Question 5
International Tax Systems: Approaches to Transfer Pricing
Globalization is the new trend as companies are increasingly expanding beyond their domestic borders. Globalization is motivated by the need to seek new markets, diversify operations internationally, take advantage of differing tax laws among a myriad of other reasons. In order to take advantage of differing tax laws, multinational companies use transfer pricing. This paper discusses transfer pricing and the various approaches to transfer pricing. This paper will also discuss the recent developments in transfer pricing.
Transfer pricing refers to the determination of prices for transfer of goods between subsidiaries both domestically and internationally. Transfer pricing arises in relation to any type of income including, but not limited to; the provision of services, the purchase or sale of goods, the payment of interest on loans and royalties. Transfer pricing is widely used by multinational to share costs and risks of acquiring an asset, service or rights such as research and development. However, companies can deliberately manipulate transfer pricing in order to shift income from high tax jurisdictions to low tax jurisdictions. This results in moving tax revenue from one nation to another. Transfer pricing may also lead to distortion of balance of payments between the host nation and home nation, which borders on undermining the host country’s sovereignty. Therefore, most countries have implemented transfer pricing laws to prevent abuse of transfer pricing by multinational companies.
Most countries implement international tax laws based on the arms length principle as per the definition of the Organization for Economic Co-operation and Development (OECD) model. The OECD guideline proposes seven methods; comparable uncontrolled price method (CUP), Cost plus method (CP), Resale price method (RP), Profit split method (PS), comparable profit method, comparable uncontrolled transaction method and other method. Normally, companies enter into advance pricing agreements with the tax authority. These are prior agreements between companies and tax authorities on the most appropriate transfer pricing method.
OECD has been instrumental in enabling economies incorporate the arm’s length principle of transfer pricing in their tax laws. The OECD has also been instrumental in developing models intended to enhance the relationship between tax authorities, tax intermediaries and tax payers. OECD conducted a study on the role of accounting firms and law firms, financial institutions and other advisors on tax matters. It specifically aimed to understand the role of tax intermediaries in “unacceptable tax minimization arrangements”. It also sought to identify ways of strengthening relationships between tax authorities, tax intermediaries and tax payers. The recommendations of the study were the focus of the OECD tax forum in Cape Town in 2008. The report recommended that in order to understand the role played by tax intermediaries, a broader approach needs to be taken. There is a tripartite relationship; tax intermediaries and taxpayers are in a supply-demand relationship with the tax authorities being the other party. The report explored various strategies that could be adopted to improve relationships between large taxpayers and revenue bodies.
In USA, transfer pricing is governed by the Internal Revenue code 482 which was first incorporated in Revenue Act in 1934 and was significantly revised in 1994. Generally, the guidelines used to determine arm’s length transaction prescribed by Section 482 of the Revenue Act are consistent with the OECD guidelines on transfer pricing for multinational entities. Under section 482, an unspecified transfer pricing method can only be used by a tax payer if, in the opinion of IRS examiners, the method would provide the most reliable arm’s length price under the given circumstances. This is referred to as the best method principle. The onus of documentation is on the tax payer to justify the transfer pricing method used. However, the tax authority does not have to rely on the documentation of the tax payer in order to permit price adjustments.
In the USA, there are two types of penalties imposed on a multinational entity for non-compliance with section 482 of the Revenue Act. These penalties are encompassed in section 6662 of the Revenue Act. These penalties are transactional penalty and net adjustment penalty. The net adjustment penalty is 20 percent if the transfer price adjustment exceeds $5 million and it increases to 40 percent if it exceeds $20 million.
The USA government has increased measures to crack down on companies that are using tax havens to evade and avoid taxes. The US government has been more aggressive with Swiss and European banks calling for disclosure of US taxpayers’ holdings in those banks. In June 2012, the US government entered into an accord with Swiss and European banks for reporting information to US IRS.
A study by Grant A. Richardson and Roman Lanis on the relationship between CSR and tax aggressiveness revealed that there is a statistically significant negative relationship between CSR and tax aggressiveness. The study used a sample of 408 Australian companies which are publicly listed.
Several countries, other than the USA, are increasing adopting the OECD guidelines by incorporating them in the tax laws with modest modifications. These countries include; UK, Japan, Germany, France and Netherlands. There is increased concern by governments around the world to eliminate transfers pricing manipulations. This is evidenced by the increased number of countries requiring documentation of the transfer pricing method used. National tax authorities of various countries are increasing staff specializing in transfer pricing. Increased consultation with specialist and increased communication between various national tax authorities around the world. Therefore, it is paramount for MNEs to view transfer pricing policies of the entire organization because inconsistencies maybe detected during routine audits and attract attention of tax authorities. This will not only increase compliance risk but also result in increased compliance costs.
