$20,000 for a Refrigerator? Abusive Transfer Pricing Explained

August 2nd, 2010

Towards the end of last month, Ann Hollingshead blogged about Businesses and Investors against Tax Haven Abuse, a coalition of over 400 small business owners and investors looking to curb the use of tax havens and shell companies by their larger multinational competitors.  But how exactly do these multinational entities use tax havens?  One method, which takes advantage of the disparity in tax rates between jurisdictions, is transfer pricing.

Representative Sander Levin (D-MI), Chairman of the House Ways & Means Committee, called a hearing on the practice of abusive transfer pricing last month. | Photograph by the Canadian Embassy

Transfer pricing is an issue that has been described as incredibly lucrative to those involved and excruciatingly boring to everyone else.  So naturally, this was the subject of a July 22nd Congressional hearing by the House Ways & Means Committee.  The hearing, which was called by Committee Chairman Sander Levin to examine “transfer pricing issues in the global economy,” followed the release by the Joint Committee on Taxation (JCT) of a report on income shifting and transfer pricing and featured numerous witnesses from the Treasury Department, business, and academia.

The JCT report examined the mechanisms used by six unnamed corporations to reduce their worldwide tax liability.  Each of these corporations had an effective worldwide tax rate of less than 25 percent, with some reporting average tax rates as low as 10 percent.  This is a far cry from the U.S. statutory tax rate of 35 percent.  While the JCT report explicitly stated that these “six case studies do not represent a random selection of U.S.-based multinational corporations,” the studies still provide meaningful insight into how a corporation might use oversees subsidiaries and disregarded entities to conduct transfer pricing and manipulate its overall tax liability.

But what exactly is “transfer pricing”?  In its simplest form, transfer pricing is the pricing of products that are bought and sold between two related parties, such as a parent company and its subsidiary or two subsidiaries of the same corporation.  For example, assume the following (extremely simplified) transfer pricing scheme.  Corporation X, which makes and sells widgets, owns two subsidiaries, a manufacturer based in the United States and a distributor based in Switzerland.  Assume that it costs the manufacturer $100 to build a widget.  The manufacturer will then sell that widget to the distributor at a price of $130, and the distributor resells the widget to the end-consumer for $150.  While Corporation X makes a total of $50 in profit per widget, that profit is split between the manufacturer and the distributor.  The end result is that $30 of that profit is located with the manufacturer in the United States and $20 is located with the distributor in Switzerland.

This distribution of profits among a corporation’s various subsidiaries is perfectly fine as long as the distribution accurately reflects the activities of the subsidiaries and the true market price of the goods.  In the above example, there is more risk associated with manufacturing than with distribution, so it makes sense that the market price of widgets is one that ensures the manufacturer retains a greater share of the profits.

Transfer pricing becomes abusive, however, when corporations intentionally manipulate their internal prices to avoid taxes.  Corporations achieve this by pricing goods and services in a way that shifts profits to specific locations with lower tax rates.  Taking the above example, assume (hypothetically) that the United States taxes profit at a rate of 30 percent, whereas Switzerland has no corporate tax.  Under the above scheme, Corporation X has to pay 30 percent of its U.S.-based profit, or $9, in U.S. taxes.  Now, assume that Corporation X, in order to reduce its U.S. tax liability, directs its manufacturer to lower the price it charges the distributor from $130 to $110.  The distributor then sells the widget to the end-consumer at the regular price of $150.  The U.S.-based manufacturer now makes only $10 in profit per widget, which means that it only has to pay $3 in U.S. taxes.  Overall, Corporation X still makes a profit of $50 per widget.  However, in the new scheme, Corporation X has actually saved $6 per widget by manipulating its internal prices to reduce its U.S. tax liability.  This works because of the general rule that foreign earnings are not subject to U.S. tax until repatriated into the country.  While certain exceptions to this rule are provided in sections 951-965 of the Internal Revenue Code, companies (or their tax advisors) are generally cognizant of how to avoid those exceptions.

Combating abusive transfer pricing is especially difficult because whether a particular transfer pricing transaction is abusive is entirely based on the specific circumstances surrounding that transaction.  For example, evidence that a foreign subsidiary based in a low-tax jurisdiction recorded significantly higher profitability than its U.S.-based parent may at first glance indicate the presence of abusive transfer pricing.  However, it is entirely possible that the foreign subsidiary’s profitability derives from its own product development or investments and not from a manipulation of internal transactions between the subsidiary and its parent.

Issues become even more complicated when these transactions involve the internal transfer of intangible goods and intellectual property by U.S.-based multinational corporations to overseas subsidiaries, which was a major focus of the July 22nd Congressional hearing.  Companies often establish research and development (R&D) operations in the United States to take advantage of the significant tax credit provided on the expenses of these endeavors.  Once these R&D projects near completion, however, some companies will start to outsource the manufacturing, production, and distribution of the end-products to subsidiaries in low-tax jurisdictions.  This outsourcing usually occurs through the sale of licenses or cost-sharing arrangements, in which the foreign subsidiary pays a fee (which can be either ongoing royalties or a one-time payment) for the right to use the intellectual property.

Issues arise when the fee paid by the foreign subsidiary is not reflective of the actual value of the right that is being transferred.  According to U.S. law, whether or not the price of a good reflects its actual value is determined by the “arms-length standard.”  U.S. Treasury Regulation § 1.482-1(b)(1) states that a transaction is consistent with the arms-length standard if similar outcomes “would have been realized if [unrelated parties] had engaged in the same transaction under the same circumstances.”  The tricky part is figuring out how unrelated parties would have actually priced a unique intangible that was created not more than a few months ago.

R. William Morgan, Managing Director of Horst Frisch Incorporated, was one of the many witnesses who brought this issue to light at the Congressional hearing.  In his testimony, Morgan pointed to a recent Tax Court case involving Veritas, a U.S. software manufacturer.  Veritas gave its Irish subsidiary the rights to use pre-existing intangible property in exchange for a buy-in payment.  While Veritas valued the rights to this intangible property at $118 million, the Internal Revenue Service claimed that its value was closer to $1.675 billion.  As Morgan stated, “[Veritas] and the IRS both used smart people and applied the same set of rules, but came up with wildly different results.”

For this reason, obtaining reliable data on the prevalence of abusive transfer pricing has proven to be highly problematic.  Even concrete data on the level of trade between related parties, legitimate or otherwise, is scarce because existing customs records do not distinguish between related and unrelated parties.  Multinational corporations also currently do not report their taxes and profits on a country-by-country basis, information that would be vital in determining how a company distributes its profits.  But surprisingly, the Congressional hearing paid very little attention to addressing these data problems.  While it is important to understand the possible mechanisms that corporations can use to manipulate their overall tax base, it is incredibly difficult to combat the broader use of abusive transfer pricing without having the data necessary to understand its prevalence and its effects.  Congress needs to understand that obtaining reliable data on the prevalence of transfer pricing and the distribution of corporate profits would dramatically improve its ability to combat abusive transfer pricing.  While last month’s hearing represents a positive step forward, the next step should be to address the data problem.

Written by Collin Swan

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