π
e S = Π at t ∈ (t, T ). Unlike the benchmark case, the tax-manipulation effectcase, i.e., Πdisappears and the two countries are indifferent as to the location choice. In this generalized
setting, we still see that the imposition of the ALP may change the location pattern as argued
in the text.

A.4.

Many Local Firms in the Downstream Industry

As in A.3, we see here that our main conclusions are maintained in a more generalized setting
than in the text. Consider N local firms in the downstream industry. The local firms are
assumed to be symmetric and have the same marginal cost c. If N is set to be unity, all thefollowing results reduce to the corresponding results in the text.
The demand functions for the downstream affiliate and the local firm j are respectively
given by
p = 1 − q,p∗j = 1 − q∗j .
The following procedure is the same as in the text and we solve the problem backward.
Considering the above demand schedules, the downstream firms choose quantities to maximize their own profits:
1−g,
2
1 − g∗j
q∗j =
.
2

q=

Benchmark Case. Given the optimal quantities the downstream firms choose, the MNE
sets input prices to maximize its post-tax profits. In the co-location scheme, the equilibrium
input prices are given byg = c,
1+cg∗ =,2
where g∗j = g∗ holds for all j and the SOCs trivially hold.

30

The total post-tax profits in equilibrium are calculated as
Π = (1 − T )π̄ +(1 − t)(1 − c)2 (2 + N ).
8The equilibrium input prices in the separate-location scheme are given by(1 − c)(t − T ),t − 2T + 1
1+c
,
g∗S =
2

gS = c +where t − 2T + 1 > 0 and the SOCs hold under (A1): t > t. Under t < T , the second termof g S is negative so that the tax-manipulation effect works in the same way as in Eq. (6).
The total post-tax profits in equilibrium are calculated as(1 − c)2 {N t − 2(1 + N )T + 2 + N }SΠ = (1 − T ) π̄ +.
8(t − 2T + 1)
Taking difference between the post-tax profits in the two schemes givesΘ0 (1 − c)2 (T − t),16(t − 2T + 1)
where Θ0 ≡ 2(2 + N )t + 4(1 + N )T + 2N.
Π − ΠS =The profit difference becomes zero at t = T and t = t0 where t0 is the solution of Θ0 = 0. It
can be confirmed that t0 is in between (t, 1] if N is not sufficiently large. 29 In this case, wehave Π − ΠS < 0 for t ∈ (t, t0 ) and Π − ΠS ≥ 0 for t ∈ [t0 , T ). We can conclude that the MNEchooses the separate location if the tax difference is large as in Proposition 1.
ALP Case. Analogous to the benchmark case, the equilibrium input price under the colocation scheme becomesg̃ =c + N + cN,
1 + 2N

where the SOC trivially holds. It can be confirmed that g < g̃ < g∗ holds as in the text. The
total post-tax profits are given by22

e = (1 − T )π̄ + (1 − t)(1 − c) (1 + N ) .
Π4(1 + 2N )29 It always holds that t0 < T . t0 is decreasing in N if N is not sufficiently large, implying t0 > t for not
sufficiently large N .

31Turning to the separate-location scheme, the equilibrium input price becomesg̃ S =

c + N + cN
(1 − c)(1 + N )(t − T ).
+| 1 +{z2N } (1 + 2N )[t − 2(1 + N )T + 1 + 2N ]=g̃We can check that as long as N is not sufficiently large, g S < g̃ < g∗ holds as in the text.
The total post-tax profits under the separate-location scheme are given by(1 − T )(1 − c)2 (1 + N )2Se
Π = (1 − T ) π̄ +,4{t − 2(1 + N )T + 1 + 2N }where the SOC requirest − 2(1 + N )T + 1 + 2N > 0.
The profit difference then becomes
2

2

e −Π
e S = (T − t)(1 − c) (1 + N ) [t − (1 + 2N )T + 2N ] ,Π
4(1 + 2N )[t − 2(1 + N )T + 1 + 2N ]which is positive as long as the SOC holds. This implies that in the ALP case the MNE
always chooses the co-location scheme as in Proposition 2.

A.5.

