Sunday, 2 June 2013

Tax avoidance #3: transfer pricing

When will they ever learn? Just when it looked like a politician had finally begun to get real over tax avoidance Ed Miliband goes and shoots himself in the foot again.

First he pledges that if elected PM he will tackle corporate tax avoidance without international agreement if necessary. So far, so good. But then he falls for the same misguided arguments as the rest of the political class by seeking to blame the existence of avoidance techniques on the companies that use them. Principal amongst these is the technique known as transfer pricing.

This is a technique used by multinationals where the prices for goods or services traded internally within the company but across international frontiers are set either artificially high or artificially low in order to move profits from one (high tax) country to another (low tax) country. As a problem it is not new. Economics texts have been highlighting the issue for over forty years (for proof see Chapter 19 of Economics of the Real World, by Peter Donaldson, published in 1973). The received wisdom is that all that is needed in order to counter this activity is some form of international agreement, greater corporate transparency, more resources for HMRC staff and a modicum of moral pressure. Robert Philpot of Progress tried to make some of these arguments again last week on the Huffington Post. Yet none of this is true.

As I have pointed out before, under capitalism companies are driven by the imperative to maximize profit, not some moral obligation to maximize government tax revenues. The moral choice is to do what is best for the shareholders, not what is best for the wider community. And anyway, why should Google or any other company be obliged to pay more than it needs to in tax when to do so could put it at a competitive disadvantage with respect to its rivals?

The arguments in favour of international agreements are equally flawed. Such agreements would require all countries to sign up to the same set of rules as those that didn't would gain a competitive advantage over those that did. Yet as long as countries compete against each other to attract multinational corporations to their territories, either in order to generate greater tax revenues at the expense of other nations, or to attract inward investment at the expense of other nations, then there will never be any hope of a binding international agreement. There will always be one country that refuses to be bound by the wishes of the majority in order to gain advantage. And given the size of multinational profits in comparison to national incomes, the power to undercut on tax will always favour the small nation (e.g. Luxembourg, Switzerland, Austria, Ireland) over the large nation. Countries like the USA and UK can therefore never hope to compete with these smaller countries by lowering their corporate tax rates. They need to look for a different approach. That means implementing tax laws that are not reliant on the actions or agreement of governments in competitor countries, but are instead based on objective measures of business activity within each country's own borders. One possible solution is the Common Consolidated Corporate Tax Base (CCCTB) proposed by the EU.

At the heart of the transfer pricing problem is the thorny issue of corporate profits and how they are calculated. Even at the best of times the quantification of a company's true annual profit is something of a black art, one that is complicated by one-off asset write-downs, debt interest, rolled over losses from previous financial years, and the deferral or front-loading of capital investment. Yet over time most of these factors cancel themselves out. However, on top of all that there is the problem of how those profits are spread across the different divisions of the company. Again, if all the divisions of the company are located within the same country it matters not a jot. The total profit of the company in that tax jurisdiction is the same however it is divided between subsidiaries, and so the tax paid is the same. Yet, as soon as the profit is spread across subsidiaries in different countries with different tax rates, problems abound.

This is where transfer pricing comes into its own. There are a number of variants of this type of scheme that essentially only differ in the form of the goods used as the vehicle for the price transfer mechanism. In its most classical manifestation the goods are typically manufactured components of a larger or more complex final product. However, increasingly transfer pricing schemes have begun using brand licences or other intellectual property as the good that is traded internally within the company (as used for example by Starbucks). As an illustration of how transfer pricing works it may help to consider the following hypothetical example.

Suppose a car maker has two production facilities. The main assembly plant is in the UK and is owned and run by subsidiary A. However, the engines are manufactured in country Z by the company's subsidiary B. Now suppose it costs £4000 to build the engine and another £4000 to construct the rest of the car, but the car sells for £10,000. The profit is therefore £2000 per car. If the car company builds 1,000,000 cars each year then its annual profit will be £2bn, but which in country should this profit be declared and taxed; the UK or country Z?

The answer is that it depends on the price that subsidiary B charges subsidiary A for its engines. For most goods bought by ordinary consumers or firms the price is set by the market and it is therefore beyond the capabilities of any single agent to dictate this price unilaterally. In transfer pricing schemes, however, the commodity or good at the centre of the scheme is only ever traded within the multinational company. There are no external customers and so there is no objective market price for the good. Whatever the multinational charges for the good it ends up paying to itself, so it can set its own price for its own reasons. That reason is usually tax.