In conclusion, many countries are adopting transfer pricing guidelines based on the OECD model to determine the appropriateness of prices for transfer of goods between subsidiaries both domestically and internationally. In the US, transfer pricing is governed by section 482 of the Revenue Act. The US government has increased its efforts in preventing corporate tax payers from manipulating transfer pricing and evading tax using tax havens. The OECD has been instrumental in enhancing the capacity of revenue authorities as evidenced by the Seoul and Cape Town forums on Tax Administration.
Question 6
The impacts of the global financial crisis and the incidence of tax competition on the national tax systems of the world and how the governments have responded
Taxation is a dynamic concept and changes as new developments in the economy emerge. The global financial crisis and the occurrence of tax competition have had an insightful impact on the national tax systems of the world. The global financial crisis started in the USA in July 2007 and spilled over on the world economy turning it into a global coordinated economy. The recession alongside tax competition adversely affected all tax revenues. The major impacts of the recession and tax competition on the tax system are the following.
The first impact of the global financial crisis is that it led to a fall in aggregate demand for goods leading to falling trade these led to the fall in affected tax revenues collected by customs agencies for the government. The impact has hit badly mostly those countries that depend on the exports.
The second impact of the financial crisis is that the national tax systems have reviewed the tax regulations and tax enforcement measures. The governments are making the tax laws more homogeneous to reduce tax evasion and avoidance.
Another impact of the tax regulation is the lobbying of United States multinationals for tax holidays and repatriation of foreign holdings profits. The multinationals have increased their lobbying for tax holidays to mitigate the impacts of the crisis on their profits. Due to the crisis the multinationals have also set the transfer price for goods they obtain from their subsidiaries where corporation tax is low high. The profit made by the subsidiary is higher than that of the parent company on the goods obtained. This makes the proportion of tax paid by the parent company lower and that by subsidiary higher but overall the tax paid by the company is lower. The company is therefore able to do their tax planning more easily.
The other impact of the global financial crisis on tax systems is the tax economic stimulus given by government to attract investments. Business are becoming more global and doing business across national boundaries. The financial crisis has led to countries reducing their corporate tax rates to attract more investment from foreign companies which will increase the tax revenue.
The tax yield in different countries is different and this has led to incidences of tax competition. Tax competition comes in different forms with the most common being tax havens, tax cuts and tax holidays. Organizations are moving their headquarters to countries where tax regimes are friendlier to benefit from these tax regimes. For example companies in the UK have moved their headquarters to Switzerland quoting the lower tax rates.
In response to the global financial crisis and tax competition the national tax systems have taken various measures to mitigate the impacts. Some of the measures taken by the national governments include the following.
One of measure taken by government to mitigate the risk caused by tax competition is information sharing to reduce the incidences of tax evasion. Ireland and other countries in the European Union call for information sharing. The OECD and G8 countries have a tax haven list used by the government to put pressure on government to share information and prevent organizations and individuals from evading taxes. Where the tax havens are no cooperative the nations take other measures to gain information for example in 2008 Germany paid for information on clients of LGT Bank in Liechtenstein who reside in Germany, USA, Canada and Sweden. Swiss banks also reduced banking opportunities for US clients.
One of the responses used by national governments is attempts to harmonize tax systems (Deloitte touche Tohmatsu, 2009). Some of the measure that has already been implemented includes abolishing double taxation in many countries and having a code of conduct for transfer pricing. The pacific association of tax administrators set up a coordinated a combined documentation on transfer pricing that members could use to provide information on tax payers. The tax payers can volunteer to use the PATA documentation principles in transfer pricing to avoid penalties.
The other response measure taken by the government is the reviewing of tax regulations to become less complex for business to comply with and make tax planning easier, different governments are also comparing their tax systems with other economies to benchmark them with the best (Deloitte touche Tohmatsu, 2009). In 1990 Members states of the EU have took measure to avoid double taxation and tax avoidance. In 1997 the EU adopted measure to avoid harmful tax competition including code of conduct for business taxation while in 2006 the documentation on transfer pricing was completed. The governments have taken measures to reduce indirect taxation and eliminate excise duty and make some goods duty free to improve movement of goods within the EU
The other measure that government took to mitigate the effect of the global economic crisis is encouraging local consumption through incentive tax measure to personal income taxes (Deloitte Touche Tohmatsu, 2009). The tax for individuals was reduced and the companies are able to sell more in the local economy.
In conclusion, the financial recession and tax competition affected the tax system of national governments in a number of ways including reduction in tax revenues and changes in tax policies. The governments took various measures to mitigate the harmful effects. These measures include sharing information, harmonization of tax systems and reviewing national tax regulations.
