Tax authorities squeeze multinationals over transfer pricing

The ‘B word’ is now regularly used by multinationals as they struggle to deal with the increasingly complex world of transfer pricing.

The B word we are talking about is billions; as in the amount of pounds and dollars being collected by the authorities around the globe in back taxes, interest and penalties.

Those billions are the price that multinationals and their subsidiaries are having to pay for being less than forthright in charging market rates for goods, services and – increasingly, nowadays – intellectual property.

For British-based multinationals, the recent fine of $3.1bn (£1.7bn) imposed by the Internal Revenue Service (IRS) in the US on GlaxoSmithKline must have touched a nerve. True, the amount covered 16 years of tax returns on the relationship between the British company and its US subsidiary, but even so it is a staggering amount, and the highest ever settlement won by the IRS.

Computer software company Symantec is also fighting a $1bn IRS assessment over its dealings with its operations in Ireland.

Putting a subsidiary in a low-tax country like Ireland is a clear red rag to the IRS. But Bob Ackerman, who heads up transfer pricing services for Ernst & Young’s Americas region, argues there is nothing wrong with moving to a low-tax regime if such a decision is best for the business.

Sometimes, though, companies make two common mistakes when they locate a subsidiary, both of which raise the suspicions of the tax authorities. First, they put a subsidiary in a country purely to avoid tax. The tax tail should never wag the business dog, Ackerman says.

Second, multinationals get overly aggressive in trying to put more profit in low-tax countries. When that happens, it is going to be challenged by the taxman.

Multinationals are hiring more people in their tax departments to deal with transfer pricing. Not to be out-muscled, tax authorities around the world are hiring compliance inspectors as fast as they can.

The extent of dubious pricing is difficult to judge, but some US trade figures illustrate some clear abuses.

Research by Professor Simon Pak of Pen State University and Professor John Zdanowicz, of Chapman Graduate School of Business, found businesses drastically under or over charge subsidiaires for goods.

Analysing US trade data, they found loo rolls being sold to China for more than £2,000 a kilogram, whilst thermometers were being imported from Germany for six cents each.

If that is a guide to general business practice, you can understand why the authorities are concerned.

The IRS is notoriously aggressive in cracking down on companies it suspects are dodging taxes through transfer pricing, but it is not alone.

Experts say the tax authorities in Canada, Japan and Australia can also be classified as aggressive. In Europe the Germans, British and French, while not aggressive, are ‘focused’. And China is set to become a major player eventually.

As proof of Australian zeal for transfer pricing revenues, the country has stepped up its operations to track down what tax commissioner Michael D’Ascenzo described as ‘very large royalty flows’ to related offshore companies by big business.

The Australia Tax Office has just announced it has raised more than A$2.5bn (£1bn) in assessments from transfer pricing audits in the past five years.

To be fair it is not easy for multinationals to perfect a transfer pricing strategy. Some 48 countries have transfer pricing rules and each country says it follows guidelines on the matter that were issued by the Organisation for Economic Cooperation and Development. Those guidelines are supposed to spell out what ‘arm’s length’ or market rate pricing should be.

The problem, according to Ackerman, is that each country has a different approach to defining what arm’s length actually means. More specifically each country follows different processes to try and determine whether a company’s transactions are arm’s length or not.

There is no doubt that some transactions in particular will set alarm bells ringing in the various tax authorities. Specific triggers include the charging out of high-value services, the migration of intellectual property, and changes in the supply chain that could be abused.

To keep an audit at bay, Ackerman advises companies to keep up to date. It is all well and good knowing the various laws of the land, but it is even more important to stay current, and to follow judgments in court cases to understand better what is allowable and what is not.

The bottom line is that transfer pricing tax laws are becoming more complicated, both for taxpayers to comply with and for the authorities to administer. The US, for instance, is introducing new rules for services and intangibles starting next January.

Such a scenario leads only to controversial decisions and in the future such controversies can only multiply.