Transfer Pricing

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Transfer Pricing


Tax avoidance by multinational companies poses a serious problem for governments. Governments began to grow aware of eroding tax bases as multinational business expanded in the late 1960s. Since tax systems differ from country to country, multinational companies can reduce their tax burden by shifting profits to countries with relatively low tax rates.

Transfer pricing is one method of tax avoidance. A transfer price is a price used for transactions among affiliates. Multinational companies can move income among affiliates located in different countries by manipulating the transfer price used in intrafirm transactions. For example, suppose a parent company in the United States sells goods to a subsidiary in Germany. Suppose also that the corporate tax rate in the United States is higher than the corporate tax rate in Germany. Assuming that a multinational company maximizes joint after-tax profits earned in the two countries, the company reduces its tax payments by using a lower transfer price. A lower transfer price allocates less profit to the United States parent company and more profit to the German subsidiary. The transfer pricing benefits the company via increased after-tax profit. However, the U.S. government suffers a decrease in tax revenue.

Tax avoidance, as outlined above, has also been brought to the publics attention as an equity issue. Domestic companies are subject to higher effective corporate tax rates when compared to multinational companies. Domestic companies are not able to manipulate their profits, as multinational companies do, for tax-saving purposes.

Corporate tax laws address illegitimate income allocation among a companys related affiliates. For example, in the United States, Section 482 of the Internal Revenue Code regulates income allocation among affiliates. Many countries employ similar regulations on this type of transaction among affiliates. These regulations require companies to use the so-called arms length price for the purpose of filing a tax return. The arms length price is defined as the transfer price that would have been used if the intrafirm transaction took place between nonassociated parties in the market. However, determining the arms length price is not straightforward, especially when transactions involve intangibles and services.

In 1991 the Advanced Pricing Agreement (APA) was introduced by the U.S. Internal Revenue Service to resolve disputes associated with determining the arms length price. The purpose of the APA is to allow taxpayers and tax authorities to reach a consensus regarding the arms length price before taxpayers file a tax return. The APA has been extended to the Bilateral Advanced Pricing Agreement (BAPA), which aims to coordinate the confirmation of the arms length price between two countries. The necessity of coordination results from efforts to eliminate international double taxation, which occurs when tax authorities in each jurisdiction apply a different arms length price.

Transfer pricing can also occur when transactions between affiliates take place in the same country, though the term usually refers to tax evasion across national borders. The United States has a long history of regulating transfer prices, since transfer price manipulation allows companies to allocate income among affiliates located in different states. Regulation pertaining to interstate transaction dates back to 1928.

The U.S. government has been leading transfer pricing discussions in the Organisation for Economic Cooperation and Development (OECD), an international organization that coordinates tax policies across countries. The OECD has made several proposals for transfer pricing solutions, one being the Model Tax Convention on Income and on Capital. Providing an outline when two countries enter into a tax treaty, the Model is a suggestion and is not legally binding. The first draft was published in 1963, and the committee on fiscal affairs accepted it in 1977. Since then, the contents of the Model have been periodically updated.

Tax legislation for multinational businesses prompted numerous studies as it became one of the critical policy issues presented by economic globalization. The earlier literature of the 1970s and 1980s tried to provide a theoretical framework for the decision making of multinational companies under different tax rates across countries. The literature demonstrated that multinational companies could increase global income by shifting their profits to lower-taxed jurisdictions by transfer price manipulation. While it is clear that the mechanism of transfer pricing can serve as an arbitrage device to reduce the tax burden of companies, these studies treated tax policies as exogenous.

The literature of the 1990s studied policy planning as it applied to a less-informed government that was attempting to regulate tax evasion. Transfer pricing information is private and generally beyond government control. The literature proposed an analysis of mechanism design using a principal-agent model. The question posed was how to implement tax policies that induce appropriate transfer prices from multinational companies.

The policy concern became one of efficiency loss rather than information constraints after the introduction of the APA and BAPA. The literature in the early 2000s argues that the BAPA system causes efficiency losses since multinational companies, while integrated under common control, cannot internalize the costs of intrafirm transactions. The BAPA separates the profits earned by two different affiliates within the same company for the purposes of imposing taxes in each country. Corporate profits (and tax revenue) will, consequently, be lower.

SEE ALSO Markup Pricing; Taxes; Transaction Taxes


Organisation for Economic Co-operation and Development. 2001. Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Paris: Author.

Tomohara, Akinori. 2004. Inefficiencies of Bilateral Advanced Pricing Agreements (BAPA) in Taxing Multinational Companies. National Tax Journal 57 (4): 863873.

Akinori Tomohara

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Transfer Pricing

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