Transfer Pricing: Means To Evade Tax

By Priyamvada Jain

Transfer pricing refers to the pricing set between two related companies in intra-company transactions or trading. The latter can involve buying and selling of goods, patents or services between a parent company and a subsidiary, or between two subsidiaries controlled by a common parent, etc. With the advent of globalisation a lot of MNC’s have entered India and set up their subsidiaries here. They have also invested and acquired stakes in various Indian companies and carry huge transactions with these companies.

With increased globalisation and economic liberalisation, there has been a manifold increase in cross-border transactions. This has also resulted in increased opportunities for sophisticated schemes for avoiding tax payment using the different tax rules of different countries and use of tax havens. Global trade amongst various arms of MNEs has also increased substantially and accounts for a significant proportion of global trade. It also means increasing misuse of transfer pricing, leading to estimations that developing countries might be losing significant resources due to transfer-pricing manipulation.

Today, more than 60 per cent of global trade is carried out between associated enterprises of multinational enterprises (MNEs). These transactions are bringing 3 types of taxation problem:

• Jurisdiction
• Allocation
• Valuation

The first issue asks which government has a right to tax the transaction and if both the governments claim the tax then which government should have priority. The second issue is allocation. The various affiliates of MNE’s share the resources owned by the MNE. The problem that arises from government’s perspective is that how the allocation of expense and income of the resource should be done among the various enterprises. The third issue is valuation. The MNE’s expenses and income must not only be allocated among the various affiliates but it should also be valued. This leads us directly to the transfer pricing: the valuation of intra-firm transfers.

MNEs enjoy considerable discretion in allocating costs and prices to particular products/services and geographical jurisdictions. Such discretion enables them to transfer profit/income to no tax or low tax jurisdictions. Differing tax rates in different tax jurisdictions can create perverse incentives for corporations to shift taxable income from jurisdictions with relatively high tax rates to jurisdictions with relatively low tax rates as a means of minimising their tax liability. For example, a foreign parent company could use internal ‘transfer prices’ for overstating the value of goods and services that it exports to its foreign affiliate in order to shift taxable income from the operations of the affiliate in a high tax jurisdiction to its operations in a low-tax jurisdiction. Similarly, the foreign affiliate might understate the value of goods and services that it exports to the parent company in order to shift taxable income from its high tax jurisdiction to the low tax jurisdiction of its parent. Both of these strategies would shift the company’s profits to the low tax jurisdiction and, in so doing; reduce its worldwide tax payments.  In this context, transfer pricing has emerged as the biggest tool for generation and transfer of black money. In recent years, after the 9/11 incident in the USA due to intense scrutiny of banking transactions, enhanced security checks at airports and ports, and relaxation of exchange controls, transfer of money through hawala has reduced significantly but now transfer pricing is  being extensively used to transfer income and avoid taxes at will across countries. Also, with the relaxation of exchange controls and liberalisation of banking channels, the popularity of the hawala system for legitimate transfers has reduced substantially. The increasing pressure on financial operators and banks to report cash transactions has also helped in curbing hawala transactions. Tax evasion through transfer pricing is largely invisible to the public and difficult and expensive for tax officers to detect. It is used as a means by the MNE’s to transfer their incomes to low tax countries and tax havens so as to avoid the liability of high taxes.

A British Parliamentary report released in early December criticised US companies for what it described as tax avoidance. The report focused on the tax practices of Starbucks, Amazon and Google, which use lower-tax jurisdictions in Europe like Ireland, Luxembourg and Switzerland to record most of the revenues they earn in Britain, France and Germany. Prior to that, Starbucks had revealed that despite making sales revenue of $398 million, it paid no corporate tax in Britain. Starbucks was reducing its taxable income in Britain by channelling revenue through its other subsidiaries in lower-rate jurisdictions. It was reported that one unit in the Netherlands was, for example, receiving royalty payments from Britain, which are deductible from taxable income. By showing the technology payments to the Netherlands subsidiary as costs, the British subsidiary is able to bring down its taxable income too.

In the case of Google, it has been brought to light that across Europe, Google’s customers sign contracts with the company’s subsidiary in Ireland, rather than with local branches. Thus Google records most of its international revenue at its European headquarters in Ireland, where the corporate tax rate is 12.5%. This low tax rate, together with EU membership (that lets companies based in one member state operate across the 27 member countries) and an extensive set of double tax avoidance agreements/treaties (DTAAs/DTATs), makes Ireland a very attractive destination for foreign investment.

The Directorate of Transfer Pricing has detected mispricing of 67,768 crore in India in the last two financial years (44,531 crore in the current financial year). This has effectively stopped transfer of equivalent amount of profits out of the country. The table below shows the TP adjustments from the year 2004-2012-

SOLVING THE PROBLEM

It would suffice to state here that efforts made by the Government of India to create greater transparency and facilitate exchange of information need to be carried further. Stricter rules and transparency norms should be designed and implemented by the government of the country. The issues which are still under a controversy should be resolved and clear guidelines in respect of them should be presented.  There is also need to create a robust database of remittances made by corporates out of India and carry out an analysis of their backward and forward linkages in order to understand the nature and legitimacy of the transmitted funds. Separate authorities should be appointed by the government to keep a check on the remittances and carry their proper analysis. Recently the Nigerian government has created a separate TP Unit so as to tackle the TP problems. Surrounding the establishment of a Transfer Pricing Unit there have been two main areas of activity: those at the Head Office and other activities carried out in the field. In the central office, a committee was formed to produce draft regulations for Federal Inland Revenue Management approval. The draft regulation is being forwarded to the sub technical committee of the Board for consideration and ratification. The Minister of Finance was briefed on the steps being taking on the Transfer Pricing administration and units have been created in two of the Large Taxpayers’ offices (the office in charge of our Oil & Gas and Non-Oil). In the Revenue Authority to have the buy in of the taxpayers and their advisors it has commenced sensitisation of the major Tax Representatives on its implementation of Transfer Pricing rules in Nigeria. In the field, the TP teams have formed and have started the documentation of identified MNEs – the non resident taxpayers and their Nigerian affiliates. The Units keep a diary of activities on the issues arising on TP particularly when they go out on regular tax audit exercise. Potential TP cases have been identified from general audit conducted on the companies. In India, the FIU-IND may be empowered by law to receive reports (similar to other reports submitted to it) on all international fund transfers through the Indian financial system, on the lines of the FIUs of Australia and Canada. International regimes can also be set up by the various governments to resolve these problems. International regimes are a set of functional and behavioural relationships among national governments that have been established in response to problems at international level in particular issue areas.

The author is presently pursuing BCom( Hons) from the Shri Ram College Of Commerce and have successfully completed my 1st year. She aspires to do an MBA in the field of Finance. Has worked with Ernst and Young in the past and is constantly associated with the Rotary Club. She can be contacted at jainpriyamvada@gmail.com