Trade Costs

We introduce here trade costs for inputs. If the upstream affiliate is located in the parent
country, the downstream firms pay an extra unit trade cost τ > 0 when importing inputs(Kind et al., 2005). If it is located in the host country, trade costs play no role and theanalysis is the same as in the text. Thus, we present only the results in the separate-location
scheme in the following.
Benchmark Case.

The maximization problems of the downstream firms are modified as
max π S = (pS − g S − τ )q S ,qmax π∗S = (pS∗ − g∗S − τ )q∗S .
q∗Solving these gives
1 − gS − τq =,2
1 − g∗S − τ
q∗S =
.
2
S

32

The total post-tax profit of the MNE is also modified accordingly:ΠS = (1 − T )[π + (g S − c)q S + (g∗S − c)q∗S ] + (1 − t)(pS − g S − τ )q S .
The equilibrium input prices to maximize it are given by(1 − c − τ )(t − T ),t − 2T + 1
1+c−τ
g∗S =
.
2

gS = c +We impose an assumption of τ < 1 − c to ensure positive outputs. The equilibrium total
post-tax profit is calculated as(1 − c − τ )2 (t − 4T + 3)S.
Π = (1 − T ) π̄ +8(t − 2T + 1)
Taking difference between the post-tax profits in the two schemes gives
F (t),16(t − 2T + 1)
where F (t) ≡ −3(1 − c)2 t2 + [τ {2(1 − c) − τ } + (1 − c)2 (7T − 1)]t
+ τ [2(1 − c) − τ ](1 − T )(3 − 4T ) + T (4T − 1)(1 − c)2 .
Π − ΠS =We check (i) whether F (t) = 0 has two real roots and (ii) whether at least either of themfalls into (t, T ).
F (t) = 0 has two real roots if its determinant D is positive:D(τ ) ≡ (1 − T )2 [τ 4 − 4(1 − c)τ 3 − 30(1 − c)2 τ 2 − 68(1 − c)3 τ + (1 − c)4 ] > 0, for τ ∈ [0, 1 − c).
We can verify this inequality by noting the following relations:
D(τ = 0) = (1 − T )2 (1 − c)4 > 0,
D(τ = 1 − c) = 36(1 − T )2 (1 − c)4 > 0,D0 (τ ) = −4(1 − T )2 (1 − c − τ )[τ 2 − 2(1 − c)τ − 17(1 − c)2 ] > 0.
Let t1 and t2 be respectively the smaller and the larger root of F (t) = 0. From thefacts that F (t) has a negative coefficient of the quadratic term and that ∂F (t; τ )/∂τ =2(1 − T )(1 − c − τ )(t − 4T + 3) > 0 holds, we see t1 is decreasing in τ while t2 is increasingin τ . At τ = 0, t1 is reduced to t∗ = (4T − 1)/3 and t2 to T .
If T > 3/4 holds, t1 lies in (0, T ) regardless of τ so that the separate-location scheme ischosen for t ∈ (0, t1 ). If T ≤ 3/4 holds, t1 may become negative at sufficiently high trade
costs. The maximum level of trade costs that allows for the separate-location scheme is given

33

by
s
τ = (1 − c) 1 −8T 2 − 8T + 3.
(1 − T )(3 − 4T )Even if T ≤ 3/4, we observe the separate-location scheme for t ∈ (0, t1 ] as long as τ < τ .
In sum, as in Proposition 1, assuming the parent’s tax rate is high enough (T > 3/4), the
MNE locates the upstream affiliate in the high-tax parent country if the host’s tax rate is low
enough (t ∈ (t, t1 ]) and otherwise locates it in the low-tax host country. Higher trade costs
reduce the range of tax rates where the separate-location scheme is chosen, i.e., dt1 /dτ < 0.
ALP Case.
is given by

Analogously, the equilibrium input price to maximize the total post-tax profitg̃ S =

1 + 2c − τ
2(1 − c − τ )(t − T )+.
33(t − 4T + 3)

The associated total post-tax profit becomes(1 − c − τ )2 (1 − T )SeΠ = (1 − T ) π +.
t − 4T + 3
The profit difference is given by
2

2

e −Π
e S = (1 − c) (t − 3T + 2)(T − t) + 3τ [2(1 − c) − τ ](1 − T ) > 0,Π3(t − 4T + 3)
where we note that τ < 1 − c < 2(1 − c). This implies that with the ALP the MNE always
chooses the co-location scheme as in Proposition 2.

