International Taxation: Transfer Pricing - Research Paper Example

?In the corporate and financial market, transfer pricing is one of the controversial issue which is being debated at large. In international taxation, transfer pricing has become a heated issue. Corporation on one hand see it as a legitimate tool for tax evasion and tax avoidance, while on the other hand, the regulators and legislators, see it as unlawful and is frowned upon. [Shaxon, N. (2012)] In order to acquaint with the concept of transfer pricing, consider two companies, that is a parent companies and a subsidiary company or two subsidiaries that have the same parent company, actively involved in trading with each other. For the purpose of the subject under consideration, it is also assumed that the subsidiary company in the aforementioned group structure is a foreign company and the Parent is a local company. When the companies in the group structures are involved in transactions with each other, they put a price on the transaction. This price is termed as the ‘transfer price’. This can further be illustrated with the help of the following example: Company A, the parent company, is situated in USA and its subsidiary company, Company B is situated in UK. Suppose that Company A has outsourced its financial activities to its subsidiary company, which means that Company A does not have any staff which are performing finance related activities (such as preparing financial statement, filing tax return, involved in budgeting etc.) instead the finance department of Company B is performing these activities for Company A and in return is charging a fee. Although the owners of both Company A and Company B are the same, but still one company is charging a fee for performing a particular service to another company in the capital structure. Transfer pricing is not a legal activity in its substance, but its misuse can label it as abusive. Transfer mispricing is quite common in manufacturing concern all across the globe where the transfer of services are involved rather than the transfer of services. A safe estimate made by the economists and financial analyst presents the fact that around 60% of the international trade that place globally, is between the countries under the same corporate structure. In addition to this figure, the economists also put forward the fact that due to transfer mispricing, billions of dollars is lost for tax revenue. The tax authorities argue the fact that transaction between associated companies within a group should take place on arms length basis. The arms length price is the price at which two unrelated parties in the market would agree to proceed with the transaction. The arms length pricing is a result of genuine negotiation in the market. But usually what happens in the global market is that companies usually distort the transfer prices at which the transaction is recorded. This usually assists the companies in avoiding tax and report higher profit for the financial year. Illustrative Example No. 1 (all figures in USD)   Subsidiary Company (fully owned and controlled by the parent company)   Parent Company (Head Office of the Multinational)         Host Country (China) Home Country (USA)                   Price of good bought   Transfer Price   Selling price Total Case 1 100   200   300   Profit Before Tax 100 100 200 Tax Rate (%)[Ey.com 2013] 25% 40%   Tax paid 25 40 65 Profit after tax   75   60   135 Case 2 100   280   300   Profit Before Tax 180 20 200 Tax Rate (%) 25% 40%   Tax paid 45 8 53 Profit after tax   135   12   147 Case 3 100   300   300   Profit Before Tax 200 0 200 Tax Rate (%) 25% 40%   Tax paid 50 0 50 Profit after tax   150   0   150 In the first illustrative example, we are considering two companies situated in USA and China. The company situated in the USA is the parent company whereas the company situated in China is the wholly owned subsidiary company of the Parent. The Parent company is involved in the trading of FMCGs. The items that the company A sale to the general public is manufactured by the subsidiary company in China. In the above illustration, the company in China manufactures the good incurring the cost of $100 and sells the same to the parent company at a price of $200. The parent company then sells the same good to the general public at a price of $300. Both the subsidiary company and the parent company derive a profit of $100 through this transaction. The tax rate in China and USA is 25% and 40% respectively. A glance at the total column of the above illustration presents the fact that the multinational earned a profit before tax of $200 and paid total tax of 65, thus a net profit of $135. In all the three cases, the profit before tax remained the same as the company cannot change the final price at which the commodity is sold to the consumer as it would adversely impact the demand and thus the overall revenue of the product. However, through manipulating transfer price, the company can increase its net profit by lowering the tax burden. Manipulation through transfer pricing can proved to be quite tricky as it is an interchange between who will pay the higher tax, the parent or the subsidiary. Comparative benefit can be derived if more tax is paid by the company which is exposed to lower tax rate, in the above example the company situated in China. As illustrated in the above tabular information, if the company B increases the transfer price from $200 to $280 or to $300, the overall can be increased to $147 and $ 150 respectively. It would be quite interesting to note that the overall tax paid also decrease, which results in the enhanced net profit after tax. Case 3 is the ideal situation for the overall group if we analyze the above calculation; however it is also the situation in which Company B is paying the highest tax. Thus eventually, the decision rests with the management of the parent whether they are looking for overall high group profits or they are treating subsidiary B as