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TAX AVOIDANCE BY MULTINATIONAL

ENTERPRISES THROUGH TRANSFER PRICING

AUTHOR:
DR. MUHAMMAD KHALID MALIK

Dissertation submitted in partial fulfillment of the requirements for the Master of


Law degree in International Economic Law at the University of Warwick.

Submitted: September 2006


Total Words: 8,236

TABLE OF CONTENTS

Chapter Content

Page

Abstract

Introduction

Transfer Pricing

Tax Implication of Transfer Pricing

13

The Arms Length Method to Counter 18


Transfer Pricing

Anti-Transfer Pricing Measures undertaken 31


by

International

Organizations

and

National Governments
6

Unitary Taxation

36

Anti-Transfer Pricing Strategies in Practice 43

Conclusion

46

ACKNOWLEDGEMENTS

I wish to express thanks to many people who helped me directly or indirectly in


finalization of this dissertation.

I am grateful to the Government of Pakistan for sponsorship of my studies here at the


University of Warwick.

I am indebted to Ch. Faqir Husain Faqir, Commissioner of Income Tax and my


supervisory officer in Pakistan, for his encouragement for pursuing higher education.

Here at the University of Warwick, most thanks are due to Mr. David Salter, my
teacher and supervisor for this dissertation. I learnt a lot from him in classes of Issues
in the Taxation of International Business. He spared time for me from his busy
schedule and generously guided me from time to time. I gratefully acknowledge my
debt to him,

Lastly, I am grateful to Dr. Fauzia Khalid, my wife for taking care of our children,
Muhammad Malik and Ayesha Khalid while I remained busy in studies at home or at
libraries.

DECLARATION

I, Dr. Muhammad Khalid Malik, hereby declared that the material contained in this
dissertation has never been used or published by me.

(DR. MUHAMMAD KHALID MALIK)

ABSTRACT

In the present age, a major chunk of the cross-border trade is in the hands of
multinational enterprises, which undertake the majority of their transactions within
different entities under common control. The prevalence of intra-group transactions
has facilitated fixing their internal price at less or more than market value-a practice
known as transfer pricing. One of the repercussions of the transfer pricing
manipulation is tax avoidance, which is the most important issue in international
taxation today.

This dissertation examines, in detail, transfer pricing, its role in tax avoidance and
various counteractive measures which have been or can be adopted by states.

Chapter 1 is introductory and gives a brief overview of salient patterns and features
of international trade in the contemporary era. Chapter 2 takes up the issue of
transfer pricing in detail describing its anatomy and non-tax benefits. Chapter 3
discusses briefly mechanisms of tax avoidance through transfer pricing. Chapters 4
and 5 give detail of counteractive arms length approach and its implementation in
international treaties and national laws. Chapter 6 explores an alternative
approach-unitary taxation. Chapter 7 sums up anti-transfer pricing strategies in
practice. Chapter 8 discusses the future prospects of both approaches and
suggestions for improvement.

CHAPTER 1

INTRODUCTION

The present international trade is marked with a few unprecedented momentous


developments.

Firstly,

thanks

to

technological

innovations

especially

in

transportations, communications and information technology (like internet), removal


of tariff and non-tariff barriers, emergence of rule-based trade regulated by the World
Trade Organization (WTO) and easy cross-border movements of goods and capital,
the volume and geographical extent of international trade has increased
tremendously. In 1960, the foreign trade in goods and services constituted 10% of
Gross National Product (GNP) and in 1982, it increased to 22%.1 Between 1970s and
1980, approximately 80% of new jobs were export-related.2

Secondly, a major chunk of this international trade is in the hands of big


multinational enterprises (MNEs). An MNE is an enterprise which partly or fully
owns controls and manages income-generating assets in more than one state.3 It is
incorporated and organized in one country and conducts cross-border transactions
beyond the country of origin through branches, partly or wholly-owned subsidiaries,
affiliates and joint ventures

Thomas G. Evans, Martin Taylor and Oscar Holzmann (1985) International Accounting and
Reporting, Macmillan Publishing Company New York/Collier Macmillan Publishers London, Page 3.
2
Ibid, Page 3.
3
Peter Muchlinski (1999) Multinational Enterprises and the Law, Blackwell Oxford UK and
Cambridge USA, Page 12

About ten years ago, MNEs accounted for 25% of the world trade and 25% of
worlds GNP.4 The same trend continues to rise and now the world is dominated by
500 MNEs which control 90% of all the world foreign direct investment (FDI) and
over 50% of the trade. More than 40% of the global market has been captured by USbased MNEs like Coca-Cola, Gillette, Lucent, Boeing and GE Power System in
Asia.5 About 95% of the all foreign production is in the hands of these biggest 500
MNEs (Dunning, 1988, p 328).6 Noreena Hertz claims that the hundred largest MNE
control 20% of global foreign assets and that out of the worlds 100 largest
economies, 51 are corporations, only 49 states.7 In the early 1990s, the bigger MNEs
owned 16% of the privately-held global assets (Owners, 1993).8

Thirdly, there is significant rise in intra-group (also called intra-firm) transactions.


The majority of the transactions in cross-border international trade take place
between affiliated entities within an MNE (subsidiaries and affiliates). An affiliate is
an entity partially or wholly owned and controlled by an MNE and includes
subsidiaries, branches, joint ventures or any legal entity under partial or complete
control.9 Subsidiary company is a legal term defined under national laws, generally
as a company which is fully or partly owned and or controlled by another company
(the parent company).

Paul Kirkbride, Paul Pinnington and Karen Ward (2001) Globalization: The Internal Dynamic (Paul
Kirkbride and Karen Ward (ed) John Wiley & Sons Ltd, Page 4
5
Ibid, Page 4
6
Lorraine Eden (1993) Multinational in the Global Political Economy, Lorraine Eden and Evan H.
Potter (ed), St Martins Press, Page 47.
7
Noreena Hertz (2001) The Silent Takeover, Global Capitalism and the Death of Democracy, William
Heinemann London, Page 7.
8
OECD (1996) Controlled Foreign Company Legislation OECD, Page 9.
9
Jerry M. Rosenberg (1994) Dictionary of International Trade, John Wiley and Sons Inc. Page 6

The intra-group transactions have been estimated to be more than 60% by Rohatgi
and the OECD10 and constitute more than 30% of export of the leading countries like
US, UK and Japan, especially in high-technology sector like chemicals, machinery
and transport equipments (UN 1998, Page 93, UN 1978).11
The increase in intra-group cross-border transactions by MNEs facilitates them to
manipulate prices, inter alia, to avoid tax.

10

Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, Page 412.
Also OECD (1996) Controlled Foreign Company Legislation, OECD, Page 9.
11
Sol Picciotto (1992) International Business Taxation- A Study in Internationalization of Business
Regulation, Weidenfield and Nicolson, Page 171

CHAPTER 2

TRANSFER PRICING

Part A: The Anatomy of Transfer Pricing

The majority of transactions in the international trade take place between related
entities within MNEs without passing though the neutral and independent market,
enabling them to fix internal prices of their goods and services according to their
own convenience and motives in respect of transactions between themselves. These
prices are called transfer prices (also known as internal prices or accounting prices
or inter-corporate transfer prices). It may be defined as the price at which goods or
intangible properties are transferred or services rendered between the related
enterprises and which does not represent true, normal, natural and real market prices
of the transactions.12 Transfer pricing connotes an idea of artificial manipulation of
prices of internal transactions between related enterprises in order to alter or shift the
true business profit. The transfer price is usually contrasted with the market or arms
length price which is price of the similar transaction in the open market between
unrelated third parties.13 In the corporate sector, transfer pricing takes place between
related enterprises like between parent and subsidiaries, between subsidiaries of the
same parent, between parents and foreign affiliates. The transactions involved in
transfer pricing, inter alia include: transfer of tangible goods, capital assets and other
such tangible asserts, transfer of intangible property rights, rendering of services,

12

OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD Page 3.
13
Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition) Kluwer Law
International , the Hague/London/New York, Page 55

provision of finance and others like property rental, leasing arrangements etc.14. The
price in such transactions may be enhanced (over-pricing or high transfer price) or
reduced (under-pricing or low transfer price).