A.6.

Costs of Transfer Pricing

Some studies in the literature assume that MNEs are subject to an extra concealment costof transfer pricing (e.g., Nielsen et al., 2003, 2008; Kind et al., 2005). We formulate here theconcealment cost as a quadratic function of the difference between the transfer price and thearm’s length price, i.e., C(g, g∗ ) = δ(g − g∗ )2 /2 with δ ≥ 0. Following the above-mentioned
studies, we assume that the upstream affiliate bears this cost. Thus, the concealment costdoes not affect the optimal choices by the downstream firms, which are the same as thosegiven in the text.

34

Benchmark Case.

In the co-location scheme, the total post-tax profit is modified as

Π = (1 − T )π + (1 − t)[(g − c)q + (g∗ − c)q∗ − C(g, g∗ ) + (p − g)q],
where C(g, g∗ ) = δ(g − g∗ )2 /2, δ ≥ 0,
noting that the optimal outputs (q, q∗ ) chosen by the downstream firms are the same as thosein the text: q = (1 − g)/2; q∗ = (1 − g∗ )/2. The equilibrium input prices to maximize it are
given by
δ + c(1 + 2δ),
1 + 3δ
1 + 2δ + c(1 + 4δ).
g∗ =2(1 + 3δ)g=

The equilibrium total post-tax profit then becomesΠ = (1 − T )π +(1 − t)(1 − c)2 (3 + 8δ).
8(1 + 3δ)In the separate-location scheme, we can analogously define the total post-tax profit andcompute the equilibrium input prices as follows:(1 − c)[t − T + δ(t − 2T + 1)],
t − 2T + 1 + δ(t − 4T + 3)
(t − 2T + 1)(1 + c + 2δ) + 4cδ(1 − T ).
g∗S =2[t − 2T + 1 + δ(t − 4T + 3)]
gS = c +The equilibrium total post-tax profit is calculated as(1 − c)2 {t − 4T + 3 + 8δ(1 − T )}S
Π = (1 − T ) π +.
8{t − 2T + 1 + δ(t − 4T + 3)}
Taking difference between the post-tax profits in the two schemes gives
G(t)(1 − c)2 (T − t),8(1 + 3δ)[t − 2T + 1 + δ(t − 4T + 3)]
where G(t) ≡ (1 + δ)(3 + 8δ)t − 8(3T − 2)δ 2 − (20T − 9)δ + 1 − 4T,Π − ΠS =noting that its sign only depends on G(t). G(t) = 0 holds at t∗∗ , which is defined byt∗∗ =4T − 1 8δ(2 + 5δ)(1 − T )−.
3
3(1 + δ)(3 + 8δ)Without the concealment cost, t∗∗ is reduced to t∗ defined in Eq. (8). When T > T = 1/4

35

holds as in the text and δ is not too high, t∗∗ becomes positive. 30 In this case, as in Proposition
1, we observe the separate-location scheme for t ∈ (t, t∗∗ ] and the co-location scheme fort ∈ (t∗∗ , T ). The more difficult concealment is, the less likely we are to observe the separatelocation scheme, i.e., dt∗∗ /dδ < 0.
ALP Case. As the transfer price must be equal to the arm’s length price, the concealment
cost plays no role. The results in both schemes are the same as those in the text.

A.7.

Differentiated Inputs

In the text, the downstream affiliate and the local firm purchase the same input from the
upstream affiliate. We consider here the situation where the two downstream firms needa different type of inputs. The upstream affiliate produces the two different inputs using
different technology. That is, the marginal cost of input for the downstream affiliate isc ∈ [0, 1), while that for the local firm is c∗ ∈ [0, 1).
As the input for the downstream firm is not perfectly comparable to that for the local
firm, tax authorities cannot require that the prices of the two inputs must be the same.
Instead, they allow for a certain range of arm’s length price. This arm’s length range gives
the MNE room for price differentiation even under the ALP. The partial comparability ofthe two inputs implies that they are produced using more or less the same technology. We
thus assume the difference of marginal cost is not too large: |c∗ − c| < 1 − c.
Benchmark Case.
In the co-location scheme, the total post-tax profit isΠ = (1 − T )π + (1 − t)[(g − c)q + (g∗ − c∗ )q∗ + (p − g)q],
where the optimal outputs (q, q∗ ) chosen by the downstream firms are the same as those in
the text: q = (1 − g)/2; q∗ = (1 − g∗ )/2. The equilibrium input prices to maximize it are
g = c,
1 + c∗g∗ =,2where we note g < g∗ . The equilibrium total post-tax profit then becomes(1 − c)2 (1 − c∗ )2Π = (1 − T )π + (1 − t)
+
.
4
8
ˆ
ˆ
30 δ is bounded above by δ ≡ min{δ̂, δ̂},
where δ̂ ≡ sup{δ : t∗∗ > 0} and δ̂ ≡ min{sup{δ : Π > 0}, sup{δ :S

