Summary report on the transfer pricing seminar held in Helsinki on 13-14 June 2012

 Transfer Pricing: Alternative Methods of Taxation of Multinationals

Seminar held at the Parliament of Finland, Helsinki, June 13-14, 2012

Rapporteur’s Summary

Emanuel Rasche

      Preceding remarks

This report on the seminar “Transfer Pricing: Alternative Methods of Taxation of Multinationals”, hosted by the Ministry of Foreign Affairs of Finland, Tax Justice Network and KEPA, provides a broad overview of the matters discussed and restricts itself to exploring overall lines of reasoning discussed during the seminar and indicating how to proceed in its aftermath. It does not provide a detailed statement of the technical discussions within the course of the seminar.  For the sake of brevity, the summary is selective in choosing what matters to report on, and readers are advised to consult the powerpoint presentations and papers provided by speakers at the seminar, available here.

       Day 1

In his opening remark TJN’s director, John Christensen, stressed the overall objective of the seminar to highlight persistent and systemic problems arising from attempts to tax multinational companies (MNCs) under the transfer pricing guidelines promoted by the Organization for Economic Cooperation and Development (OECD).  MNCs continue to shift their profits to tax havens, while accounting for the costs of production and services in countries with moderate and high tax rates. Christensen specified that the aim of the seminar was to discuss the problems arising from, and alternatives to, the current guidelines, and noted that the seminar brought together a wide range of expertise, including theoretical thinkers as well as practitioners from across the world.  

In his welcoming remarks, Finnish Minister of Foreign Affairs, Erkki Tuomioja expressed the commitment of the Finish government to tackling tax avoidance, promoting more cooperation of jurisdictions by mechanisms such as Automatic Information Exchange, and its efforts to promote adoption of a Financial Transaction Tax. He noted the differing views with respect to the current transfer pricing regime and expressed that the Finnish Government did not expect a unanimous consensus from the conference, but expected the seminar to provide a space for constructive dialogue on this important subject. He also stressed the willingness of his Ministry to further cooperate with TJN and related civil society organisations.

Heidi Hautala, the Finnish Minister for International Development, noted that discussion on international development is steadily moving beyond aid to making tax a major point of interest. The Minister stressed the common problems of developing and developed countries in this respect, in dealing with the extractive industries for instance, and she acknowledged the willingness of the Finnish Government to support governments of developing countries that seek to achieve more transparency and democratic control of land and resources.

Tatiana Falcao outlined the Brazilian transfer pricing system as a possible alternative to the OECD guidelines. She stressed the workability of the Brazilian approach, which relies on a fixed mathematical formula based on the MNCs own data. The system could reduce the excessive administrative burden that developing countries incur when trying to apply the OECD’s guidelines. The Brazilian system also provides juridical certainty for government and taxpayers.  Tatiana emphasised how the Brazilian system gives priority to tackling tax avoidance, particularly in situations involving the use by MNCs of tax havens, which she referred to as “Privileged Tax Regimes”, even if they are not directly linked to Brazilian entities.

In the following contributions by practitioners from various countries, a pattern of problems with the current transfer pricing regime became unmistakably clear.  Presentations by Zhang Ying from the State Tax Administration of China, Anita Kapur from the Ministry of Finance in India, Julius Bamidele from the Nigerian Federal Inland Revenue Service, and Gertrude van der Westhuysen from the South African Revenue Service, drew attention to the problems arising from attempts to apply the OECD’s arm’s length method of transfer pricing in situations where accurate and timely pricing comparables from non-related parties cannot be obtained or do not exist. The general lack of suitable comparables and databases to successfully apply the arm’s length method was also stressed by Indian tax practitioner Vikram Vijayaraghaven, who posed the simple question: Comparables: Whither Art Thou?

Another topic that recurred throughout conference was the growing challenge posed by intangible trading within MNCs. In cases of intangible trading it is evident that suitable comparables are typically entirely missing, enabling huge profits shifting from source countries to tax havens.

            Chennai-based Vijayaraghaven expressed concerns about protracted litigation processes arising from transfer pricing controversies in India. He concluded that the transfer pricing regime requires “a sea change” and proposed sector wide safe harbours and formulary apportionment as possible solutions.

