Abstract

In this modern age states incur losses due to the increase in tax-avoidance schemes. These losses are difficult to account for and this problem is considered serious. Most media reports show that the multinational companies pay very low taxes. These tax-avoidance schemes are well known and are documented. They include the use of jurisdictions with lower-tax rates, transfer pricing, over-charging companies in higher-tax territories to decrease taxable profit, and legally to conclude the settlement in a lower tax nation, different from the parent country. The digital economy contributes to this menace together with the increase in intangible asset worth such as brands, and patents. The practices of these multinationals make it difficult for the current tax laws to be fully effective. The multinationals greatly benefit from this mismatch but the biggest losers are the domestic companies which will not secure an identical tax advantage and the governments. The clarity of the problem is registered and legislators want the companies to not only operate within the confines of the law but also the spirit it was intended. The multinational corporations argue that they have fully complied with all tax laws and tax payables, and that it is not their responsibility but that of the government to determine tax regimes. A resolution to this problem would be tougher to achieve due to the complexity and constraints of the international tax environment. At present most companies undertake transactions within different firms which are under common control. These intra-group transactions have led to internal price fixing way below the market value also known as transfer pricing. The practice of transfer pricing manipulation leads to tax avoidance. This paper will evaluate tax avoidance among multinational companies and the role transfer pricing plays in tax avoidance.

Tax Avoidance among Multinational Companies

International trade is controlled by huge multinational corporations (MNC). An MNC is a company that wholly or partially owns and controls the income generating assets in more than one country[1]. The company is incorporated in one territory but conducts cross-border transactions beyond its parent country through subsidiaries that are either partly or wholly owned, joint ventures, and affiliates. A decade ago multinationals contributed about 25% to international trade and accounted for a quarter of the world’s GNP[2]. The trend continues with MNCs growing to more than 500, and controlling up to 90% of foreign direct investment.

Many US multinationals have secured more than 40% of global market share. They include companies like General Electric, Google, Boeing, and Gillette[3]. These large MNCs are the biggest providers of products and services, and control more than 95% of total production[4].

The volume of global trade has been tremendously increased by unprecedented developments in technological innovations concerning transport and communications, telecommunications especially the internet, the emergence of trade organizations, the removal of tariff and non-tariff barriers, and open borders that serve to ease the movement of goods and services. The contribution of international trade to Gross National Product has been on an upward trend. Also, jobs created in the recent past are export-related and contribute to approximately 80% of new jobs created[5].

There is a recorded increase in intra-firm transactions. Increasingly, these transactions happen between affiliates within one MNC. An affiliate can be defined as a firm that is wholly or partially owned by an MNC and comprises of branches, subsidiaries or joint ventures[6]. A subsidiary company is a legal term in law, meaning a company which is partly or wholly owned and/or controlled and run by another firm (the parent company).

The Organization for Economic Cooperation and Development has estimated intra-firm transactions to go as high as 60% and contribute to about 30% of exports to the leading nations like Japan, UK and U.S[7]. These exports are concentrated in high technology sectors such as the chemical industry, machinery, and transport vehicles[8]. The expansion of intra-group transactions across borders by the multinationals enables them to distort prices and therefore avoid tax. This paper aims at analyzing the topic of tax avoidance among multinational companies.

The Objectives of the paper are;

To analyze the issue of transfer pricing and its non-tax benefits
To analyze the historical and legal framework of tax avoidance through transfer pricing.
To investigate different approaches to unitary taxation and analyze anti-transfer pricing strategies already in practice
To propose prospective approaches and suggestions for improvement informed by best practices from different jurisdictions
Literature Review

Background Information on Tax Law

Adam Smith once quoted in his famous book, “The Wealth of Nations” that every individual is required to contribute proportionately to their income to the government and this also applies towards the companies or joint ventures[9]. The lack of proportionate contribution towards the government leads to the maxim that is known as inequality of taxation[10].

The terms “tax evasion” and “tax avoidance” differ based on legality. Tax evasion leads to criminal prosecution since natural and artificial persons falsify their tax returns and bookkeeping accounts to free themselves from tax liabilities[11]. Tax avoidance, on the other hand, is the use of legal methods to pay less tax. Many companies utilize tax loopholes and exploit them within legal boundaries[12][13].

Different jurisdictions have different tax systems whose operations differ[14]. There are diverging views on why multinationals avoid tax, but many individuals believe that firms should contribute their share of tax revenues fully in support of their governments. There are two primary tax systems. The first one is the transaction-based system which is used in the US, Germany and Canada. This system exempts taxation on service income and company sales on active business income in foreign countries. The second system is practiced in the UK, Japan and France where taxes are levied based on jurisdiction. Therefore, all foreign subsidiaries pay tax but with an exception for active business income with a local connection so as to spur foreign direct investment[15].

