TAXATION
In debate on the parking of untaxed money in off shore companies, successive governments in Pakistan have ignored the menace of tax avoidance by multinationals firms in both developed and developing economies.
The developed economies and many developing economies have enacted transfer pricing laws but inter-government cooperation is essential to close loopholes that enable companies to manipulate transfer pricing. Some of the largest global corporations have been found to evade taxes.
An IT giant for instance recently agreed to pay $181 million in taxes to the British government that it had evaded in the past ten years. Still taxation experts view that the UK government had been lenient. However, at least a beginning has been made at the international level.
But what escaped the watchdogs in developed economies is actually very small because of better governance and adherence to rules and regulations. Still multinational firms have developed ingenious ways to hoodwink even the best governed governments. The damage caused through transfer pricing to the weakly governed developing economies is definitely enormous. The United Nations says developing countries lose $100 billion annually in revenues that are not paid to them by foreign corporations.
Pakistan’s tax revenue makes up only ten to 11 percent of its GDP (gross domestic product), compared with 35 percent in the developed world. However, no one can deny that Pakistan depends more on taxes than the rich countries. The inability to collect taxes hampers the ability of governments to deliver essential public services such as health or education. These basic necessities are denied due to paucity of resources. But these services are critical ingredients for driving economic growth.
Multinationals operate on code of corporate governance and the laws of their home countries that forbid them from any unethical practices. They do operate legally but have found out loopholes in every system to avoid taxes. They indulge in tax avoidance through transfer mispricing. They adopt ingenious methods to avoid paying taxes even in developed economies. To produce an end product, they have made components in different countries.
The original manufacturer opens subsidies in each of these countries, where their sister concerns pay local taxes. These companies, though owned by the same corporation, operate as independent companies that trade with each other and maintain independent accounts. For example, a US company selling computers in Canada, assembles them in Taiwan and using few parts procured from some African country. For accounting purposes, the subsidiaries are independent companies trading with each other.
The African subsidiary spends money on mining and in its accounts it states that the minerals have been sold to the Taiwanese subsidiary which in its accounts writes that it has ‘sold’ the finished phones to the sales subsidiary in Canada, which puts down in its accounts the price for which it sold the phones to consumers, and either takes this as profit, or ‘sells’ its revenue up the chain to the parent company.
Since no cash is involved as the goods move from one subsidiary to the other as the movement is recorded as internal transaction, the corporation can manipulate the prices for each transaction and determine which subsidiary files profits with tax authorities and which posts loss or nominal profit.
In practice the final profit that is generated through sales of computers is distributed across subsidiaries. But most of that profit is declared in countries where taxes are lowest and losses are declared in the countries where taxes are high. This way the multinational corporations reduce their tax burden.
These manipulations deprive high tax-rate countries like Pakistan of both tax revenue and earnings that can be reinvested in businesses locally. Instead these profits go up the chain, at the parent company level.
This tax avoidance has nullified the liberal policies adopted by successive governments to court foreign investment through privatisation of state owned enterprises. The common man does not see the benefits of such investments as actual taxes are avoided. It is true that all institutions that were privatised pay more taxes than what they paid as state entities and local investors pay more than their foreign counter parts. Moreover, there is no check on transfer pricing by car manufacturers or multinational pharmaceuticals. Technology used by companies to track their internal supply chain logistics can be used by the governments to track where profits are generated.
It does not mean that all foreign investors indulge in transfer pricing, but those that do, transfer a lot of tax free foreign exchange to their principle office. They feel no check pressure because there is no transfer price law in Pakistan. It is in practice in neighboring India. The chances of transfer pricing in exports is dim because the exporting industry has to compete globally; because they cannot load undue costs on their cargoes.
Transfer pricing deprives the shareholder in host country of fair return on their investment because the product cost is jacked up by importing inputs at higher rates. It however increases the profits of the controlling foreign shareholder. Transfer pricing has become more and more important to companies aiming to comply across national jurisdictions, making the most of their assets and departmental utilities.
It refers to the sum or price used in accounting which is paid for the transfer of intangible assets, goods, use of money, services and comparable transactions from one entity to another. Countries use appropriate laws to control related party transfer pricing since inapt use can alter profits from one jurisdiction to the other. In theory, businesses are meant to be in full command of their transfer pricing issues. This is significant because if they do not position their transfer prices in compliance with the rules of each jurisdiction they interact with, they could risk penalties, high interest and underpaid fees.
A large proportion of countries enforce tax laws that are based on the arm’s length principle as termed within the OECD. The arm’s length theory as adopted by Article 9 of the OECD Model Tax Convention serves the purpose of ensuring that transfer pricing between corporations of multinational businesses are established on a market value basis. It is used specifically in contract law to arrange an equitable agreement that will stand up to legal scrutiny, even though the parties may have shared interests (eg, employer-employee) or are too closely related to be seen as completely independent (eg, the parties have familial ties).
These transfer pricing guidelines for multinational enterprises and tax administrations, limit how transfer prices can be set and ensure that each country gets to tax “a just and fair” share. Transfer pricing can be used as a profit allocation method to attribute a multinational corporation's net profit (or loss) before tax to countries where it does business. Transfer pricing results in the setting of prices among divisions within an enterprise.
The writer is a staff member
