Transfer pricing is one of the most important issues in international tax.
“Transfer pricing is the leading edge of what is wrong with international tax”
– Lee Sheppard, Tax Analysts, August 2012
Transfer pricing happens whenever two companies that are part of the same multinational group trade with each other: when a US-based subidiary 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. (Transfer mispricing is a form of a more general phenomenon known as trade mispricing, which includes trade between unrelated or apparently unrelated parties – an example is reinvoicing.)
It is estimated that about 60 percent of international trade happens within, rather than between, multinationals: that is, across national boundaries but within the same corporate group. Suggestions have been made that this figure may be closer to 70 percent.
Estimates vary as to how much tax revenue is lost by governments due to transfer mispricing. Global Financial Integrity in Washington estimates the amount at several hundred billion dollars annually. A March 2009 Christian Aid report estimated $1.1 trillion in bilateral trade mispricing into the EU and the US alone from non-EU countries from 2005 to 2007. The “Magnitudes ” section of our website contains a range of estimates and data.
See also our page Taxing Corporations, for a basic overview of the corporation tax and its uses.
The Arm’s 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 arm’s 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.
How does World Inc. shift its profits into a tax haven?
For example, World Inc. grows a crop in Africa, then harvests and processes it and transports and sells the finished product in the United States. It has three subsidiaries: Africa Inc. (in Africa), Haven Inc. (in a zero-tax haven) and USA Inc. (in the U.S.).
Africa Inc. sells the produce to Haven Inc. at an artificially low price. So Africa Inc. has artificially low profits – and therefore an artificially low tax bill in Africa. Then Haven Inc. sells the product to USA Inc. at a very high price – almost as high as the final retail price at which USA Inc. sells the processed product. So USA Inc. also has artificially low profits, and an artificially low tax bill in the U.S. But Haven Inc. is different: it has bought cheaply and sold at a very high price, creating very high artificial profits. Yet it is located in a tax haven – so it pays no taxes on those profits. Voila! A tax bill disappears.
The example in the box illustrates how this is done. The “Arm’s Length” principle is supposed to stop this by ensuring that the prices are recorded as if the trades were conducted at ‘arm’s length.’ In practice, it is unworkable in many if not most situations: a lot of multinational corporate tax avoidance happens for this reason.
Consider what has happened in the example in the box with World Inc. These games have not resulted in more efficient or cost-effective production, transport, distribution or retail processes in the real world. The end result is, instead, that World Inc. has shifted its profits artificially out of both Africa and the United States, and into a tax haven. As a result, tax dollars have been shifted artificially away from both African and U.S. tax authorities, and have been converted into higher profits for the multinational.
This is a core issue of tax justice – and unlike many issues which are considered to be either “developing country” issues or “developed country” issues – in this case the citizens of both rich and poor nations alike share a common set of concerns. Even so, developing countries are the most vulnerable to transfer mispricing by multinational corporations.
Transfer mispricing: traditional approaches
The conventional international approach to dealing with transfer mispricing is through the “arm’s 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 “arm’s length” principle, and it is widely used as the basis for bilateral treaties between governments.
Many companies strive to use the arm’s length principle faithfully. Many companies strive to move in exactly the opposite direction. In truth, however, the arm’s 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 “arm’s length” price is not obvious. Or consider the case of a company’s 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 “arm’s 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 arm’s 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 “arm’s length” method.
While the arm’s 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 multi-jurisdictional corporate entities be taxed by each state? Gross receipts within the state? Assets? How should they tax the railroad’s 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 group’s 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 unit’s 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 system’s 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 “arm’s 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 subected to Cayman’s 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 company’s 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 “arm’s 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 Arm’s 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 TJN’s 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 arm’s length principles are being complied with.
The June 2009 publication Country by Country Reporting, Holding Multinational Corporations to Account Wherever They Are, written by Richard Murphy for The Task Force on Financial Integrity and Economic Development, explores the importance of this topic, including for formulary apportionment. See the TJN summary, entitled Confronting Transfer Mispricing by the Use of Country by Country Reporting, here and the full report Task Force report here. More material on country by country reporting is available on the TJN A-Z Archive.
