The growing abuse of transfer pricing by MNCs By Kavaljit Singh

{‘Transfer pricing’, a financial accounting device used by multinational corporations (MNCs) to rake huge financial benefits, has long been a major problem facing host countries. Kavaljit Singh discusses this phenomenon in the wake of the recent disclosure of resort to this practice by the pharmaceutical giant, Glaxo Smith Kline. }
The large-scale tax avoidance practices resorted to by multinational corporations (MNCs) came to public notice recently when the giant drug MNC, Glaxo Smith Kline, agreed to pay the US government $3.4 billion to settle a long-running dispute over the tax dealings between the UK parent company and its American subsidiary. This was the largest settlement of a tax dispute in the US. The investigations carried out by the Internal Revenue Services (IRS) found that the American subsidiary of Glaxo Smith Kline overpaid its UK parent company for drug supplies, mainly its block-buster drug.Zantac, during the period 1989-2005. These over payments were meant to reduce the company’s profit in the US and thereby its tax bill. The IRS charged Europe’s largest drug company with engaging in manipulative ‘transfer pricing’.

Transfer pricing relates to the price charged by one associate of a corporation to another associate of the same corporation. When one subsidiary of a corporation in one country sells goods, services or know-how to another subsidiary in an other country, the price charged for these goods or services is called the transfer price. All kinds of transactions within corporations are subject to transfer pricing including those involving raw material, finished products and payments such as management fees, intellectual property royalties, loans, interest on loans, payments for technical assistance and know how and other transactions. The rules on transfer pricing require MNCs to conduct business between their affiliates and subsidiaries on an ‘arm’s length’ basis, which means that any transaction between two entities of the same MNC should be priced as if the transaction was conducted between two unrelated parties.
Manipulating the accounts
Transfer pricing, a very controversial and complex issue, requires closure scrutiny not only by the critics of MNCs but also by the tax authorities in the developing world. Transfer pricing is a strategy frequently used by MNCs to obtain huge profits through illegal means. The transfer price could be purely arbitrary or fictitious, therefore different from the price that unrelated firms would have had to pay. By manipulating a few entries in the account books, MNCs are able to reap obscene profits with no actual change in the physical capital. For instance, a Korean firm manufacturers an MP3 player for $100, but its US subsidiary buys it for $199, and then sells it for $200. By doing this, the firm’s bottom line does not change but the taxable profit in the US is drastically reduced. At a 30% tax rate, the firm’s tax liability in the US would be just 30 cents instead of $30.

MNCs derive several benefits from transfer pricing. Since each country has different tax rates, they can increase their profits with the help of transfer pricing. By lowering prices in countries where tax rates are high and raising them in countries with a lower tax rate. MNCs can reduce their overall tax burden, thereby boosting their overall profits. That is why one often finds that corporations located in high-tax countries hardly pay any corporate taxes.

A study conducted by Simon J Pak of Pennsylvania State University and John S.Zdanowiczn of Florida State University found that US corporations used manipualtive pricing schemes to avoid over $53 billion in taxes in 2001. Based on US import and export data, the authors found several examples of abnormally priced transactions such as tooth-brushes imported from the UK into the US at a price of $5,655 each, flashlight imported from Japan for $5,000 each, cotton dish towels imported from Pakistan for $153 each, briefs and panties imported from Hungary for $739 a dozen, car seats exported to Belgium for $1.66 each, and missile and rocket launchers exported to Israel for just $52 each.
With the removal of restrictions on capital flows, manipulative transfer pricing has increased manifold
With the removal of restrictions on capital flows, manipulative transfer pricing has increased manifold. According to the United Nations Conference on Trade and Development (UNCTAD)’s World Investment Report 1996, one-third of world trade is basically intra-firm trade. Because of mergers and acquisitions, intra-firm trade, in both number and value terms, has increased considerably in recent years. Given that there are over 77,000 parent MNCs with over 770,000 foreign affiliates, the number of transactions taking place within these entitles is unimaginable. Hence, it becomes extremely difficult for tax authorities to monitor and control each and every transaction taking place within a particular MNC. The rapid expansion of Internet-based trading (e-commerce) has further complicated the task of national tax authorities.

Not only do MNCs reap higher profits by manipulating transfer pricing: there is also a substantial loss of tax revenue to countries, particularly developing ones, that rely more on corporate income tax to finance their development programmes. Besides, governments are already under pressume to lower taxes as a means of attracting investment or retaining a corporation’s operations in their country. This leads to a heavier tax burden on ordinary citizens for financing social and developmental programmes. Although several instances of fictitious transfer pricing have come to public notice in recent years, there are no reliable estimates of the loss of tax revenue globally. The Indian tax authorities are expecting to garner an additional US$111 million each year from MNCs with the help of new regulations on transfer pricing introduced in 2001.

In addition, fictitious transfer pricing creates a substantial loss of foreign exchange and engenders economic distortions through fictious entries of profits and losses. In countries where there are government regulations preventing companies from setting product retail prices above a certain percentage of prices of imported goods or the cost of production, MNCs can inflate import costs from their subsidiaries and then charge higher retail prices. Additionally, MNCs can use over priced imports or underpriced exports to circumvent governmental ceilings on profit repatriation, thereby causing a drain of foreign exchange. For instance, if a parent MNC has a profitable subsidiary in a country where the parent does not wish to reinvest the profits, it can remit them by overpricing imports into that country. During the 1970s, investigations revealed that average overpricing by parent firms on imports by their Latin American subsidiaries in the pharmaceutical industry was as high as 155%, while imports of dyestuff raw materials by MNC affiliates in India were overpriced in the range of 124 to 147%.

Given the magnitude of manipulative transfer pricing, the Organisation for Economic Co-operation and Development (OECD) has issued detailed guidelines. Transfer pricing regulations are extremely stringent in developed countries such as the US, the UK and Australia. In the US, for instance, regulations related to transfer pricing cover almost 300 pages, which dents the myth that the US espouses ‘free market’ policies.
However, developing countries are lagging behind in enacting regulations to check the abuse of transfer pricing. India framed regulations related to transfer pricing as late as 2001. However, in many countries including Bangladesh, Pakistan and Nepal, tax authorities have yet to enact regulations curbing the abuse of transfer pricing mechanisms. Such abuse could be drastically curbed if there is enhanced international coordination among national tax authorities.