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Transfer mispricing

From Wikipedia, the free encyclopedia

Transfer mispricing, also known as transfer pricing manipulation or fraudulent transfer pricing,[1] refers to trade between related parties at prices meant to manipulate markets or to deceive tax authorities. The legality of the process varies between tax jurisdictions; most regard it as a type of fraud or tax evasion.

Generally, if two independent, unrelated parties negotiate with one other for a financial transaction and eventually reach a price, a transaction in correct market price will take place. According to the arm's length principle, the price, at which the transaction occurs, is preferred for tax purposes as it is a fair reflection of the value of the goods or services. [2]

Whereas when the parties which negotiates with one other for transaction are related, they set on purpose an artificially lower the price with the intention to minimise the tax bills for both parties. Since both sides wins in this kind of situation, it is preferred by the majority of large enterprises, although tax collectors are not in favour of it. [3]

YouTube Encyclopedic

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  • Transfer pricing and tax havens | Taxes | Finance & Capital Markets | Khan Academy
  • "Transfer Mispricing" by Liam Perera
  • T516 US Intl Tax Outbound_Sec 5-03 Transfer Pricing-Sec 482_Transfer Pricing Methods.m4v

Transcription

Man: Let's say that I run a country or I run a company, I should say, that is based inside of the United States. So this right over here is my company. Maybe I have some smokestacks of some kind. So that is my company and it makes a million dollars in pretax profits. 1 million dollars and this is before tax, so pretax profits. Let's say that the country that I'm in and the way that I have drawn it, this is the United States. Let's say at the time that I make those pretax profits, the corporate tax rate is 35%. So it's pretty straightforward to think about how much taxes I would have to pay. I would pay 35% on this 1 million dollars or essentially I would pay $350,000 in taxes. I would have $650,000 left in profit. Now what I want to think about. Let's say my company wants to get a little bit more creative about how it might save on taxes. So what it does is it realizes that there is an island not too far off the US coast and there are actually several of them that has a substantially lower tax rate and I'm just picking it arbitrary but let's say it has a 5% corporate tax rate. So how can this company, which is physically, or for the most part based in this country, somehow benefit from this lower tax rate that is happening offshore? Well what they'll typically do is set up another subsidiary, one that this company owns and controls, but it is set up in this little island nation. So let's set it up right over here. So that's the other company. And what it'll do is it will tend to oftentimes it will give it some intellectual property, maybe patents, trademarks, things like that. So it gets all of the intellectual property of the parent company. Then what it can say is, and this is owned by the parent entity, so I'll draw a little dotted line here. It's owned and controlled by this country, this company that is based in the US. And what they'll say is, "Look we don't have a "million dollar pretax profit anymore "because we essentially licensed the use "of this intellectual property," whether it's trademarks, copyrights, patents, "We've got to pay this entity right over here some amount of money "to use that intellectual property." So let's say that they say that we're going to pay them I don't know, $800,000. This is essentially transfer pricing. In theory there should be a way of deciding what is the fair rate for that intellectual property but oftentimes that intellectual property is fairly unique so it's hard to determine a market rate which really just leads this company to decide it for itself. Let's go into that reality, where instead of this reality, this company, before it had a million in pretax profits, but now it's paying $800,000 in royalties and licensing to this entity right over here. So out of that 1 million you have $800,000 going offshore. So the real pretax profit for this company now based on accounting for it this way, based on paying this subsidiary that is offshore for use of the intellectual property, the company now has 200K in pretax profits. That was before the licensing, now this is after the licensing. This is the new pretax number. So the US it would only pay 35% of the $200,000. Instead of paying $350,000 in taxes, it would now pay, so it's no longer $350,000 in taxes. 35% of 200K is 70K in taxes. The US, I guess you could say parent company, would show a profit of 200K minus the 70K of $130,000. I would call it net profit, or we could say posttax profit. Then this character right over here, let's say it has very minimal cost. Let's say it has no cost for simplification. It would have some to do some paperwork. All of this would essentially be profit. Maybe have a few thousand dollars in cost but we'll ignore that for now. So all of this would be its pretax profit. It would have to pay 5% of it. 5% in taxes to this country right over here. So 5% of $800,000 is $40,000. So it would pay $40,000 in taxes to the government of this island right over here. Then it would be left with the remainder $760,000, so it would have $760,000. I guess you could call that it's net profit after paying taxes. So you can see here the company saved substantially on taxes. It paid $70,000 in the US and $40,000 abroad. So it paid a total of $110,000 in taxes versus the $350,000 it would have had to pay if it was based purely in the United States. You might say, "Hey this is a great thing. "Why even have a $800,000 transfer price, "why not do a million?" Obviously if you do it a little bit too ridiculously it will get more and more scrutiny, so there is some balancing influence there. Obviously if there is a market for this intellectual property or that type of intellectual property, or if you are licensing to other people, that might dictate what this is. You might say, "Well why not do this night and day?" Well the question is, you now have this profit and it might be in the form of cash. We go into other videos in more depth when it might not be. But you have essentially this profit. You won't be able to get it back into the United States without paying a tax on it. So if you want to get it back in the United States, that's actually the check. The reason why we do tax, repatriation of funds, is so that companies can't do this night and day. Essentially transfer profits abroad and then bring the cash back in. In order to close this loophole, that's why the repatriation of these funds are actually taxed. I want you to think about, and it obviously depends on what the transfer prices are and things like that, but essentially what this tax rate would have to be in order for a company to come out neutral. There are other ways of getting around it and I'll do other videos later, of ways that this cash could be put to use and it still is not actually taxed.