The transfer pricing manipulation is primarily done for enhancement of total after-tax
profit of the MNE (business profit and profit repatriated from subsidiaries) and
reduction of before-tax declared profit.15
Part B: Non-Tax Considerations for Transfer Pricing

A parent enterprise can increase its profit and decrease profit of its affiliates by
overpricing. Similarly, it can achieve opposite results from under-pricing-reduction
in its profit and enhancement of profit of its affiliates. These manipulations can be
employed to obtain required figure of apparent profits earned by different entities
within an MNE with a view to achieve various pre-determined goals set by the
management.

An MNE can use overpricing to counter restriction on repatriation of dividends by its


foreign subsidiary16 and to minimize exchange risk17. Overpricing by a parent
company makes apparent look of subsidiaries weaker and less profitable and can be
employed to counter risk of nationalization or expropriation of profitable foreign

14

Roy Rohatgi (2002) The Basic International Taxation,, Kluwer Law International, London/The
Hague/New York Page 412-3
15
Walter A. Chudson (1981) Multinationals Beyond the Market, Intra-Firm Trade and the Control of
Transfer Pricing, Robin Murray (ed), The Harvester Press, Page 17.
16
Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 2.
17
Ibid, Page 2

10

enterprise18 and demands of high wages by trade unions or governments of host


country.19 When the government in the country of foreign affiliate fixes price
ceilings based on the manufacturing or production costs for certain products, overpricing can be employed as a justification to request by the foreign affiliate for
enhancing price of final product to consumers on ground of increase in cost.20
Similarly, the overpricing may be used to reduce the profit of a joint venture
comprising of subsidiary of an MNE and foreign entity. The reduction in profit of the
subsidiary is balanced by the corresponding increase in profit of the parent company
leaving foreign entity alone to bear the reduction in profit or even loss.21 Transfer
pricing is one of the major sources of conflict in joint ventures. Over-pricing can also
be used to obtain benefits of export incentives.22

Under-pricing by a parent company can make apparent look of its foreign affiliates
stronger and more profitable. It enables foreign affiliate to sell its products to end
customers at cheaper rates and can be employed to support the newly-established
foreign affiliate,23 to gain access to foreign market24

and knock-out the

18

Thomas G. Evans, Martin E. Taylor and Oscar Holzmann, (1985) International Accounting and
Reporting, Macmillan Publishing Company New York/Collier Macmillan Publishers London, Page
292.
19
Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 2
20
Sylvain R.F.Plasschaert (1979) Transfer Pricing and Multinational Companies-An Overview of
Concepts, Mechanisms and Regulations, Saxon House, Page 66.
21
Ibid, Page 65.
22
Thomas G. Evans, Martin E. Taylor and Oscar Holzmann (1985) International Accounting and
Reporting, Macmillan Publishing Company New York/Collier Macmillan Publishers London, Page
294.
23
Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 2.
24
Sylvain R.F.Plasschaert (1979) Transfer Pricing and Multinational Companies-An Overview of
Concepts, Mechanisms and Regulations, Saxon House, Page 67.

11

competitors.25 This artificial better financial worth can help subsidiaries to obtain
loans from local banks and financial institutions.26
Transfer pricing can be used to transfer the funds to an entity lacking liquidity27 and
to return investment from the subsidiary.28 Transfer pricing manipulation can be
employed as a tool to make the apparent look of a particular economic activity as
profitable or unprofitable by under-pricing or over-pricing respectively, solely
because of internal managerial considerations of the management29

It is pertinent to refer to the most well-known case of transfer pricing manipulation


involving sale of medicines (Librium and Valium) in UK at a price significantly
higher than in international market. UK authorities after establishing that the parent
company Hoffman-La-Roche had manipulated prices (overpricing) on transactions to
its UK subsidiary Roche Products, ordered Roche Products to reduce the price of
Librium by 40% and that of Valium by 25%.30

25

Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 2
26
Thomas G. Evans, Martin E. Taylor and Oscar Holzmann, (1985) International Accounting and
Reporting, Macmillan Publishing Company New York/Collier Macmillan Publishers London, Page
293.
27
Sylvain R.F.Plasschaert (1979) Transfer Pricing and Multinational Companies-An Overview of
Concepts, Mechanisms and Regulations, Saxon House, Page 68.
28
Ibid, Page 69.
29
David R. Tillinghast, (1984) Tax Aspects of International Transactions, (2nd Edition) Matthew
Bender, Page 188.
30
C.R. Greenhill and E.O. Herbolzheimer, (1981)Control of Transfer Prices in International
Transactions: The Restrictive Business Practices Approach, Robin Murray (ed) Multinationals
Beyond the Market, Intra-Firm Trade and the Control of Transfer Pricing, The Harvester Press, Pages
187-188.

12

CHAPTER 3

TAX IMPLICATIONS OF TRANSFER PRICING

Part A: Introduction

An MNE may indulge in practice of tax avoidance for various reasons.


Firstly, the taxation which is of vital importance to a state is rarely liked by a
business enterprise. The desire and practice to avoid tax remained prevalent in all era
and among all the professions. Tax frauds have been estimated to cost five to six
times as much as the aggregates of all conventional crimes (Levi 1987a).31 As
reported in Financial Weekly on 30th March 1970, Sir William Pile, the Chairman of
the Inland Revenue opined that the income on which tax was evaded constituted
7.5% of GNP.32 Sir Norman Price, the successor of William Pye stated that tax
avoidance has become a national habit.33 The British Prime Minister Gladstone said
in 1874,Income tax makes a nation of liars.34 Tax avoidance has been stated to be
like common cold-prevalent, no certain cure, no cause for alarm, but often seems to
be worse than it really is.35 An MNE is no exception to the general trend of tax
avoidance and may avoid tax through, inter alia, treaty shopping, tax havens and the
transfer pricing etc.36

31

Hazel Croall (2001) Understanding White Collar Crimes, Open University Press, Page 30.
A.R. Ilersic, D.R.Myddelton, Christie Davies, Anthony Christopher and Lord Houghton (1979) Tax
Avoision-The Economic, Legal and Moral Interrelationship between Avoidance and Evasion, The
Institute of Economic Affairs, Page 5
33
Ibid, Pages 5-6.
34
Ibid, Page 91.
35
Ibid, Page 91.
36
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Page 343
32

13

Second factor inducing tax avoidance by an MNE is double taxation of same profits
by different states as a result of simultaneous use of nationality and residence based
taxation by the home government and source-based taxation by the host government.