            James Henry, Senior Adviser to TJN, provided empirical insights into the “Quantification of Transfer Pricing Issues”. He noted that estimates of the harm caused by transfer mispricing range between US$100-150 billion annually. He requested that priority be given to further empirical research to disaggregate the data provided by corporations to better understand their value chains. He also proposed undertaking country specific studies.

            In his contribution on “Tax-Administration in Sub-Saharan Countries”, Joseph Guttentag, former senior adviser to the OECD’s Committee on Fiscal Affairs, stated that the OECD’s arm’s length method could be applied successfully by developing country governments and rejected the idea that other mechanisms, such as unitary taxation with formulary apportionment could function on a global level. He did, however, propose a long list of measures that could be adopted by Sub-Saharan-Countries to improve the use of the OECD’s arm’s length method. Most importantly he stressed the need for more transparency and the disclosure of information by MNCs. He further suggested making use of hybrid methods, such as the Profit Split Method, which is de facto based on a formulary approach, to overcome the difficulties confronting Sub-Saharan-Countries.

              Case studies presented by Martin Hearson and Felicity Lawrence illustrated how MNCs create complex legal structures to shift profits to tax havens. Despite their elaborate codes of conduct on social responsibility, paying tax is not widely seen as a sustainability criterion under existing MNC codes of conduct. It became clear that tax compliance by MNCs requires constant monitoring by civil society.

            In their session, JuanCarlos Campuzano, from the Tax Administration of Ecuador, Ricardo Barrientos, from the Central American Institute of Fiscal Affairs and Gonzalo Arias, from the Inter American Centre of Tax Administration, raised the need for a practical approach to tackling transfer mispricing in South American Countries. They stressed that developing countries suffer from a lack of expertise and sufficient funds to make the arm’s length method practicable in their countries. They also noted the problem of “revolving doors” involving skilled staff leaving tax authorities for the private sector, while former employees of the private sector enter the revenue authorities of governments: conflicts of interest almost inevitably arise.

            David McNair concluded that the sheer complexity of the arm’s length method, combined with the absence of timely and reliable comparator data, poses huge obstacles for developing countries with limited technical resources to investigate transfer pricing abuses.  The situation cries out for simplification.

      Day 2

Opening the seminar’s second day, Marlies de Ruiter, Head of the Tax Treaty, Transfer Pricing and Financial Transaction Division of the OECD’s Centre for Tax Policy and Administration, reported on OECD efforts to overcome the current problems and dissatisfaction with its guidelines from various sides. She explained that the arm’s length method was initially designed to establish a market-based level playing field between MNCs and local companies.  Discussants noted, however, that the trend towards highly integrated MNC business models in recent decades has led to a situation in which competition between MNCs and their locally based competitors is distorted by the former’s ability to use subsidiaries based in tax havens for profit shifting purposes. De Ruiter acknowledged that the treatment of intangibles poses significant problems when trying to apply the arm’s length method and outline the OECD’s efforts to build expertise, especially in developing countries to cope with these challenges. De Ruiter also referred to attempts by the OECD to simplify its guidelines.

            TJN’s Richard Murphy explained that Country-by-Country Reporting was a concept that required disclosure of financial accountancy for every single jurisdiction where a MNC operates.  He argued that the public has a right to have access to this information due to the considerable privilege offered to MNCs in form of limited liability. If the countries in which MNCs operate are required to bear the risk of their failure, then the public similarly has a right to receive full information and account for tax payments. Furthermore, disclosure of this information would provide reliable and timely pricing information for use in collating data for pricing comparables.  Murphy argued that such information might partially overcome the weakness of the arm’s length method, which is significantly restricted by the absence of comparables.

            Mike McIntyre from Wayne State University (another senior adviser to TJN) outlined the US system of taxing MNCs, which focuses on taxing the economic substance of their activities in the different states where they operate. The US requirement for “Combined Reporting”, McIntyre’s preferred term, treats MNCs as a single “unitary business” (hence the term “unitary taxation”) which must file financial records covering all the states in which it operates. The combined income of the MNC is taxable according to an agreed formula, for instance based on payroll, property and sales, which allocates a share of the taxable profits to each state in which the MNC is present. McIntyre rebutted suggestions that this approach is hard to apply in practice, and noted that there is no need for agreement on one particular formula: varied formulae can be applied as appropriate to different sectors of an economy.

