When businesses operate in multiple countries, they regularly provide products and services to themselves. This can happen in the normal order of business where a large manufacturer has subsidiaries in different countries each making component parts of a larger product. For instance, a German manufacturer could have subsidiaries in Slovakia and Poland that make parts used in a product that is assembled in Germany.
For tax purposes, what price should the Slovakian and Polish subsidiaries charge for the products sold to the German assembly plant? In a sense this would be like your right hand selling a service to your left hand. Without a guide to what the price should be or what the tax consequences of that transfer are, the intracompany trade could sit in a gray area.
This is where the tax concept of transfer pricing comes in. Because intracompany transactions are not priced on the market, there are standards for determining what price the Polish or Slovakian subsidiary should charge the parent company in Germany. These rules exist because there can be strong incentives for companies to inflate the prices of goods and services sold across borders, especially when there is a huge difference between the corporate tax rates in different countries.
After accounting for municipal trade taxes, the combined corporate income tax rate in Germany is nearly 30 percent. In Poland the rate is 19 percent and in Slovakia it is 21 percent. The German headquarters can generally deduct the costs for products it buys from its foreign subsidiaries and lower its taxable profits in Germany. If the company could choose whatever price it wants, then it would likely choose to inflate the real costs of the inputs, thus shifting the taxable profits from Germany to Poland or Slovakia, where the profits are taxed at lower rates.
This behavior can happen with many different types of cross-border transactions, and governments have taken measures to limit businesses from mispricing products and services that they sell to themselves. These transfer pricing regulations outline the steps that businesses should take to show that their intracompany transactions are priced appropriately. The foundation for transfer pricing is what is called the “arm’s length principle.”
Following this principle means that prices for transactions within a multinational group of companies should be determined as if the transaction were between two independent entities. In many cases, the arm’s length price is a contrived market price for the transaction. When a tax authority disputes the price that a company has set for a transfer, the company can lay out its reasoning that resulted in that price. Further adjudication can be necessary if the tax authority does not accept the price that the company determined.
For intangible assets, the issues already discussed can become even more challenging. While a company may be able to find comparable transactions for intra-company sales of tangible assets, intangible assets like brands, patents, and software can have very few or no comparable transactions. This makes the challenge of ascertaining the arm’s length price difficult both for the company and for the tax authority that may dispute that price.
Businesses already have incentives to locate income from intangibles in lower tax jurisdictions or in countries with preferential regimes for intellectual property. The challenge of pricing intra-company sales and use of intangibles therefore presents an additional challenge to taxing income from these assets.
Adjudicating transfer pricing disputes between countries and companies can be quite challenging. According to OECD statistics, in 2017 transfer pricing disputes took 30 months on average to resolve. While during that same year the number of transfer pricing cases closed exceeded cases started, the lengthy resolution process adds compliance costs to businesses and administrative costs to governments.
In the 2015 report “Aligning Transfer Pricing Outcomes with Value Creation,” the OECD pointed out some of the specific challenges that intangible assets pose for transfer pricing. The report presented revised guidance for applying transfer pricing in the context of intangible assets. The recommendations include focusing on facts beyond the owners of the assets, including where the valuable activities associated with the asset take place, and allocating income to the most important economic activities.
Both prior to the OECD report and in years since, many countries have introduced regulations to more directly manage the tax consequences of transfer pricing. These regulations can include requirements for documentation, specific methods for determining the arm’s length price, and penalties for noncompliance.
In effect, the regulations require companies to justify more consistently and clearly how they determined the price at which they would be providing themselves a product or service. These regulations can partially reverse the activities that businesses previously undertook to minimize their tax burden through transfer pricing. Directly increasing the tax burden on multinational businesses can have measurable results. These results can include impacts on revenue and business investment (including foreign direct investment [FDI]).
Research from 2013 by economist Molly Saunders-Scott shows that transfer pricing regulations reduce the reported profits in foreign subsidiaries of multinationals, leading to more reported profits in the headquarters country. However, in cases where reported profits in foreign subsidiaries are not related to profit shifting, the transfer pricing regulations lead to an increase in compliance costs without shifting the tax burden to the headquarters country.
Another paper from 2013 by economists Theresa Lohse and Nadine Riedel suggests significant impacts of transfer pricing regulations in the European context. They find reduction in profit shifting by multinationals as high as 50 percent following the introduction of transfer pricing regulations. Although they note that stricter transfer pricing rules are not only more likely to have any impact on profit shifting, they also show that these stricter regimes have more significant impacts overall.
However, these are not the only impacts of transfer pricing regulations. According to a 2018 study by IMF economists Ruud De Mooij and Li Liu, transfer pricing regulations can directly impact business investment (specifically FDI) in a way that is similar to an increase in the corporate income tax rate. In fact, they find that transfer pricing regulations decrease investments in foreign subsidiaries of multinationals by more than 11 percent. They also identify spillover effects to other countries. Noting the policy implications, the authors conclude that “…unilateral introduction of transfer pricing regulation will distort the international allocation of capital; and the negative investment effect can make countries reluctant to adopt them or make them more lenient.”
These studies, taken together, show some of the trade-offs and weaknesses of transfer pricing regulations. They also raise questions about the way the current system of international taxation is arranged and the ability of governments to protect their tax bases in the face of continued innovation and changing business models.
As with other anti-base erosion policies, transfer pricing regulations reveal the challenges of designing rules that address problems associated with various strategies businesses use to minimize their tax burdens. While countries may want to target specific abuses, the way the rules are designed can have real economic impacts on cross-border investment.
This post is part of a series about the economic impact of tax policies addressing base erosion and profit shifting (BEPS). The series includes a total of seven posts focusing on CFC rules, patent box nexus rules, thin-capitalization rules, transfer pricing rules, and country-by-country-reporting.