Abusive transfer pricing is widespread

Transfer pricing – or transfer mispricing as this widespread practice might be more aptly called – distorts trade and taxation. Transfer pricing abuses prevent governments from collecting a fair and appropriate share of taxes from multinational corporations – but also subject multinational companies to double taxation. Abusive transfer pricing does considerable damage in developing countries.

According to the OECD almost two thirds of the worldwide trade in goods and services does not take place on the free market but in transactions between subsidiaries of the same corporate parent. Transfer prices are what subsidiaries of the same corporation charge each other for goods and services.

One example: a Swiss computer company buys microchips from its South Korean subsidiary. How much does the parent pay the daughter for the merchandise? The price determines how high the daughter’s profit and thus the taxes owed in South Korea will be. If the Swiss company were to buy the chips from an independent supplier in South Korea it would have to pay a market price. If it pays less, the profit of its South Korean subsidiary is smaller, resulting in a smaller tax payment to the South Korean state.

The transfer price mechanism is necessary but easily abused. The OECD is aware of that and has drawn up a comprehensive, complex, and detailed system of transfer pricing rules based on what is known as the ‚arm’s length principle’. This means that intra-corporate transfer prices should be calculated in the same way as prices between independent companies.

Transfer prices are abusive if the cost of purchases in countries with a high tax rate is inflated (overbilling) or the profits from sales are artificially reduced (underbilling). This increases profits in countries with a low tax rate and increases costs in countries with a high tax rate. In this way the company reduces its tax burden in the high-tax-country and books its profits in the low-tax-country. The company’s total tax burden decreases.

Examples of such manipulations abound. Simon Pak of Penn State University and his co-authors discovered paper tissues imported from China to the US for a price of $ 4121 per kilo and color monitors exported for $ 21.90 a piece from the US to Pakistan.

No one has ever tried to assess the amount of tax revenue lost globally through these manipulations nor the damage they inflict on developing countries. The American author Raymond Baker estimates, based on interviews and surveys, that 60 percent of the trade with African countries, both imports and exports, are based on phony transfer prices, with billed amounts deviating from real prices by an average of 11 percent. For Latin America Baker estimates false prices for almost half of all goods and services traded. In another study, Simon J. Pak estimates that underbilling of African exports to the US and overbilling of imports to Africa has increased the amount of capital leaking out of Africa from 1,9 billion in 1996 to 4.9 billion in 2005.

Another indication: in 2005, Ernst&Young surveyed international corporations whose transfer prices had been investigated under a tax audit. 44 percent of the parent companies and 34 of the subsidiaries said that local tax authorities ordered them to correct and adapt their accounting methods after the audit. Their false transfer prices had not been accepted.

In view of the widespread abuse, more and more governments and tax authorities have started to examine transfer prices. Ten years ago very few countries had laws and rules for documentation in these matters. Meanwhile over 40 States do, but few of them are in Africa or Latin America. Because tax authorities in many developing countries are so weak, the risk of being audited is very low. The OECD is aware of that and is offering technical assistance to draw up and implement transfer pricing rules.

Given the rate of technological change and the constant shifting of prices and exchange rates for common goods and services, tax authorities are finding it hard to keep up with market prices, let alone with keeping tabs on intra-corporate prices of services, patents, licenses, credits etc.

How to fight abuse?

Lack of transparency in financial reporting and in the publication of annual reports and financial statements by transnational corporations encourages tax evasion worldwide. The Tax Justice Network (TJN) thus pleads for more stringent reporting standards for transnational corporations. In particular, the TJN strongly favors some form of country-by-country reporting. Financial reporting by countries would force transnationals to be specific about the countries and names they operate in and under. Financial reports must be detailed by country – including sales, purchases, costs of financing, wages and salaries, numbers of employees, pre-tax income, local taxes paid, etc. The International Accounting Standards Board (IASB) could introduce such rules immediately.

For more information:

TJN: Closing the Floodgates. Collecting taxes to pay for development. Paper commissioned by the Norwegian Ministry of Foreign Affairs, Chapter 4 (How companies reduce their tax bills) and chapter 9 (The next Steps) and chapter 11 (Simon J. Pak, Capital flight and Tax Avoidance through Abnormal Pricing in International Trade –the issue and the solution).
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TJN: Country-by-Country Reporting will make global markets more transparent, 2008
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