A Scenario for Conflict

The delicate balance between the interests of MNEs and their host or home governments is even more important than ever. Transfer pricing is one crucial area where it is essential that this balance is maintained. Frequent legislative changes and the differing regimes of jurisdictions continue to increase the burden of compliance for MNEs and provide fertile ground for conflict. Yet, I need to make it very clear that fractious relationships between MNEs and the taxing authorities are not the only source of conflict arising from transfer pricing policies. Figure 3.1 provides a graphic illustration of the extent of this policy conflict.

Figure 3.1. Possible fractious relationships.

When related entities transfer products or services across jurisdictions, transfer prices play a role in the calculation of the entity’s overall income tax liability. In this situation, the entity’s transfer pricing policy can become a tax-planning tool. The United States has agreements with most other nations that determine how MNEs are to be taxed in the respective jurisdictions where they have operations. Since transfer prices represent revenue to the upstream entity and an expense to the downstream entity, the transfer price affects the calculation of entity profits that represent taxable income in the nations where they are based.

For example, a pharmaceutical company manufactures a drug in a factory that it operates in Ireland and transfers the drug to its marketing entity in the United States for sale. A high transfer price increases the taxable income of the Irish entity, which obviously results in a higher tax liability in Ireland. At the same time, the high transfer price increases the cost of product to the US marketing division, which lowers its income leading to lower US taxes. The entity’s incentive in using such a transfer pricing policy depends on whether its marginal tax rate is higher in the United States or in Ireland. If the marginal tax rate is higher in the United States, the entity prefers a high transfer price, whereas if the marginal tax rate is higher in Ireland, it will prefer a low transfer price. The general rule is that the entity will look to shift income from the high tax jurisdiction to the low tax jurisdiction.

There are limits to the extent to which companies can shift income in this manner. When a market price is available for the goods or services transferred, the taxing authorities will usually impose the market-based transfer price. When a market-based transfer price is simply not available, the tax law in many jurisdictions contains detailed and complicated rules that limit the extent to which companies can shift income out of their jurisdiction. For example, in Australia, transfer pricing rules are designed to ensure that the country receives an appropriate share of tax revenue from the international dealings of MNEs, reflecting contributions made by their Australian operations to the overall group’s operating performance. These rules, intended to protect the integrity of the Australian tax system, have been introduced to ensure that its government revenue is not compromised and that consistency is maintained with its international tax treaty partners. Paradoxically, the operation of these rules is limited to cases where its application would result in greater tax receipts in Australia and discretely ignored should they result in a benefit to another country.

Transfer pricing often becomes relevant in the context of other regulatory issues, including international trade disputes. For example, when tariffs are based on the value of goods imported, the transfer price of goods shipped from a manufacturing division in one country to a marketing division in another country can form the basis for the tariff. As another example, in order to increase investment in their economies, developing nations sometimes restrict the extent to which multinational companies can repatriate profits. However, when a product is transferred from manufacturing divisions located elsewhere into the developing nation for sale, the local marketing division can export funds to “pay” for the merchandise received. As a final example, when nations accuse foreign companies of “dumping” product onto their markets, transfer pricing is often involved. Dumping refers to selling product below cost, and it generally violates international trade laws. Foreign companies frequently transfer products from manufacturing divisions in their home countries to marketing affiliates elsewhere, so that the determination of whether the company has dumped products depends on comparing the transfer price charged to the marketing affiliate with the upstream division’s cost of delivering their product.

In theory, transfer pricing and customs rules seek to impose a similar standard on related-party pricing—prices should reflect those that would exist if the parties were unrelated. However, there is a long history of tension between tax and customs administrations. The relevant rules are governed by different international ruling bodies (the WTO for customs, the OECD for transfer pricing) and have different objectives. Tax administrations generally have an incentive to minimize the cost of goods sold and thus import prices. Conversely, customs administrations generally have an incentive to maximize the cost of goods sold and thus import prices, resulting in higher dutiable value and processing fees. Other differences include:

• different sets of regulations;

• different filing time periods (generally entry-by-entry for customs versus annual tax returns);

• different methods for determining an arm’s-length price;

• different presumptions as to the key determinants of comparability (product/industry for customs versus functional equivalence for tax).

