International trade is one of the pillars of globalisation and one of the jobs of customs officers is to help trade contribute to socio-economic development by making sure that goods flow efficiently across borders. Ensuring that customs duties are collected in a fair, effective, and efficient manner is a major part of this task. But it is one that is complicated by certain trends shaping the international economy, including the emergence of global value chains (GVC) and the fact that a significant amount of the movement along GVC is intra-firm trade between the different parts of multinational enterprises.
It’s hard to say precisely how much of world trade occurs within multinational enterprises, since apart from the United States, countries do not collect the data needed to measure it precisely. Figures for the United States put intra-firm trade at nearly half of goods imports and nearly a third of goods exports. Partial data for 9 countries analysed in an OECD paper suggest that intra-firm exports of foreign affiliates represent 16% of total exports. Adding the exports of parent companies to their affiliates abroad suggests a figure of one third, as measured in US trade statistics.
When a firm is in effect selling something to itself, the price is called a “transfer price”. The transfer price used will have the effect of allocating profits among the different parts of the company, which in turn will determine how much tax the multinational pays and in which country. Most countries require that the transfer price is calculated based on “the arm’s-length principle”. Broadly, this means that operations should be priced by comparing them with similar operations carried out on a commercial basis at market prices, as if the parties were independent entities – at arm’s length from one another.
This can be a lot more complicated than it sounds, and the OECD has produced Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations on the application of the arm’s length principle. Customs officials are also interested in the price of goods sold across international borders within MNEs, and the World Trade Organization’s Valuation Agreement sets out the methodology for establishing the customs value used to calculate customs duties. The Agreement provides tests for ensuring that the price is set as if the parties were not related and had been negotiated under normal business conditions. So, while there are differences between the rules for customs valuation and transfer pricing, both aim at essentially the same goal, and therefore the information found in the transfer pricing documentation supplied by companies to tax authorities could also be useful for the customs authorities. Similarly, customs valuation information could be useful for tax authorities.
At the end of April, the World Customs Organization (WCO) announced a new instrument adopted by the Technical Committee on Customs Valuation (TCCV) that will help customs officials take into account transfer pricing information in the course of verifying that the tests set out in the WTO Valuation Agreement are met. This also helps a firm where they have already calculated the transfer price for the tax authorities, and the information provided may be helpful in demonstrating that the declared import price of a related-party transaction is not influenced by that relationship.
The TCCV instrument, which is based on a case study, can be downloaded on line. In the study, XCO, a manufacturer in country X, sells relays to its wholly-owned subsidiary, ICO, a distributor in country I. ICO imports the relays and does not purchase any products from sellers unrelated to its parent company. Likewise, XCO does not sell relays or similar goods to unrelated buyers. So how do you work out whether ICO and XCO were buying and selling at a “real” price and not one influenced by the fact that XCO and ICO are related? In the case study, the answer is found by using the company’s transfer pricing study, based on the Transactional Net Margin Method. What that means here is comparing ICO’s operating margin with those of similar, but unrelated companies doing similar business in the country.
In the case study, ICO’s operating profit margin fell within the range of those earned by the eight comparable unrelated distributors used in the transfer pricing study. ICO’s operating expenses were judged to be acceptable too, since they were paid to unrelated companies. The case study concludes then that “the relationship between the parties did not influence the price”. The conclusion notes that the use of a transfer pricing study for examining the circumstances surrounding the sale must be considered on a case-by-case basis. The case will be published in the WCO Valuation Compendium, subject to approval by the WCO Council in July 2016.
Mr. Kunio Mikuriya, WCO Secretary-General, has congratulated the Technical Committee on the work achieved: “This new instrument is an important step for the WCO and demonstrates its relevance by providing guidance on the management of Customs valuation in an increasingly complex trade landscape, whilst maintaining consistency and strengthening co-operation with tax authorities.”
