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This paper studies the multinational firm's choice of transfer prices when the firm uses separate transfer prices for tax and managerial incentive purposes, and when there is penalty for non-compliance with the arm's length principle. The optimal incentive transfer price is shown to be a weighted average of marginal cost and the optimal tax transfer price plus an adjustment by a fraction of the marginal penalty for non-arm's length pricing. Insofar as the tax rates are different in different jurisdictions, the firm optimally trades off the benefits of tax arbitrage against the penalty for non-arm's length pricing.
