Taxing global firms

The right price

How multinationals and related firms calculate their internal global transactions for tax purposes is always under scrutiny, and even more so since the start of the crisis. The widely accepted way is to compare the value of those transactions with similar real market transactions. This arm’s length approach has its critics and competition is brewing. Here are the pros and cons.

Albert Einstein said the hardest thing in the world to understand is income tax. Though that may be true, spare a thought for the taxation of multinationals operating in several countries at once. Major global firms, such as Volkswagen and Apple, trade among their related constituent firms, rather as separate firms do. Volkswagen Mexico, for instance, may make a car transmission based on a patent owned by VW Germany and then sell the component to VW USA, which assembles and sells the finished vehicle in the US.

The magnitude of such cross-border transactions among related companies is huge: according to a recent UN report, it may account for more than 30% of all international transactions and appears to be growing steadily. And just as for trade between separate unrelated firms, those transactions are subject to tax. However, as the valuations assigned to their “internal” transactions are not prices set outside on the open market, they must be defined by applying corresponding prices from the marketplace. These “transfer prices” form the basis of the OECD and UN-supported model for taxing cross-border transactions among related enterprises, and few people would dispute their potential complexity.

They are controversial too, because they determine the allocation of taxable income among different jurisdictions in a world where neither governments nor enterprises wish to be out of pocket. The rules for transfer pricing are based on the arm’s length principle, which means that for a cross-border transaction between related entities (in the same global firm, for instance), the parties should use the same price as two unrelated parties for a similar transaction under similar conditions in the external marketplace. The principle is elegantly simple in theory, but is more complex in practice. What if similar trades in a poor local market are priced lower than trades taking place within a major sophisticated firm? Some argue that such a situation puts corporations and their well-trained accountants at an advantage by allowing them to use transfer prices that are either too high or too low to shift income to tax-favourable locations. Authorities, particularly in developing economies, sometimes feel obliged to accept the prices the companies establish, and may forgo significant tax revenues as a result. Some believe that to avoid the income shifting that can result from mispricing transactions, the arm’s length principle should be replaced by a simpler mechanism. Are they right?

“Arm’s length transfer pricing is not so much legally complex as it is factually complex,” says Joe Andrus, head of the OECD’s Transfer Pricing Unit. The principle relies on the identification of appropriate market comparables, which can demand a substantial amount of time and data to identify. In some cases, independent comparables may simply not exist, as some transactions would not be replicated in any normal market, particularly complex transactions involving specialised know-how and other “intangibles”. For example, a company might not license the patent protecting its most important product to a potential competitor, but may license that patent to an affiliate in a tax-favourable jurisdiction as part of structuring its business operations. In such situations, finding the right royalty for the licence in the absence of comparable transactions can be very challenging.

Understanding and applying the arm’s length principle also absorbs administrative capacity, which can be challenging for developing countries. There may be a lack of auditors with appropriate expertise or experience, and inadequate enforcement mechanisms and inadequate–or even non-existent–transfer pricing legislation. “These can all be pretty big hurdles to get over,” says Mr Andrus.

No surprise, therefore, that some critics call for replacing arm’s length transfer pricing with a simpler approach that would take 100% of a multinational’s income and allocate it according to a formula based on indicators of where its economic activity really took place, how much revenue was made, what the payroll is, and so on. The system of income allocation used by US states is widely cited as the successful example of this type of approach. However, says Mr Andrus, “The US system has almost 80 formulas for 50 states and leads to double taxation. This is not a huge problem simply because the state tax rates are low.” But if each national jurisdiction adopted its own formula, this would inevitably lead to problems of multiple taxation. And taxing the same corporate income more than once distorts investment decisions and the flow of income.

To avoid this, Mr Andrus says, all countries would need to adopt the same formula, which is “an unlikely scenario, given their competing economic interests.” Countries would also need to adopt a consistent measure of corporate accounting income as a base for the formula. “Without consistency,” he says, “double taxation would be inevitable and there would be no way to resolve disputes.”

In contrast, the arm’s length principle has been proven to work effectively in the great majority of cases and to be the most promising approach for minimising both double taxation and double “nontaxation”. So rather than discarding it, the OECD, the UN and other organisations have focused on ways of simplifying the arm’s length system for all countries and addressing the challenges faced by poorer countries, and in those specific situations where the arm’s length principle is difficult to apply, finding practical solutions that can be accepted consistently by countries. One promising approach for some situations involves “safe harbour” arrangements that allow companies to declare a minimum amount of income in a country and to enter into agreements with other countries so that they are not double-taxed on those transactions. “This type of approach does not require as much legal or factual sophistication and holds real promise in specific situations where the activity in a country is a routine one,” notes Mr Andrus. He points to countries such as Viet Nam and Costa Rica, whose developing textile industries manufacture clothing for big producers in industrialised countries. “All of these sewing operations are largely doing the same kinds of things, involving the performance of routine services. In this type of situation, it should be possible, based on economic data for a country, to agree to accept the cost of performing the services plus, say, a 5% or 10% markup as an appropriate price for the services, and to have that result accepted both in the country where the manufacturing takes place and in the country where the purchaser is located.” In May 2013 the OECD issued new guidance on the safe harbour approach.

Training is another area that can give support, and the OECD conducts training seminars for tax administrators of developing countries at locations around the world each year. In addition, a joint OECD/UN transfer pricing manual designed for developing countries has recently been launched.

Dialogue is important, and beginning in 2012 the OECD, under the auspices of the Global Forum on Transfer Pricing, held an annual conference on transfer pricing issues—bringing together both developed and developing country tax administrators. The issues they address are very current. For example, one of the key recommendations in the OECD’s base erosion and profit shifting (BEPS) action plan released in July is a more consistent mechanism for reporting to all countries, where relevant, the income that a company earns in each country and the amount of tax that it pays in each country.

Such transparency would give developing countries more information about the economic activities of multinational enterprises outside their territory, providing another tool for more effective transfer pricing benchmarks that tax officials, as well as Einstein, would understand. Gerri Chanel

For more on transfer pricing, contact Joe Andrus at the OECD.


Neighbour, John (2002), “Transfer pricing: Keeping it at arm’s length,” in OECD Observer No 230, January.

OECD (2013), Revised Section E on Safe Harbours in Chapter IV of the Transfer Pricing Guidelines, OECD Publishing

OECD (2012), Dealing Effectively with the Challenges of Transfer Pricing, OECD Publishing

OECD (2013), Action Plan on Base Erosion and Profit Shifting, OECD Publishing

United Nations (2013), United Nations Practical Manual on Transfer Pricing for Developing Countries, United Nations, New York


© OECD Observer No 295 Q2 2013

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