Tax havens and cross-border licensing with transfer pricing regulation

Area of Science:

• Economics
• International Business
• Taxation

Background:

• Multinational enterprises (MNEs) strategically utilize transfer pricing to minimize tax liabilities.
• Intangible assets, particularly technology patents, facilitate cross-border profit shifting.
• The Organisation for Economic Co-operation and Development (OECD) introduced the arm's length principle (ALP) to curb tax avoidance.

Purpose of the Study:

• To analyze the impact of the arm's length principle (ALP) on MNEs' technology patent licensing strategies.
• To investigate the welfare implications of ALP-induced licensing distortions in a model incorporating a tax haven.
• To differentiate the effects of ad valorem versus per-unit royalties on MNEs' strategic decisions and welfare outcomes.

Main Methods:

• Development of a theoretical economic model analyzing MNEs' licensing behavior.
• Inclusion of a tax haven to simulate profit-shifting incentives.
• Comparative analysis of licensing outcomes under different royalty structures (ad valorem vs. per-unit).

Main Results:

• The ALP can distort MNEs' licensing decisions by limiting profit-shifting opportunities through comparable transactions.
• Licensing termination under ALP may negatively impact domestic welfare if the licensee and MNE subsidiary do not compete domestically.
• Conversely, domestic welfare may improve if the licensee and MNE subsidiary are domestic competitors.
• Outcomes differ significantly between ad valorem and per-unit royalty systems.

Conclusions:

• The arm's length principle, while intended to ensure fair taxation, can inadvertently alter MNEs' international licensing strategies.
• The net welfare effect of licensing termination due to ALP depends crucially on the competitive landscape within the domestic market.
• Policy implications regarding international taxation and intellectual property licensing require careful consideration of royalty structures and market competition.