Transfer pricing is a method of pricing goods and services transferred within a multinational company in order to reduce tax burdens and maximise profits for the whole enterprise. It is one of the reasons why globalisation has increased and why operating in more than one territory can be beneficial for firms looking to minimise their overall tax liability. The purpose of transfer pricing is to push profits into territories where either the tax rates are more favourable, or where more loopholes exist to be exploited.
As a response to increasing public concern regarding the practice, and what to what many regarded as a failure or absence of self-regulation, the OECD introduced its Transfer Pricing Guidelines in 1995. These rules provided guidelines on cross-border services, intangibles, costs contribution arrangements and advance pricing arrangements. These were further modified in 2010 to provide guidance on what transfer pricing method would be appropriate in a variety of circumstances. The underlying philosophy is that pricing of transferred resources should reflect how prices might be determined if the parts of the multinational were not connected – which can be summarised as the ‘arm’s length’ principle (ALP).
The first investigated case that tested the ‘arm’s length’ principle in the UK was in 2008, and involved the provision of extended warrantees by Dixons Insurance Services Limited – operating in the Isle of Man - to other members of the same group (including Dixon’s stores, Currys and PC World). It was found that group profits were inflated and that the provision of insurances services within the group was not based on the ‘arm’s length’ principal. (Source: HMRC)
By 2014, over 50 countries had adopted some form of transfer pricing rule based on the ‘arm’s length’ principle. In the wake of considerable media attention (notably focusing on US giants, including Starbucks, Apple, Amazon and Google), the OECD continues to refine its approach and to develop further guidelines, and will complete its review by 2015.
A level playing field
Given that different countries can adopt different rules regarding how they deal with transfer pricing, it may be argued that countries may be tempted to adopt favourable tax rulings to either encourage multinationals to locate in their territory, or to ensure that they continue to locate there. In June 2014 the European Commission opened three investigations to assess whether tax authorities in Ireland, The Netherlands and Luxembourg complied with EU rules on state aid regarding their dealings with three companies - Apple, Starbucks and Fiat Finance and Trade. Under EU rules, tax authorities must not allow companies to pay less tax than they should. Tax advantages are regarded by the EU as state aid, and subject to strict controls.
While rational multinationals will attempt to consolidate their tax liability, and avoid paying ‘double tax’ when they operate in more than one territory, there is increasing concern that transfer pricing can have a negative effect on the pattern of global economic activity, employment and investment. For example, by denying some countries tax revenue, governments may need to raise other taxes (which may be regressive), or borrow (which may increase debt burdens), or simply reduce their spending. Given that public spending is largely on merit goods, public goods and income transfers, the impact is likely to be on the less well off. The UK’s tax collecting department, the HRMC, estimates around 25% (some £8 billion) of the ‘tax gap’- the difference between tax collected and the tax that would be collected if all individuals and companies paid what they should law - is attributable to large firms avoiding taxation through strategies such as transfer pricing.
Of course, multinationals that do practice transfer pricing will argue that although they may pay little profits tax in some territories, they pay income tax and other taxes, and contribute to the economic well-being of an economy in many other ways. Of course, some economists go further by arguing that taxation of any form can distort how markets work and that tax avoidance is simply a rational reaction to excessive tax and large public sectors.