International Business Law
Module Code: 4.708
Prepared for – DR. RICHARD WORTH
Title: Corporate Profit Shifting
Name: Manmohan Moriya
Student ID: 20151386
Email: Manmohan_moriya@yahoo.com
Word Count: 2737
Table of Content
1.0 Question No. 1 of Assignment ……………………………………………… Page No. 3
2.0 Question No. 2 of Assignment………………………………………………. Page No. 7
3.0 Question No. 3 of Assignment …………………………………………………Page No. 9
4.0 Question No. 4 of Assignment……………………………………………..… Page No. 10
5.0 Reference List………………………………………………………………………… Page No. 12
1.0 Question 1: What are the methods of profit shifting which are commonly used?
Answer: Methods of Profit Shifting:
1. Comparable Uncontrolled Price Method:
Comparable uncontrolled price method is method to justify the Arm’s length price for the sale of physical tangible/intangible goods or services however there should be similar transaction between other/unrelated parties for comparison use. The Goods/Services which is under transaction should be standard to be sold in open market. Due to this reason the patented/trade secret or unique products are not suited in comparable uncontrolled price method.
“A method of pricing based on the price charged between unrelated entities in respect of a comparable transaction in comparable circumstances”
It is required the products or services that are involved should be close to similarities in nature. Where the prices of the products or services are stable over a period of time, such prices can be gathered, studied and can be made standard price for comparison purpose.
For Example: ABC Company is New Zealand based and it is into manufacturing of boats and they are shipping boats to Australia for related and unrelated boat business. The Boats are very similar for related and unrelated business. However ABC Company has given 90 days payment terms to related customer and only 45 days payment terms to unrelated customers. Based on above information we can evaluate that ABC Company is having comparable uncontrolled price method for related company price transfer.
2. Resale Price Method (RPM)
“A method of pricing based on the price at which a product is resold less a percentage of the resale price” . “RPM computes purchase price paid to related party based on its resale price to unrelated party. RPM is typically useful to determine ALP of purchases made by the distributor (trader) from related party”
According to Arm’s length price principle the reseller can deduct appropriate amount as discount on the resale items as various activities involved by the reseller from the actual price. The appropriate discount is the gross margin or various overhead earned by reseller on the sale of product that is bought and resold in an uncontrolled transaction. In the CUP method, the discount may be adjusted by the reseller to maintain the differences between related transaction and the comparable unrelated transaction.
For Example: Kukabura Company is into manufacturing of Cricket kit and it is based in Bangladesh having its subsidiaries in Sri Lanka and India serve as distributors in their respective market. Through a search it is learnt that independent distributors earn 15% of gross margin and independent distributors are also doing research and design for the cricket kit whereas related distributors just serve as distributor. The independent distributors are further charging 2% of royalty fees on sales for designing kits. Therefor gross margin of related distributors reduced by 2% from 15 to 13% to adjust the absence of research and design.
3. Cost Plus Method (CPM)
“The cost-plus method begins with the costs incurred by the supplier of property or services in a controlled transaction for property transferred or services provided to a related purchaser. An appropriate arm's length cost-plus mark-up is then added to this cost, to make an appropriate profit in light of the functions performed, assets used, risks assumed and the market conditions” .
The cost plus method determine the Arm’s length price by addition of required markup to the manufacturing cost. The mark up is the percentage earned by producer on unrelated party sale similar the related parties transaction. This method is used by companies for doing part manufacturing in other place and final assembly in other place.
For Example: TBEA CN is transformer manufacturing company in China and having its subsidiary in India by name TBEA – IN, they are doing part manufacturing in China for critical equipment and then they are shipping the part manufacturing items to their Indian subsidiary company for final assembly and sale in Indian Market. In this transaction TBEA IN is transferring their profits to TBEA CN with in the related parties.
4. Profit Split Method (PSM)
“This method established transfer pricing by dividing the profits of a multinational enterprise in a way that would be expected of independent enterprises in a Joint Venture Relationship” . In profit split method of transfer pricing the profit/loss incurred by the multinational companies are divided in an anticipated way of group companies in a Joint Venture Relationship. Profit Split methods regulates the group profit/loss on combined data sheet for this kind of profit transfer there is requirement of extensive data for each entity in each country hence this kind of method is hardly used for profit transfer.
5. Transactional Net Marginal Method:
“A transfer pricing method based on an analysis of the operating profit derived by a business from a particular related party transaction or group of transactions” . “This pricing method is based on comparisons made at the net profit level between the taxpayer and independent parties, in relation to a comparable transaction or dealing” .
The Transactional Net Marginal Method determines the net profit margin of controlled transactions to the uncontrolled comparable transactions at the similar net profit margins and also it can be compared with other unrelated comparable firms.
6. Comparable Profits Method (CPM)
“A transfer pricing method based on the comparison of the operating profit derived from related party transactions with the operating profit earned by third parties undertaking similar business activities” . The CPM evaluates whether the amount charged in a controlled transaction is arm’s length based on objective measures of profitability, known as ‘profit level indicators’, derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances’ . Under this method the operating profit of related party of a company is compared with unrelated parties which are into similar kind of business activities.
