Harmony or Conflict?

In a global economy where MNEs play a prominent role, governments are keen to ensure that the taxable profits of these organizations are not artificially shifted out of their jurisdiction. The revenue authorities also need to be satisfied that the reported tax base in their country reflects the economic activity undertaken by the local unit(s) of the MNE. In 2004, Australia, Canada, the United Kingdom, and the United States of America formed the Washington-based Joint International Tax Shelter Information Centre (JITSIC) in a bid to stem the flow of cross-border revenue losses. The objective of JITSIC is to deter promotion of, and investment in, abusive tax schemes through information exchange and knowledge sharing.

Driven by the impact of the current financial crisis, cash-strapped ­governments around the world are aggressively targeting transfer pricing in their jurisdictions. In early 2010, the Obama administration announced that it was stepping up the Inland Revenue Service’s review activities in an attempt to recover US$12 billion of the estimated US$60 billion in tax that is avoided through transfer pricing every year. Canada also has cracked down on MNEs that dodge tax through inflating profits or losses in dealings with their related companies overseas by imposing the full tax rate, plus a penalty. The Australian Taxation Office sees a risk that MNEs will shift Australian profits to subsidiaries that suffered losses in the global financial crisis and has been conducting transfer pricing audits to protect their revenue base.

Despite revenue authorities’ determination to wage war on transfer pricing around the world, it is significant that they have lost the last couple of battles6 when MNEs have decided to fight back in the courts. For these organizations, it is essential to limit the risks of double taxation that may result from a dispute between two countries on the determination of the arm’s-length remuneration for their cross-border transactions with associated enterprises. Recognizing this, the Organisation for Economic Co-operation and Development (OECD) released transfer pricing guidelines7 that elaborate on the arm’s-length principle and provide methodologies to evaluate an arm’s-length transfer price.

However, in reality, the application and interpretation of the ­arm’s-length standard varies among OECD member countries with a number of them setting up more detailed transfer pricing regulations. One thing is sure, transfer pricing is highly subject to interpretation and judgment making it hard, if not impossible, to find the right answer. This absence of uniform practices among tax administrations has caused transfer pricing issues to become a real bone of contention between MNEs and revenue authorities. What is more, these variations in practice have become a prime area for international conflict between the revenue authorities themselves.

These conflicts of interest will continue to give rise to many disputes between MNEs and the revenue authorities that will inevitably find their way into the courts in search of settlement. Ultimately, every MNE needs to make a decision about its approach to the thorny issue of transfer pricing. This is likely to be influenced by the organization’s size, the extent of its foreign related party dealings, its attitude to risk, and the desired relationship with the revenue authorities in each jurisdiction in which it operates. The outcome will surely have an impact on its structure and strategy as the organization seeks to mitigate the regulatory risk of ­cross-border transactions.

Summary

We have seen many changes in the nature of organizations over time and there can be little doubt that we shall see many more in the years to come. Changes in technology, the physical environment, and the regulatory environment will ensure that this happens. Come what may, there will always be conflict between commercial organizations, of whatever size, and the revenue authorities over matters pertaining to taxation. The key issue relates to the extent of those disagreements and whether they can be resolved amicably or by judicial means.

Perhaps, one of the most important factors in determining that key issue is the regulatory style of the revenue authorities. The continuum of that style is bounded at one end by a close consultative relationship and by adversarial legalism at the other. Neither is particularly satisfactory and so the starting point should probably be where all parties see the law as an instrument of legitimate policy to be respected. This does not presuppose that one side or the other is the protagonist in this conflict but that both need a change in attitude if there is to be any chance of harmony.

To achieve this, it first requires changes in revenue authorities’ attitudes toward taking a more cooperative approach to MNEs, which may help them change their attitude toward the revenue authorities. They may then regard the revenue authorities as legitimate agents of the law rather than as players of perpetual tax games and so refrain from considering tax legislation as material to work on. This may lead to greater transparency and accountability between both parties from which it becomes possible to build a trusting relationship that forms an essential part of an MNE’s transfer pricing management policies.

Such a change is unlikely to eventuate unless there is some form of supranational regulatory framework to create more uniformity in transfer pricing regulation across diverse regulatory cultures. Mutual cooperation and coordination between revenue authorities in international tax enforcement is being seen as increasingly essential in the context of overcoming the difficulties that MNEs face in complying with the law. It should lead to a significant reduction in the compliance burden, uncertainty surrounding transfer pricing issues, and penalty risks. Failure to progress such a change is likely to result in a rethink of organizational structure and a resurgence in the use of low-tax jurisdictions by those organizations for which significant structural change is improbable.