Further reading: entry level
These analyses immediately below provide further non-specialist illustrations for the general reader.
- In this Youtube video Richard Murphy explores some basic principles of transfer pricing and the arm’s length principle.
- Nov 2010 – ActionAid’s 2010 report on the brewer SABMiller and tax avoidance in Africa: a high-quality in-depth example of transfer mispricing issues in a developing country.
- Guardian Banana. In November 2007 Britain’s The Guardian newspaper conducted an in-depth study into transfer pricing in the banana trade. Read the main story, as well as thissupplementary article and this very clear interactive guide to transfer pricing.
- Unitary tax. This short, colourful summary explains the basic principles.
- ICTD research archives on unitary taxation. Cutting-edge research, for the more technically minded.
Further reading: more detailed reports on transfer pricing:
This long article from Citizens for Tax Justice from September 1980s provides a useful and readable alternative overview of Unitary Taxation.
A more detailed document is available here, from Professor Michael J. McIntyre (a Senior Adviser to TJN), presented in December 2009 to the Multistate Tax Commission.
TP Ostwal, a chartered accountant from Mumbai, has written this 2009 account of transfer pricing, with special attention to the needs of developing countries, and to the potential importance of formulary apportionment methods. The TJN summary of the article is here, and the full article is here.
See also Making Transfer Pricing Work for Developing Countries by Michael C. Durst, December 2010
A proposal for unitary taxes on the profits of transnational corporations, with a focus on developing countries, Uneca, April 2004
A Two-Option Compromise for Intangibles Pricing Guidelines, by Michael C. Durst, June 2012
The OECD has Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations which provides considerable detail as to how to apply the arm’s length principle. Yet the OECD’s approach is deeply flawed, as our other reports explain.
This article by Thomas Rixen and Susanne Uhl for the Frederich Ebert Stiftung looks at transfer pricing and the related problem of tax competition in a European context, and specifically proposes a Common Consolidated Corporate Tax Base (CCCTB) and a minimum or harmonised tax rate in Europe. See the four-page summary by Rixen, Uhl and Christian Kellermann here, and a concise TJN summary.
The Brookings Institution’s Hamilton Project also hosts a June 2007 proposal for formulary apportionment for the United States, written by the tax experts Reuven Avi-Yonah and Kimberly Clausing. Read the TJN summary here. The full paper, along with policy brief and presentation, are available here.
See this TJN summary of a January 2010 article in TaxAnalysts by Michael Durst, a former director of the U.S. Internal Revenue Services’s Advanced Transfer Pricing Program. It is a scathing attack on the OECD’s ineffective “Arm’s Length” Standard. Durst says: “Experience to date is sufficient to demonstrate that the current system is based on faulty assumptions regarding the way multinational business is conducted, so that the system, no matter how hard one seeks to reform it, simply is not capable of functioning acceptably.” (The original article is here.) Durst went further in a subsequent article in Tax Notes in January 2011, summarised by TJN here in which he argues that the method is “based on a fundamental misunderstanding of practical economics.”
The Use of Combined Reporting by Nation States, by Michael J. McIntyre. An expert-level paper exploring technical issues and recommending combined reporting: it is known to work successfully; it is less complex and more transparent to operate than the ‘Arms-length’ method, and it rests on a stronger theoretical method. See TJN’s summary here.
Between Formulary Apportionment and the OECD Guidelines: A Proposal for Reconciliation, University of Michigan Law School, Reuven Avi-Yonah, 2009. Avi-Yonah, an advocate of formulary approaches, recognises the political difficulties of making progress on the issue, and proposes a compromise: using formulary apportionment within the “arm’s length” system.
Formulary Apportionment: Myths and Prospects, by Reuven Avi-Yonah and Ilan Benshalom, October 2010. This seeks to re-examine the formulary alternative to transfer pricing by inquiring whether partial integration of formulary concepts into current practices would offer a reasonable alternative to transfer pricing rules.
