In today’s globalized world, a corporation might have a retail store in one country, a factory in another, and financial services provider in yet a third.
Corporate interconnectedness has brought investment and growth, to be sure, but it has also added complexity to the work of tax authorities. Increasingly, developing-economy governments come face-to-face with corporations that employ sophisticated strategies with the aim of paying fewer taxes. With our recently published handbook, "Transfer Pricing and Developing Economies: A Handbook for Policy Makers and Practitioners,” we hope to support efforts to protect countries’ corporate tax bases.
This will not be easy. To capture revenues from multinational corporations, tax authorities must master rule-making, enforcement, and auditing around a technical accounting practice called “transfer pricing.” This practice is important because it is how corporations that work in multiple countries determine where their profits are made.
Essentially, a corporation sets the prices for transactions between its subsidiaries – say the price for a tee-shirt made in a factory in Honduras and sold to a retail store in Germany. This, in turn, determines the corporation’s tax liability in those countries – if the tee-shirt is more expensive, the factory makes more profit; if it’s cheaper, the retail store does.
Transfer pricing is necessary to determine profits, losses, and taxes. Problems arise when a corporation intentionally manipulates transfer prices to its advantage, depriving countries and their citizens of millions of dollars. Abusive transfer mispricing is among the most urgent problems in international tax planning confronting tax officials around the world. Take the ongoing dispute – with several billion dollars at stake – over the appropriate valuation of Facebook’s intellectual property, which was transferred to Ireland in 2010. Valuation challenges are equally relevant in developing economies, which tend to rely more on revenue from corporate tax.
At the same time, if governments are too aggressive or careless, they can subject corporations to double taxation, which risks undermining investor confidence. Multinational corporations frequently cite transfer pricing as one of their most important tax concerns, and one that may affect investment decisions. Tax authorities need to balance revenue goals with the desire to maintain a fair and predictable investment climate.
In practice, developing economies often have basic legal provisions around transfer pricing principles. But only a small number operate effective transfer pricing regimes that incorporate a thorough legal framework and credible enforcement capabilities. Drawing on our experience with tax authorities around the world, the handbook summarizes approaches that have been successful and unsuccessful. Our aim is to present lessons learned and to provide a range of examples in building and implementing more effective transfer pricing regimes. We also discuss strategies to encourage taxpayer compliance and help to prevent and resolve disputes.
To be clear, the handbook is a technical read. It gets into the details, and provides nuance for tax policy makers. We are trying to reach those who can make the day-to-day changes in the governments that need it most.
We also recognize that transfer pricing is only one of many priorities confronting tax administrators. So we emphasize the need to identify the transfer mispricing risks that are specific to individual countries – is there a certain sector that is more vulnerable? Does that sector have the potential to provide much more public revenue? And we recommend that any government properly assess the costs and benefits of investing in transfer pricing capacity. Tailoring is critical – the approach taken by a country with few large multinationals in a small number of priority sectors will differ from the approach of a country with a large number of active foreign affiliates.
In our experience, strengthening measures against corporate base erosion, such as building robust transfer pricing regimes, tends to yield good returns on investment. In initial pilot programs delivered by the World Bank, OECD and EU, additional revenue collection from transfer pricing adjustments in Colombia, Kenya, Vietnam and Zambia have been encouraging. Similarly, aggregate analysis using firm-level information, and very recent work done at the OECD suggest that requiring firms to provide more robust documentation of their transfer pricing practices and introducing related anti-avoidance rules may reduce profit-shifting by multinationals.
We hope that this handbook will help inform policy makers in evaluating different policy options and in implementing effective transfer pricing regimes. We hope it will help make the rules a little bit clearer for everyone, from government to taxpayer.