The Transfer Pricing Labyrinth
By Michele Fletcher, June 26, 2014
Last week, Namibian activists raised concerns about transfer pricing in Africa’s extractive sector in an open letter to De Beers. Their letter comes at a critical time in which transfer pricing and tax havens have contributed to an exorbitant amount of capital flight from developing countries. Namibia’s economy is hugely dependent on the extractive sector, particularly in diamond exports, which alone account for 10% of GDP. With increased scrutiny into transfer pricing just across the border in South Africa’s platinum mines, these Namibian activists have delivered a timely, earnest demand to investigate transfer pricing in their own country.
Multinational corporations (MNCs), especially those which operate in Africa, are coming under increased scrutiny by governments, media, and the public over their bookkeeping and payments to governments. The extractive sector in particular has been the focus of new regulations on financial transparency: an extremely positive development, but one which has so far missed an opportunity address larger issues concerning abusive transfer pricing and how MNCs of all sorts conduct their fiscal operations.
Transfer pricing itself is a perfectly legal accounting method for MNCs. Though often necessary for risk management, such as harmonizing supply chains, legal obligations, and management structure, the flow of goods, services, and money across borders between MNC subsidiaries can enable companies to avoid taxes in some jurisdictions by shifting taxable profits (usually to where the tax rate is lower.) Although most transfer pricing does not result in money changing hands—rather, it’s only noted in the MNC’s books—it can have devastating effects on developing countries who cannot afford the due diligence to ensure they aren’t being cheated out of revenue.
Fair transfer prices are traditionally delineated using an arms-length price: the price at which two unrelated companies would trade internationally. Overvaluation and undervaluation of raw goods beyond the arms-length price is perhaps the easiest to study because it’s simply easier to track: the market price, the import and export costs, tariffs, and the selling price are generally available to piece together a picture of potential discrepancies. The majority of international transfer pricing research has been at this level, and has uncovered billions of dollars worth of abusive transfer pricing:
Plastic buckets from the Czech Republic have been priced at $972.98 each, fence posts from Canada at $1,853.50 each, a kilo of toilet paper from China for $4,121.81, a litre of apple juice from Israel for $2,052, a ballpoint pen from Trinidad for $8,500, and a pair of tweezers from Japan at $4,896 each.
For the year 2001 alone, such practices may have deprived the US government of US$53.1 billion of tax revenues.
While these numbers clearly indicate abuse is occurring, the line between abusive and non-abusive transfer pricing is not always clear. Especially in monopolized markets or the sale of intermediate goods where there is no obvious competitive market, arms-length prices can be difficult (if not impossible) to calculate.
If the prices were horribly exaggerated, you could see it, but that’s not the way this process works. It’s usually done through reasonable percentages, anywhere between 5% and 25% of the normal price.
-GFI President Raymond Baker
Yet MNCs, especially those with complicated chains of production like extraction companies, can set transfer prices at any link in that chain between which assets—tangible or intangible—shift between subsidiaries.
In fact, the most flagrantly abusive transfer pricing is typically that of intangible assets, such as patents or trademarks, which can be licensed from offshore, low-tax jurisdictions. These patents can be held in low-tax jurisdictions as well, and facilitate the flow of extensive royalty payments (which are, by the way, tax deductible) to areas where they will be minimally taxed. In some countries, in particular the Netherlands, the cost of acquiring trademarks can even be written off over time against other taxable profits: another incentive to keep patents offshore. Intangible assets, such as WorldCom’s “management foresight”, have been hugely lucrative, even when such assets seemed, on their own, fairly useless. The payout from this intangible was huge: royalties that WorldCom collected exceeded their net income from 1998-2001, and between 80-90 percent of the net income of many of its subsidiaries.
However, even though abusive transfer pricing has risen to the forefront in the context of international law, the advantages of abusive transfer pricing extend beyond tax dodging. Abusive transfer pricing via overpriced imports or underpriced exports can be used to circumvent the ceilings on profit repatriation governments set for MNCs. This would incentivize companies to undersell their exports in order to avoid additional tariffs. MNCs may also be able to attain lower tariff rates by exporting intermediate goods instead of final goods, routing them through tax havens and then reimporting them.
Even more dangerously, it could incentivize companies to misinvoice exports and imports, thus participating in trade misinvoicing, which is highly illegal. If the imports are over-invoiced and exports under-invoiced—often done in secrecy jurisdictions—tariffs can be minimized on both sides and ill-gained capital can be swept into a tax haven or invested elsewhere.
Minority shareholders and members of the board from developing countries have not been enough to effectively address abusive transfer pricing within their organizations. Because the ownership structures and books of large companies are exceedingly complicated, in part due to their utilization of secrecy jurisdictions, neither shareholders nor the board of directors, not to mention the host government itself, will attain an accurate picture of the company’s transfer pricing strategies or whether they are abusive.
Developing countries are particularly vulnerable, since the responsibility to investigate and evaluate transfer pricing strategies largely falls on the shoulders of local governments, which have neither the time nor resources to address the issue. The knowledge that these countries’ tax authorities are hamstrung by capacity and political concerns may lead MNCs to try more risky or abusive transfer pricing methods, as they know they are more likely to get away with it. This leads to more outflow and even less critical revenue.
In part, the global community’s failure to curtail illicit transfer pricing comes from the lack of information surrounding its prevalence and methods. The problem is vast but its overall reach is unclear. Opening books for large companies, including measures to implement country-by country reporting, is a critical first step: only then can repercussions for abusive behavior be effectively imposed and tax policies altered as necessary to hold MNCs accountable for paying their fair share.
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