How transfer pricing actually works – and why it’s abused

Multinational tax avoidance is proving to be a sore point for Australians. You’ve heard about the big players – Facebook, Google, Apple – and there is speculation they might be engaging in dodgy transfer pricing practices.

The problem is, while everyone’s steeped in a debate about fiscal-moral-legalism, nobody’s explaining the practical implications of a mispricing system that seems endlessly lucrative for corporate heavyweights all over the world.

What is transfer pricing?
When two companies that are part of the same group trade with each other, they need to establish a price for that transaction. That amount is the transfer price.

Say an Australian-based subsidiary of Facebook buys something from a France-based subsidiary of Facebook. The price Australia pays for its purchase is the transfer price.

Transfer pricing is necessary. The two parties being separate legal entities have to establish a commercial contract. It is not illegal, and does no harm by itself. Transfer MISpricing, however, may do harm for government revenues.

What is transfer mispricing?
Transfer mispricing happens when two related parties (two subsidiaries of a single parent group) intentionally distort the price of a trade to minimise the overall group’s tax bill.

Using the example above, if ForestClean Australia buys $4,500 worth of computer servers from ForestClean France but the two parties agree to record a purchase price of $2,000, ForestClean France has lost $2,500 of revenue and ForestClean Australia has gained $2,500 in reduced expenses. A transfer pricing issue may occur if the French and Australian tax rates are different – if they are, the transaction may result in a minimised tax bill for the group.
This type of arrangement is not necessarily illegal. It happens all the time between friends and family members, but there’s a key difference.

Say Sally is in the business of selling boats and decides to sell a yacht to her brother. The yacht’s retail value is $45,000, but she agrees to sell it for cost at $30,000. Sally gets her $30,000, which is $15,000 less she must pay tax on. The transaction isn’t morally questionable, though, because Sally is doing her brother a favour and is losing revenue from the sale. They’re related like subsidiaries but their financial interests are separate.

The key difference involves a principle called the arm’s length principle.

The arm’s length principle?
When two unrelated parties trade with each other, they’ll decide on a market price for the goods sold. This is an arm’s length transaction, and tax authorities accept it because it is the result of a real negotiation.

Big multinational companies are supposed to treat their subsidiaries as if they are separated by arm’s length – this ensures they pay the right amount of tax in any jurisdiction in which they operate. These activities are causing big tax losses for Australian and international governments.

What can we do about it?
A few wide-reaching global lobbyists are putting pressure on multinational corporations suspected of profit shifting and transfer mispricing, but the culprits are faceless and their paper trails inscrutable. The Organisation for Economic Cooperation and Development (OECD) and United Nations Tax Committee have endorsed full adoption of the arm’s length principle, but it is proving difficult to implement because it’s not always easy to determine what the market value of a good is. Basically, what you cannot see, you cannot tax.

Consider a situation where two related subsidiaries are trading a computer chip for a smartphone, which is only made for that smartphone and isn’t made by anyone else.

How is the market value set for that computer chip?
Comparing it with a similar computer chip in a similar smartphone may not suffice, because the goods cannot be compared. How can two subsidiaries operate within arm’s length if there is no market-supported guideline for value? A catch-all remedy is yet to be found, but there could be a preventative measure.

Since profits can be manipulated perhaps the only solution is to tax on the revenue level – like a withholding tax. But that is a major change to our tax system – and a further complication that is still in the too hard basket. The only suggestion so far is to name and shame and let the consumer do the talking.

What about profit shifting?
Essentially, transfer pricing leads to profit shifting. The transition works like this:
Subsidiaries justify potentially harmful transfer pricing practices by basing more of their goods or intellectual property (IP) in jurisdictions with lower tax rates.

By doing this, they’re saying that low-tax jurisdiction is where the taxable goods or IP belong, are owned, or developed. If a company says its technology IP originates in Ireland, and then sells that IP to its Australian subsidiary for a high premium – an artificially high premium, established through “transfer mispricing” – then its Irish tax bill will be high and its Australian tax bill will be low. The problem is its Irish tax bill will be close to nil because Ireland is a tax haven.

Profit shifting makes questionable use of subsidiaries. It works like this:
Forest Incorporated grows its carrots in Australia and transports them to the United States to be sold. It has three subsidiaries: Forest Australia (in Australia), Forest US (in the United States), and Forest Haven (in a zero-tax country).

Forest Australia sells its carrots to Forest Haven at an artificial, below-market-value price. Straightaway, Forest Australia’s profits are low, so its tax bill will be low. Then, Forest Haven sells the carrots to Forest US at an artificial, above-market-value price (but not as high as the US retail price of the carrots). So Forest US has low recorded profits and a low resulting tax bill. Forest Haven is left with very high artificial profits, but it is located in a zero-tax country, so it pays no tax on the profits. Just like that, a tax bill is totally gone.

TransferPricingInfographic

The macrocosmic problem of multinational tax avoidance has a microcosmic parallel: everyday taxpayers are always accountable to tax authorities and faceless multinational companies are not. Until the offenders are revealed on the world’s stage or multilateral action is taken, we can’t expect the practice to cease.