Corporate Taxation, Transfer Pricing, Growth, and Efficiency
Kash treats us to a recent analysis of corporate taxation from the CBO with page 9 addressing transfer pricing:
Internal transfer pricing provides another means for shifting profits out of high-tax countries. Multinational corporations engage in a substantial amount of international trade between affiliated companies located in different countries. A multinational firm may try to shift profits out of high-tax countries by setting their internal prices artificially high or low for goods or services that are traded between its business affiliates in different countries. For example, the firm may shift income out of a high-tax country when an affiliate in that country is paid too little for its export sales to affiliates in low-tax countries. It may also shift income when an affiliate in a high tax country pays too much for imports purchased from affiliates in low-tax countries. In such instances, the cross-country tax differentials may also influence where businesses choose to invest but in a more complicated way than by simply moving their production operations to low-tax countries. Instead, tax planning may require that businesses structure their activities in ways that make it easier to shift income. Such planning may result in economically inefficient behavior by the company, both in terms of how it must structure its operations and finances to shift the income and in terms of the direct costs that it must pay to acquire planning expertise and either avoid or resolve controversies with tax authorities.
The incentives to shift profits between two countries depend for the most part on the differences between statutory tax rates. That contrasts with the incentives for the location of capital used in production, which depend on the ways in which a wider range of tax provisions work together to determine the taxes imposed on new investment. When a company shifts profits from a high-tax to a low-tax country, the company pays tax on those profits at the lower statutory rate. The company’s tax saving equals the amount of profits shifted times the difference between the statutory tax rates in the two countries. In that way, the shifting of income may also redistribute tax revenue between the two countries, as the company pays tax to the low-tax country – at a lower rate- instead of paying it to the high-tax country. As a result, only part of the revenue lost by the high-tax country represents a reduction in the taxes paid by the company. The rest is revenue gained by the low-tax country.
Footnote 29 is of special interest:
The United States and other member countries of the Organization for Economic Cooperation and Development impose limits on the ability of companies to manipulate such internal transfer pricing, generally on the basis of the arm’s-length principle. Under that approach, the “correct” price is the price at which companies or people would be willing to trade if those traders were not economically related. In many cases, determining the correct arm’s length price – especially when the item traded is unique, such as a patent or a trademark- is difficult. As a result, taxpayers and tax authorities often disagree about the correct price.
There are two points contained in this brief statement. One relates to the issue of intangible valuation, which we discussed here. While we noted that representatives of multinationals often game this issue, tax authorities also play advocacy games at times. The OECD introduces transfer pricing thusly:
A large share of world trade consists of transfer of goods, intangibles and services within multinational enterprises. To determine tax liability in each jurisdiction, the right price (arm’s length price) has to be applied, the OECD has issued guidelines on this principle to avoid double taxation.
One summary of the OECD Transfer Pricing Guidelines notes:
These guidelines maintain the arm’s length principle of treating related enterprises within a multinational group and affirm traditional transaction methods as the preferred way of implementing the principle. These controversial issues are not just of interest to tax experts. National tax administrations, taxpayers and business people alike, all have a share in avoiding conflicting tax rules which might seriously hamper the development of world trade.
Simply put – the central goal of the OECD to promote growth and free trade with adherence to arm’s length pricing for intercompany transactions seen as a central element of achieving this goal. The concern that national tax authorities such as the IRS or Revenue Canada might try to advocate positions contrary to this goal is shared by not only the OECD but also by Kash and Alfons J. Weichenrieder as co-authors of Tax Competition And Transfer Pricing Disputes:
Transfer pricing regulations, which are designed to limit multinationals’ profit shifting activities, have been tightened in recent years in the US. These new regulations have been enacted to increase the tax revenue collected from multinationals, in response to domestic political concerns that foreign companies are not contributing adequate tax revenues. This paper examines the implications of such a struggle by governments to collect tax revenues from multinational firms. It is shown that such behavior will lead to a non-cooperative equilibrium characterized by the double taxation of corporate profits, and consequently by a depressed level of international trade. Conversely, cooperation between governments could potentially increase both tax revenues and trade.
Interestingly, a December 8, 2005 Memorandum of Understanding between the IRS and Revenue Canada “to resolve disagreements in respect of the underlying facts and circumstances in [double tax] cases”, which followed a June 3, 2005 Memorandum of Understanding that vowed to strive for reciprocity and consistency in resolving double tax cases. The two tax authorities have been quarreling with each other on a host of transfer pricing issues, but finally agreed to a process where these double tax disputes would be resolved using the arm’s length standard based on the actual facts in each case. I guess one might applaud these agreements except for the fact that both Canadian and U.S. law codified the arm’s length standard, which is an economics principle that must look at the actual facts in any particular case, many years ago. So the cynic in me asks what do these Memorandum of Understandings do other than say that the tax authorities will follow their own laws? Duh!
But you might ask don’t the tax authorities have economists working for them as do the representatives of national tax authorities. While they do, I would ask you to review some of the insightful (if not jaded) comments from AB reader OldVet as to how the attorneys for the IRS seem to get in the way of effective transfer pricing enforcement while those pretending to be economists for the representatives of the taxpayer play the economists at the tax authorities for fools with “analyzes” so disingenuous that I suspect the National Review would refuse to put their writings up as being credible. Note, however, that the point that Kash and Alfons J. Weichenrieder make is that tax authorities often ask their economists to also act like overpriced whores. At the end of the day, honest multinationals have to pay more to avoid double taxation, while those who engage in transfer pricing manipulation to evade U.S. taxation somehow escape effective scrutiny. I wish it were as simple as the line in Shakespeare’s Henry VI: “The first thing we do, let’s kill all the lawyers”. Yet, these lawyers are trained to be advocates. Economists are not trained to be paid whores, but alas we see so many behaving that way.