The Implied Tax Revenue Loss from Trade Mispricing, by Ann Hollingshead, Global Financial Integrity, Washington, DC, February 2010: a study of losses to developing countries through re-invoicing. Read the TJN summary here and the full report here.
Transfer Pricing, Tax Havens and Global Governance, by Ganapati Bhat, an officer of the Indian Revenue Service in the Directorate of Transfer Pricing. The study, published by the German Development Institute in 2009, compares the prevalent Arms’ Length Principle approach to the formula apportionment approach. The full study is here; the TJN summary is here.
The Dark Side of Transfer Pricing by Prem Sikka. Providing an overview of transfer pricing issues, but also examining this in the context of the corporation and its relationship to state tax authorities, shareholders and other possible stakeholders.
Corporate Income taxes. This 2011 document from the Institute on Taxation and Economic Policy (ITEP) describes on p46 how U.S. states use formula allocation approaches.
U.S. MNCs’ Offshore Operations: An Unbiased View. Jan 2012. Richard Harvey, a former senior IRS official, argues that U.S. policy makers face a choice between a system that favours US multinationals over domestic firms, or a system that puts US multinationals on a level playing field with foreign multinationals. He adds: “anyone who believes the IRS can effectively enforce the arm’s-length standard is an eternal optimist — or delusional.”
Bloomberg Lexapro and Google. Jesse Drucker’s highly readable May 2010 Bloomberg story follows the paper trail of a $99 bottle of Forest Laboratories’ Lexapro, a leading antidepressant, via Dublin, Bermuda and Amsterdam. It cites a U.S. representative comparing the OECD’s dominant transfer pricing roles to “asking the Internal Revenue Service to connect the ends of two different plates of spaghetti.” The article is accompanied by a sidebar exploring the roles of other U.S. drugs multinationals, and a helpful interactive graphic. Drucker followed this in October 2010 with this story exploring how Google pays just a 2.4% tax rate, and this was followed in 2011 by an IRS investigation. These articles involve the use of Ireland in transfer pricing strategies; see also the Progressive Tax Blog on Ireland; scroll down to a headline “Why Ireland is an EU corporate tax haven” to see how Ireland is typically used to get around transfer pricing rules.
Christian Aid: Death and Taxes. Christian Aid’s May 2008 study showing $160 billion lost to developing countries from transfer mispricing and false invoicing. Read the TJN summary here and the full report here .
Michael Hudson. This 2004 interview in CounterPunch provides colourful evidence from a practitioner in the oil and banking industries, on how it was once done.
Experts have called the “arm’s length” method “a cumbersome creation of stupefying complexity” with “rules that lack coherence and often work at cross purposes.” (More quotes are available on our quotations page under “transfer pricing and mispricing.”)
The Dar Es Salaam Transfer Pricing Seminar, Oct 2013
A wealth of presentations and analysis, including:
- Case study onAssociated British Foods subsidiary, Zambian Sugar
Pamela Chisanga, country director, Action Aid, Zambia
Gerdi Van Der Westhuysen, South African Revenue Service
Practical nature of South African transfer pricing system
Thembinkosi Dlamini, governance manager, Oxfam South Africa
Brazilian transfer pricing system
Marcos Valadao, Brazilian Ministry of Finance
- Practical nature of the Brazilian transfer pricing
Dao Real Pereira dos Santos, director of institutional relations, Instituto Justica Fiscal
- Base erosion and profit shifting: OECD approach
Lee Corrick, senior adviser, OECD
- OECD action plan: actions and alternatives
Prof Sol Picciotto, senior adviser, TJN
Country by country reporting with a combined report in the extractive industries
Krishen Mehta, senior global justice fellow,Yale University
Country by country reporting in Kenya
Ane Foged, TJN Africa
Transparency in extractives
Collins Magalasi, executive director, Afrodad
Project by project reporting in Tanzania
Silas Olan’g, Revenue Watch Institute, Tanzania
Dominican Republic system of extractive industry taxation
Wanda Montero, Dominican Republic Internal Revenue Authority
Transfer pricing in North Africa
Slim Gargouri, chartered accountant and tax journalist
Tanzania case studies
Hon. Zitto Kabwe, MP
Transfer pricing in Tanzania
Charles Bajungu, Tanzania Revenue Authority
Rwanda transfer pricing case study
Dr Attiya Waris, senior lecturer, Law School, University of Nairobi
Ugandan transfer pricing case study
Milly Isingoma, Uganda Revenue Authority
Unitary taxation option for the region
Erika Dayle Siu, International Centre for Tax and Development
Base erosion, transfer pricing and developing countries
Michael Durst, senior adviser, Tax Justice Network
Practical options for transfer pricing, Ghana
Joyce Rita Addae Kumi, Ghana Revenue Service
Lincoln Marais, director, institutional development, ATAF
The Helsinki Transfer Pricing Seminar, June 2012
Other News and updates
June 6, 2013 – UN transfer pricing manual: what Brazil, India and China do differently –Martin Hearson. Chapter 10 of the UN Transfer Pricing manual “functions as a comprehensive critique of the OECD guidelines – almost a manifesto.”