The OECD provided input to the TCCV discussions and like the WCO, is encouraging closer co-operation between customs and tax authorities. “ This will be increasingly important in a global environment” said Pascal Saint-Amans, Director of the OECD Centre for Tax Policy and Administration. “As a result of the OECD’s Base Erosion and Profit Shifting (BEPS) project, more and more countries are applying transfer pricing rules, and those rules are becoming stronger and more sophisticated, in particular with regards to the treatment of risks and intangibles, rather than just tangible goods”.
Companies, customs, and tax authorities all stand to gain from this in making a system that is fairer, more predictable, and more efficient.
Customs Environment Scan Tadashi Yasui, WCO Research Paper 31, 2014
Queen Elizabeth sent her first email long before you did. I got that from one of those sites giving details of this day in history, according to which she sent it on March 26th 1976 from the Royal Signals and Radar Establishment. (The Ministry of War used real names in those days, whereas now RSRE is part of something that calls itself QinetiQ.) Anyway, I was looking to find some great OECD-related anniversary that I could write about (the first lip reading tournament held in America?) to justify not reporting on the Annual International Meeting on Transfer Pricing under the auspices of the Tax Treaty and Transfer Pricing Global Forum being held here today and tomorrow.
Transfer pricing is important and interesting, it’s just that, as Brian Atwood, chair of the OECD Development Assistance Committee noted in this post the other day, it’s one of those subjects that’s “founded on concepts that are both technically demanding and arduous to understand and implement”. In fact, delegates to the meeting will be working on how to simplify and streamline the process, since even the experts admit that the rules are complex.
So what is transfer pricing and why does it matter?
Around 60% of world trade actually takes place within multinational enterprises, for example the headquarters in the US paying a subsidiary in India to carry out research or manufacture components. This payment is a transfer price. Transfer prices are used to calculate how profits should be allocated among the different parts of the company in different countries, and are used to decide how much tax the MNE pays and to which tax administration.
They’re also useful to the company itself first, because they can avoid being taxed twice if the various countries they are active in have signed agreements with each other on how to tax MNEs. In most cases, these are based on the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
In many cases, they’re calculated using a technique with the deceptively simple name of “the arm’s-length principle”, although some countries, notably Brazil, use other methods. The ALP states that operations should be priced by comparing them with similar operations carried out on a commercial basis at market prices, as if both parties were independent entities – at arm’s length from one another.
In practice, this can be extremely difficult, particularly in developing countries. For instance, the developing country subsidiary may be the only firm in its particular line of business, so there’s nobody to compare with. Likewise, transactions involving high value-added services or intangible assets like intellectual property may be unique. And in many countries, publicly available information that the tax authorities can use is limited.
Given that there is no simple method for calculating a transfer price, the final value is the result of a negotiation between the company and the tax authority. In an ideal world, this would be based on equal access to information, a shared objective and a “zero sum game” where being taxed in one jurisdiction is offset by an exemption in another.
Of course it doesn’t work like that. Companies want to pay as little tax as possible and governments need tax revenue. There’s a whole international business whose goal is to help companies “manage the level of taxes paid on a global basis at a competitive level” as PwC put it in their prospectus. These international consultancies have more people working on transfer pricing than any national tax authority. Writing in The Guardian, Prem Sikka of Essex Business School, co-author of a paper on The Dark Side of Transfer Pricing, claims that “Ernst & Young alone employs over 900 professionals to sell transfer pricing schemes. The US tax authorities employ about 500 full-time inspectors to pursue transfer pricing issues and Kenya can only afford between three and five tax investigators for the whole country.”
The meeting at the OECD coincides with an initiative from The International Tax Review to ask tax practitioners to vote for who they think are the leading forces in global transfer pricing development. Apart from PwC, there are NGOs like ActionAid, MNEs like GlaxoSmithKline, and multilateral agencies and international organisations, including the OECD. You can vote here.
The OECD Observer has good articles explaining transfer pricing in more detail: