Arellano University School of LawInternational Trade Law

Research paper on

Transfer Pricing

Submitted to:

Atty. Ever Rose Y. Higuit

Submitted by:

Gonzales, Allene O.2012-0574

Introduction

The enormous growth in International Trade has made inter-company and intra-company pricing an everyday practice in a majority of businesses. This is particularly true in multi-national companies.

Transfer pricing is done when there is a transaction between two divisions of a multinational enterprise. Here, the export value of the producing division will equal the import value of the acquiring division. This will leave the companys overall profits unchanged, no matter what price it chooses to value the transaction.

For example, XYZ Company, Division A manufactures car engines and Division B produces cars. When Division A sells car engines to Division B to be used in their production of cars, the price chose to value the transaction if called the transfer price.

When different divisions of a multi-entity company are in charge of their own profits, they are responsible for their own Return on Investment. When divisions are required to transact with each other, they use transfer price to determine the cost.[footnoteRef:1] Transfer prices become the cost of acquisition from the other division, similar to purchase price if bought from another company. [1: Investopedia, http://www.investopedia.com/terms/t/transferprice.asp ]

It would appear that the firm can choose whatever transfer price it wants, but, for multinational companies with international transactions where there are different business income taxation, it will be very hard.

Transfer Pricing in Multinational Companies

In 2010, Google was investigated by Internal Revenue Service of the U.S. for using transfer pricing to evade $3 Billion in taxes. Tax authorities suspect that companies use transfer pricing to shift profits to low tax jurisdiction by failing to charge intercompany transactions.[footnoteRef:2] Google spokeswoman, Jane Penner, said Googles practices are very similar to those at countless other global companies operating across a wide range of industries. [2: Bloomberg Business, http://www.bloomberg.com/news/articles/2010-10-21/google-2-4-rate-shows-how-60-billion-u-s-revenue-lost-to-tax-loopholes ]

Facebook, the worlds biggest social network, has also a similar scheme as that of Google. It is aims to send earnings from Ireland to the Cayman Islands, though not confirmed by the company spokesperson.

The tactics of Google and Facebook depend on transfer pricing, paper transactions among corporate subsidiaries that allow for allocating income to tax havens while attributing expenses to higher-tax countries. According to Reed College professor Kimberly Clausing, this income shifting costs the U.S. government as much as $60 billion annual revenue.

If the US government charges 40% income tax and Switzerland charges 12%, a U.S. company can declare income in Switzerland to save 28% on tax payable to the government.

The four main theoretical concepts for a transfer price are:a. the external market or arms length transfer price;b. the efficient transfer price;c. the profit maximizing transfer price; andd. the economic transfer price suitable for collection by a statistical agency.

The external market price concept is feasible if there is a well-defined price for the specific trade commodity which the units can be traded at a common price. This common price is the arms length transfer price.

The efficient transfer price concept arises when there is no external market for the commodity traded by the production units. It is generated by solving a joint profit maximization problem of the two units of a multinational company. It is a Lagrange multiplier, or shadow price, which corresponds to the constraint that says the output of the producer must be equal to the input of the purchasing unit. If there are no tax distortions, transfer price is computed by setting up two profit maximization problems for the two units. Again, the commodity selling price of the producing unit is also the purchase price of the other producing unit.

The profit maximizing transfer price concept considers the tax distortions in the two jurisdictions. The profit maximizing price will generally be different from the efficient transfer price. This is because the tax authorities will not allow extreme transfer prices. They will either impose a transfer price or the multinational will choose a strategic transfer price that is acceptable to the taxing authority.

In the economic transfer price concept, the economic transfer price will coincide with the external market transfer price or the efficient transfer price in case of no tax distortions. It is suitable for collection by a statistical agency and will be a marginal cost for the exporting unit or a marginal revenue for the importing unit.

