Growing Abuse Of
Transfer Pricing By TNCs
By Kavaljit Singh
28 May, 2007
large-scale tax avoidance practices used by transnational corporations
(TNCs) came into public notice recently when the giant drug TNC, GlaxoSmithKline,
agreed to pay the US government $3.4 billion to settle a long-running
dispute over its tax dealings between the UK parent company and its
American subsidiary. This was the largest settlement of a tax dispute
in the US. The investigations carried out by Internal Revenue Service
found that the American subsidiary of GlaxoSmithKline overpaid its UK
parent company for drug supplies during 1989-2005 period, mainly its
blockbuster drug, Zantac. These overpayments were meant to reduce the
company's profit in the US and thereby its tax bill. The IRS charged
the Europe’s largest drugs company for engaging in manipulative
What is transfer pricing?
Transfer pricing is the price charged by one associate of a corporation
to another associate of the same corporation. When one subsidiary of
a corporation in one country sells goods, services or know-how to another
subsidiary in another country, the price charged for these goods or
services is called the transfer price. All kinds of transactions within
the corporations are subject to transfer pricing including raw material,
finished products, and payments such as management fees, intellectual
property royalties, loans, interest on loans, payments for technical
assistance and know-how, and other transactions. The rules on transfer
pricing requires TNCs to conduct business between their affiliates and
subsidiaries on an “arm's length” basis, which means that
any transaction between two entities of the same TNC should be priced
as if the transaction was conducted between two unrelated parties.
Transfer pricing, one of
the most controversial and complex issues, requires closer scrutiny
not only by the critics of TNCs but also by the tax authorities in the
poor and the developing world. Transfer pricing is a strategy frequently
used by TNCs to book huge profits through illegal means. The transfer
price could be purely arbitrary or fictitious, therefore different from
the price that unrelated firms would have had to pay. By manipulating
a few entries in the account books, TNCs are able to reap obscene profits
with no actual change in the physical capital. For instance, a Korean
firm manufactures a MP3 player for $100, but its US subsidiary buys
it for $199, and then sells it for $200. By doing this, the firm’s
bottom line does not change but the taxable profit in the US is drastically
reduced. At a 30 per cent tax rate, the firm’s tax liability in
the US would be just 30 cents instead of $30.
TNCs derive several benefits
from transfer pricing. Since each country has different tax rates, they
can increase their profits with the help of transfer pricing. By lowering
prices in countries where tax rates are high and raising them in countries
with a lower tax rate, TNCs can reduce their overall tax burden, thereby
boosting their overall profits. That is why one often finds that corporations
located in high tax countries hardly pay any corporate taxes.
A study conducted by Simon
J. Pak of Pennsylvania State University and John S. Zdanowicz of Florida
State University found that US corporations used manipulative pricing
schemes to avoid over $53 billion in taxes in 2001. Based on US import
and export data, the authors found several examples of abnormally priced
transactions such as toothbrushes imported from the UK into the US for
a price of $5,655 each, flash lights imported from Japan for $5,000
each, cotton dishtowels imported from Pakistan for $153 each, briefs
and panties imported from Hungary for $739 a dozen, car seats exported
to Belgium for $1.66 each, and missile and rocket launchers exported
to Israel for just $52 each.
With the removal of restrictions
on capital flows, manipulative transfer pricing has increased manifold.
According to UNCTAD’s World Investment Report 1996, one-third
of world trade is basically intra-firm trade. Because of mergers and
acquisitions, intra-firm trade, both in numbers and value terms, has
increased considerably in recent years. Given that there are over 77,000
parent TNCs with over 770,000 foreign affiliates, the number of transactions
taking place within these entities is unimaginable. Hence, it makes
the task of tax authorities extremely difficult to monitor and control
each and every transaction taking place within a particular TNC. The
rapid expansion of Internet-based trading (E-commerce) has further complicated
the task of national tax authorities.
Not only do TNCs reap higher
profits by manipulating transfer pricing: there is also a substantial
loss of tax revenue to countries, particularly developing ones, that
rely more on corporate income tax to finance their development programs.
Besides, governments are under pressure to lower taxes as a means of
attracting investment or retaining a corporation’s operation in
their country. This leads to a heavier tax burden on ordinary citizens
for financing social and developmental programs. Although several instances
of fictitious transfer pricing have come to public notice in recent
years, there are no reliable estimates of the loss of tax revenue globally.
The Indian tax authorities are expecting to garner an additional US$111
million each year from TNCs with the help of new regulations on transfer
pricing introduced in 2001.
In addition, fictitious transfer
pricing creates a substantial loss of foreign exchange and engenders
economic distortions through fictitious entries of profits and losses.
In countries where there are government regulations preventing companies
from setting product retail prices above a certain percentage of prices
of imported goods or the cost of production, TNCs can inflate import
costs from their subsidiaries and then charge higher retail prices.
Additionally, TNCs can use overpriced imports or underpriced exports
to circumvent governmental ceilings on profit repatriation, thereby
causing a drain of foreign exchange. For instance, if a parent TNC has
a profitable subsidiary in a country where the parent does not wish
to re-invest the profits, it can remit them by overpricing imports into
that country. During the 1970s, investigations revealed that average
overpricing by parent firms on imports by their Latin American subsidiaries
in the pharmaceutical industry was as high as 155 per cent, while imports
of dyestuff raw materials by TNC affiliates in India were overpriced
in the range of 124 to 147 per cent.
Given the magnitude of manipulative
transfer pricing, the Organization for Economic Co-operation and Development
(OECD) has issued detailed guidelines. Transfer pricing regulations
are extremely stringent in developed countries such as the US, the UK,
and Australia. In the US, for instance, regulations related to transfer
pricing cover almost 300 pages, which dent the myth that the US espouses
“free market” policies.
However, developing countries
are lagging behind in enacting regulations to check the abuse of transfer
pricing. India framed regulations related to transfer pricing as late
as 2001. However, many countries including Bangladesh, Pakistan, and
Nepal, tax authorities have yet to enact regulations curbing the abuse
of transfer pricing mechanisms. The abuse of transfer pricing mechanisms
could be drastically curbed if there is an enhanced international coordination
among national tax authorities.
Kavaljit Singh is Director, Public Interest Research
Centre, New Delhi. The above article is based on his latest report,
Why Investment Matters: The Political Economy of International Investments
(FERN, The Corner House, CRBM and Madhyam Books, 2007). The full report
could be downloaded from: http://www.thecornerhouse.org.uk/pdf/document/Investment.pdf
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