Thirdly, since the taxation of MNEs is entirely within the domain of national laws, in
absence of any international law in this field. The domestic taxation systems with
variable tax rates, different accounting standards and methods of computation of
taxable income in accordance with the provisions of national tax laws may facilitate
MNEs to arrange their internal transactions between different entities in a manner
which reduces their overall worldwide tax liability by employing various legal,
quasi-legal and illegal strategies

Noreena Hertz pointed out that Rupert Murdochs News Corporation paid only 6%
tax worldwide and up to the end of 1998, paid no corporation tax in UK despite
having earned profit there amounting to 1.4 billions since June 1987.37

Transfer pricing used by a company which has no cross-border transactions does not
result in overall reduction of tax liability because the reduction in profit of one entity
is balanced by increase in profit of other entity within the MNE and the state gets due
tax from the overall profit of the MNE.38

Transfer pricing is one of the most debated issues in taxation. All international and
multilateral organizations as well as the states are showing concern and working for

37

Noreena Hertz (2001) The Silent Takeover, Global Capitalism and the Death of Democracy
William Heinemann London, Page 7.
38
Sylvain R.F.Plasschaert, (1979) Transfer Pricing and Multinational Companies-An Overview of
Concepts, Mechanisms and Regulations, Saxon House, Page 1.

14

evolving strategy to counteract. The Ruding Report 1992 declared transfer pricing as
the one of the most important areas for future in international taxation and the
internal market (EU).39

Part B: Tax Avoidance through transfer pricing


1) Reduction of Income or corporation tax liability

a) Shifting of business profits from high-tax country to low-tax country or


countries

An MNE can alter its profit and that attributable to its subsidiaries through transfer
pricing. Overpricing by an MNE results in high and low profit for the parent
company and its subsidiaries respectively. Under-pricing by the parent company has
just opposite effect. This enables an MNE to shift the profit to a country where rate
of taxation is lower, resulting in reduction in overall tax liability without altering its
overall business profit.40
The tax saving (TS) by an MNE in this manner can be computed by following
formula:41

TS = (P2-P1) (t1-t2)
Whereas

P2 is the high transfer price


P1 is the low transfer price

39

European Commission (2002) Company Taxation in the Internal Market, European Commission,
Page 331.
40
Sylvain R.F.Plasschaert (1979) Transfer Pricing and Multinational Companies-An Overview of
Concepts, Mechanisms and Regulations, Saxon House, Pages 48-49.
41
Clive R. Emmanuel and Messaoud Mehafdi (1994) Transfer Pricing, Academic Press Harcourt
Brace and Company, Publishers, Page 73.

15

t2 is the income tax rate in the receiving country


t1 is the income tax rate in the supplying country
b) Other Maneuvers for Income Tax Reduction by Transfer Pricing
i) The business profit may be transferred to the country which allows more
admissible expenses against income like higher depreciation rates and other tax
benefits like liberal policies regarding set off and carry forward of business losses of
the company or subsidiaries.
ii) The prices of capital assets may be overpriced to increase their written-down
value enabling the subsidiary to claim higher depreciation expenses resulting in
decrease in taxable income.42
iii) The business profit may be shifted to the country where tax avoidance is easier
because of tax incentives and relief, lower documentation & disclosure requirements,
less strict implementation and enforcement of fiscal laws, presence of loophole in the
laws and prevalence of corruption.

c) Avoidance of withholding tax on imports and exports


By under-pricing, the value of goods transferred, and the quantum of ad valorem
withholding tax on imports in the receiving country and on export in the supplying
country can be reduced.

d) Avoidance of other withholding taxes


A subsidiary usually makes payment to the parent company on account of dividends
on its divisible income, interest on the loan borrowed by the subsidiary from the
parent company and royalty. The country of the subsidiary may impose withholding
42

Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 2

16

taxes on above payments, which can be avoided by an MNE by transfer pricing


manipulation.43

2) Avoidance of Custom Duties


a) import duties

Through under-pricing, an MNE can reduce ad valorem import duties.44 The amount
of import duty avoided (IDS) by transfer pricing can be determined by the following
formula;45
IDS = (P2 P1) d2

Whereas

P2 is the high transfer price


P1 is the low transfer price
d2 is the import duty.

b) Export Duties
The under-pricing and the resultant under-valuation of the goods transferred reduce
ad valorem export duties.46
3) Simultaneous avoidance of Custom duties and Income or Corporation
tax.
An MNE can also achieve the goal of simultaneous reduction of custom duties and
income tax.
43

Clive R. Emmanuel and Messaoud Mehafdi, (1994) Transfer Pricing, Academic Press Harcourt
Brace and Company, Publishers, Page 74.
44
Sylvain R.F.Plasschaert (1979) Transfer Pricing and Multinational Companies-An Overview of
Concepts, Mechanisms and Regulations, Saxon House, Page 58.
45
Clive R. Emmanuel and Messaoud Mehafdi (1994) Transfer Pricing, Academic Press Harcourt
Brace and Company, Publishers, Page 73
46
Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 1

17

CHAPTER 4

THE ARMS LENGTH METHOD TO COUNTER TRANSFER PRICING

There are two approaches to compensate tax avoidance caused by transfer pricing
manipulations: the arms length approach which has been discussed in detail in this
chapter and the non-arms length approach (global formulary apportionment method)
which is discussed at length in chapter 6.

Part A: General Overview

1) Introduction

Transfer prices for the transactions agreed between related enterprises are usually not
at par with the prices in the open market for similar transactions between unrelated
parties determined by the market forces and therefore the transfer price may be
greater or lesser than the market price depending on the mutually agreed
considerations. Such higher or lower transfer prices are inappropriate, abnormal or
unfair, requiring remedial action by the tax authorities. One way of removing the
disparity between transfer price and market price is the determination of the market
price of similar transaction taking place between unrelated parties acting
independently under similar circumstances. Such price is called arms length
price.

18

2) The Arms Length Price


The 1979 OECD Report defined the arm's length price as the price that would have
been agreed upon between unrelated parties engaged in the same or similar
transactions under the same or similar conditions in the open market.47

In other words, the arms length price is correct monetary value of a transaction
settled by market forces and agreed between unrelated parties. A transfer price may
be an appropriate transfer price when it meets the arms length standard, otherwise it
is an inappropriate the transfer price.48 An inappropriate transfer price can be
managed by tax authorities on the basis of the arm's length method in two steps;

Step one: finding the arm's length price of the transaction under consideration, and
Step two: modifying the declared transfer price accordingly (called transfer pricing
or corrective adjustment) bringing it at par with the arm's length price.49

The arms length principle has been accepted and adopted in the OECD MC, the UN
MC and in most of the bilateral tax avoidance treaties and also in the OECD
Guidelines.

3) The OECD Guidelines for Comparability analysis

The factors taken into consideration for the comparability of transactions under
consideration include:50 similarity of characteristics of goods and services, functional
47

Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Pages 413-414.
48
Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer Law
International, the Hague/London/New York, Page 60.
49
Ibid, Page 57.

