Transfer Pricing

Background
Transfer pricing is one of the most important issues in international tax.
Transfer pricing happens whenever two companies that are part of the same multinational
group trade with each other: when a US-based subsidiary of Coca-Cola, for example, buys
something from a French-based subsidiary of Coca-Cola. When the parties establish a price for
the transaction, this is transfer pricing.
Transfer pricing is not, in itself, illegal or necessarily abusive. What is illegal or abusive is
transfer mispricing, also known as transfer pricing manipulation or abusive transfer pricing
which could lead to tax avoidance and tax Evasion.
Example
Consider a profitable computer group in country A that buys flash-memory drives
from its own subsidiary in country B: how much the parent country A company pays
its subsidiary country B company (the transfer price) will determine how much
profit the country B unit reports and how much local tax it pays. If the parent pays
below normal market prices, the country B unit may appear to be in financial
difficulty, even if the group as a whole shows a reasonable profit margin when the
completed computer is sold.
From the perspective of the tax authorities, country As tax authorities might
agree with the
profit reported at their end by the computer group in country A,
but
their country B counterparts may not agree - they may not have the expected profit to tax on
their side of the operation. If the computer company in country A bought its flashmemory drives from an independent company in country B it would pay the Market
price, and the supplier would pay taxes on its own profits in the normal way. This approach
gives scope for the parent or subsidiary, whichever is in a low-tax jurisdiction, to be
shown making a higher profit by fixing the transfer price appropriately and thereby
minimising its tax incidence.
So, when the various parts of the organization are under some form of
common control, it may mean that transfer prices are not subject to the full play
of market forces and the correct arms length price, or at least an arms length
range of prices (an issue discussed further below) needs to be arrived at.

The Arms Length principle

If two unrelated companies trade with each other, a market price for the transaction will
generally result. This is known as arms-length trading, because it is the product of genuine
negotiation in a market. This arms length price is usually considered to be acceptable for tax
purposes.

But when two related companies trade with each other, they may wish to artificially distort
the price at which the trade is recorded, to minimise the overall tax bill. This might, for
example, help it record as much of its profit as possible in a tax haven with low or zero taxes.
The Arms Length principle is supposed to stop this by ensuring that the prices are recorded
as if the trades were conducted at arms length. In practice, it is unworkable in many if not
most situations: a lot of multinational corporate tax avoidance happens for this reason.
Multinational use price transfer pricing to shift its profits artificially out high tax jurisdictions
into a tax haven to earn higher profits for the multinational.
Transfer mispricing: traditional approaches
The conventional international approach to dealing with transfer mispricing is through the
arms length principle: that a transfer price should be the same as if the two companies
involved were indeed two unrelated parties negotiating in a normal market, and not part of
the same corporate structure. The OECD and the United Nations Tax Committee have both
endorsed the arms length principle, and it is widely used as the basis for bilateral treaties
between governments.
Many companies strive to use the arms length principle faithfully. Many companies strive to
move in exactly the opposite direction. In truth, however, the arms length principle is very
hard to implement, even with the best intentions.
Imagine, for example, that two related parties are trading a tiny component for an aircraft
engine, which is only made for that engine, and not made by anyone else. There are no
market comparisons to be made, so the arms length price is not obvious. Or consider the
case of a companys brand. How much is the Shell Oil logo really worth? There is great scope
for misunderstanding and for deliberate mispricing providing much leeway for abuse,
especially with regard to intellectual property such as patents, trademarks, and other
proprietary information.
The resulting damage from the prevalent arms length approach has been, and is,
substantial. Governments around the world are systematically hobbled in their ability to
collect revenues from the corporate tax system. Billions of dollars are wasted annually around
the world on governmental enforcement efforts that have little chance of success, and on
meeting expensive compliance requirements.
Alternative approaches: unitary taxation with profit apportionment
While multinationals tend to favour the arms length principle as the basis for determining
transfer pricing it gives them tremendous leeway to minimise tax academics, some public
sector and private sector practitioners and, increasingly, non-governmental organisations,
favour an alternative approach: combined reporting, with formulary apportionment and
Unitary Taxation. This would prioritise the economic substance of a multinational and its
transactions, instead of prioritising the legal form in which a multinational organises itself
and its transactions.
These terms may seem complex and baffling, but the basic principles are quite
straightforward, and the system is far simpler than the ineffective arms length method.

