Transfer Pricing

Transfer pricing is one of the most important issues in international tax.

Transfer pricing happens whenever two related companies – that is, a parent company and a subsidiary, or two subsidiaries controlled by a common parent – trade with each other. This happens when, for instance, a US-based subidiary of Coca-Cola buys something from a French-based subsidiary of Coca-Cola. When the parties establish a price for the transaction, they are engaging in transfer pricing.

Transfer pricing is not, in itself, illegal or abusive. What is illegal or abusive is transfer mispricing, also known as transfer pricing manipulation or abusive transfer pricing. (Transfer mispricing is a form of a more general phenomenon known as trade mispricing, which includes trade between unrelated or apparently unrelated parties - an example is reinvoicing.)

It is estimated that about 60 percent of international trade happens within, rather than between, multinationals: that is, across national boundaries but within the same corporate group. Suggestions have been made that this figure may be closer to 70 percent.Estimates vary as to how much tax revenue is lost by governments due to transfer mispricing. Global Financial Integrity in Washington estimates the amount at several hundred billion dollars annually. A March 2009 Christian Aid report estimated $1.1 trillion in bilateral trade mispricing into the EU and the US alone from non-EU countries from 2005 to 2007. The Magnitudes ” section of our website contains a range of estimates and data.

Mispricing and the Arm’s length principle.

If two unrelated companies trade with each other, a market price for the transaction will generally result. This is known as “arms-length” trading, because it is the product of genuine negotiation in a market.  This arm’s length price is usually considered to be acceptable for tax purposes.

But when two related companies trade with each other, they may wish to artificially distort the price at which the trade is recorded, to minimise the overall tax bill. This might, for example, help it record as much of its profit as possible in a tax haven with low or zero taxes.

For example, take a company called World Inc., which produces a type of food in Africa, then processes it and sells the finished product in the United States. World Inc. does this via three subsidiaries: Africa Inc. (in Africa), Haven Inc. (in a tax haven, with zero taxes) and America Inc. (in the United States).

Now Africa Inc. sells the produce to Haven Inc. at an artificially low price, resulting in Africa Inc. having artificially low profits – and consequently an artificially low tax bill in Africa. Then Haven Inc. sells the product to America Inc. at a very high price – almost as high as the final retail price at which America Inc. sells the processed product. As a result, America Inc. also has artificially low profitability, and an artificially low tax bill in America. By contrast, however, Haven Inc. has bought at a very low price, and sold at a very high price, artificially creating very high profits. However, it is located in a tax haven – so it pays no taxes on those profits.

What has happened here? This has not resulted in more efficient or cost-effective production, transport, distribution or retail processes in the real world. The end result is, instead, that World Inc. has shifted its profits artificially out of both Africa and the United States, and into a tax haven. As a result, tax dollars have been shifted artificially away from both African and U.S. tax authorities, and have been converted into higher profits for the multinational.

This is a core issue of tax justice – and unlike many issues which are considered to be either “developing country” issues or “developed country” issues – in this case the citizens of both rich and poor nations alike share a common set of concerns.  Even so, developing countries are the most vulnerable to transfer mispricing by multinational corporations.