19

analysis of the transaction [i.e. functions performed by the entity including assets
used/economical activities undertaken (like design, manufacturing, assembly,
research and development etc) and risk involved ( like market risks, risk of loss with
investment and property, credit risks, exchange risks and interest rate variability
etc)], analysis of contractual terms, analysis of economic circumstances/market
comparability like geographic location and size of market, extent of competition,
availability of substitute goods and services, level of demand and supply, consumer
purchasing power, production cost, date and time of transactions etc and analysis of
business strategies like innovation and development of new product, degree of
diversification etc.
Part B: methods for determination of the arm's length price
These methods can be classified into two broad categories:
a) Transactional Price (Traditional or Primary) Methods
These are based on the analysis of transactions under consideration and include
Comparable Uncontrolled Price Method (CUP), Resale Price Method (RPM) and
Cost Plus Method (CPP)
b) Transactional (or transaction-based) Profit Methods
These methods analyze the profit arising out of controlled transactions between
related entities51 and include Transactional Net Margin Method (TNMM) and Profit
Split Method (PSM). These have been called Other Methods for determination of
the arm's length price by OECD Guidelines.
These methods are briefly discussed as follows:

50

OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Pages II-9-15.
51
Ibid, Page III-1

20

1) Comparable Uncontrolled Price Method (CUP)

a) Basic Features

This method compares the transfer price in a controlled transaction (taking place
between related entities) in a comparable uncontrolled transaction (occurring
between an entity within the MNE and third party or between two independent third
parties) in comparable circumstances.52
Any difference between the two prices (i.e. in controlled and uncontrolled
transactions) means that the transfer price settled between the related enterprises is
not the arms length price and the price in the controlled transaction is not
comparable to price in uncontrolled transaction. Therefore, in order to make both
prices comparable, the price in the controlled transaction should be replaced by the
price in the uncontrolled transaction.53

The comparables for the purposes of comparability may be external or internal


comparables. The internal comparables relate to comparables in transactions
between a controlled entity within MNE and third independent uncontrolled party.
The external comparables relate to transactions between uncontrolled independent
third parties external to the MNE.54 The methods based on these comparables are
called internal CUP or internal price comparison and external CUP or external
price comparison.55

52

Ibid, Page II-2


Ibid, Page II-2
54
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Page 415.
55
Chris Adam and Peter Graham (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Pages 11-12.
53

21

A controlled transaction is considered to be comparable to the uncontrolled


transaction, if any of following two conditions is met:
i) There is no significant difference between controlled and uncontrolled transactions
and with the market price or
ii) The difference can be accurately quantified by making that adjustment and
difference can be removed.56

This method is more suitable for transactions involving transfer of goods,


intangibles, loans and provision of financing.57
b) Merits

It is the most direct and reliable method of determining the arm's length price
wherever comparable uncontrolled transactions are found.58

c) Demerits
Firstly, as discussed above, the edifice of CUP is built on comparables. In the
contemporary era, when the vast majority of transactions are intra-group, it is very
difficult to find comparables.59
Secondly, the MNEs usually do not enter into transactions with un-related entities
except with the end-consumer, so the chances of finding comparables in respect of
intermediate transactions are rare.60
56

OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Page II-2-3.
57
Chris Adam and Peter Graham (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 21
58
OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Page II-3.
59
European Commission (2002) Company Taxation in the Internal Market, European Commission,
Page 339.

22

Thirdly, the structures and business patterns of the MNEs is unique and so it is very
hard to find exact comparables.61
Fourthly, reliance on commercial databases (like Amadeus, GlobalVantage,
Kompass, Modys Company Data and worldbase etc.) for comparables can also be
problematic because

these too are mostly based on intra-group transactions,

information on product to product basis is not available and there is no common


definition of cost.62
Fifthly, the MNEs usually do not transfer intangible assets like technology,
marketing know-how, patents etc to the unrelated entities, making it very difficult to
find comparables.63
Sixthly, the comparables are not easy to find in certain industries like petroleum
where transactions to unrelated entities are seldom made.64
Seventhly, the comparable products in the open market may be outwardly similar,
yet may be unique and incomparable for purpose of use in CUP because of some
unique attributes like brand name, newness etc.65
Finally, it cannot be applied on transfer of semi-finished goods which need value
addition.66

60

European Commission (2002) Company Taxation in the Internal Market, European Commission,
Page 340.
61
Ibid, Page 340.
62
Ibid, Page 339.
63
Wagday M. Abdullah (1989) International Transfer Pricing Policies-Decisions-Making Guidelines
for Multinational Companies, Quorum Books, New York, Westpost, Connecticut, London, Page 85.
64
Ibid, Page 85.
65
Sylvain R.F.Plasschaert (1979) Transfer Pricing and Multinational Companies-An Overview of
Concepts, Mechanisms and Regulations, Saxon House, Page 10.
66
Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 39.

23

2) Cost Plus Method (CPP)


a) Basic Features

The starting point in this method is the cost to the seller or supplier to which an
appropriate amount of profit is added. This appropriate profit is determined by
multiplying the cost with gross profit percentage in comparable uncontrolled
transactions. The arm's length price in this method is cost plus appropriate profit
calculated as percentage of cost.67

b) Merits
This method is most suitable in respect of transfer of semi-finished goods, rendering
of services and long-term buy and sell arrangements.68

c) Demerits
The profit margin cannot always be calculated accurately and objectively,69 as no
business can always generate income as a percentage of its cost all the time under all
circumstances.

67

Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer, (2nd Edition), Kluwer
Law International, the Hague/London/New York, Page 63.
68
Chris Adam and Peter Graham (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 21
69
Peter Muchlinski (1993) Multinational Enterprises and the Law, Blackwell Oxford UK and
Cambridge USA, Page 284

24

3) Resale Price Method (RPM)

a) Basic Features

It is also known as Sales-minus or re-sale minus method.70


The starting point in this method is the price at which a product is resold to an
independent unrelated third person by an entity within an MNE, after purchasing
from a related entity. The object is to determine the original sale price. From the
resale price, an appropriate mark up to give the reseller a reasonable profit over and
above his costs called the sale (or resale) price margin is subtracted and other
relevant adjustments on account of expenses incurred in relation with purchase like
custom duties etc. are made to arrive at the arm's length price. The appropriate mark
up is calculated as percentage of resale price in comparable transactions between
unrelated parties.71 In other words, the arm's length price under this method is the
resale price minus the mark-up.

This method is most suitable for transfer of finished products.72

Factors to be considered for the determination of appropriate mark-up include: value


of operations performed and risks taken by the intermediary, expertise requirement
of the intermediary, addition of any form of intellectual property like trade mark,

70

Ibid, Page 284.


Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer
Law International, the Hague/London/New York, Page 62 and Chris Adam and Peter Graham (1999)
Transfer Pricing: A UK Perspective, Butterworths London, Edinburgh & Dublin, Page 13.
72
Chris Adam and Peter Graham (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 21
71

25

exclusive sale rights with the intermediary and comparable mark-ups in similar
transactions between unrelated parties.73

b) Merits

It is more useful where product comparables are not available and there is no valueaddition to the product by the intermediary before resale.74

c) Demerits

Firstly, this method is not of much help where the intermediary party is engaged in
significant value-addition to the product before resale.75
Secondly, if there is too much time interval between the purchase and subsequent
resale, some additional factors also needs to be considered like changes in market
conditions, interest rates etc.76
Thirdly, the final price may be artificially increased for various motives including
gaining a monopoly, making this method having a wrong starting point.77

73

Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 43.
74
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Page 416
75
Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 43
76
Ibid, Page 43
77
Peter Muchlinski (1993) Multinational Enterprises and the Law, Blackwell Oxford UK and
Cambridge USA, Page 284.

