Transfer Pricing (A Tax Post!)

A month ago a commentor asked about the practice known in the tax community (and more broadly) as "transfer pricing" and reigning in some of its effects.  

As background, "transfer pricing" generally (very generally) refers to how to account for transactions between related entities for tax purposes.  That is, if wholly owned subsidiary A sells a product to wholly owned subsidiary B, what should the price be?  Similarly, if Finance Subsidiary loans money to Operating Subsidiary, what should the interest rate be?

The standard for setting these prices/rates, in the United States, the OECD, and pretty much everywhere else (Brazil being an outlier), is that the theoretical "arm's length" price should be charged.  That is, what would Subsidiary A charge Subsidiary B if they were not controlled by the same corporate parent (similar issues arise in transactions between family members)?  Unsurprisingly, there is a very very very large volume of regulations in the US tax code, and similarly large OECD transfer pricing guidelines, that attempt to figure this theoretical price out.

This can be simple.  For example, if you're selling, say, gold between subsidiaries there's not much question of what the "arm's length" price should be.  But what if the headquarters company is charging for the services it provides (e.g., IT, human resources, regulatory, etc.) to its worldwide subs?  Or, more importantly, what about the transfer uniquely valuable intellectual property (IP), or the rights to the next generation of that IP?  How does that get priced?  This is particularly problematic as, because it's IP, there aren't any "comparable" transactions that the transfer might be compared to.  

The proper amount of interest to charge might be easier to model, but that brings up what I'm driving at:  why, in the world, do tax authorities respect transactions between related entities?  That is, if all I'm doing is transferring money from one pocket to another, why should that be respected?  Especially in cases where, say, the payor subsidiary deducts an expense at a 35% rate and the payee subsidiary takes it into income at only 5%?  It's mind-boggling to me.

And yet, this is common practice all around the world, supported and driven by large multinationals and their advisors, not to mention the actual legal rules.  So, what to do?  Well, one approach would be to adopt what most U.S. states do, which is to mostly ignore transactions between affiliates and allocate income and expenses based on certain factors (such as the location of sales, assets, and payroll).  The FASB rules also ignore transactions between affiliates.  

AFAICT, there is some recognition by nation-states that this is a problem, but the most important ones still seem to think the theoretical arm's length standard is critical to...something.

Comments

[Tom H.]

What do you mean in paragraph 5 by "respect"? Am I missing some technical sense, or is it just a simple reading comprehension failure?

[McKinneyTexas]

I'm trying to remember who that commenter was?

Two predictions: this very important topic will not produce a lot of comments. Second, you're right, nothing will be done.

How does GE show incredible profits and pay no US income tax? Transfer pricing. Income earned in the US should be taxed in the US. But, until corporate tax rates fall here, precipitously, the system will remain unchanged.

Lower corporate tax rates significantly and tax the money here (15% of a any number is more than 0% of infinity). A potential collateral benefit of lowering the tax rate is, I suspect but haven't seen any studies, that more favorable rates will mitigate overseas outsourcing.

I complain, not without reason, that Obama hasn't done squat to make the kind of private sector legislative changes that could materially impact the economy and that don't involve spending a ton of money.

This is one area where there ought to be bipartisan consensus.

[Slartibartfast]

reining in

[McKinneyTexas]

What do you mean in paragraph 5 by "respect"?

I am pretty sure he means "pay any attention to", "notice", "give credence to", "recognize" or otherwise treat as anything other than an internal bookkeeping entry without external, i.e. tax, consequences. Normally, and Ugh can probably say this better, it is what a business buys or how it spends, rather than where it moves its money, that should drive what is and is not income and and what is and is not a valid charge against that income for tax purposes.

[Ugh]

slarti: reining in

God. Dammit. :-)

[Ugh]

Tom H.: What do you mean in paragraph 5 by "respect"?

Essentially what McKinney notes in his 10:39am comment, perhaps I would phrase it as "give tax effect to."

If I'm a Luxembourg bank and my sub in the Caymans loans money to my sub in the U.S., why would the U.S. government allow the U.S. sub to deduct the interest payments on the loan for purposes of determining the U.S. sub's net income, which is taxed at 35% and at likely 0% in the Caymans? What has changed from the perspective of the Luxembourg bank?

[CharlesWT]

A corporation has a subsidiary with cost plus government contracts...

[Ugh]

Don't tease me CharlesWT, how does it end?

[liberal japonicus]

So this is the Double Irish strategy employed by Apple?

[Turbulence]

until corporate tax rates fall here, precipitously, the system will remain unchanged.

Let's say the US cuts its corporate tax rate by 80% tomorrow. Why would you expect the system to change? Wouldn't companies still have an incentive to use tax avoidance schemes so and take advantage of tax havens where the effective tax rate is zero?

I mean, this is a race to the bottom right?

more favorable rates will mitigate overseas outsourcing.

What relates these two phenomena? Outsourcing is driven by the labor (and perhaps regulatory) price differential, no? I mean, companies outsource because they prefer paying $1/day to $8/hour or because they want to dump arsenic and lead into the ground water without some nosy beaurocrat from the EPA stopping them. It seems to me that those benefits are independent of taxation.

[JeffnSon]

Can anyone refer be to a source that will explain to me how to offshore my income?

this source was no help: http://smallbusiness.chron.com/tax-breaks-offshoring-21655.html
nor this: http://underthemountainbunker.com/2012/04/10/26-highly-profitable-corporations-paid-zero-taxes-last-year-while-taking-in-billions-in-profits/

[Phil]

I complain, not without reason, that Obama hasn't done squat to make the kind of private sector legislative changes that could materially impact the economy and that don't involve spending a ton of money.