Question 7
Financial Reporting: Comparing ASEAN members and EU
The Association of South East Asian Nations (ASEAN) was incepted in 1967. Its main aim was to enable the free flow of resources and products; by creating a free trade area. Its members are; Indonesia, Malaysia, Philippines, Singapore, Thailand, Brunei Darussalam, Vietnam, Laos, Myanmar (Burma) and Cambodia. It has a population of about 560 million people, a gross domestic product of $ 1,071 billion and a total trade of $ 1,442 billion. In a bid to create accounting harmonization, ASEAN members formed The ASEAN Federation of Accountants (AFA) in 1977.Accounting harmonization is the process is the process of deliberately minimizing differences in accounting practices among various countries. This paper discusses why and how the approach taken by ASEAN members towards harmonization of financial reporting contrasts the one taken by members of the EU.
Studies were conducted in ASEAN members on accounting regulatory framework and accounting harmonization by International Finance Corporation in 1994 and by the Asian Development bank in 1995. The studies excluded Singapore because it was a Newly Industrialized Country (NIC). It also excluded Brunei and Vietnam because they were still new members. The study revealed there were variation the regulatory frameworks as well compliance enforcement mechanisms among member states. It also revealed that there variations in the audit requirements and regulations and the quality of audit as well. However, over the years ASEAN members have tried to embrace accounting harmonization.
The main difference between EU and ASEAN approach to accounting harmonization is that; whereas EU has adopted regional accounting harmonization, ASEAN has largely adopted global accounting harmonization. ASEAN members have embraced global accounting harmonization by either adopting IAS in full as the national accounting regulations or incorporating accounting policies that are suggested by IAS in their national accounting policies. AFA’s efforts to achieve regional accounting harmonization have been largely unsuccessful. Most of the accounting professional bodies in ASEAN countries have supported global accounting harmonization instead. They advocated for large scale adoption of IAS as a basis of the national accounting standards. By 1997, all the original member states of ASEAN had adopted IAS with the exception of Philippines. Philippines draw its accounting regulation from US FASB for historical reasons. In contrast, the EU accounting harmonization has occurred among member countries only.
There are various reasons that have influenced the large-scale adoption of IAS by ASEAN members. The first reason is that ASEAN members have modest research resources and research capabilities as compared to the EU member countries. Therefore, government regulators in ASEAN member states view adoption of IAS as a low cost option of developing an accounting framework. The second reason is that IAS guidelines are easier to implement. IAS guidelines are flexible because they provide readily available alternatives. This makes it easier for users to comply. This explains why countries like Malaysia, Indonesia, Thailand and Singapore adopted IAS instead of the US FASB. The third reason is political consideration. IAS represents accounting policies that are internationally accepted. Therefore, their adoption is considered more neutral. Current ties to colonial rulers have also played a big role. The adoption of IAS by Philippines has been greatly impeded by the United States accounting system. Philippines was colonized by US between 1898 and 1946.Adoption of IAS by Singapore and Malaysia has been much easier because their accounting regulations, which originated from UK, are more flexible than the US accounting system.
The global accounting harmonization approach adopted by ASEAN as opposed to the regional accounting harmonization approach adopted by EU can be attributed to several reasons. First, whereas EU depends on regional trade, ASEAN depends on foreign trade with non-ASEAN members. A study in 1993, which compared worldwide exports of ASEAN and EU members, revealed that more that 60 percent of exports of EU members was to other EU countries. On the other hand, intra-regional trade among ASEAN accounted for only 20 percent with 80 percent being exported to non-ASEAN members. The second reason is that there is concrete cooperation between EU civil service and EU member accountancy bodies which is lacking among ASEAN member states.
In conclusion, ASEAN member countries have embraced a global accounting harmonization approach accounting harmonization while EU has adopted a regional accounting harmonization approach. This is attributed to ASEAN dependence on foreign trade and the lack of cooperation between the civil service and accountancy bodies among ASEAN member countries. Most ASEAN members have fully adopted IAS.
Choi, F. D., Frost, C. A., & Mee, G. K. (2002). International accounting (4 ed.). New Jersey: Prentice Hall.
Deloitte Touche Tohmatsu. (2009, June 6). Tax Responses to the Global Economic Crisis. Retrieved June 28, 2012, from adko.hu: http://www.adko.hu/01_files/adotanulmanyok/2009/deloitte-tanulmany2009.pdf
Saudagaran, S. M., & Diga, J. G. (1997). Accounting Regulation in ASEAN:A Choice Between the Global and Regional Paradigms of Harmonization. Journal of International Financial Managent and Accounting .