For a successful tax planning system and implementation of tax avoidance, firms are incorporating in tax haven countries. Currently, tax haven jurisdictions hold more than 10 trillion dollars in untaxed assets. In 2002, US MNCs had untaxed assets amounting to $639 billion[16]. This statistic illustrates how widely tax havens are utilized.

To utilize the advantages of tax havens, firms move their assets into affiliates located in these jurisdictions. The easiest way of doing this is by transfer pricing. It distorts information in the company’s financial statements and increases profits in these tax havens. Companies set up production plants and subsidiaries in different countries and then engage in intra-firm trade. But the subsidiary mainly acts as an address that will declare huge profits but doesn’t engage in any production[17].

A new regulation known as “Check the Box” was implemented by the US in 1997. It allows MNCs to incorporate their subsidiaries as separate entities in another country. MNCs situated in the US are allowed to utilize hybrid entities. The law was mainly meant to help small enterprises in line with the freedom of organizational form for tax reasons and reduce their administrative burdens[18]. Another significant feature of these incorporated affiliates is their structure of ownership interest. A new form of ownership known as a brother-sister affiliation emerges. MNCs set up many subsidiaries around the world which own each other’s stake. For instance in 1999, UPS which had incorporated an insurance agency in Bermuda, had contracted it to charge risk insurance to the shipper. The tax court of US found that the insurer was overcharging UPS threefold and they determined that they had a brother-sister relationship and thus was liable to pay 1.7 billion dollars in penalties and taxes[19].

Different strategies are used that are centered on transfer pricing. These include the strategic use of debt, intellectual property and royalties’ income. These strategies are going to be the primary focus of the analysis of transfer pricing. First and foremost, US multinational companies in regard to development and research use subsidiaries in different low tax countries to handle their intellectual property and royalty streams thus are lowering their tax liability[20]. Secondly, when using company debt, the MNCs would locate their debt in high tax countries. This is referred to as earnings stripping. The affiliated companies would loan out to each other with the biggest receivers of loans being the subsidiaries in high-tax companies. In most jurisdictions including Germany, interest payments are tax deductible, but this can vary from territory to territory[21].

Different companies make use of tax havens and transfer pricing. Mostly, limited liability companies and government sponsored corporations are the biggest culprits. For instance in 2004, 59% of US federal contractors had subsidiaries in tax havens[22]. Many of these companies have more than one subsidiary or tax havens used, which increases costs to the economy since the home countries have to incur administrative costs for continuous reporting and policing of these companies[23]. Currently, The OECD is working on internationally agreeable tax standards that will ease tax revenue losses[24][25]. The agreement will not prevent companies from using tax havens but instead will promote ease of information flowing from these territories[26].

Case Law

Tax avoidance cannot be fully prevented. However, the legislative arm of governments through the amendment of certain laws and criminalization of the practice have helped to minimize it[27]. Courts hold that no legal obligation should befall a taxpayer to contribute higher taxes than they are bound legally, and no party is prevented from committing to a bona fide transaction that can in effect reduce their tax liability. This stance is supported by various court decisions. Lord Clyde in Ayrshire Pullman Motors Services and D M Ritchie v IRC held that no person should allow the Inland Revenue Authority to deplete the taxpayers pocket by arranging his legal status to that of his business or property [28]. The taxpayer is allowed, in honesty and truth to prevent the depletion of his pockets by the Revenue Authority.

Lord Tomlin, in the famous case of Duke v Westminster, held that people can organize themselves in such a way that the tax attached to their assets is otherwise less than it should be [29]. If one succeeds in his or her ingenuity, the person cannot be held liable to pay extra taxes. In the above cases, it can be concluded that the courts viewed ingenuity of paying lower taxes, if honestly done and within the law, as legal[30].

In 2013, the South African Revenue Service (SARS) authored a paper on tax avoidance which discussed issues regarding impermissible tax avoidance[31]. It attempted to define impermissible tax avoidance practices that are beyond what is deemed legal. Reference is made to the Australian Report on Business Taxation which attempts to define tax avoidance misuse that is precipitated by exploiting structural loopholes in statutes that are against the spirit of the law [32]. Lord Templeman expounded on this in the United Kingdom case CIR v Challenge Corporation Ltd[33].