7. Gross Services Margin Method
Gross Services Margin Method determines the cost charged in controlled transactions in arm’s length is realized in comparable uncontrolled transactions. “The GSMM is comparable to the resale price method of tangible property transfer pricing regulations. Under this method, evaluating the appropriateness of inter-company services pricing arrangements relies on the gross profit margins earned in comparable uncontrolled services transactions as benchmark. The Gross services margin method is appropriate is a situation where a controlled taxpayer provides services (e.g. agency or intermediary services) in connection with a related uncontrolled transaction involving a member of the controlled group and a third party” .
8. Marginal Costing
“Marginal costing is a method of pricing that applies only the variable production costs to the costs of a product. Marginal costing is often used by companies and multinational enterprise groups for internal cost accounting and management control purposes. However, its use in setting transfer prices on international dealings between associated enterprises for tax purposes is acceptable only if pricing on the basis of marginal costs represents an arm's length outcome for the transfer of goods or services into the particular market” . Marginal costing is a method in which there is adding of variable cost on the fixed cost of a product and it is used by companies in accounting books.
9. Cost Contribution Arrangement
Cost Contribution arrangement is a method in which group companies of MNCs agrees to act in a performance to innovate tangible or intangible properties for the benefit of each member and they share the risk and costs. “A cost-contribution arrangement is one where members of a multinational group act in concert for the benefit of each of the participants to: produce or provide goods, intangible property or services, or acquire these jointly from a third party and agree to share the actual costs and risks undertaken” .
10. Apportionment of income/cost
The Cost Contribution arrangement method allocates the cost/income which is associated with the transaction/services between related parties.
2.0 Question 2: What is the significance of tax information exchange agreements and what are the core provisions in such agreements?
Answer:
The Organisation of Economic Cooperation and Development (OECD) have developed a process to eliminate the tax avoidance and tax evasion practices by various multinational organisations in various countries. The process is called Tax Information Exchange Agreements (TIEAs) by which all the participating countries will share the information on taxes. It is bilateral agreement between two or more countries for sharing the financial information as required for tax computation purpose. By this practice participant countries will know the transfer of profits by various multinational organisations to minimize their taxable income and to reduce various taxes.
“The Purpose of this agreement is to promote international cooperation in tax matters through exchange of information. It was developed by the OECD Global Forum working Group on Effective Exchange of Information. The Agreement grew out of the work undertaken by the OECD to address harmful tax practices. The lack of effective exchange of information is one of the key criteria in determining harmful tax practices. The Agreement represents the standard of effective exchange of information for the purposes of the OECD’s initiative on harmful tax practices” .
“The Organization for Economic Co-operation and Development (OECD) has established standards on transparency and exchange of information for tax purposes, and has strongly encouraged countries to adopt these standards. The OECD and the Financial Action Task Force, members of which are the G-20 countries, have stated that a country must have a minimum of twelve (12) TIEAs in order to be regarded as co-operating in matters of tax information exchange transparency Jurisdictions that fail to do so will be regarded as non-cooperative jurisdictions, and the G-20 countries have stated that action will be taken against such jurisdictions. Whilst twelve (12) TIEAs are the minimum standard at the present time, G-20 countries are encouraging international financial centers to execute collaborative treaties in excess of this mandated requirement. Currently, OECD and non-member countries are negotiating more than 40 separate tax information exchange agreements, many of which will be signed and ratified over the coming year. TIEAs are intended to allow full exchange of information on criminal and civil tax matters between the two signatories. Each TIEA will come into force once both countries have given legal effect to it” .
The Tax Information Exchange Agreements are not automatic system for the sharing of information, the parties has to request from each other for the required information. Parties have to request formally and in specific requirement to ensure that the parties has genuine and strong request.
3.0 Question 3: How should government deal with the issue of loss of significant tax revenues from profit shifting?
Answer:
It has been observed that multinational companies are establishing their facilities in different countries and expanding their business globally, however due to profit shifting by these companies the local administrative government cannot get benefited due to decrease in taxes due to profit shifting.
Government has to develop a fair, effective and practical tax system which can help in improving the economic growth of the country and helpful for the community. Following are some suggestions:
1. There should be more agreements between the countries for exchanging information for the multinational companies.
2. Government should work closely with treasury and companies, regular audits should be conducted to ensure the healthy tax system and its process.
3. Government can also put lock-in period for the FDI such as MNC cannot take profits out of the establishment country for a certain period.
4. Local government should implement system for neutralize the tax effects such as double taxation, double deduction etc.
5. There should proper policy and rules for transfer pricing which can be audited by statutory and multinationals should provide information about their global income and allocation of resources.
6. Government should promote domestic industry and develop more policies for foreign companies for income and taxes.
7. Governments should have arbitration clause for dispute resolution in their agreements for sharing information of taxes.