26

4) Transactional Net Profit Margin Method (TNMM)

a) Basis Features

It is also sometimes called the comparable profit method (CPM).78 This method
looks into the profit from controlled transactions (between related entities) as a
percentage of an appropriate base (like sales, cost or assets etc).79 In other words, the
ratio between profit from a controlled transaction and some base like sales, assets or
capital (e.g. profit to sales ratio, profit to assets ratio etc) is determined.80 Thereafter,
comparison of the net profit margin is made between a controlled transaction and
comparable uncontrolled transactions to see whether or not the net profit margin
meets arm's length standard.81 To make it more accurate and reliable, several TNMM
calculations (called TNMM range) in respect of uncontrolled transactions are made.82
It is most useful in transfer of semi-finished goods, rendering of services and transfer
of finished goods where RPM cannot be applied.83

b) Merits

Firstly, net margin is less likely to affected by transactional differences than that is
with price (like that in CUP) or sale price margin (like that in RSM).84
78

Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer Law
International, the Hague/London/New York, Page 66.
79
Chris Adam and Peter Graham, (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 19
80
Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer Law
International, the Hague/London/New York, Page 66.
81
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Page 417.
82
Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer Law
International, the Hague/London/New York, Page 66.
83
Chris Adam and Peter Graham (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 21.

27

Secondly, the determination of functions performed and risks involved is not


required.85
Thirdly, this method is relatively simple because it examines only one party to the
controlled transaction.86

c) Demerits

Firstly, unlike tax authorities, the taxpayers may not have access to the information
on comparable transactions.87
Secondly, this method can be manipulated by the taxpayer or tax authorities in
accordance with their desired value by choosing the comparable companies which
suit them for this purpose.88

5) Profit Split Method (PSM)

a) Basic Features

This method computes total world taxable profit/income derived from the controlled
transactions carried on by the related entities engaged in a common economic
activity. The total profit so computed is then split and allocated among the related

84

Ibid, Page 20.


OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Page III-10.
86
Chris Adam and Peter Graham (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 20.
87
OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Page III-10.
88
Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer Law
International, the Hague/London/New York, Page 68.
85

28

entities in proportion to their contribution they are considered to have made in


generating that profit.89
To put it simply, this method involves two steps:
Step 1: Determination of the divisible profit (which requires to split) for the related
entities from the controlled transactions wherein the related entities are engaged,
Step 2: Allocation of the profit computed in the step (1) between related entities is
determined on the basis of the contribution made by each entity on the arm's length
standard (the appropriate profit split).90

The OECD Guidelines provide that the contribution of each entity be determined by
taking into account functional analysis of the each entity [which means analysis of
the function performed [giving due consideration to the assets used and risks taken,
as briefly mentioned in Chapter 4, Part A (3)] and valuation of the contribution of
each entity on the basis of external market data.91

This method differs from unitary taxation in that the basis of allocation of the profit
of the MNE among its entities is a pre-determined formula evolved after considering
various factors of production like assets used, manpower employed, sales etc without
taking consideration of the arm's length principle.92

89

Chris Adam and Peter Graham, (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 18.
90
Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer Law
International, the Hague/London/New York, Pages 64-65
91
OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Page III-3.
92
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Page 418.

29

It is most useful in transactions involving integrated services provided by more than


one enterprise.93

b) Merits

Firstly, the method does not place reliance on comparables and so can be used in
their absence.94
Secondly, it gives due consideration of specific and unique factors present in an
MNE and absent in comparable unrelated entities95.
Thirdly, it avoids arriving at the unrealistic figure of profit, because both parties to
the transaction are examined.96
b) Demerits

Firstly, the method is less direct and less reliable than traditional methods.97
Secondly, allocation of costs to property and services rendered in controlled
transactions between related parties may be difficult to decide.98

93

Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer Law
International, the Hague/London/New York, Pages 65-66.
94
OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Page III-3.
95
Ibid, Page III-3.
96
Ibid, Page III-3.
97
Chris Adam and Peter Graham (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 18.
98
Ibid, Pages 18-19.

30

CHAPTER 5

ANTI-TRANSFER

PRICING

MEASURES

UNDERTAKEN

BY

INTERNATIONAL ORGANISATIONS AND NATIONAL GOVERNMENTS

Part A:

Measures undertaken by the International and Multilateral

Organizations

a) United Nations (UN)

The UN in its Guidelines 1984 encouraged the exchange of information on transfer


pricing among member states, discussed the mechanism of tax evasion and tax
avoidance through transfer pricing in detail and provided CUP, RSP and CPP
methods for determination of the arm's length price.99
The UN Model Double Taxation Convention between Developed and Developing
Countries 2001 (UN MC) adopted the concept of transfer pricing in Article 9 as
provided in the Article 9 of the OECD MC. It also has provisions for a mutual
agreement procedure (Article 25) and exchange of information (Article 26).100

b) OECD

Since the emergence of the transfer pricing issue, the OECD has devoted a lot of
time and energies to determine its tax implications and to evolve the measures to

99

UN (1984), Guidelines for International Co-operation against Tax Evasion and Avoidance of Taxes
(with special reference to Taxes on Income, Capital and Capital Gains) UN, Pages 4-5.
100
UN (2001) United Nations Model Double Taxation Convention between Developed and
Developing Countries, UN, Page 138.

31

counter its undesirable effects. The Committee on Fiscal Affairs, which is the main
body of the OECD regarding tax policy, issued various reports on transfer pricing,
which include: Transfer Pricing and Multinational Enterprises (the 1979 Report),
Transfer Pricing and Multinational Enterprises: Three Taxation Issues (the 1984
Report), Tax Aspects of Transfer Pricing within Multinational Enterprises: The
United States Proposed Regulations (1993) and Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations (the 1995 Guidelines)101
The 1995 Guidelines show preference for use of any traditional method for the
computation of the arm's length price and reserves the other methods in
circumstances when the traditional methods cannot be applied.102
The OECD Model Tax Convention on Income and Capital (OECD MC) provides for
adjustment of profits between associated enterprises in Article 9.103 This provision is
usually construed to be recognition of the arm's length price, as stated within the
OECD Guidelines 1995.104

c) Bilateral Double Taxation Avoidance Treaties


These usually contain provisions on transfer pricing and exchange of information.
d) Multilateral Treaties

There are only few such treaties, like between Nordic and Benelux countries. These
have provisions for exchange of information.105

101

OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Page 4.
102
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Pages 414-415.
103
Ibid Page 636,
104
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Page 414.
105
Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 90.

32

Part B: Measures undertaken in Domestic Legislation by National Governments

With the widespread use of transfer pricing, inter alia, as a tool of tax avoidance and
shifting of profit, governments of most of countries enacted counter-acting
legislation and framed rules and regulations to frustrate the efforts on tax avoidance
enabling them to receive their fair share in the tax revenue relatable to the income
generated from economic activities having nexus with that country. In this part,
relevant legal provisions in the domestic law of some countries will be examined
briefly.

1) USA

Section 482 (allocation of income and deductions among taxpayers) of the Internal
Revenue Code (IRC) empowers the Internal Revenue Service (IRS) to apportion and
allocate income and deductions etc among the related enterprises.106
Section 482 is short and simple consisting of only two sentences. The first sentence
sets up a general rule, empowering the IRS to apportion and allocate income,
deductions, credits or allowances between entities related to each other by common
ownership or direct or indirect control when such apportionment or allocation is
necessary to prevent tax evasion or to reflect their true income.107 The second
sentence deals with super royalty and provides that any transfer or license of

106
107

http://www.intltaxlaw.com/SHARED/TRANSFER/irc.htm#Section%20482
Visited on 15th August 2006.
Ibid Visited on 15th August 2006.