Transfer pricing rules suggest that a transaction between related organizations meets the arm’s-length standard if the results of the transaction are consistent with the results that would have been realized if independent organizations had engaged in the same transaction under the same circumstances. In reaching this conclusion, the tax transfer pricing rules often look at not only the transaction itself but also at the various functions, such as research and development, manufacturing, sales, marketing, distribution, and services, such as back-office activities, which support each and every transaction.

The customs value of imported goods is generally its transaction value, which is the price actually paid or payable for the goods when sold for export to the country of importation, provided that the buyer and seller are not related. When they are related, the transaction value may be acceptable for customs purposes as long as the revenue authority in the receiving country is satisfied that the relationship did not influence the price.

The challenge for MNEs lies in reconciling these differences to achieve, support, and document an arm’s-length result in a way that satisfies the general principles of both sets of rules. The clarification of transfer pricing rules and the use of effective transfer pricing planning are becoming more and more important if MNEs are to avoid double, or even multiple, taxation, which can limit the opportunity for economic growth through international trade.

The International Peacekeeper

Is it possible to find an arbiter to pour oil on troubled waters? If we think of all the international nongovernmental institutions that could be involved, we see that several have a direct interest in one side of the conflict or the other. As I mentioned earlier, the WTO is particularly interested in the trade aspects of transfer pricing, whereas the OECD is more keenly involved in the taxation aspects.

Perhaps, we could look to the World Bank, or the International Monetary Fund (IMF), to take on the role of a peacekeeper in this increasingly fractious situation. Looking at the latter, one of its objectives is to facilitate international trade. Yet, understandably, given the seemingly unending global economic crisis, their priorities are directed toward bringing some stability to, and the strengthening of, the international monetary system.

Returning then to the possibility of the World Bank taking on the role of a peacemaker, we can find evidence that they have not been disinterested in this policy conflict. In 2006, in conjunction with PricewaterhouseCoopers, they produced a report entitled Paying Taxes: The Global Picture3 that provided a comparison of the world’s tax regimes with the overall aim of encouraging improvements in the design of tax systems that would benefit all parties—businesses, governments, and tax authorities. It doesn’t address the issue of transfer pricing specifically but the emphasis is on designing a system that considers the total tax contribution rather than the individual components such as profits tax and trade levies.

Clearly, these two organizations have bigger pictures to look at, which leaves us with a return to expecting the WTO and the OECD to work together to achieve some harmony in this perennial conflict. To this end, conferences held in 2006 and 2007 jointly between the World Customs Organization (WCO), a part of the WTO, and the OECD4 have led to an increasing dialogue toward regulatory convergence in this regard. This dialogue focuses on the comparison of customs valuation and transfer pricing methods, as well as the desirability and feasibility of having converging standards for the two systems. Out of this dialogue, there appears to have emerged two schools of thought: those who view convergence of rules and regulation as desirable and feasible, and those who are cautious with this approach.

Those who are in favor of convergence point out that a credibility question is likely to arise if two sets of rules on value determination exist within one government, whereas those who are cautious about convergence point out that the two systems are based on different principles regarding the valuation of imported goods. Trade levies are determined by the customs authorities using the value of the goods based on information available at the time of importation with respect to individual transactions. On the other hand, the profits tax implication of transfer pricing activities is determined by the value of the goods based on information available at the year end with respect to aggregated transactions in an individual business as a whole.

Currently, the tax and customs authorities treat transfer pricing in accordance with different international standards, namely, the OECD Transfer Pricing Guidelines and the WTO Customs Valuation Agreement. There are many differences and similarities between the two sets of rules that are applied by tax and customs agencies to transfer pricing and it is acknowledged that much could be done to encourage converging standards and coordinated administrative approaches. In the latter area in particular, a greater degree of acceptability by one agency of a value determination by the other, the acceptance more generally of advance pricing agreements, the conduct of joint audits, understanding the consequences of a readjustment of the transfer price made by one agency on another, regular exchange of information, and cooperation between customs and tax agencies are all considered possible ways of avoiding conflict in the future.

Of course, one size does not fit all and engaging in such initiatives would mean a long road ahead because it would involve a comprehensive review of internal processes and systems by all three parties to the ­transfer pricing conundrum—customs, tax, and business.