Contents

First Example

Assume company A, a multinational which produces a product in Africa and sells it in the United States, processes its produce through three subsidiary companies: X (in Africa), Y (in a tax haven, usually an offshore financial center) and Z (in the US), each of which acts under instruction from A. Company X sells its product to Company Y at an artificially low price, resulting in a low profit and a low tax for Company X in Africa. Company Y then sells the product to Company Z at an artificially high price, almost as high as the retail price at which Company Z then sells the final product in the US. As a result, Company Z also records a low profit and, therefore, a low tax. Most of the apparent profit is made by Company Y, even though it acts purely as a middleman without adding much (if any) value to the product (it is likely that the products never pass the country Y, but are shipped directly from X to Z) Because Company Y operates in a tax haven, it pays very little tax, leading to increased profits for the parent Company A. Both jurisdictions of companies X and Z are deprived of tax income, which they would have been entitled to if the product had at each stage been traded at the market rate.[4]

In pervious example it is not a coincidence that the selected country was from Africa. Although the amount of empirical analysis about transfer pricing is quite small, it is clear that the amount of trade mispricing occurring in African exports is higher than that of the developed world, since in Africa there is the insufficient implementation of OECD guidelines and generally less air-tight laws.

About 60% of capital flight from Africa is from improper transfer pricing.[5] Such capital flight from the developing world is estimated at ten times the size of aid it receives and twice the debt service it pays.[6][7] The African Union reports estimates that about 30% of Sub-Saharan Africa's GDP has been moved to tax havens.[8] One tax analyst believed that if the money were paid, most of the continent would be "developed" by now.[9]

Second Example

Another example is for instance some company producing cars, which has its HQ in Japan and its subsidiary in India. Suppose that the Japanese operations have losses whereas the Indian subsidiary has profits. Even though the Indian subsidiary shows profits, because of the purchases of a component from Japan parent company for an unreasonable high price, the profit of the Indian operations will come down. Therefore, its tax outgo will come down, which is great for the company as a whole. Similarly, the loss of the Japanese firm declines, because of receiving this additional money for the component from Indian subsidiary. The result is that the company producing cars, which composes of the HQ and the subsidiary, has benefited by paying less taxes. [10]

Connection to rational asymmetric development

In general, there is some connection between globalization and concerns about unbalanced development, due to the fact that transfer mispricing has also contributed to rational asymmetric development, according to Asongu: “it refers to unfair practices of globalisation adopted by advanced nations to the detriment and impoverishment of less developed countries”.[11]

Another natural and generalizing example of wrong pricing, which lay stress on rational asymmetric development and the fact that the pricing throughout countries incorrectly varies significantly explains Stiglitz : “The average European cow gets a subsidy of $2 a day; more than half of the people in the developing world live on less than that. It appears that it is better to be a cow in Europe than to be a poor person in a developing country…… Without subsidies, it would not pay for the Unites States to produce cotton; with them, the United States is, as we have noted, the world's largest cotton exporter” [12]

Avoiding the Transfer mispricing

This issue of prices, for which good and services are sold between the connected persons is addressed by the OECD Guidelines in accordance with international agreements to avoid double taxation. Since in the second half of the 20th century, transfer mispricing had started to become a major problem and therefore, the OECD (Organisation for Economic Co-operation and Development) needed to unify regulatory frameworks to efficiently combat this phenomenon. Also, since this issue is concerning various countries, it can only be solved by meticulous cooperation between countries, so the international agreements needed to be made to set forth regulatory guidelines.