Π > 0}}.

36

In the separate-location scheme, the total post-tax profit is modified as follows:ΠS = (1 − T )[(g S − c)q S + (g∗S − c∗ )q∗S ] + (1 − t)(pS − g S )q S .
The equilibrium input prices are(1 − c)(t − T ),t − 2T + 1
1 + c∗g∗S =,2
gS = c +where we note g S < g∗S . The equilibrium total post-tax profit is calculated as(1 − c∗ )2 (1 − T )(1 − c)2S
Π = (1 − T ) π +.
+84(t − 2T + 1)
The MNE prefers the co-location scheme if(T − t)[t{3 − 2c(2 − c) − c∗ (2 − c∗ )} − 2T {(1 − c)2 + (1 − c∗ )2 } + (1 − c∗ )2 ]> 0,
8(t − 2T + 3)
2T [(1 − c)2 + (1 − c∗ )2 ] − (1 − c∗ )2→ t > t∗ ≡.
3 − 2c(2 − c) − c∗ (2 − c∗ )

Π − ΠS =where we can confirm t∗ ∈ (0, T ) if T is sufficiently large:
1(1 − c∗ )2
T > T ≡ max,.
4 2[(1 − c)2 + (1 − c∗ )2 ]The co-location scheme is chosen if the host’s tax rate is close to the parent’s (t ∈ (t∗ , T ))and the separate-location scheme is chosen otherwise (t ∈ (0, t∗ ]) as in Proposition 1.
ALP Case. In the co-location scheme, the transfer price g̃ must be within the range of[g̃∗ − e, g̃∗ + e] with e > 0. We assume e is not too large, otherwise the situation is reduced
to the benchmark case. The MNE sets the price g̃∗ to the local firm and g̃ = g̃∗ + ẽ to thedownstream affiliate, where ẽ ∈ [−e, e]. It chooses g̃∗ and ẽ to maximize the total post-tax
profit:e = (1 − T )π + (1 − t)[(g̃∗ + ẽ − c)q̃ + (g̃∗ − c∗ )q̃∗ + (p̃ − g̃∗ − ẽ)q̃],max Πg̃∗ ,ẽnoting that the optimal outputs (q̃, q̃∗ ) chosen by the downstream firms are the same as thosein the text.
As the fact that g < g∗ holds in the benchmark case suggests, the MNE tries to set g̃ lower

37

than g̃∗ and thus chooses ẽ = −e. The equilibrium input prices are
1 + c + c∗ + e,
3
1 + c + c∗ − 2eg̃ = g̃∗ − e =
.
3
g̃∗ =

The total post-tax profit can then be rewritten as(2 − c − c∗ )2 e(1 − 2c + c∗ + e)e
Π = (1 − T )π + (1 − t)−.
126
In the separate-location scheme, we can analogously define the total post-tax profit andcompute the equilibrium input prices as follows:
1 + c + c∗ + e (2 − c − c∗ + 2e)(t − T )+,33(t − 4T + 3)
1 + c + c∗ − 2e (2 − c − c∗ + 2e)(t − T )+,g̃ S = g̃∗S − e =33(t − 4T + 3)g̃∗S =

where the MNE sets ẽ = −e as implied by g S < g∗S . The equilibrium total post-tax profit iscalculated as


