In recent days the Tax Gap series of articles has identified secrecy, complex organisational structures, tax havens and profit hungry accountancy firms as the key ingredients of the tax avoidance industry. They all come together in the biggest tax avoidance scheme of all, known as "transfer pricing". The name of the game is to shift profits to low tax jurisdictions and avoid taxes in countries where corporations have substantial trading operations.
Globalisation has enabled a computer microchip company to design its products in country A, manufacture in B, test in C, hold patents in D and assign marketing rights to a subsidiary in country E. Such a structure gives corporations huge discretion in allocating costs to each country and shift profits through internal trade. Around 60% of the world trade consists of transfers internal to multinational corporations. This gives them numerous opportunities for shifting profits across borders.
There are international rules on transfer pricing, but they all rely on notions of "costs" which are highly malleable. Tax rules require companies to use "arm's length" or normal commercial prices to transfer goods and services, but such prices are not always easy to find. Many markets are thin and often dominated by the same multinationals.
Transfer pricing is also big business. Ernst & Young, a major accountancy firm, markets its services with the statement that (see page 81 of this report) "successfully managing business and tax issues related to transfer pricing involves much more than documentation compliance. Transfer pricing affects almost every aspect of an MNE and can significantly impact its worldwide tax burden. Our ... professionals help MNEs address this burden ... with leading solutions. Our multidisciplinary team helps MNEs develop transfer pricing strategies, tax effective solutions, and controversy management approaches that best fit their objectives."
Tax authorities believe that multinationals manipulate the import and export prices to avoid taxes. China is an interesting case. It has enticed foreign capital by offering low taxes and other incentives. Foreign Direct Investment (FDI) has flooded in. Despite the perks, over 70% of multinational companies claim to be making losses. If so, why do they insist on making investment in China?
Christian Aid (pdf) estimates that developing countries may be losing over US$160bn of tax revenues a year, primarily through transfer pricing strategies. As a result, governments are unable to provide security, healthcare, education, sanitation facilities, clean water, transport and other essentials. Millions of people are sent to premature death.
Rather than giving credence to prices cooked up by companies, tax authorities should develop their own benchmarks. A related approach is a system of "formulary apportionment" where companies are taxed on the basis of their economic activity and income within a particular geographic jurisdiction rather than arbitrary allocation of costs to geographical areas.
Tax authorities lack the resources to combat the tax avoidance industry. Ernst & Young alone employs over 900 professionals to sell transfer pricing schemes. The US tax authorities employ about 500 full-time inspectors to pursue transfer pricing issues and Kenya can only afford between three and five tax investigators for the whole country.
Governments need to mobilise the public. Companies should be required to publish a table showing their sales, purchases, profits, assets, liabilities, taxes and employees in each country of their operations. Upon seeing that there are substantial sales and little profit, or large profit and very few employees in a jurisdiction, the public would know that some transfer pricing games have been played. Corporate tax returns should be publicly available. Companies should publish details of transfer prices actually used. The public may be horrified to learn that companies have priced (pdf) flash bulbs at $321.90 each, pillow cases at $909.29 each and a ton of sand at $1993.67, when the average world trade price was 66 cents, 62 cents and $11.20 respectively. Armed with this information people can decide to boycott the exploitative companies. Those devising abusive pricing structures should be held personally liable.
Cif editor's note: This article was published with comments off because of potential legal issues which might arise. Where possible, articles on this topic will be opened to comment during office hours. For those who want to follow all the developments in the Tax Gap series, please follow our tax blog.