Brooks and Head, who are leading South African economists, commented that tax avoidance is clearly on artificial schemes, and they do not alter the character of a transaction but may bring the activity within a tax exempt environment[34]. It is held that the terms “tax planning” and ”tax mitigation” are similar. A taxpayers mitigation of income tax leads to a reduction in their tax liability since their assessable income is also reduced.

In the UK case of CIR v Willoughby, in relation to tax avoidance the hallmark is that a tax payer manages to reduce his liability without incurring particular economic consequences that parliament had intended a tax payer that qualifies for a similar reduction in tax liability to suffer[35]. Although most see the government as a revenue-maximizing leviathan, taxation still plays a significant role in public expenditure[36]. Thus the right of individuals to minimize their liability for tax within the letter of the law should be balanced to that of other rights and obligations[37].

References

‘Australian Government Final Report Of The Review Of Business Taxation: A System Redesigned (1999)’ (Epublications.bond.edu.au, 2016)

accessed 10 March 2016

Avi-Yonah R, International Tax As International Law (Cambridge University Press 2007)

Avi-Yonah R, ‘The OECD Harmful Tax Competition Report: A Tenth Anniversary Retrospective’ SSRN Electronic Journal

Brooks M & Head J “Tax Avoidance: In Economics, Law and Public Choice” in Cooper GS Tax Avoidance and the Rule of Law (1997) International Bureau for Fiscal Documentation, Amsterdam.

Bucovetsky S and Haufler A, Tax Competition When Firms Choose Their Organizational Form (CESifo 2005)

Dharmapala D, ‘What Problems And Opportunities Are Created By Tax Havens?’ (2008) 24 Oxford Review of Economic Policy

Dharmapala D, ‘What Problems And Opportunities Are Created By Tax Havens?’ (2008) 24 Oxford Review of Economic Policy

Eden L and Potter E, Multinationals In The Global Political Economy (St Martin’s Press 1993)

Egger P, Corporate Taxes And Internal Borrowing Within Multinational Firms (National Bureau of Economic Research 2012)

Evans T, Taylor M and Holzmann O, International Accounting And Reporting (Macmillan 1985)

Fuest C and Schneider F, ‘Tax Evasion, Tax Avoidance And Shadow Economy: Introduction’ (2011) 19 International Tax and Public Finance

Hines Jr J, ‘International Tax Seminar For Congressional Staff’, International Tax Seminar International Tax Seminar for Congressional Staff for Congressional Staff (International Tax Policy Forum International Tax Policy Forum 2009)

Kanamugire J, ‘A Critical Analysis Of Tax Avoidance In The South African Income Tax Act 58 Of 1962, As Amended’ [2013] MJSS

Kirkbride P and Ward K, Globalization, The Internal Dynamic (Wiley 2001)

Larudee M, ‘Sources Of Polarization Of Income And Wealth: Offshore Financial Centers’ (2009) 41 Review of Radical Political Economics

Larudee M, ‘Sources Of Polarization Of Income And Wealth: Offshore Financial Centers’ (2009) 41 Review of Radical Political Economics

Maftei L, AN OVERVIEW OF THE EUROPEAN TAX HAVENS (1st edn, CES Working Papers)

accessed 4 March 2016

Muchlinski P, Multinational Enterprises And The Law (Blackwell 1999)

OECD Model Tax Convention On Income And On Capital: An Overview Of Available Products (1st edn, 2014)

accessed 4 March 2016

OECD Harmful Tax Competition: An Emerging Global Issue (1998) OECD Publications, Paris.

Picciotto S, International Business Taxation (Weidenfeld and Nicolson 1992)

Rohatgi R, Basic International Taxation (Kluwer Law International 2002)

Rosenberg J and Rosenberg J, The Essential Dictionary Of International Trade (Barnes & Noble 2004)

Smith A and others, The Glasgow Edition Of The Works And Correspondence Of Adam Smith (Oxford University Press 1979)

South African Revenue Service “Discussion Paper on Tax Avoidance and Section 103 of the Income Tax Act, 1962 (Act No. 58 of 1962)” November 2005, South African Revenue Service, Pretoria.

Ayrshire Pullman Motor Services & Ritchie v CIR [1929] TC, 14 (TC)

CIR v Challenge Corporation Ltd [1987] AC, 155 (AC)

CIR v Willoughby [1997] 4 ALL ER 65

Commissioner of Inland Revenue v Delfos [2007] AD, 242 (AD)

IRC V Duke of Westminister [1938] AC, 1 (AC)

[1] Peter Muchlinski, Multinational Enterprises And The Law (Blackwell 1999).