2
(1
−
T
)(2
−
c
−
c
)
−
2e{e(t
−
2T
+
1)
+
κ}
∗
S
e = (1 − T ) π +Π,4(t − 4T + 3)
where κ ≡ (1 − c)(1 − t) − (c − c∗ )(t − 2T + 1).
Taking difference between the post-tax profits in the two schemes givese −Π
e S = H(e)(T − t) ,Π12(t − 4T + 3)
where H(e) ≡ −2(t − 6T + 5)e2 + 2[1 − t + 2c(t − 3T + 2) − c∗ (t − 6T + 5)]e
+ (2 − c − c∗ )2 (t − 3T + 2).
Since T − t > 0 and t − 4T + 3 > 0 hold, the inequality is positive if H(e) > 0 holds. Notingthat t − 6T + 5 > 0 and t − 3T + 2 > 0 hold because of (A1): t > t, we see that H(e) has anegative coefficient of the quadratic term and that H(0) > 0. These observations imply that
H(e) > 0 holds if e ∈ (0, e2 ), where e2 is the larger root of H(e) = 0. In other words, if thedegree of input differentiation is so low that the arm’s length range is narrow enough, the
MNE always chooses the co-location scheme as in Proposition 2.

38

A.8.

Endogenous Profits in the Parent Market

In the text, we assume that the MNE earns exogenous profits π from different businessin the parent country. Here we endogenize it by introducing a local downstream firm in theparent. The local firm is the monopolist facing the demand curve of P∗ = 1 − Q∗ . It sources
the same type of inputs as do the downstream firms in the host, from the upstream affiliate
at the price of G∗ . As the parent’s and the host’s markets are segmented, the presence of thelocal firm does not affect the equilibrium outputs and input prices for the downstream firms
in the host. It only affects the location choice of the MNE, as we shall see below.
Benchmark Case.

In the co-location scheme, the total post-tax profit is modified as

Π = (1 − t)[(g − c)q + (g∗ − c)q∗ + (G∗ − c)Q∗ + (p − g)q],
where the optimal outputs (q, q∗ ) chosen by the downstream firms are the same as those in
the text: q = (1 − g)/2; q∗ = (1 − g∗ )/2. We also note Q∗ = (1 − G∗ )/2. The equilibrium
input prices to maximize it are given byg = c,g∗ = G∗ =1+c.
2

The equilibrium total post-tax profit then becomesΠ=(1 − t)(1 − c)2.
2

In the separate-location scheme, the total post-tax profit is modified as follows:ΠS = (1 − T )[(g S − c)q S + (g∗S − c)q∗S + (GS∗ − c)QS∗ ] + (1 − t)(pS − g S )q S .
The equilibrium input prices are(1 − c)(t − T ),t − 2T + 1
1+cg∗S = GS∗ =.
2
gS = c +The equilibrium total post-tax profit is calculated asΠS =(1 − T )(1 − c)2 (t − 3T + 2).
4(t − 2T + 1)

The profit difference takes a complex form and is hard to characterize analytically. We thus
rely on numerical simulations. Fig. A1 draws the total post-tax profits in the two schemes

39for different levels of the host’s tax rate. 31 In Fig. A1.(a), where the parent’s tax rate is high(T = 0.35), the separate-location scheme is chosen for t ∈ (0, t∗ ) and the co-location scheme
for t ∈ [t∗ , T ). In Fig. A1.(b), where the parent’s tax rate is low (T = 0.2), the co-location
scheme is chosen for the entire range t ∈ (0, T ). We have experimented various parametervalues and confirmed the qualitatively same results as in Proposition 1. That is, the higher
the parent’s tax rate is, the more likely we are to observe the separate-location scheme as
Fig. A1.(a) shows.

Fig. A1.

Production location choice in the benchmark case: (a) high T and (b) low T

ALP Case. Analogous to the benchmark case, the equilibrium input price in the co-location
scheme is derived as follows:g̃ = g̃∗ = G̃∗ =1 + 2c.
3

31 The parameter values are the same as those in Fig. 1: c = 0.3; (a)T = 0.35; (b)T = 0.2. In this numericalexample, t = 0 holds.