a profit centre (instead of cost) and thus want it to report higher profit. Illustrative Example No. 2   Subsidiary Company (fully owned and controlled by the parent company)   Parent Company (Head Office of the Multinational)         Host Country (UK) Home Country (USA)                   Price of good bought   Transfer Price   Selling price Total Case 1 50   150   250   Profit Before Tax 100 100 200 Tax Rate (%) [Ey.com 2013] 23% 40%   Tax paid 23 40 63 Profit after tax   77   60   137 Case 2 50   200   250   Profit Before Tax 150 50 200 Tax Rate (%) 23% 40%   Tax paid 34.5 20 54.5 Profit after tax   115.5   30   145.5 Case 3 50   250   250   Profit Before Tax 200 0 200 Tax Rate (%) 23% 40%   Tax paid 46 0 46 Profit after tax   154   0   154 Consider another scenario in which the Parent company situated in UK is trading with a subsidiary situated in UK. For the purpose of simplicity and understanding, it can be assumed that all the assumption as taken in illustration 1 hold good for the illustration two as well. The corporate tax rate in the UK is 23%. As mentioned in the tabular information above, the subsidiary is earning only 100 as profit but as the transfer price increase, the profit before tax of the subsidiary increase. Although it would be again interesting to note that the net profit of the parent company situated in US kept on decreasing till it reached nil. Since in this situation as well, the tax rate of the company situate in UK is lower than that of the one prevailing in USA, the favorable situation for the group as a whole would be to increase the transfer price and maximize the profit at the level of subsidiary. By indulging in exploitation of transfer pricing concept, the group as a whole can increase its total net profit. The internal revenue service, or IRS, has recently issued pronouncement where it is placing more and more emphasis on the concept of transfer pricing and ensuring that the practice remained as transparent as possible. As per the new pronouncement issued by IRS, every tax payer, being a corporate entity, should asses its transfer pricing strategies and submit a form to the IRS. The compliance form will be submitted as per section 6662(e) of the transfer pricing regulation issued by IRS, and the audit of this form will be conducted by IRS as soon as it is received. [Irs.gov] If during the risk assessment process of the transfer pricing, conducted by IRS, it is deemed that the transactions between the corporate entities within a group was conducted within arm’s length, than no penalty shall be imposed. In any case otherwise, the penalty shall be imposed and the IRS shall complete the findings within sixty to ninety days. In our above analysis, IRS is not likely to conduct any audit in the Case 1 of both illustrations, as in both cases the transactions were conducted at arm’s length. The staff of the IRS will also consider the fact that in the Case 1, the group as a whole is not manipulating the fact that the tax rate of the host country is less than the home and thus deriving tax benefits and enhancing the overall net profit. Thus it is less likely that Case 1 will be challenged by IRS department. In case the IRS calls for the audit of the transfer pricing, the corporate taxpayer should devise strategies to avoid any possible penalties. This could be done through furnishing IRS with pricing policies and documentation of the corporate entities, both parent and subsidiary. IRS scrutiny is supposed to be extensive and through so these documents should be prepared keeping in light this particular aspect. In appropriate situations, the corporate taxpayer should consider supplementing the documentation with a defense filer. This defense filer consists of supplemental information such as documents pertaining to intercompany transactions, minutes of the meetings, intercompany contracts, interview notes, sources of financial data etc. It would be most apt for the organizations to prepare this sort of information before the scrutiny starts as it would be cumbersome and tedious to do while the investigation from IRS proceeds. [PricewaterhouseCoopers (2010)] From the IRS perspective, the legitimacy of the transfer pricing policies of any corporation can be assessed by comparing it with that the market price. For example, in both the illustrations mentioned above, the IRS would compare the transfer price between the subsidiary and the parent company and thus decide upon whether there are at arm’s length or not. From the point of view of audit plan, the IRS should first select transactions between the subsidiary and the parent company on sample basis (whether through statistical or non-statistical method) and then applies its guidelines of transfer pricing on these transactions. If any misstatement is identified then further investigation should be conducted on account of transfer pricing malpractice. One major indication of transfer pricing malpractice is when the group as a whole starts paying less tax as compared to its previous financial years whereas its profit before tax does not fluctuate. References Ey.com (2013). 2013 Worldwide Corporate Tax Guide - Country list - EY - Global. [online] Retrieved from: http://www.ey.com/GL/en/Services/Tax/Worldwide-Corporate-Tax-Guide---Country-list [Accessed: 12 Jul 2013]. Irs.gov (n.d.). Untitled. [online] Retrieved from: http://www.irs.gov/Businesses/International-Businesses/Transfer-Pricing-Compliance-Directive [Accessed: 12 Jul 2013]. PricewaterhouseCoopers (2010). The IRS’s renewed emphasis on transfer pricing. [online] Retrieved from: http://www.pwc.com/us/en/tax-services/publications/irs-transfer-pricing.jhtml? [Accessed: 12 Jul 2013]. PricewaterhouseCoopers (2013). Transfer pricing. [online] Retrieved from: http://www.pwc.com/gx/en/tax/transfer-pricing/index.jhtml [Accessed: 12 Jul 2013]. Shaxon, N. (2012). taxjustice network. [online] Retrieved from: http://www.taxjustice.net/cms/front_content.php?idcat=139 [Accessed: 12 Jul 2013]. Read More