8. Governments should not take too strict actions against multinational companies so that they should not stop their operation in particular country. For example if MNC is working on 20% profit than still 80% of the money is rotating with in the country if government takes strict action and MNC call off their operations in that country then government will lose benefit of 80% money as well.
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4.0 Question 4: There is a traditional distinction between tax avoidance and tax evasion. Where do you think the line should be drawn or is there no line because of the GAAR (the General anti-avoidance rule)?
Answer:
“A GAAR is typically designed to strike down those otherwise lawful practices that are found to be carried out in a manner which undermines the intention of the tax law such as where a taxpayer has misused or abused that law. However, the objective of combating unacceptable tax avoidance can itself make the legal design of a GAAR complex. This is simply because the phrase “tax avoidance” means different things to different people. Whatever the form of a GAAR, it should give effect to a policy that seeks to strike down blatant, artificial or contrived arrangements which are tax driven. However, the GAAR should be designed and applied so as not to inhibit or impede ordinary commercial transactions. This Tax Law IMF Technical Note discusses and explores how drawing a line between those arrangements which should be caught by the GAAR is a matter of degree and can be delicate” .
The Legal system for Tax recovery should be modified and drafted in a way that tax authorities will have more power to visit and audit on business transactions of MNCs, also doing high value transactions MNCs should inform Tax Authorities with proper documentations for records and scrutiny purposes in order to control the tax avoidance. Companies should not be formed and collude their subsidiaries in lower tax regions from higher tax regions just the avoid taxes by rerouting the transactions.
The Line should be drawn by governments taking following points in consideration:
1. To make transparency in the transaction and investment of companies.
2. Some companies are opening subsidiaries and doing investments in some states or region to enjoy the low tax benefit by doing this companies are having double benefit by minimizing their taxable income and gaining the benefits of various subsidies to avoid this government can stop giving benefit on income tax for this kind of transaction instead of this government can charge income tax on full taxable income and then can invest on the particular state of region.
3. Making strict rules for violating tax laws such as seizing company’s assets in country, ban from leaving country, restriction on access of funds, reporting issues in media etc.
4. Making strict laws for submission of the forecasting of companies operation statements, account statements, annual reports, purchase and investment records to scrutinize the statements to avoid tax evasion.
5. Any intended tax avoidance should be subject the jurisdictions of GAAR and regulatory.
6. There should be law for reviewing the profits/loss commensurate to the operation and expansions of companies.
5.0 Reference List:
1. International Transfer Pricing, retrieved on June 20, 2016, from: https://www.pwc.com/gx/en/international-transfer-pricing/assets/itp-2013-final.pdf
2. International Transfer Pricing, Retrieved on June 20, 2016, from: https://www.pwc.com/gx/en/international-transfer-pricing/assets/itp-2013-final.pdf
3. Transfer Pricing Methods, Retrirved on June 21, 2016, from: http://www.kcmehta.com/pdf/transfer_pricing_methods.pdf
4. Pricing Methods, Retrieved on June 21, 2016, from : https://www.ato.gov.au/Forms/Schedule-25A-instructions-2011/?page=37
5. International Transfer Pricing, Retrieved on June 20, 2016, from: https://www.pwc.com/gx/en/international-transfer-pricing/assets/itp-2013-final.pdf
6. International Transfer Pricing, Retrieved on June 20, 2016, from: https://www.pwc.com/gx/en/international-transfer-pricing/assets/itp-2013-final.pdf
7. Pricing Methods, Retrieved on June 21, 2016, from : https://www.ato.gov.au/Forms/Schedule-25A-instructions-2011/?page=37
8. International Transfer Pricing, Retrieved on June 20, 2016, from: https://www.pwc.com/gx/en/international-transfer-pricing/assets/itp-2013-final.pdf
9. International Transfer Pricing, Retrieved on June 20, 2016, from: https://www.pwc.com/gx/en/international-transfer-pricing/assets/itp-2013-final.pdf
10. International Transfer Pricing, Retrieved on June 20, 2016, from: https://www.pwc.com/gx/en/international-transfer-pricing/assets/itp-2013-final.pdf
11. Pricing Methods, Retrieved on June 21, 2016, from : https://www.ato.gov.au/Forms/Schedule-25A-instructions-2011/?page=37
12. Pricing Methods, Retrieved on June 21, 2016, from : https://www.ato.gov.au/Forms/Schedule-25A-instructions-2011/?page=37
13. Tax Information Exchange Agreements, retrieved on June 23, 2016, from: http://www.oecd.org/tax/exchange-of-tax-information/taxinformationexchangeagreementstieas.htm
14. Guide to Tax Information Exchange Agreements, retrieved on June 23, 2016, from: http://www.higgsjohnson.com/resources/legal_guides_pdf/The%20Bahamas/TIEAs.pdf
15. Introducing a General Anti-Avoidance Rule (GAAR), retrieved on June 23, 2016, from: https://www.imf.org/external/pubs/cat/longres.aspx?sk=43662.0