Bending principles trims tax bills

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A nifty tax loophole is being exploited by multinationals to legally shift their profits to countries with more favourable tax regimes.

The Africa Progress Report 2014 Grain, Fish, Money – Financing Africa's green and blue revolutions.

Google, Apple, Starbucks and others have come under fire for using the process of transfer pricing to shuffle profits around, and to trim their tax bills in the process.

This practice, while technically legal — unlike money laundering — can be abused because of the difficulty of making sure the rules are followed. The resultant illicit money transfer costs many developing economies dearly. Thembinkosi Dlamini, governance manager at Oxfam, says no government can say it is well equipped to detect when the rules are flouted because the required technical expertise is complicated, which means no accurate figures of lost revenue are available.

He notes that, according to Global Financial Integrity, global losses between 2000 and 2010 amounted to $500-billion. “It’s a difficult and dicey issue to try and estimate the quantum of the loss to the fiscus.”

Dlamini says transfer pricing, depending on the company’s circumstances, could make business sense because it increases profitability by reducing costs. However, according to Keith Nichols, managing director at Thomson Reuters, the practice is not illegal as long as the company within the multinational that is receiving a product, such as a commodity, pays the same as what an external company would — a rule called the “arm’s length principle”.

Dlamini adds that things also get complicated when companies do not know how to price certain items, such as intellectual property.

Legal, but…

Edward Harris, head of communications at the Africa Progress Panel, explains that transfer pricing happens when companies move a product between different units across different countries, and have to work out how to charge for the item.

Dlamini notes picking up whether or not this rule has been breached is difficult when intellectual property is moved around, because customs forms at different ports of entry cannot be compared. This is what Google allegedly does to trim its tax bill.

Jens Brodbeck, executive at ENSafrica’s tax department, says transfer pricing becomes problematic when subsidiaries of a multinational company agree on artificially high or low pricing to shift profits from one enterprise, which is usually located in a high tax jurisdiction such as South Africa, to another that is often located in a low tax jurisdiction, such as a tax haven.

This becomes even more problematic if one considers that currently about 60% of world trade takes place within multinational enterprises, Brodbeck adds. He explains that moving profits to a country with a more beneficial tax system costs the originating country in tax revenue.

“This is of particular concern for developing and emerging countries, which require tax revenue to fund infrastructure, education or security to be able to achieve the sustainable growth required to empower its population and develop into stable democracies,” says Brodbeck.

Harris says this practice of trade mispricing accounts for about 80% of the world’s illicit financial flows, while sub-Saharan Africa has lost an estimated 5.7% of its gross domestic product over a ten-year period because of illicit outflows, “preventing millions of people from accessing better health and education”.

Brodbeck adds, apart from lost tax income, any form of profit shifting is also harmful for the economy for a number of other reasons: 

  • It distorts competition because it gives multinational enterprises that use aggressive or illegitimate transfer pricing planning the competitive advantage of a lower effective global tax rate over their local competitors that cannot or are not willing to resort to these forms of aggressive tax planning; 
  • It may lead to inefficient allocation of resources by distorting investment decisions towards locations, which provide a more beneficial tax system; and 
  • It undermines the equity of tax systems because it not only means that the loss in tax revenue resulting from transfer pricing abuse has to be recovered from other taxpayers, but also that it potentially undermines voluntary compliance by all taxpayers.

Developing countries often do not have transfer pricing rules, or may not have the capacity to enforce them sufficiently, which costs the fiscus, adds Billy Joubert, director and head of transfer pricing at Deloitte.

Yet, many African countries respond to this problem by imposing unfair withholding taxes on outbound payments, which can lead to increased cost of doing business and double taxation, which is investor unfriendly.

Dlamini says another consequence is that countries that are tax havens are more likely to benefit from foreign direct investment, while countries such as South Africa lose out on this potential investment. He says developing countries, and resource rich ones, lose out on tax revenue the most.

However, Deborah Tickle, director of international corporate tax at KPMG, notes the poor will lose out if multinational companies are put off from operating in a certain country, because this will cost the economy jobs. If a tax rate is so high that the multinational would rather not operate there, forcing it to pay the high taxes to counter transfer pricing may have the negative effect of reducing the country’s growth, she says.

Tickle says there may be any number of reasons, and tax may be one of them, why members of a multinational group would transfer goods and services between each other at specific prices and under specific terms.

Harris argues whether or not transfer pricing is fair is a subjective judgment. “Some companies might argue that if their actions are legal, then they are therefore fair. However, [former UN Secretary General, Kofi] Annan has repeatedly made the point that some practices may be legal, but the scale of tax avoidance has become so enormous that it has become harmful and unethical. Our international tax system has failed to keep up with the scale and the pace of globalisation.”

Solutions

However, it seems that there is currently little recourse for abuse of the arm’s length principle, other than tax authorities’ ability to adjust the amount of income it can charge the company selling the product to a sister company. And, that’s assuming the transaction is spotted. Underdeclaring the value of exports — price misdeclaration — is illegal, notes Harris.

He says transfer mispricing, a tax avoidance measure that is generally treated as illegal, may be a serious issue for African countries. However, this is difficult to measure and rarely captured in reports on, say, illicit trade flows, says Harris. Making sure that companies are not breaking the law is an issue all countries grapple with because a large amount of goods and commodities are traded and “it is practically impossible to verify the value of every shipment of ore or every container”.

Non-arm’s length arrangements can be an exchange control offence, which would make them illegal in terms of exchange control rules, explains Joubert. He says the only countries that are usually not concerned with transfer pricing rules are low tax jurisdictions or tax havens. “This is because multinationals are usually trying to maximise profits in such countries.”

Nichols says that if international companies do not follow this rule then tax authorities have the right to adjust the local affiliate’s taxable income so it reflects what it would have been under arm’s length pricing.

This article has been produced in partnership with Oxfam. Content has been independently created by the M&G’s supplements editorial team.

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