While the arms length principle gives multinational companies leeway to decide for
themselves where to shift their profits, the unitary taxation approach involves taxing the
various parts of a multinational company based on what it is doing in the real world.
Unitary taxation originated in the United States over a century ago, as a response to the
difficulties that U.S. states were having in taxing railroads. How would these multijurisdictional corporate entities be taxed by each state? Gross receipts within the state?
Assets? How should they tax the railroads rolling stock? In the state of incorporation, or in the
states in which it was used?
The U.S. Supreme Court ruled that taxing rights between states should be apportioned
fairly. Now over 20 states inside the United States, notably California, have set up a system
where they treat a corporate group as a unit, then the corporate groups income is
apportioned out to the different states according to an agreed formula. Then each state
can apply its own state income tax rate to whatever portion of the overall units income was
apportioned to it. Such a formula allocates profits to a jurisdiction based upon real factors
such as total third-party sales; total employment (either calculated by headcount or by
salaries) and the value of physical assets actually located in each territory where the
multinational operates. States can still set whatever local tax rates they want. In what may
be a sign of the systems usefulness, more states have been adopting it of late: Michigan and
Massachusetts (2008), New York and West Virginia (2007), Texas (2006) and Vermont (2004.)
Imagine a company with a one-man booking office in the Cayman Islands, with no local sales.
Under current arms length rules, it can shift billions of dollars of profits into this office,
and use this to cut its tax bill sharply. Under Unitary Taxation (formulary apportionment)
however, the formula based on sales and payroll would allocate only a miniscule portion of
the income under the formula to Cayman, so only a miniscule portion would be subjected to
Caymans zero tax rate.
The countries where real economic activity is happening Africa and the United States, in the
above example, would then be able to tax the income that is rightfully theirs to tax.
There are technical and political complexities involved in designing such an apportionment
formula, but with political will they are quite surmountable. Limited forms of unitary taxation
have been shown to work well in practice, as the experience of U.S. states shows.
The aim of unitary taxation, then, is to tax portions of a multinational companys income
without reference to how that enterprise is organised internally. In addition, multinational
enterprises with the same total income generally are treated the same under this method.
Multinational companies would have far less need to set themselves up as highly complex,
tax-driven multi-jurisdictional structures, and would simplify their corporate structures,
creating major efficiencies. Billions could be saved on tax enforcement. The big losers, apart
from multinationals, would be accountancy and legal firms, and economic consultants, who
derive substantial income from setting up and servicing complex tax-driven corporate
structures.
Developing countries should have a particular interest in this approach.
There are three main obstacles to unitary taxation:

1. Path dependency. The arms length approach is how the international tax system has
emerged, and there will be great institutional resistance to change established
practices. Still, the alternative of unitary taxation is not an all-or-nothing approach
requiring everyone to adopt it at once. It could be adopted by some states and not
others, or hybrid versions between Unitary Taxation and the Arms Length approach
could be adopted as interim steps.
2. Vested interests. Because multinational corporations like having the leeway to
manipulate transfer pricing, they have a strong interest in maintaining the status quo.
3. Technical issues. There are potentially important technical complexities in designing
an appropriate formula, and more work needs to be done in this area.

Unitary taxation is compatible in theory with country-by-country reporting, a concept

developed by TJNs senior adviser Richard Murphy. More precisely, Country by Country
reporting could serve as the accounting basis for formulary apportionment and unitary
taxation.
Current accounting standards require corporations to publish certain financial and other data,
but they allow them to sweep up all the results from a range of different jurisdictions and put
them into a single, aggregate figure, perhaps under a heading International or some such. It
is not possible to unpick multinational corporations financial statements, to determine what
is happening in each country of operation.
Country-by-country reporting would require each multinational corporation to provide the
following information:
1. The name of each country in which it operates.
2. The names of all its subsidiaries and affiliates in each country in which it operates.
3. The performance of each subsidiary and affiliate in every country in which it
operates, without exception.
4. The tax charge included in its accounts of each subsidiary and affiliate in each
country in which it operates.
5. Details of the cost and net book value of its fixed assets located in each country in
which it operates.
6. Details of its gross and net assets for each country in which it operates.

Country- by country reporting would also disclose if there was deliberate material mispricing
of goods or services across international borders. Criteria could be adapted to fit a formula
under unitary taxation.
Even without unitary taxation, Country by country reporting would be extremely valuable in
order to try to determine whether arms length principles are being complied with.