Mmmmm, "materially impact," very interesting, please tell me more. **puffs pipe, strokes chin**

[Slartibartfast]

Wouldn't companies still have an incentive to use tax avoidance schemes so and take advantage of tax havens where the effective tax rate is zero?

When your tax avoidance department starts costing more than it saves you, you start cutting back on tax avoidance.

[Turbulence]

When your tax avoidance department starts costing more than it saves you, you start cutting back on tax avoidance.

I don't understand why companies would pay US taxes if they can pay zero taxes in Ireland, no matter what the (non-zero) US corporate tax rate is. McTex suggested lowering the corporate tax rate, not eliminating the corporate tax altogether.

[Ugh]

LJ - yes, as well as respecting transactions between related entities (and, somewhat paradoxically, in certain cases not respecting them at all).

[Slartibartfast]

I don't understand why companies would pay US taxes if they can pay zero taxes in Ireland, no matter what the (non-zero) US corporate tax rate is.

The corporate tax rate in Ireland is not zero, nor is it free of cost to take your US-formed corporation and rearrange things so that your income is incurred in Ireland.

[Ugh]

Slarti: The corporate tax rate in Ireland is not zero

Correct, it is nominally 12.5%, just as the nominal US rate at the federal level is 35% (to simplify). That said, the entire point of the Double Irish with a Dutch Sandwich structure is to take that 12.5% nominal rate down to an effective rate of zero or close to it in Ireland, at least for certain types of income, while also not paying tax on that income anywhere else.

This latter part is an increasingly significant issue. The international tax system was set up to, primarily, avoid "double taxation" by allocating jurisdictional taxing rights across countries based on certain principles. What's happened in the last 20-30 years is that corporations have figured out how to use those rules, combined with domestic country rules, to not pay taxes on certain profits anywhere, or at least pay at a very low rate.

This is sometimes referred to (rather inelegantly) as "double non-taxation," or what Prof. Ed Kleinbard refers to as "stateless income."

It is a problem, and how it plays out in the next few years will be very interesting, from more than just a tax policy standpoint.

[Slartibartfast]

while also not paying tax on that income anywhere else.

According to the linked article, Apple is paying close to 10%, which while substantially less than 35% is still substantially greater than 0.

[liberal japonicus]

I'm wondering if this is related

[CharlesWT]

"Don't tease me CharlesWT, how does it end?"

It occurred to me that creative transfer pricing could be used to inflate a contract's cost.

[Ugh]

Slarti: According to the linked article, Apple is paying close to 10%, which while substantially less than 35% is still substantially greater than 0.

Well sure, hence my reference to "certain types of income."

[wj]

Perhaps someone here knows enough about international tax laws to enlighten me on this. Would you not avoid "double taxation" if you merely made taxes paid elsewhere (to the extent that they are lower than your own tax rates) be deductable? That is, your tax rate here is the difference (if positive) between the tax you actually paid there and the tax rate here. That way, you are still paying the full rate on all of your income. The only choice you get is who you want to pay.

I know that this doesn't technically solve the internal pricing question. But if you are going to end up paying the full tax on all the money coming in to the company, it doesn't really matter how your accounting department allocates income and expenses between departments/subsidiaries.

[Ugh]

wj - Would you not avoid "double taxation" if you merely made taxes paid elsewhere (to the extent that they are lower than your own tax rates) be deductible?

The current US foreign tax credit system is set up in this manner generally. You can elect to deduct rather than credit the foreign taxes, but the latter is almost always more favorable.

What business would ask is to be taxed only once on their "economic" income. Thus, if they made $1 million overall, they want to be taxed at X% on $1 million (and obviously they would like X to be a low as possible).

What they especially don't like is being taxed at X% on $2 million when in their view they only made $1 million. That is, if Japan thinks you made $1 million in Japan and $0 elsewhere and taxes you thus, and the US thinks you made $1 million in the US and $0 elsewhere and taxes you thus, but you think you only made $500K in each country, you're effective rate has suddenly doubled AND that's not mitigated by a foreign tax credit (e.g., because the US think you made $0 in Japan and won't let you credit the tax against your US taxes).

[Ugh]

Of course, the IRS can be its own worst enemy.

Less damning "official statement" reads (I can't find a link to a non-pay walled source, including on irs.gov (I didn't look very hard)):

Between 2010 and 2012, the IRS saw the number of applications for section 501(c)(4) status double. As a result, local career employees in Cincinnati sought to centralize work and assign cases to designated employees in an effort to promote consistency and quality. This approach has worked in other areas. However, the IRS recognizes we should have done a better job of handling the influx of advocacy applications. While centralizing cases for consistency made sense, the way we initially centralized them did not. Mistakes were made initially, but they were in no way due to any political or partisan rationale. We fixed the situation last year and have made significant progress in moving the centralized cases through our system. To date, more than half of the cases have been approved or withdrawn. It is important to recognize that all centralized applications received the same, even-handed treatment, and the majority of cases centralized were not based on a specific name. In addition, new procedures also were implemented last year to ensure that these mistakes won’t be made in the future. The IRS also stresses that our employees - all career civil servants -- will continue to be guided by tax law and not partisan issues.

[Countme-In]

In other news, the Tea Party apologized for threatening to water the 3-D tree of liberty with the blood of two-dimensional IRS patriots' silhouettes at NRA target ranges.