In the above example the cost of producing the engine and the car body is the same (£4000 each), so one might naturally assume that the fair way for the profits to be divided between the two subsidiaries would be in the same 50:50 split. In which case subsidiary B would charge £5000 for each engine, thus allowing it to make a profit of £1000 per engine. Subsidiary A in the UK would then buy the engines for £5000 each, build the rest of the car at an additional cost of £4000, and then sell the cars to the public for £10,000 each. Thus the cost of manufacture for subsidiary A is £9000 per car and its profit is £1000 per car, the same as for subsidiary B. If the tax rates in the UK and country Z are the same, let's say 30%, then the multinational will pay £300m of tax in each country, or £600m in total.

But if the tax rate in country Z is lower than in the UK (say 25% instead of 30%), then the car maker will pay less tax in country Z (£250m) than the £300m it continues to pay in the UK. Its total tax bill at £550m is now less than the £600m it was originally. But it can reduce its tax bill even further by raising the price of its engines.

If subsidiary B charges £6000 for each engine, then subsidiary B will make £2000 profit per car. Yet the cost of production for subsidiary A then rises to £10,000 per car, £6000 for the engine and £4000 for the body, and so it makes zero profit. Now all the profits are taxed in country Z at 25%, and so the total tax bill falls to £500m.

Similarly, if the UK were to retaliate by lowering its tax rate to 20% (as advocated by Osborne and Cameron) then the car company would respond by changing the cost of its engines once more. Now subsidiary B might charge £4000 for each engine so that it makes no profit while subsidiary A earns £10000 for each car sold but now spends only £8000 on their manufacture (£4000 on assembly costs and another £4000 buying the engine from subsidiary B). As all the profits are now located in the UK they will be taxed at the UK rate and the total tax bill for the company is now £400m.

Thus by raising or lowering the cost of its engines (or any other internally manufactured component) the car maker can in effect choose which country it wishes to be taxed in. And in so doing it can also force countries to compete against each other by competitively reducing their tax rates in a self-defeating race to the bottom where the only winner is the multinational.

One reason why the scheme is so difficult for governments to challenge is that there is usually no other external customer for the good or service used in the transfer pricing, so the price is difficult for the tax authorities to challenge. In addition, multinationals can always find one country to base their headquarters in that will offer a lower tax rate than any other. Worse still, with complex lines of procurement it is doubtful whether even the company itself can accurately determine the true cost of many of its internally sourced components. Nevertheless, despite these difficulties it is clear that many multinationals actively operate aggressive policies of tax avoidance based on transfer pricing that are designed to minimize their corporate income tax bill. It is therefore time governments adopted an alternative approach to tackling the problem.

The Solution:
There is only one realistic solution to the problem of transfer pricing, and that is to tax companies on the basis of data that they cannot challenge or manipulate. As already noted, profits can have a distinctly ethereal quality at times, particularly when looked at on a country-by-country basis. However, a company's global profit (P) is much more tightly defined. So too for that matter are other global aggregate measures of a company's performance such as its global sales (S), its global wage bill (W), and the total value of its global capital assets (K).

It is also true that, while a multinational operating in the UK can disguise its UK profit via transfer pricing, it cannot disguise the level of its UK sales, wage bill or capital investment. Its UK sales are already recorded for VAT purposes, and its wage bill for calculating its national insurance liability. As for its UK capital, that is mainly in the form of property, which is also rather difficult to conceal.

It therefore follows that governments should take the initiative when it comes to determining the profit levels of subsidiaries operating in their territories. As neither the government nor the multinational really knows the true profit level of these subsidiaries, the government should in effect use the objective data outlined above to tell the multinational what its UK profits are, rather than relying on the multinational to tell the government what it thinks it is. And it turns out that a formula for just such a calculation already exists.

In an attempt to tackle the issue of transfer pricing the European Commission has proposed the Common Consolidated Corporate Tax Base (CCCTB). This utilizes data for the company's global sales (S), wages (W), capital (K) and profits (P), together with the equivalent terms Si, Wi and Ki pertaining to any individual country i only. This allows the company's profits in country i to be estimated by taking a weighted average of the fraction of its global capital, sales and wages that are deployed in that country, and using that average to set an estimate for its profits in country i. In the absence of any more authoritative data, this estimate will de facto be assumed to be the true profit level Pi for the subsidiary operating in that country.

The coefficients are defined to be the same for all companies operating in country i, and are then set such that each is less than unity, and their sum is always equal to unity as follows.

In practice these coefficients are all likely to be set to be equal to each other as there is unlikely to be much overall variation in the proportion of wages, sales and investment capital for all multinationals within a given country i. In which case the profit in country i becomes

We have then a profit calculating mechanism that is impervious to transfer pricing. Companies cannot manipulate their profit in country i because they cannot manipulate the quantities used in Eq. (3) to calculate that profit. It is this type of approach that politicians and government tax advisers should be adopting, not the empty rhetoric of cynical political posturing.