33

intangible assets must be at the price considering the subsequent income generated
from them.108

Section 482 has been supplemented by detailed regulations (regulations 1.482-0 to


1.482-8, 1.901-2(e)(5)(i) and 1.6662-6).109 Like section 482, the transfer of tangible
and intangible properties has been dealt with separately by providing separate
methods in the regulations. Under these regulations, the prescribed methods for
determinations of the arm's length price for the transfer of tangible property are CUP,
RSP, CPP, Comparable profit method and other reasonable methods and for the
transfer of intangible property are CUP, CPM and other reasonable methods.110 The
IRS has also issued guidelines on enforcement of section 482 cases incorporated in
the Internal Revenue Field Manual.111 Case laws decided by US courts on this issue
are also helpful in this regard.
Transfer pricing adjustments by tax authorities on basis of section 482 is frequently
disputed by taxpayers leading to litigation. According to Judge Nims, Chief Judge of
US Tax Court, in 1990, more than 200 cases of alleged transfer pricing
manipulations were filed by the IRS which involved understatement of profit from $
10 millions to $ 6 billions.112 Wheeler (1990, p 11) pointed out that it is doubtful if
any area has more tax dollars involved than section 482.113

108

th

Ibid Visited on 15 August 2006.


Joseph C. Amico (1993) Introduction to the US Income Tax System, Kluwer Law and Taxation
Publishers Deventer and Boston, Page 175.
109
http://www.intltaxlaw.com/SHARED/TRANSFER/regs.htm#Definitions
Visited on 15th August 2006.
110
Joseph C. Amico (1993) Introduction to the US Income Tax System, Kluwer Law and Taxation
Publishers Deventer and Boston, Pages 176-177.
111
Alan W. Stroud and Colin D. Masters (1991) Transfer Pricing, Butterworths London, Dublin and
Edinburgh, Page 108.
112
Peter Muchlinski (1999) Multinational Enterprises and the Law, Blackwell Oxford UK and
Cambridge USA, Page 311.
113
Clive R. Emmanuel and Messaoud Mehafdi (1994) Transfer Pricing, Academic Press Harcourt
Brace and Company, Publishers, Page 79.

34

2) UK
General and special provisions on transfer pricing have been incorporated in
domestic legislation in accordance with the Article 9 of OECD MC and OECD
Guidelines.114
3) PAKISTAN
Section 108 of the Income Tax Ordinance 2001 relating to transactions between
associated enterprises empowers the taxation authorities to distribute, apportion or
allocate income or tax credits to the extent that the arms length standard is met and
section 109 empowers taxation authorities to, inter alia, re-characterize a transaction
or a part of transaction made with a view to avoid tax.115
Rules 20 to 27 of the Income Tax Rules, 2005 deal with transfer pricing and provide
application of the arms length standard in the transactions between associated
enterprises for which four methods have been prescribed: CUP, RSP, CPP and profitsplit method.116

114

Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Page 426.
115
http://www.cbr.gov.pk Visited on 17.08.06.
116
Ibid Visited on 17.08.06.

35

CHAPTER 6

UNITARY TAXATION

Part A: Introduction

At present, the general approach in taxation is to treat the affiliated entities as


separate legal persons maintaining separate accounts and filing tax returns and
paying taxes to the tax authorities of the country which holds jurisdiction over them
on basis of nationality, residence or source. An adjustment is made to transactions in
respect of transfer prices which fail to meet the arms length standard. Any resultant
double taxation is remedied by unilateral relief (either by straight exemption or credit
method) or bilateral double taxation treaties.
Unitary taxation (also known as formulary apportionment system, unitary business
method or global formulary approach) has been suggested as an alternative to this
separate entity approach and arm's length principle. It is claimed that this system
would remove all the anomalies and drawbacks associated with the current practices
to combat the inappropriate transfer pricing.

It was first introduced in California117 and is in use at sub-national level by provinces


of Canada and states of US.118 Its use has been suggested for use in cases involving
the North America Free Trade Agreement (NAFTA).119

117

Thomas G. Evans, Martin Taylor and Oscar Holzmann (1985) International Accounting and
Reporting Macmillan Publishing Company New York/Collier Macmillan Publishers London, Page
387.
118
Brian J. Arnold and Michael J. McIntyre (2002) International Tax Primer (2nd Edition), Kluwer
Law International, the Hague/London/New York, Page 80.
119
Ibid, Page 80.

36

Part B: Basic Features

All the affiliated/related entities carrying out income-generating economic activities


within or without the country of origin are treated as one unit (unitary business
enterprise-UBE, unitary business group-UBG, unitary business, or global
taxable unit). The total world income or global taxable income (or loss) of this
unitary business enterprise (generated by all its related entities) is computed (global
profit assessment). Thereafter, this income is apportioned in a pre-determined
mathematical formula (apportionment formula) evolved on the basis of predetermined factors (apportionment factors). The share of each state is distributed
to each state which applies its own tax rates in accordance with its domestic tax laws
and rules.120

Following are important components constituting unitary business approach which


need further elaboration;

1) Definition of unitary business enterprise

Charles E. McLure, Jr. defined a unitary business as the smallest division of a firm
or a group of firms, the income of which can generally be accurately indicated by
separate accounting.121

120

Ibid, Page 78.


Charles E. McLure, Jr; (1984) The State Corporation Income Tax-Issues in Worldwide Unitary
Combination, Hoover Institution Press, Stanford University, Stanford, California, Pages 90-91.
121

37

The fundamental question is what entities are to be clubbed together for unitary
business and what should be the bases for such inclusion. The US system, which is
the pioneer in this approach, does not provide any strict objective criterion for that.
Generally, different approaches have been set by the US courts which are briefly
described as under;

a) Three unities approach:


This approach was adopted by US court in Butler Brothers v McColgan by declaring
that a business is unitary if there are three unities viz. unity of ownership (like
shareholding etc), unity of operation (like purchase of equipments and incidental
items, advertisement, common accounting facilities, common legal representation,
joint efforts in expanding the business and inter-company financing and parent
guarantees etc) and unity of use (like inter-company transfer of products, shared
directors and officers, transfer of executive personnel and public image).122

b) Contribution and dependence approach:


This approach was adopted by US court in Edison California Store declaring a
business unitary when an economic activity carried on in one state is dependent on
or contributes to business activity in another state.123

c) Centralized management, functional integration and economies of scale


These factors were considered relevant by the US Supreme Court in Mobil Oil v
Commissioner of Taxes of Vermont.124

122

Benjamin F. Miller, (1984) The State Corporation Income Tax-Issues in Worldwide Unitary
Combination, Charles E. McLure, Jr (ed) Hoover Institution Press, Stanford University, Stanford,
California, Pages 140-141. [17 Cal. 2d 664 (1941)]
123
Ibid, Pages 141. [30 Cal 2d 472 (1947)]

38

d) Flow of values

Flow of values as against flow of products was considered to be main characteristic


of the unitary business by US Supreme Court in Container Corp of America vs.
Franchise Tax Board.125 The flow of value may exist when there is functional
integration, centralized management, economies of scale; management of affiliates
by the parent, engagement is same line of business and non-arms length
transactions.126

2) Computation of Total Taxable Income

Total divisible income of the unitary business enterprise from all economic activities
is determined.

3) Establishing Apportionment Formula

At present different apportionment factors are being as basis of the apportionment


formula. These include supply or sale factor (quantum of sales of goods and receipts
from rendering services), property factor and payroll factor (contribution of labor in
generating income).127

124

Sijbren Cnossen (2002) Taxing Capital Income in the European Union-Issues and Options for
Reform, Oxford University Press, Page 265. [445 US 425 (1980)]
125
Ibid, Page 265.[463 US 159 (1983)]
126
http://www.treas.gov/offices/tax-policy/library/ota83.pdf
Visited on 29th August 2006.
127
Sijbren Cnossen (2002) Taxing Capital Income in the European Union-Issues and Options for
Reform, Oxford University Press, Pages 267-170.

