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TAX NEWS - 2010

Transfer Pricing As Tax Avoidance

Multinational companies should be made to pay taxes on foreign profits.
Newspapers use the phrase "transfer pricing" as shorthand for multinational corporations shifting profits to tax havens to avoid tax in developed countries.

Tax professionals bristle at this characterization, arguing that transfer pricing is a neutral phrase to describe the process by which profits are allocated among different jurisdictions as though corporate affiliates were separate economic actors transacting with each other at arm's length.

The newspapers are correct. The members of large multinational groups of corporations are not separate economic actors. The point of vertical integration is not to have to pay arm's-length prices for some goods and services. It is a fool's errand to try to divine arm's-length prices for intragroup transactions, particularly for valuable intellectual property (IP) that is never licensed to outsiders.

Financial accounting ignores affiliates and treats the corporate group as a single entity. But the federal income tax law treats affiliates as separate economic acdtors, giving multinationals free rein to determine where their profits should be taxed, or more likely, not taxed.

Multinationals report vast profits in tax havens like the Cayman Islands, Luxembourg, Switzerland and Ireland. Economists have documented massive shifts of multinational corporations' profits to tax havens, in amounts wildly out of proportion to any economic activity taking place there. Some income is not taxed anywhere. Americans call it "nowhere income." Europeans call it "white income."

The Guardian and Bloomberg have published extensive, well-researched stories--complete with pictures laymen can understand--describing the process by which multinationals succeed in minimizing taxes in countries in which they do business.

Suppose a U.S. multinational wants to sell high-margin Chinese-made products to German customers. The multinational puts its IP in a tax haven, and requires its Chinese manufacturing affiliate to pay royalties. It converts its German distributor to a stripped-risk intermediary called a commissionaire to limit what would otherwise be sales margins taxable in Germany. Those profits are booked to a principal company in a European haven as compensation for assuming inventory risk. No profits are taxed in the United States, and little in Germany.

How did we get here? The United States imposed the so-called "international consensus" on the taxation of multinational corporations on Europe 50 years ago, and will not back away from it, even though the government is losing tax revenue. This bad system has survived due to congressional cravenness in the face of multinational corporations arguing that competitiveness depends on not paying taxes.

Nonetheless, the international consensus is under attack on several fronts. The BRICs are not playing along. India has put the United States on notice that it will not sign another tax treaty. Brazil, like most of South America, refuses to sign a tax treaty with the United States or administer its tax laws the way U.S. multinationals would wish.

Non-governmental organizations argue that transfer pricing deleteriously affects the budgets of developing countries that lack the administrative resources to fight with well-represented multinationals. Christian Aid estimates that developing countries lose $160 billion of tax revenue annually to transfer pricing.

But the most convincing blow has come from inside the OECD, from Europe itself. The European Commission, the executive arm of the European Union, is developing the common consolidated corporate tax base (CCCTB) for Europe -- a system of combined reporting and formulary apportionment of income modeled on the system used by American states for 100 years.

Who is left to defend transfer pricing? The OECD bureaucracy and American multinationals are locked in a codependent relationship that benefits both to the detriment of the federal budget. American tax professionals profit from the present system. The U.S. government throws on ineffectual fixes, while cutting secret deals with multinationals. Occasionally the government drags a multinational into court and loses badly.

Separate-company accounting appears to make logical and theoretical sense on paper. But in practice, it is unworkable. The quest for the perfect economic answer--the stated goal of separate company accounting -- is a pointless exercise that serves only to guarantee employment for economists.

There is no perfect answer for assignment of multinationals' income to specific tax jurisdictions. The law should recognize this fact and move toward a system that is fair and administrable. The international consensus is neither. Formulary apportionment, as the Europeans have recognized, is the fairest multilateral approach.

IP migration to tax havens is the biggest problem in transfer pricing, enabling pharmaceutical and software companies, among others, to minimize tax in their markets. IP is the largest component of the value of most multinationals. Most IP has already been sent to tax havens, so that the associated royalty income can be booked there.
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