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Taxing multinationals: The trouble with transfer pricing

MailOnline claims to be the world’s largest English-language newspaper website, with 168m monthly global unique visitors, so Christian Aid has reached a potentially very large audience with a comment piece by Joseph Stead on 6 January.

Stead is senior economic justice adviser at Christian Aid. His article focused on the need for greater tax transparency, particularly in the extractive (eg. oil and gas) industries. He acknowledged that there are several initiatives requiring country-by-country reporting by multinationals. He wrote:

“Christian Aid estimates that tax dodging by multinational companies currently robs poor countries of US$160bn a year – far more than rich countries give them in aid. Of course, extractive firms are not responsible for all of this but they account for a high proportion of poor countries’ exports, so they very likely bear a disproportionate share of blame.”

The $160bn estimate drew some criticism on Twitter, and Stead has accepted that “we could do with better estimates”. The figure has been cited several times over the last five years and has been challenged by a (very small) number of tax professionals.

However, it does not include the impact of much of what the OECD calls “base erosion and profit shifting” (BEPS). There will be some overlap. Broadly speaking, Christian Aid’s estimate deals with deliberate mispricing, while BEPS is about the impact of gaps in the international tax system.

In both cases, the current transfer pricing system is a key feature.

Christian Aid’s report “Death and taxes: The true toll of tax dodging”, published in 2008, said developing countries were losing corporate taxes of $160bn a year due to two forms of “corporate evasion”. It added:

“The first of these is known as ‘transfer mispricing’, where different parts of the companies [this is a reference to different companies forming part of a multinational group] sell goods or services to each other at manipulated prices. [The] potential scope of this practice can be seen from the staggering fact that some 60% of all world trade is now thought to take place between global corporations and their subsidiaries. The other, ‘false invoicing’, is where similar transactions take place between unrelated companies.”

Christian Aid said that “these two forms of evasion are estimated to account for about 7% of global trade transactions each year”, and it combined that figure with World Bank figures on the volume of trade, and corporate tax rates, to calculate the implied loss of tax revenues.

That 7% estimate (see table 1 on page 53) is “Ray Baker’s ‘conservative estimate’ that 7% of trade volumes is illicit capital movement, by false invoicing between unrelated parties and by abusive transfer pricing within multinational groups”.

Baker is president of Global Financial Integrity, a think tank based in Washington DC. Its latest study, published last month, found that “crime, corruption, and tax evasion drained $946.7bn from the developing world in 2011”.

Baker’s 7% estimate was published in 2005. It was based largely on 550 interviews with senior executives of trading companies in 11 countries – respondents were assured of anonymity – in order to examine “the amount of mispricing in international trade between unrelated parties”. He wrote in “Capitalism’s Achilles Heel”:

“Mispricing in order to generate kickbacks into foreign bank accounts was treated as a well-understood and normal part of transactions.” He concluded that “thousands of companies provide helpful mispricing services to tens of thousands of their overseas customers in hundreds of thousands of transactions moving billions of dollars into western accounts”.

Moving on to transfer pricing between affiliates (ie. companies in the same multinational group), Baker said he had not done a formal investigation:

“I have, however, observed enough transactions, seen enough exaggerated intracompany (sic) prices, asked enough questions in dozens of countries, and collected and reviewed more than enough trade data to have every reason to conclude that, on a global scale, abusive transfer pricing between affiliated entities greatly exceeds mispricing between unaffiliated entities.”

He took the percentage for abusive transfer pricing to be the same as that for mispricing between unrelated parties in order “to be conservative”.

There is a distinction between deliberate mispricing (ie. lying) and applying a price that is within the range of possible answers that the law provides. The latter is an essential part of the tax compliance process and it may be the subject of negotiation with the tax authorities. But the system is flawed.

The OECD’s action plan is designed to fix weaknesses in the current rules that “create opportunities” for BEPS, which “relates chiefly to instances where the interaction of different tax rules leads to double non-taxation or less than single taxation”. Four of the 15 “actions” deal with transfer pricing.

