Sorting into outsourcing: Are profits taxed at a gorilla's arm's length?

► We analyze taxation in a model where firms choose between outsourcing and FDI. ► With heterogeneous firms, the arm's length principle misvalues transfer prices. ► MNEs are able to shift profits abroad even if they fully comply with the tax code. ► Optimal organization provides a rationale for the empirically low tax burden of MNEs.