April 2013 – The case of HSBC and Barclays and how unitary taxation would help the UK collect the tax that appears to be owing to it. Tax Justice Briefing.
Feb 10, 2013 – ActionAid report on the Zambian tax scandal. Original here; news articleshere and here. “We estimate that the tax- haven transactions of just this one British headquartered food multinational has deprived the Zambian public purse of a sum over 14 times larger than the UK aid provided to Zambia to combat hunger and food insecurity in the same period.”
Jan 23, 2013 – Yahoo, Dell Swell Netherlands’ $13 Trillion Tax Haven
Oct 15, 2012 – Reuters Special Report: How Starbucks avoids UK taxes
Aug 9, 2011 – U.S. Trade Deficit Largely Due to “Intra-Firm” Trade
June 22, 2012 – A new expert, François Vincent, slams OECD transfer pricing rules, says they create ‘secret body of law’
June 2012 – The Tax Justice Network / Kepa / Finland Government Seminar on Transfer Pricing, Helsinki, June 13-14, 2012.
April 28, 2012 – How Apple Sidesteps Billions in Taxes – New York Times in-depth investigation. See also associated articles “Double Irish with a Dutch Sandwich’ and CTJ’sletter to the NYT in response, explaining how to help curb these abuses, with a fuller CTJ report here.
March 28, 2012 – David Spencer: Guest blog on rifts between the OECD and United Nations on international tax
March 2012 – Brazil’s Approach to Transfer Pricing: A Viable Alternative to the Status Quo? by Tatiana Falcão.
June 17, 2011 – Tatiana Falcão of Machado Associados e Consultores writes Brazilian transfer pricing rules: a new approach?
Mar 7, 2011 – US, UK, OECD oppose developing countries having stronger voice on tax
Dec 2010 – Dodging Repatriation Tax Lets U.S. Companies Bring Home Cash, Bloomberg. On how U.S. companies bring deferred offshore profits back home without triggering taxes.
Nov 2010 – ActionAid on the case of SABMiller and tax avoidance in Africa.
Nov 2010 – An investigation into the practical application of combined reporting for U.S. state. TJN hasn’t parsed this in detail.
Oct 2010 – Jesse Drucker of Bloomberg on Google’s 2.4% tax rate
Oct 2010 – Martin Sullivan of Taxanalysts “Microsoft Moving Profits, Not Jobs, Out of the U.S.”
July 2010 – See these statements from assorted experts at a hearing on Transfer Pricing and the U.S. tax system on July 22, 2010 in Washington, notably from Martin A. Sullivanand Reuven Avi-Yonah.See also this Bloomberg story analysing a report on transfer pricing prepared by the Staff of the Joint Committee on Taxation and submutted to the House Committee on Ways and Means on July 20, 2010
June 2010 – Lee Sheppard of TaxAnalysts’s useful short overview of transfer pricing in Forbes, endorsing formulary apportionment approaches.