40

The associated total post-tax profit becomese = (1 − t)(1 − c)(5 − 8c) .
Π9e positive, we assume c < 5/8.
To make Π
In the separate-location scheme, the equilibrium input prices and the resulting total posttax profit areg̃ S = g̃∗S = G̃S∗ =1 + 2c 2(1 − c)(t − T )+.
33(t − 4T + 3)

The associated total post-tax profit becomes22

e S = 2(1 − T ) (1 − c) (t − 3T + 2) .
Π(t − 4T + 3)2
Because the profit difference is difficult to characterize analytically, we again use numericalsimulations. Fig. A2 illustrates the total post-tax profits in the two schemes for different
levels of the host’s tax rate. 32 Unlike the benchmark case, the co-location scheme is chosen for
the entire range even when the parent’s tax rate is high. We have conducted many simulations
and confirmed that the ALP prevents the MNE from choosing the separate-location scheme
as in Proposition 2.
32 The parameter values are the same as those in Fig. 1: c = 0.3; (a)T = 0.35; (b)T = 0.2.

41

Fig. A2.

A.9.

Production location choice in the ALP case: (a) high T and (b) low T

Welfare Analysis

We confirm here that the results on tax revenues stated in Proposition 3 carry over tosocial welfare. That is, the location change induced by the ALP decreases the host country
welfare, while increases global welfare.
Host Country Welfare. Assuming T > 1/4, we show that when t ∈ (t, t∗ ), the social welfarefH .
of the host country in the benchmark case, WH , are greater than that in the ALP case, Wf
WH and WH are defined as follows:
WH =(q S )2 (q∗S )2++ (1 − t)(π S + π∗S ) + t(π S + π∗S ),{z} | {z }
2
2
|
{z
} |
Consumer surplus
2

fH =
W

q̃
2×
| {z 2}

Consumer surplus

Producer surplus

Tax revenues+ (1 − t)(π̃u + 2π̃) + t(π̃u + 2π̃),|{z} | {z }Producer surplus

where we note q̃ = q̃∗ and π̃ = π̃∗ .
42

Tax revenues

Taking the difference of these two gives(q S )2 + (q∗S )22f
WH − WH = q̃ −+ [π̃u + 2π̃ − (π S + π∗S )] .
|
{z
}
2
(−)

As we know from Proposition 3 that the second square bracket term is negative, it suffices
to check the first square bracket term is negative:(1 − c)2 f (t)(q S )2 + (q∗S )2=,2
288(t − 2T + 1)2
where f (t) ≡ 23t2 + 46(1 − 2T )t + 56T 2 − 20T − 13.
q̃ 2 −

This is negative if f (t) < 0. We can confirm f (t) < 0 by noting that (i) f (t) is monotonicallyincreasing in t for t ∈ (t, t∗ ) and (ii) f (t) takes a negative value at the two endpoints of t
and t∗ . The host country attains a higher consumer surplus under no regulation than underthe ALP. Without the ALP, the lower transfer price helps the downstream affiliate reduce
its price, benefiting the host’s consumers more.
We can thus conclude that the location change triggered by the ALP reduces the hostcountry welfare.
Global Welfare. We show that global welfare under no regulation is higher than that under
fP ) be the social welfare of
the ALP for t ∈ (t, t̂), where t̂ is smaller than t∗ . Let WP (or W
the parent country under the regulation (or under the ALP), which are given by
WP = T (π + πuS ) + (1 − T )(π + πuS ),| {z }|{z}
Tax revenues

Producer surplus

fP =
W

Tπ
|{z}

Producer surplus+ (1 − T )π .
| {z }Tax revenues

Global welfare is defined as the sum of the host’s and parent’s social welfare. Comparing
the global welfare under the ALP with that under no regulation yields


S 2
S 2
(q
)
+
(q
)
∗
2
S
S
S
fP + WfH − (WP + WH ) = π + q̃ + π̃u + 2π̃ − π +W+ π u + π + π∗
2
(1 − c)2 h(t)=,288(t − 2T + 1)2
where h(t) ≡ 97t2 + 2(25 − 122T )t + 136T 2 − 28T − 11.
This is positive if h(t) > 0. We can confirm h(t) = 0 at t = t̂ ∈ (t, t∗ ) by noting that (i) h(t)is monotonically decreasing in t for t ∈ (t, t∗ ), (ii) h(t) > 0, and (iii) h(t∗ ) < 0.
We can conclude that if the international tax difference is sufficiently large (t ∈ (t, t̂)), thefP + WfH −(WP +WH ) > 0.
location change induced by the ALP increases global welfare, i.e., W
43

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