Reforming transfer pricing with outdated ideas

The debate over whether multinationals pay their fair share of taxes took the correct turn on Monday, when in the Australian Financial Review, Coalition communications spokesman Malcolm Turnbull summarised the crux problem of inadequate taxes paid by multinationals when he said "the people at fault are the government”.

This will come as big news to many whose default is to blame the players on the field and not the rules under which they play.

The fact is multinationals pay what many regard as tiny amounts of taxes in high tax countries mainly because their operations in those countries report very low profits. Shifting costs between different parts of a multinational group, so called “transfer pricing” is one perfectly legal tool used to achieve these ends.

The transfer pricing regime that exists in Australia is aimed at regulating global enterprises that have cross border dealingswith other associates or branches around the world within the group. The regime provides guidanceon how to price inter company dealingsfor tax purposes, especially fordealings between related parties.

Australia’s position on the topic has been pretty much static since Malcolm Fraser was in the Lodge. In 2010 the Organisation for Economic Co-operation and Development released guidelines that contained a number ofchanges to the generally accepted approach to transfer pricing.The purpose of these was to ensure that appropriate taxes are paid in the jurisdictions where revenues are generated. The particular focus was on cross border transactions entered into members of multinational groups.

The Federal government is en route to bring Australia’s rules in line with international developments. Clayton Utz solicitor Carynne Howitt summarises the range of issues the proposed reforms will address, with transfer pricing rules being a key component of the Consultation Paper of November 2011.

The shepherding in of the “arm’s length” principle for the valuation, for tax purposes, of cross-border transactions between associated entities is new. Proponents of this change claim that in a global economy where multinationals play a prominent role, governments must ensure that the taxable profits of such corporations are not artificially shifted in and out of jurisdictions with the express aim of minimising taxes but rather taxes paid should reflect the economic activity undertaken in the various jurisdictions.

Ms Howitt notes that mention is made inthe Consultation Paper released in November 2011, that acknowledges, “that practitioners, the ATO and Treaty partner administrators have ‘extensively’ relied on the OECD Guidelines in applying and interpreting transfer pricing profit allocation rules in Australia”. [But] also notes “courts in Australia have not endorsed the use of the OECD Guidelines in this manner”.

Precisely because the relevant standing these rules have had has never been certain in practice, the Federal government is adopting the OECD approach into legislation.

So while the champions of the “arm’s length” principle, both in the Federal government and within the OECD - where this concept first drew breath - are shrieking its merits, the principle has its critics.

Enter David Spencer of the Tax Justice Network, an independent body launched in the British Houses of Parliament in March 2003. On 24 May he demolished the standing of the “arm’s length” principle by noting it is faulty in both theory and practice. In his paper, “Will the OECD adjust to reality” he reminds readers of just how (irrationally) wed to the concept the OECD is, illustrating that the OECD itself says the “arm’s length” principle “may not always be straightforward to apply in practice”.  And while the OECD claims [that transfer pricing] does generally produce appropriate levels of income between members of [multinationals]…A move away from the arm’s length principle would abandon the sound theoretical basis described above, and threaten the international consensus”.

And there’s the rub. You see, the OECD guidelines never describe just what it means by “sound theoretical basis.” 

In Spencer’s paper he quotes Michael Durst who from 1994 to 1997 served as Director of the U.S. Internal Revenue Service’s Advanced Pricing Agreement (APA) Program who in turn extends Spencer’s argument against the OECD’s position on transfer pricing. Durst explains that the main weakness of the “arm’s length” principle is that “the basic tenet of arm’s-length transfer pricing – the availability of  ‘uncontrolled comparables’ for transactions between commonly controlled parties – is based on a fundamental misunderstanding of practical economics”.

Multinationals form precisely because it’s economically better off as an integrated unit. This is common in some industries where manufacturers and distributors are integrated. It makes no economic sense to have these functions as distinct entities. 

That means that for transactions between different elements of the one multinational – namely the transactions for which transfer pricing rules are important – the comparable prices on which the current rules try to depend seldom if ever exist.

But according to Durst, a veteran of 20 years working in the transfer pricing space,  “the inescapable problem, however, is that the failure of the arm’s length system is not rooted merely in the particular way the system is implemented. The problem lies in the assumption, on which the entire system is based, that the tax results of multinational groups can be evaluated as if they were aggregations of unrelated independent companies transacting with one another at arm’s length”.

One can only conclude that its very complexity and difficulty in enforcing are the reasons why so many tax authorities worldwide embrace the arm’s length principle.