International Tax: Transfer Pricing - Assignment Example

International Tax: Transfer pricing Contents Question 3 Problems of current Transfer pricing rules 3 Arm Length Principle 3 Advantages of Arm Length Principle 3 Disadvantages of Arm Length principle 4 GFA (Global formulary apportionment) 4 Advantages of GFA 4 Disadvantages of GFA 5 APAs (Advance Pricing Agreement) 5 Advantages of APA 5 Disadvantages of APA 5 Question 2 6 Difference in transfer pricing as determined for management accounting and tax purposes 6 Transfer pricing in management accounting 6 Transfer pricing for tax purposes 7 Question 3 8 Arm’s length principle is not an effective tool 8 9 Reference 9 Question 1 Problems of current Transfer pricing rules Transfer pricing mainly deals with the transfer of the goods and the services between the related parties. The main problem that is associated with the transfer pricing is that it can deprive the governments of its fair share taxes arising from the global corporations and exposing the multinational towards the double taxation. It is not expected by any country whether it may be a poor country or a wealthy country that its tax base to suffer due to transfer pricing. Previously transfer pricing was treated as the subject for the tax administrators but now a days the politicians, business people and even the economist have focused on identifying the people who pays tax and for what type of international transaction within the reach of same corporation. Due to the increase in the cross border transaction and the compliance of the transfer pricing fulfilling the desired requirements has resulted in the overlapping of the various jurisdiction of tax which is very complex and much time consuming for the business. The application of Transfer pricing is difficult because at the time of analyzing the transfer pricing along with the revenue objectives related to the multiple authorities of tax because of the differences in the interpretation and judgment of the facts. Arm Length Principle Arm length principle mainly deals with the transfer price of the inter company transaction that is carried out across the cross border should be same if the transaction would have been taken place between the third parties that are unrelated. Advantages of Arm Length Principle 1. Arm length principle has been developed as a standard for guiding the transfer pricing 2. Arm length principle is mainly used for making necessary adjustments by improving and rectifying the adjustments and providing a resolution to the disputes arising out of transfer pricing. 3. Arm length reduces the potential for levying double taxation. 4. Arm length principle establishes the relationship between the enterprises by determining the price of the transactions. Disadvantages of Arm Length principle The disadvantages of applying arm length principle can be stated as follows: 1. Arm length principle mainly deals with the production and integration of specialized goods that are mainly unique tangibles and in making provisions for providing specialized services. 2. Arm length principle is mainly engaged in the transaction that is independent in nature 3. Arm length principle may lead to the adoption of tax burden for carrying out cross border transactions and for evaluating the tax administrations. GFA (Global formulary apportionment) Global formulary apportionment is mainly concerned with dividing and allocating the total global profit on the basis of the pre agreed global formula. Now days the firms do not have any tax incentive in order to shift its income to low tax locations. This will help in safeguarding the US tax base in decreasing the features of the current tax system (Clausing and Yonah 2007). Advantages of GFA 1. GFA provides a development or modification over the vulnerabilities related to the shifting of income that would facilitate in increasing the simplicity in the system of international tax and also the foreign tax credit. 2. The simplification in GFA would help in eliminating the cost that is required for compliance in the present system which will result in providing administrative savings both for government as well as for the tax payers. 3. GFA benefits in reducing the tax incentive and overcoming the problems related to transfer pricing and shifting of profit directly. Disadvantages of GFA The disadvantages of GFA are: 1. A shift from separate accounting to Formulary apportionment may lead or result in economic distortion. 2. Formulary apportionment is used or applied for allocating the income on the basis of reality economically to the extent where the taxpayers can easily manipulate the factors. And it is not developed on the basis of arm length principle. APAs (Advance Pricing Agreement) Advance pricing agreement between the tax authorities and the tax payers that mainly transfer prices that are mainly acceptable and the price that will not be challenged. Advantages of APA 1. It provides an opportunity to develop the reputation with the tax authorities and also with the public. 2. It reduces the risk of penalties and eliminates the double taxation. 3. It increases the certainty in respect to the outcome of the tax payers relating to the international transaction. Disadvantages of APA The main disadvantages of APA are: 1. Advance pricing agreement is very time consuming and its application is very expensive. 2. It generally or often deals with secret deals. The confidentiality maintained is not clear. 3. It provides strain on the resources that is available and the information that is provided can be misleading. Question 2 Difference in transfer pricing as determined for management accounting and tax purposes In vertically integrated firms transfer pricing plays a major role in both management accounting decisions and tax reporting purpose. Central to both these fields is the context that transfer price is used to determine the appropriation of income amongst various subsidiaries of the company. The major objective of transfer pricings as is commonly viewed by managers in different firm is to maximizing operating performance and optimizing tax structure. However the view to transfer pricing as has been adopted for managerial accounting and tax purposes differs considerably. Transfer pricing in management accounting The managerial accounting literature has viewed transfer pricing as a tool to coordinate the production and sales decisions of the several business segments that the company has. Transfer pricing is used by the divisional managers as a source of information to determine the cost and profitability of intra-company transactions. For a divisional manager the parameter to measure his performance is his or her divisions’ profitability. In this case transfer pricing plays a key role in deciding on how to allocate resources between the various divisions of the company such that it results in maximum profitability for the particular