The first 10 actions address:

  • the tax challenges of the digital economy (and in particular, the allocation of taxing rights between countries);
  • the effects of hybrid mismatch arrangements;
  • controlled foreign company rules (“CFC rules of many countries do not always counter BEPS in a comprehensive manner”);
  • base erosion via interest deductions and other financial payments;
  • harmful tax practices (broadly, preferential tax regimes);
  • tax treaty abuse;
  • artificial avoidance of “permanent establishment” status; and
  • transfer pricing issues including BEPS by (a) movement of intangibles among members of a multinational group, (b) transferring risks among, or allocating excessive capital to, group members, and (c) engaging in transactions which would not, or would only very rarely, occur between third parties.

The OECD has not tried to estimate the cost of BEPS. Pascal Saint-Amans is director of the OECD Centre for Tax Policy and Administration and is leading the BEPS project. There is an issue, he said last summer, but it cannot be measured: “We are not naive and we don’t want to come up with figures.”

But critics of the current “separate entity” approach, which relies heavily on the arm’s length principle for transfer pricing, argue that the whole system is flawed. Some say that a form of unitary taxation – with global profits allocated to tax jurisdictions on the basis of a formula – would eliminate profit shifting.

Sol Picciotto, a senior adviser to the Tax Justice Network, argues that unitary taxation would provide “a more sound foundation for the international tax system, one that matches the economic reality of [transnational corporations] as integrated firms”.

This week Ajay Gupta, editor of Tax Notes International, was looking back to 2013 and declared that “in the light of … multiple demonstrations of dysfunction and decay, we have selected the persisting vegetative state of global transfer pricing enforcement as the international tax development of the year”.

Last October Lee Sheppard, a contributing editor at Tax Analysts, wrote of the “twilight of the international consensus”. This consensus was “intended to permit multinationals to do business in treaty countries while paying tax only on income earned locally through separate entities and permanent establishments”. Sheppard added:

“This limitation of tax jurisdiction is key to the OECD model treaty. Of course, multinationals are vertically integrated and don’t transact with their affiliates at market prices. So an economic philosophy – which appears nowhere in the OECD model treaty – that multinationals should transact with their affiliates at hypothetical arm’s-length market prices was grafted on later.

“It has been an open secret for some time that multinationals – led by the Americans and their huge tax departments – have abused these privileges. The affected countries are no longer limited to corrupt, badly governed, resource-exporting countries. They now include European states with sophisticated tax administrations and the home governments of multinationals. Every country is just another country to be exploited.”

The trouble with the transfer pricing system is that it is based on fiction, but the OECD has claimed that it would be impractical to replace it. The OECD itself said that multinationals “have been able to use and/or misapply [the current] rules to separate income from the economic activities that produce that income and to shift it into low-tax environments”.

Unitary taxation seems, at least, to be based on economic reality. There is a strong argument that the OECD project will not be enough, and that root and branch reform of the system is necessary. And that should involve a long, hard look at the arm’s length principle and whether a different approach – such as a gradual move to unitary taxation – would be better.

1 reply »

  1. It seems to me that the arms length principle upsets a lot of people. But it should be noted that the use of a market value is very common practice, in UK tax law at least.

    This is typically stated as an equitable ideal through statute, but also in interpretation of statute. In some cases, a market value has been argued as being a fair and reasonable basis of determining what constitutes expenditure which is wholly and exclusively incurred for the purposes of the trade.

    For example, where a trader employs a family member, HMRC would seek to ensure that only a market value is treated as an allowable deduction. (

    The principle of using market value must be considered to be reasonably fair given its wide affirmation by lawmakers and courts. Arguably, perhaps it is considered that there is nothing fairer in relation to taxation.

    I have not heard anybody advocating the complete removal of using an arms-length principal in tax law, and we are talking exclusively about allocation of taxing rights on profit, believe. It would be regrettable, however, to mistake the flawed implementation of a sound ideal with a fault in that ideal.