7-day free trial Book a demo
Transfer Pricing: An insight into how it leads to tax avoidance

Transfer Pricing: An insight into how it leads to tax avoidance

Posted by justis1 | 18 May 2015

European regulators are investigating major U.S. firms, including Apple and Starbucks, over how these multi-national businesses allocate their tax dollars internationally. If regulators find that Apple received unfair tax breaks in Ireland and Starbucks received unfair tax breaks in the Netherlands, both companies could be required to pay back the tax dollars they saved. The current case between the two international companies is something practitioners in commercial law, particularly on taxation, as well as students earning an LL.M. in Taxation should be following, especially as it could shape changes for the future.

How Transfer Pricing Works

Filing_cabinet

Transfer pricing allows related companies or company segments to sell something to another related party. When Division A sells a part to Division B, the sales price should be comparable to what the Division A would have charged a non-related entity in the free market. This illustrates the “arms-length” principle, in which the transfer price has to be comparable to the free market price.

Problem No. 1: Unfair Pricing

Some countries follow the Organisation for Economic Co-operation and Development’s (OECD) principles of transfer pricing, which allows companies to set flexible transfer prices based on a number of market variables. Other countries like Brazil let the government set fixed transfer prices without taking variables into consideration. Most of the time, companies get accused of violating the arms-length principle, but some would argue that the Brazilian transfer price structure also violates the arms-length principle. Brazil fixes transfer pricing to achieve its own economic goals instead of being beholden to the market.

The arms-length principle was designed to keep businesses from shifting profits to tax-friendly countries. If Division A in Korea, which has a top corporate tax rate of about 24 percent, sold a part to Division B in the U.S., which has a top corporate tax rate of 39.1 percent, then the company has an interest in recording more of its profit in Korea.

Here’s a sample scenario:

  • The Korean division charges the U.S. $9,000 for a component part.
  • The U.S. division sells the final product for $9,100.
  • The U.S. division reports a profit of $100 in the U.S., which is taxed at a higher rate.
  • The Korean division’s income of $9,000 is charged at a lower rate.

If the Korean component part would sell for $3,000 on the open market, the U.S. company violates the arms-length principle. By shifting the profit to the Korean division, it avoids paying taxes in the U.S.

Problem No. 2: Double Taxation

In principle, graduate students learn, a company should only be taxed once when it creates value for the economy. Transfer pricing can sometimes set businesses up for double taxation:

  • A company located in Korea manufactures a product at a cost of $9,000.
  • A U.S. subsidiary distributes the product in the U.S. at a cost of $1,000.
  • The U.S. subsidiary sets the transfer price at $10,000 and the retail price at $11,000.
  • The product sells for $11,000, netting a $1,000 profit for the Korean company.
  • The U.S. subsidiary shows a profit of $0.

Hypothetically, the Korean company wouldn’t pay tax in the U.S., but it would pay taxes in Korea on the $1,000 profit. If the IRS, however, thinks that the transfer price should have been $9,000 instead of $10,000, the company would then owe taxes on its $1,000 profit in the U.S. in addition to its Korean taxes.

Problem No. 3: Intergovernmental Disputes

In the E.U., countries are supposed to set similar tax rates for corporations. The principle ensures that E.U. members can compete fairly for companies’ business. If Ireland gave Apple a special tax deal, offering it a much lower tax rate than comparable E.U. members, then Ireland has violated the E.U.’s principle of competitiveness by giving Apple a lucrative tax break.

The European Commission, which is the E.U.’s antitrust authority, says that Ireland’s tax break is the equivalent of giving state aid to Apple. If the tax break violated E.U. laws, the state aid was illegal, and Apple would have to pay it back. Also, if the European Commission finds that Apple violated the arms-length principle so that it could shift profits to Ireland, Apple could be in trouble with both the E.U. and the IRS. In 2013, a Senate panel found that Apple had found loopholes in U.S. and Irish tax laws to avoid paying taxes on almost $74 billion.

Balancing Everyone’s Interests

The best transfer pricing policies balance the interests of each country with the interest of the business. Shifting profits to avoid one country’s tax rate isn’t fair, but neither is forcing Apple and Starbucks to pay double taxes on their profits.

Related Blogs

Posted by david-hand | 4th April 2018
A contributing author to Justis, Mukta Balroop, a Chevening Scholar, investigates the impact of online case law services on judgment writing in the Caribbean region, through a series of interviews...
Posted by david-hand | 30th March 2018
In October 2017 we launched the first ever Law & Technology International Writing Competition. The competition drew submissions from students across five continents at world-leading universities, including the University of...
Posted by david-hand | 1st March 2018
Over the past few months law students around the globe have been waiting in anticipation for the final judging. Earlier this year we quietly hand-selected four judges to sit alongside...