division of the company (Hiemann and Reichelstein, 2012). In line of this objective the goal of transfer pricing can be said to be maximizing the profit potential of a decentralized firm. Transfer pricing for tax purposes In contrast to the management accounting approach to transfer pricing the transfer pricing used for tax purposes is different. The tax based literature on the application of transfer pricing in the particular field is monolithic. So, the function of internal resource allocation has played a subordinated role. The transactions in between the business segments of the firm are viewed as given. The major goal of the firms in respect of tax liability is to minimize the tax that the firm has to pay while remaining within the confines of arm length standard. The problem with the transfer pricing approach to tax purposes is that it is very complex and difficult to comprehend for general public and tax practitioners. Only those who are experienced in the field can actually decipher whether the company is actually using some loopholes in the law to avoid taxes. Another problem with transfer pricing and arm length principal as applied to tax context is the fact that it is impossible for the tax office to always find an alternate business transaction between two third party or unrelated companies in the same lines as that between the subsidiary and parent company to determine whether there has been a deviation from the rules in order to achieve unfair tax gains. The case is particularly more pronounced in the case of pharmaceutical companies where transfer pricing is used to account for the payments for using of patents and copyrights of a product by a subsidiary. For example the famous case of GlaxoSmithKline is a particular point of reference in this direction. In case of GlaxoSmithKline it has been estimated that the company in between 1989 and 2005 the company’s American unit improperly paid more than the required amount to the British parent firm for using the patent for the drugs manufactured by the British parent. GSK had to pay $3.4 billion to settle the nearly 2 decade long dispute. Question 3 Arm’s length principle is not an effective tool Transfer pricing is the price at which financial transactions take place between subsidiary and parent of a multinational company. The transfer pricing laws are so complex that it is impossible for the public to understand it. Keeping aside the public even the most specialized tax practitioners actually understand the implication of transfer pricing laws. Arm length principal suggests that transfer price for inter company cross border transaction as that which would have been used if the transaction would have happened between two unrelated different parties. But this fundamental premise on which the entire arm length principal is based upon is the root cause of all faults(Durst, 2010). It requires no sophisticated analysis to understand the fact that multinational companies arise mainly because there are certain transactions that cannot occur in an economically efficient way between unrelated parties (Vincent, 2005). Examples of such type of transactions are manufacturing and marketing of expensive consumer durable products globally, or in case of pharmacy or IT companies where there is a question of intellectual properties involved in transactions. Such transactions often involve trade secrets and are far too complex and risky to be performed between unrelated parties. The transactions for which an alternative business transaction between unrelated parties is not available, the arm length principal cannot be used effectively to gauge whether the company has or has not adopted unfair means in order to avoid taxes. Arm length principle deals with the contracts that have no related entities and economic effects which allow the multinational companies to enter into the contracts and shift their interest in the valuable intangibles. Arm length principle does not specify clearly that whether the contracts are to be established or developed among the related parties or among the unrelated parties. The activities of unrelated activities are different from that of the related activities. The unenforceability or the application of the arm length standard is derived not from its implementation but from the central premises. Arm length principle has experienced a failure in case of the financial institutions that were responsible for safeguarding and protecting the interest of the public. In the case of Glaxo, the company is very intended and contended to sell the drugs in US as it carries out its research and development in Britain and it gave explanation and convinced that the British parent company has charged drugs from its American unit. The main issue is the profit derived from Zantac which is regarded as the best selling drug in mid of 1980. Glaxo mainly paid its taxes from the profit of Zantac in Britain. But the profit is much less than that of the profit that has been assigned to the US. Glaxo maintained a very poor record in maintaining the record. Glaxo decision is related to the settlement of disputes and it maintains a very poor track record in winning the disputes that involves the practice of accounting at a stake (IRS, 2006). Arm pricing leads to the occurrence of conflict between the corporate tax payers and the IRS. The main reason for practicing manipulation by the multinational companies s that every countries aims at maximizing the revenue derived from the tax on goods and services inside its borders and the aim of every company is that it provides incentive to book profits where the tax is very low which creates a dispute between the tax authorities and the companies over its proper pricing. Reference Clausing, K.A. and Yonah, R.S. 2007. Reforming Corporate Taxation in a Global Economy: A Proposal to Adopt Formulary Apportionment [Online]. Available at: http://www.brookings.edu/research/papers/2007/06/corporatetaxes-clausing. [Accessed 16 December 2014] Durst, M. C. 2010. It’s Not Just Academic: The OECD Should Reevaluate Transfer Pricing Laws.[Pdf]. Available at. http://www.taxjustice.net/cms/upload/pdf/Durst_1001_OECD_-_not_just_academic.pdf. [Accessed 16 December 2014] Hiemann, M. and Reichelstein, S., 2012. Transfer pricing in multinational corporations: an integrated management- and tax perspective. [Pdf]. Available at: http://link.springer.com/chapter/10.1007%2F978-3-642-25980-7_1 [Accessed 15 December 2014]. IRS., 2006. IRS Accepts Settlement Offer in Largest Transfer Pricing Dispute.[Online]. Available at. http://www.irs.gov/uac/IRS-Accepts-Settlement-Offer-in-Largest-Transfer-Pricing-Dispute. [Accessed 16 December 2014] Vincent, F., 2005. Transfer Pricing and Attribution of Income to Permanent Establishments: The Case for Systematic Global Profit Splits (Just Don’t Say Formulary Apportionment). Canadian Tax Journal, 53(2), pp. 409-416. Read More