        Michael Durst highlighted the central fallacy of the arm’s length method, namely that subsidiaries of MNCs can be treated as though they are non-related parties. This assumption ignores the economies that arise from the integration of a wide range of activities within an MNC structure. He noted that a formulary system, based on taxing real economic activity, should yield a reasonably clear measure of a company’s taxable income. While there is no “ideal system”, the theoretical flawsinherent to the arm’s length method makes it less preferable to unitary taxation using formulary apportionment.

            Reuven Avi-Yonah proposed how improvements could be made to the arm’s length method. He stressed that financial transactions and the use of debt within MNCs must be reconsidered to make income shifting between related entities more difficult. He stressed that the price for capital can be determined with arm’s length tools under the current approach but the form of capital investment was beyond its scope. He proposed “re-characterising” related transactions within MNCs as long-term subordinated debt. Under this re-characterization, MNC affiliates would be seen as paying high interest rates on a regular basis and income shifting manipulation could therefore be reduced using the existing arm’s length method.

            Both Avi-Yonah and Ilan Benshalom suggested that a way forward from the currently unworkable system might involve a “hybrid system”, applying the arm’s length method where relevant comparables are available and formulary arrangements where they are lacking, especially in respect of intangible trade. Both argued that formulary apportionment processes are often misunderstood and problems with applying these processes are frequently exaggerated. Their key argument was that there is no “all-or-nothing paradigm”: formulary apportionment can be used selectively to overcome the obvious weaknesses of the arm’s length method.

            Kerrie Sadiq deepened this line of pragmatic reasoning by exploring possibilities to tax multinational banks according to formulary arrangements. She noted mounting awareness of the problems related to taxing Multinational Financial Institutions (MNFIs) under the OECD’s guidelines, and suggested that MNFIs can be regarded as a unique subset of MNCs due to the specific services they supply and their “integrated trading model”.  Sadiq argued that formulary arrangements would yield a substance-over-form approach, which would take account of MNFIs real economic activities within specific jurisdictions and disregard their extensive use of complex legal structures to shift profits to tax haven subsidiaries. Moreover taxing MNFIs on the basis of real economic activity reflects internalisation theory, which states that companies become multinational precisely because of the benefits they can achieve by internalising costs; benefits which are not taken account of in the arm’s length method. Sadiq suggested that a formulary approach to taxing MNFIs would lead to enhanced certainty, improved tax compliance, reduced complexity, and a reduction in the potential for double taxation and double non-taxation. For these reasons she proposed that applying formulary apportionment on a sectoral basis to MNFIs might provide a useful test for its wider application.

            Sol Picciotto reported on Europe’s Common Consolidated Corporate TaxBase (CCCTB), which attempts to establish a single set of rules for companies operating within the European Union. The CCCTB exemplifies the EU’s approach to tackling transfer mispricing by moving towards a formulary approach and, Picciotto suggested, could serve as role model for other regions.

            In the final session, chaired by Christensen, Nicholas Shaxson remarked that a principal objective for the future was to bridge the gulf between experts and people on the street by adopting a simplified language that could convey the basic issues to ordinary persons. There is also a need to build effective communications between practitioners and theoretical experts. Shaxson also stressed the need for more empirical data on profit shifting and case studies to illustrate how it is done.

            One contributor stressed that the current situation requires “sticking to problems and bringing proposals forward rather than sticking to labels”, while another contributor remarked that TJN should select a specific position and lobby for it. These apparently contradictory remarks highlight two strands of reasoning that were notable throughout the seminar: on the one hand the “all or nothing solutions” tending towards either the arm’s length method or unitary taxation based on formulary apportionment, and the more pragmatic proponents with a “problem-focus” tending towards hybrid solutions on the other hand.

Emanuel Rasche

Helsinki, June 2012