39

Part C: Merits

If the unitary taxation is adopted worldwide, it would result in the following benefits
for states and taxpayers;
Firstly, all the entities within a unitary business earning taxable profits from
economic activities in different countries will be taxed only once at one place and no
further tax liability would arise128 and the taxpayers will no longer be subjected to
different tax jurisdictions in respect of its foreign affiliates. It will greatly facilitate
international trade, since there will be freedom of transactions between affiliates and
major uncertainties in matter of international taxation like transfer pricing
adjustments and conflicting and overlapping jurisdictions will be removed.129
Secondly, since all the states will be getting their due fair share in tax revenue, these
will no longer need to appease the MNEs for making investment in their jurisdiction
by indulging in harmful tax practices like tax havens and harmful preferential tax
regimes. There will be no race to the bottom or harmful tax competition between
states.130 Thirdly, it will reduce the administrative cost of tax collection by states131
and the compliance cost (monetary and time costs) of taxpayers. Fourthly, shifting of
profit by the MNE from one country to another for tax consideration will be
discouraged.132 Finally, neither the transfer prices between related will need to be
monitored, nor will determination of the arms length price be necessary and

128

Brian J. Arnold and Michael McIntyre (2002) International Tax Primer (2nd Edition), Kluwer Law
International, Page 79.
129
S.O. Lodin and M.Gammie (2001) Home State Taxation, IBFD Research Department, Page 16
130
Brian J. Arnold and Michael McIntyre (2002) International Tax Primer (2nd Edition) Kluwer Law
International, Page 79.
131
T. Scott Newlon (2002) Taxing Capital Income in the European Union-Issues and Options for
Reform, Sijbren Cnossen (ed) Oxford University Press, Page 235.
132
Thomas G. Evans, Martin Taylor and Oscar Holzmann (1985) International Accounting and
Reporting, Macmillan Publishing Company New York/Collier Macmillan Publishers London, Page
391.

40

consequently the problems of transfer pricing related tax avoidance will be solved
once for all.
Part D: Demerits
Firstly, it has not been favored by international organizations so far. It was
considered and rejected in Ruding Report, 1992133 and also in the OECD
Guidelines134 and disapproved by the Group of Four Report of April 19982.135
Secondly, it has received a lot of criticism from the US and foreign MNEs as well as
foreign governments. MNEs have threatened boycott and foreign governments have
announced retaliatory legislation. UK government, vide section 54 of the Finance
Act 1985, has been empowered to retaliate if a British company is taxed on unitary
basis.136 Thirdly, a single apportionment formula covering all the industries and
sources of income may be difficult to devise.137 Fourthly, a precise definition of the
unitary business and the parameters for inclusion of business entities in it, have not
been agreed upon so far. Fifthly, there will be exchange rate problems for taxpayers
as well as tax collectors.138 Sixthly, it may create conceptual confusions like
abandoning the well-established separate entity and limited liability doctrines.

139

Seventhly, the measurement and valuation of the apportionment factors like property
(tangible and intangible) and sales etc may pose various problems. Finally, it will be
difficult to collect the information and books of accounts necessary to compute

133

Charles E. Miller. Jr; and Joan M. Weiner (2002) Taxing Capital Income in the European UnionIssues and Options for Reform, Sijbren Cnossen (ed) Oxford University Press, Page 273.
134
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Page 418.
135
Jill C.Pagan and J. Scott Wilkie (1993) Transfer Pricing Strategy in a Global Economy, IBFD
Publications, Page 28.
136
Peter Muchlinski (1999) Multinational Enterprises and the Law, Blackwell Oxford UK and
Cambridge USA, Page 301.
137
Charles E. McLure, Jr. and Joan M. Weiner (2002) Taxing Capital Income in the European UnionIssues and Options for Reform (ed) Oxford University Press, Page 260.
138
Ibid, Page 261.
139
OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Pages III-23-24.

41

taxable income from foreign affiliate because of not having competence to enforce
compliance and lack of jurisdiction.140

140

Frances Stewart (1981) Taxation and the Control of Transfer Pricing, Multinationals Beyond the
Market, Intra-Firm Trade and the Control of Transfer Pricing, Robin Murray (ed) The Harvester Press,
Page 179.

42

CHAPTER 7

ANTI-TRANSFER PRICING STRATEGIES IN PRACTICE

1) Transfer Pricing Adjustments on the Basis of the Arms Length Price


Determined by Tax Authorities

The objective of the determination of arms length price through various methods is
to make a transfer pricing adjustment in order to bridge the difference between the
transfer price and the arm's length price. Therefore, tax authorities make appropriate
adjustments (called transfer pricing or primary adjustments) to the transactions and
profits based on difference between the arm's length price (as determined by various
methods discussed above) and the transfer price, as provided in the domestic
legislation of the country concerned.

There are currently two approaches for determination of the arm's length price viz.
negotiated approach as adopted by UK tax authorities and strict rules and regulationbased determination of the transfer prices, as followed by US.141

The transfer pricing (or primary) adjustment based on the arm's length principle can
result in a number of further problems like disagreement by the MNE on the arm's
length price determined by the tax authorities leading to litigation and refusal of
other country to make correlative or secondary adjustment leading to double taxation

141

Peter Muchlinski (1999) Multinational Enterprises and the Law, Blackwell Oxford UK and
Cambridge USA, Page 288.

43

2) Advance Pricing Agreement (APA)

The unilateral determination of the arms length price by tax authorities is frequently
disputed and litigated by the taxpayers, besides creating uncertainty in taxation.
Some countries have tried to resolve these problems by negotiating agreements with
the taxpayers on the methodologies to determine transfer prices before any such
dispute arises. Such an agreement, called an advance pricing agreement or
arrangement is binding on all parties.142 It may be unilateral (between taxpayer and
one tax authority), bilateral or multilateral (involving more than one tax
authorities).143 The APA procedure was first introduced in US in 1991 and followed
by other countries.144
The APA has various advantages like removal of elements of uncertainty, reduction
of compliance costs, fostering amicable milieu between taxpayers and tax collector,
avoidance of time and money consuming litigation and reduction of economic double
taxation (bi- or multilateral APAs). However, it has certain drawbacks arising from
unpredictable change in market conditions, disagreements on APAs conclusions on
various transactions, lack of corresponding adjustment by tax authorities of other
countries and misrepresentation or fraud in concluding APAs.145

142

Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Pages 420-1.
143
Chris Adam and Peter Graham (1999) Transfer Pricing: A UK Perspective, Butterworths London,
Edinburgh & Dublin, Page 45.
144
Ibid, Page 47.
145
OECD (2001) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,
OECD, Pages IV-46-51.