[2] Paul S Kirkbride and Karen Ward, Globalization, The Internal Dynamic (Wiley 2001). p.4

[3] Ibid, p. 4

[4] Lorraine Eden and Evan H Potter, Multinationals In The Global Political Economy (St Martin’s Press 1993).

[5] Thomas G Evans, Martin E Taylor and Oscar Holzmann, International Accounting And Reporting (Macmillan 1985).

[6] Jerry Martin Rosenberg and Jerry Martin Rosenberg, The Essential Dictionary of International Trade (Barnes & Noble 2004).

[7] Roy Rohatgi, Basic International Taxation (Kluwer Law International 2002).

[8] Sol Picciotto, International Business Taxation (Weidenfeld and Nicolson 1992).

[9] Smith A and others, The Glasgow Edition Of The Works And Correspondence Of Adam Smith (Oxford University Press 1979)

[10] Lorraine Eden and Evan H Potter, Multinationals In The Global Political Economy (St Martin’s Press 1993).

[11] Clemens Fuest and Friedrich Schneider, ‘Tax Evasion, Tax Avoidance And Shadow Economy: Introduction’ (2011) 19 International Tax and Public Finance.

[12] Ibid

[13] South African Revenue Service “Discussion Paper on Tax Avoidance and Section 103 of the Income Tax Act, 1962 (Act No. 58 of 1962)” November 2005, South African Revenue Service, Pretoria.

[14] Egger P, Corporate Taxes And Internal Borrowing Within Multinational Firms (National Bureau of Economic Research 2012)

[15] James R. Hines Jr, ‘International Tax Seminar For Congressional Staff’, International Tax Seminar International Tax Seminar for Congressional Staff for Congressional Staff (International Tax Policy Forum International Tax Policy Forum 2009).

[16] Loredana Maftei, AN OVERVIEW OF THE EUROPEAN TAX HAVENS (1st edn, CES Working Papers)

accessed 4 March 2016.

[17] M. Larudee, ‘Sources of Polarization of Income and Wealth: Offshore Financial Centers’ (2009) 41 Review of Radical Political Economics.

[18] D. Dharmapala, ‘What Problems And Opportunities Are Created By Tax Havens?’ (2008) 24 Oxford Review of Economic Policy.

[19]Avi-Yonah, International Tax As International Law (Cambridge University Press 2007).

[20] D. Dharmapala, ‘What Problems And Opportunities Are Created By Tax Havens?’ (2008) 24 Oxford Review of Economic Policy.

[21] D. Dharmapala, ‘What Problems And Opportunities Are Created By Tax Havens?’ (2008) 24 Oxford Review of Economic Policy.

[22] M. Larudee, ‘Sources of Polarization of Income and Wealth: Offshore Financial Centers’ (2009) 41 Review of Radical Political Economics.

[23] Avi-Yonah R, International Tax As International Law (Cambridge University Press 2007)

[24] Avi-Yonah R, ‘The OECD Harmful Tax Competition Report: A Tenth Anniversary Retrospective’ SSRN Electronic Journal

[25] OECD Harmful Tax Competition: An Emerging Global Issue (1998) OECD Publications, Paris.

[26] OECD Model Tax Convention On Income And On Capital: An Overview Of Available Products (1st edn, 2014)

accessed 4 March 2016.

[27] Bucovetsky S and Haufler A, Tax Competition When Firms Choose Their Organizational Form (CESifo 2005)

[28] Ayrshire Pullman Motor Services & Ritchie v CIR [1929] TC, 14 (TC).

[29] IRC V Duke of Westminister [1938] AC, 1 (AC).

[30] Commissioner of Inland Revenue v Delfos [2007] AD, 242 (AD).

[31] Jean Chrysostome Kanamugire, ‘A Critical Analysis Of Tax Avoidance In The South African Income Tax Act 58 Of 1962, As Amended’ [2013] MJSS.

[32] Australian Government Final Report of the Review of Business Taxation: A System Redesigned (1999) at 6.2(c).

[33] CIR v Challenge Corporation Ltd [1987] AC, 155 (AC).

[34] M Brooks & J Head “Tax Avoidance: In Economics, Law and Public Choice” in GS Cooper Tax Avoidance and the Rule of Law (1997)

[35] CIR v Willoughby [1997] 4 ALL ER 65.

[36] Brooks & Head at 82-91; G Brennan & JM Buchanan “Towards a Tax Constitution for Leviathan” (1977) 8 Journal of Public Economic 255.

[37] SARS Discussion Paper on Tax Avoidance at 14
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Posted on May 11, 2016Author TutorCategories Question, Questions