The Double Irish Method

The Double Irish method is a tax avoidance technique involving the use of a combination of Irish and Dutch subsidiary companies to shift profits to low or no tax jurisdictions. The double Irish with a Dutch sandwich technique involves sending profits first through one Irish company, then to a Dutch company and finally to a second Irish company headquartered in a tax haven. This technique has allowed certain corporations to dramatically reduce their overall corporate tax rates.[footnoteRef:3] [3: Investopedia, http://www.investopedia.com ]

This is just one of a class of similar tax avoidance schemes done by big companies. This involves arranging transactions between subsidiary companies to take advantage of the tax laws in different countries. Technology companies can easily take advantage of this method by simply assigning intellectual property rights to subsidiaries abroad.

Double Irish Method[footnoteRef:4] [4: http://frenchweb.fr/amazon-apple-facebook-google-microsoft-des-milliards-au-soleil/74188 ]

The scheme works by (1) moving your money to Ireland, (2) transfer to the Netherlands, and (3) finally, to a tax haven such as Bermuda, in that order. The steps[footnoteRef:5] are the following: [5: Techcrunch, http://techcrunch.com/2013/10/28/the-double-irish-could-be-endangered-preventing-companies-like-google-and-twitter-from-shedding-tax-liabilities/ ]

1. Develop technology or other intellectual property in the United States.2. Set up a corporate subsidiary in Ireland, and sell (or license) foreign rights to said intellectual property. However, ensure that this company is headquartered in Bermuda, or a different but similar tax haven.3. Foreign profits that come from revenue based on that intellectual property can now be assigned to that entity. This means that the parent company will not pay home-market taxes on the full profit bill. Instead, it will pay home-market taxes only on the fees that the Irish subsidiary remits to the parent corporation itself.4. Have the subsidiary pay as little as possible for the sold or licensed intellectual property. This shifts the maximum amount of profit to Ireland and away from the parent companys home-market tax rate.5. Now, set up a second Irish corporation. Your first Irish company will own this company. The second company will do the work of selling products and recording revenue. However, its profits wont stay put.6. Send the profits from the second Irish corporation through a third subsidiary corporation in the Netherlands. Ireland has tax-free transfers inside the European Union. The profits from the second Irish corporation are now safely ensconced in Holland.7. Now, route that profit from the Netherlands back to the first Irish subsidiary, which is headquartered in Bermuda.8. According to Irish law, if a company is managed elsewhere (Bermuda), its profits can, in the words of the New York Times, skip across the world tax free.9. Ship the profits sent to the first subsidiary to its headquarter location in Bermuda and no taxes are paid.

In this scheme, the gainers are the shareholders and the losers are governments becausethe projected tax collection from these companies are not realized.

Effect of Government Policies

Transfer pricing rules have recently been introduced or reformed in a number of countries. Others are now in the process of reviewing the effectiveness of their existing transfer rules and practices. The efforts of different governments threatens[footnoteRef:6]: [6: https://www.pwc.tw/en_GX/gx/international-transfer-pricing]

1. the risk of very large local tax assessments,2. the potential for double taxation income has already been taxed elsewhere,3. significant penalties and interest on overdue tax,4. the potential to carry forward of the impact of unfavourable revenue determinations,5. secondary tax consequences adding further cost,6. uncertainty as to the groups worldwide tax burden, leading to the risk of earnings restatements and investor lawsuits,7. conflicts with customs and indirect tax reporting requirements,8. conflicts with regulatory authorities, and9. damage to reputation and diminution of brand value as a consequence of the perception of being a bad corporate citizen.

Tax authorities are to some extent in competition with their counterparts in other jurisdictions in order to get a share of the taxable profits of multinational companies. This may lead to double taxation of the same profits by the two transacting countries. On the side of the multinational companies, economics dictate that they shift to more favouring countries with less taxes and duties and bilateral treaties.

Conclusion

There are international transactions where the rates of business income taxes differ in different countries. The multinational company should choose a strategically and financially-sound transfer price to reduce the amount of taxation paid in both the importing and exporting countries. In its attempt to maximize the after sales profit, it should do so legally, considering both the income tax and customs duties.

It is presumed that the pace of change in the government regulations would bring about more restrictions on transfer pricing. A multinational company should maintain its vigilance to ensure that recent policies and standards imposed by taxing authorities are met.

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