44

3) Reporting and Record Keeping Requirements


The requirement of reporting and disclosure vary from country to country. However,
each country prescribes minimum criteria of transactions to be reported to tax
authorities and record and books of accounts to be maintained.146
4) Penalty Provisions
Penalties are instruments of compliance and deterrence to the delinquents. These
penalties are either flat-rate penalties (for various defaults like non-filing of returns
or any documents) or the percentage penalties (for various defaults like underreporting or concealment of income) which are calculated as the percentage of tax
sought to be avoided.147
5) Exchange of Information
Article 26 of OECD MC and UN MC provide for exchange of information in tax
matters between tax authorities.148 The majority of the bilateral avoidance of double
taxation treaties has similar provisions. Such exchange is very helpful in undoing tax
effects of inappropriate tax prices.
6) Imposition of Anti-Dumping Duty (ADD)
In all WTO signatory countries, if an entity sells a product in a country other than the
country of origin at less than its normal value (less than sale price in the exporting
country or less than the cost of production), the importing country can impose antidumping duty (ADD) not exceeding the amount of margin of dumping, as per
provisions of Article VI of the General Agreement on Tariff and Trade (GATT).149

146

Jill C.Pagan and J. Scott Wilkie (1993) Transfer Pricing Strategy in a Global Economy, IBFD
Publications, Pages 68-60.
147
Ibid, Pages 70-71.
148
Roy Rohatgi (2002) The Basic International Taxation, Kluwer Law International, London/The
Hague/New York Pages 643 and 660.
149
Peter Van Den Bossche (2005) The Law and Policy of the World Trade Organization, Text, Cases
and Materials, Cambridge University Press, Pages 512-521.

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CHAPTER 8

CONCLUSION

Transfer pricing, like science and technology, is a neutral phenomenon. It is its use or
abuse (intended or unintended) which makes it an innocuous commercial practice or
a condemnable and cognizable offence. Transfer pricing per se is not an immoral or
illegal act. As we have seen above, it can be purely for business considerations
without any intentional or unintentional endeavor to defraud government or any
concerned party. Therefore transfer pricing is generally conceived as a permissible
practice like other administrative or commercial practices of business entities. No
country has outlawed transfer pricing practices, nor has any international
organization declared it as an undesirable act. Neither bodies of the accountants nor
the organizations of lawyers consider it a sin or crime. Therefore, transfer pricing
should be taken as a perfectly normal routine business practice and business decision
of the management of business entities.

Every transfer pricing incidence does not result in tax avoidance. Transfer pricing
may be purely for business considerations and yet it may have an unintended side
effect of tax avoidance. Tax authorities make their appearance on the stage of
transfer pricing only when they smell the rat by establishing that the transfer
pricing under consideration has resulted in tax avoidance. The visions of tax officials
and MNEs are diametrically opposite. An MNE thinks big and a tax official thinks
small. An MNE thinks globally concentrating on its global profits and operations and
by contrast, the focus of attention of tax authorities is national, spending all its

46

energies to ensure that their country is not deprived of its legitimate share in tax on
the income having nexus with the country by shifting of profit or reduction of tax
liability.

So far, the only method in practice to counter tax avoidance through inappropriate
transfer pricing is making an adjustment on the basis of the arm's length price
determined by tax authorities. Though the methods employed for that are not perfect,
yet these are the only available means and should be used till any workable
alternative is found out, in line with the famous quote of Sir Winston Churchill that
the democracy is the worst form of government except all others which have been
tried. Any resultant double taxation is manageable by exemption or credit method
in accordance with domestic legislation or avoidance of double taxation treaties.

Just as transfer pricing is a cross-border phenomenon used by MNEs undertaking


cross-border business, its associated adverse effects on taxation can best be done by
measures agreed by the international community. Both the OECD MC and the UN
MC provide for a mutual agreement procedure and exchange of information. The
bilateral double taxation agreements usually contain similar clauses.

A lot more needs to be done to combat tax avoidance through the transfer pricing at
international level:

Firstly, the difference in tax rates needs to be minimized, so that the inducement for
transfer of business profits is minimized consequently.

47

Secondly, what hundreds of bilateral double taxation avoidance treaties could not
achieve regarding transfer pricing, the single multilateral treaty can achieve. Such an
international treaty between the all or most nations (like WTO) can resolve practical
handicaps like issues of secondary adjustment when primary adjustment is made by
one country, the double taxation, the disputes on the valuation or method of valuation
between counties and exchange of information.
Thirdly, so far the taxation dealing with cross-border transactions is purely a
domestic subject. There is neither any codified international tax law (comparable to
WTO law or UN laws etc) nor any international supervisory organization. This
results in a lot of problems like jurisdictional conflicts, double taxation, disputes on
valuation, harmful tax competition and problems in compliance, enforcement and
recovery. Establishment of an international body like International Tax Organization
(ITO) has been suggested.150 Such a proposal was considered by the UN in 2001.
The ITO was to be assigned various functions like offering technical assistance,
provision of a forum for development of international tax norms, maintenance of tax
surveillance, restraining harmful tax competition and arbitration of tax disputes.
However, it was not found practicable.151
However, the idea of ITO is not that unworkable and may materialize in future. It
should not be forgotten that International Trade Organization was to be established at
the same time when IMF and World Bank came into existence. However, it became
reality after several decades in 1980s and now it is most uncontroversial international

150

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Visited on 11th August 2006.
151
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Visited on 11th August 2006

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organization entrusted with ensuring rule-based international trade and equipped with
its own dispute resolution mechanism.

In my opinion, the establishment of such an international organization is


indispensable. Like WTO, it can provide forum for dispute resolution, form rules for
issues in international taxation, ensure exchange of information between nations,
combat tax avoidance and tax havens, make rules for transfer pricing and resolution
of jurisdictional and other disputes between nations.

Can unitary taxation be substituted by the arm's length approach?

This question has been widely debated with a lot of arguments for and against. It has
been claimed that it would be a panacea for all transfer pricing related ailments
affecting international taxation. However, in the present international political and
economic situation where accounting standards, methods of computation of taxable
income, tax laws etc are different; the unitary taxation does not seem to be workable.

A lot has to be done before unitary taxation can replace the arms length approach:

Firstly, the accounting standards, methods of computation of taxable income and


methods of valuation of goods and services etc will have to be harmonized.
Secondly, for implementation, this approach presupposes international cooperation.
That is possible only after promulgation of formal international codified law
consensually agreed by the nations. No serous effort has been made so far in this
regard.

49

Thirdly, even after adopting international law, we need an international


implementing organization for supervision, dissemination of information and dispute
settlement.
Fourthly, the determination of apportionment factors like sales, property etc and
methods of their valuation require consensual agreement by nations.
Fifthly, the apportionment formula acceptable to all countries involved needs to be
evolved. Finding a one-suit-fit-all type of mathematical formula may not be possible.
Probably, we need sector-by-sector dynamic and flexible formulae arrived at after
careful analysis by experts and debates in appropriate forums.
Finally, disputes arising between nations cannot be effectively resolved unless there
is an effective International Tax Organization.

Therefore, in the present circumstances, the unitary taxation is too utopian to put into
practice.

Despite having many imperfections and several shortcomings, the arms length
approach is the best system available so far. However, there is a lot of room for
improvement as suggested above. Unitary taxation can replace the arms length
approach, after obtaining consensus over various issues and concluding international
agreement. Both approaches can also work simultaneously by reserving unitary
taxation for the specified big MNEs and keeping the arms length approach for rest
of MNEs. Establishment of an International Tax Organization is a key to many
problems associated with both approaches.

50

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WEBSTIES

http://www.austlii.edu.au/cgibin/disp.pl/au/journals/UWSLRev/2004/3.html?query=^%20transfer%20pricing%20t
ax%20avoidance

http://www.cbr.gov.pk

http://www.intltaxlaw.com/SHARED/TRANSFER/irc.htm#Section%20482

54

http://www.intltaxlaw.com/SHARED/TRANSFER/regs.htm#Definitions

http://www.treas.gov/offices/tax-policy/library/ota83.pdf

55