Concerning this topic, OECD has newly in July 2017 published new consolidated version of the OECD Guidelines called OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017, which includes the revised guidance on safe harbours adopted in 2013, as well as some corrections of the BEPS Actions Plan. The keystone of this OECD Guideline is the Arm’s Length Principle, defined in the Article 9 of the OECD Model Tax Convention as "conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly." [13]

Governments have also devised many measures to avoid the misuse of transfer pricing thanks to these OECD publications, which outline several methods that may be used to assess legitimacy of a given transaction. Exactly there are 5 extensively used methods: The Comparable Uncontrolled Price (CUP) method, The Resale Price method (RPM), The Cost Plus (C+) method, The Profit Split Method (PSM) and The Transactional Net Margin Method (TNMM). The Transactional Net Margin Method is the most commonly used method to verify the correctness of transfer pricing to make sure that it is not case of transport mispricing. Big advantage of this method is that all information necessary for application of this method are freely available from all public and commercial databases. [14]


Solutions include corporate “country-by-country reporting” where corporations disclose activities in each country and thereby prohibit the use of tax havens where real economic activity occurs.[5] Progress is being made in this direction, as documented on a map.[15] Whereas appropriate transfer pricing of tangible goods can be established by comparison with prices charged for similar goods to unrelated parties, transfer pricing of intangible goods, products of intellectual efforts, rarely has comparable equivalents. Transfer prices then have to be established based on expectations of future income.[16] Mispricing is rife.[citation needed] Khadija Sharife and John Grobler, writing for the World Policy Journal,[17] exposed $3.5 billion minimum in transfer mispricing of African diamonds from Angola and DRC, through the use of intra-company valuation, shell companies and tax havens, notably Dubai and Switzerland.

In Sweden (a high-tax country) it was popular in 2005-2010 to have "interest loops", where simple loans or investments were placed between a Swedish company and a tax haven company in both directions, and where the interest rate was mispriced to create a tax deduction in Sweden. This loophole was closed in 2013.


See also

References

  1. ^ "Transfer Pricing". Tax Justice Network. Taxjustice Network. Retrieved 2012-08-09. 
  2. ^ "How transfer mispricing works". The Daily Star. Star Business Desk. 15 July 2012. Retrieved 1 May 2018. 
  3. ^ Juranek, Steffen; Schindler, Dirk; Schjelderup, Guttorm (February 2018). "Transfer pricing regulation and taxation of royalty payments". Journal of Public Economic Theory. 20 (1): 67–84. doi:10.1111/jpet.12260. 
  4. ^ "How transfer mispricing works". The daily star. 2012-07-15. Retrieved 2012-08-09. 
  5. ^ a b Sharife, Khadija (2011-06-18). "'Transparency' hides Zambia's lost billions". Al-Jazeera. Retrieved 2011-07-26. 
  6. ^ Kristina Froberg and Attiya Waris (2011). "Introduction". Bringing the billions back: How Africa and Europe can end illicit capital flight (PDF). Stockholm: Forum Syd Forlag. ISBN 9789189542594. Retrieved 2012-07-26. [permanent dead link]
  7. ^ "Africa losing billions in tax evasion". aljazeera.com. 16 January 2012. Retrieved 18 May 2013. 
  8. ^ Mathiason, Nick (2007-01-21). "Western bankers and lawyers 'rob Africa of $150bn every year'". The Guardian. London. Retrieved 2011-07-05. 
  9. ^ "Africa losing billions in tax evasion". Al Jazeera. 16 January 2012. Retrieved 18 May 2013. 
  10. ^ TOJO, José (16 May 2015). "What is mean by transfer pricing and transfer mispricing? - IndianEconomy.net". Indian Economy. Retrieved 1 May 2018. 
  11. ^ Asongu, S. A. (2015). "Rational Asymmetric Development, Piketty and the Spirit of Poverty in Africa". African Governance and Development Institute. Yaoundé. (No. 15/006). 
  12. ^ Stiglitz, Joseph E. (2007). Making globalization work ([Pbk. ed.]. ed.). New York: W.W. Norton & Co. ISBN 0393330281. 
  13. ^ [http:/dx.doi.org/10.1787/tpg-2017-en "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017"] Check |url= value (help). OECD. Paris: OECD Publishing. 10 July 2017. doi:10.1787/tpg-2017-en. Retrieved 1 May 2018. 
  14. ^ [http:/dx.doi.org/10.1787/tpg-2017-en "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017"] Check |url= value (help). OECD. Paris: OECD Publishing. 10 July 2017. doi:10.1787/tpg-2017-en. Retrieved 1 May 2018. 
  15. ^ Atlas Fiscalisten N.V.: Status of country-by-country reporting in the BEPS-participating countries (OECD and G20), update: February 2, 2016. [1]
  16. ^ Gio Wiederhold (2013): Valuing Intellectual Capital, Multinationals and Taxhavens Chapter 4; Springer Verlag, New York, August 2013.
  17. ^ http://www.worldpolicy.org/journal/winter2013/kimberleys-illicit-process
This page was last edited on 22 September 2018, at 18:28
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