Academic journal article Duke Journal of Comparative & International Law

A Proposed Framework for Resolving the Transfer Pricing Problem: Allocating the Tax Base of Multinational Entities Based on Real Economic Indicators of Benefit and Burden

Academic journal article Duke Journal of Comparative & International Law

A Proposed Framework for Resolving the Transfer Pricing Problem: Allocating the Tax Base of Multinational Entities Based on Real Economic Indicators of Benefit and Burden

Article excerpt

"[W]hen there is an income tax, the just man will pay more and the unjust less on the same amount of income."--Plato (1)

INTRODUCTION

Globalization has produced a world where capital is highly mobile and deployed across multiple taxing jurisdictions by single corporate taxpayers. This mismatch between global capital and national taxing jurisdictions has proved vexing for national taxing authorities as they attempt to allocate global corporate income and deductions on a national basis. One of the most significant manifestations of this allocation problem is the phenomenon of multi-national enterprises (MNEs) shifting profits to relatively low-tax jurisdictions through intra-firm transfer pricing, creating what is called the transfer pricing problem.

To illustrate the problem, consider the hypothetical case of a United States company that wishes to build a factory in Hong Kong for the manufacture of fiat screen televisions, with the intention of marketing the televisions in the U.S. Assume a marginal cost of production of $100, a retail price of $150, and U.S. and Hong Kong corporate income tax rates of 35% (2)q and 16.5%, (3) respectively. In terms of corporate structure, the parent

company (Parent) has two basic options: build the factory as a foreign branch within the corporate structure of Parent, or establish the factory through a wholly owned subsidiary (Sub) incorporated as a Hong Kong entity. Under the first option, the tax consequences are relatively straightforward. Since Parent both manufactures and sells the televisions, a U.S. tax is assessed on the profit derived by Parent from the manufacture and sale, which will be roughly equivalent to the sale price less the cost of production, or $50 x 35% = $17.50 corporate tax assessed per unit sold.

The second option introduces an additional step in the chain of production and sale. Upon manufacture of the televisions, the Parent must set the transfer price--the intra-firm price the Sub will charge the Parent-for the televisions. Consider the pricing incentives in light of the considerable rate differential between the U.S. and Hong Kong. In the absence of any restrictions on the intra-firm price, the natural incentive will be to set the transfer price at $150 per television, booking $50 of profit to the Sub and $0 of profit to Parent. This price minimizes the overall tax burden to the firm by locating the entire profit of the production and sale enterprise in Hong Kong, the low-tax jurisdiction. In this hypothetical, a Hong Kong tax is assessed on the sale to Parent of $50 x 16.5% = $8.25 corporate tax assessed per unit. Parent realizes no gain on the resale of the televisions in the U.S., and accordingly no U.S. tax is levied. (4) From this example we see that the transfer price effectively functions to allocate profit between Parent and Sub, with the blended tax rate on the productive activity equal to the average of the two tax rates weighted by the percentage of profits allocated to each jurisdiction, respectively. (5)

The above example illustrates how transfer pricing creates the incentive for MNEs to shift profits to low tax jurisdictions. Absent some legal constraint, the transfer pricing problem would erode the corporate tax base of relatively high-tax jurisdictions. The prevailing legal mechanism for preventing this erosion, embodied in U.S. law (6) and as an international standard, (7) is to adjust the price of the transaction to reflect what the parties would have bargained for at arms-length. This principle, known as the arms-length standard (ALS), requires firms to set transfer prices according to their hypothetical equivalent arms-length price, and empowers taxing authorities to reset prices, reallocating income and deductions accordingly. This price setting is principally achieved by looking to comparable uncontrolled prices and transactions.

Consider how ALS would be used to correct strategic pricing behavior in the original hypothetical. …

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