Chapter 1 Introduction
1.1 Research Background
Chapter 1 Introduction
1.1 Research Background
The trend of globalization prospers international trade. Many integrated multinational enterprises (MNEs)1 engage in international division of labor by setting up downstream and/or marketing subsidiaries abroad in searching for lower production cost and/or marketing opportunity. Those MNEs face a common problem, which is how to price the products between divisions. According to Eun and Resnick (2014), transfer price is the accounting value that is assigned to goods and services flowing from one division of a firm to another division. Haake and Martini (2013) argue that transfer pricing is a compensation of upstream division received from the downstream division for delivering the intermediate input. Transfer pricing can be seen as a strategic instrument for the divisions to act in the whole company’s benefit.
Stonciuviene and Uzkuraite (2015) express that transfer pricing is one of the characteristics and benefits of a decentralized company.
Transfer pricing plays diverse roles in real world: (1) strategic competition tool – a company can set a lower transfer price for its marketing division and enhance the marketing division’s competitiveness to stand in a favored market position; (2) tax arbitrage -- a company may raise the transfer price for its high tax-rate affiliates and effectively saves tax payment; (3) support negotiation -- the headquarter of a company can manipulate the transfer price while bargaining with labor union of an affiliate on salary-increasing; (4) counter to currency control -- MNEs may set the transfer price high enough to exploit foreign affiliate’s profit while host government exercises currency control regulations.
From the perspective of government, transfer pricing will erode tax income.
Most countries have regulations controlling transfer pricing. Yao (2013) demonstrates that the concerned regulations on transfer pricing in the U.S. is to ensure that
1 Integrated enterprise refers to a company which is divided into two or more divisions, and one or some divisions are specialized in upstream intermediate input manufacturing, the other divisions focus on downstream final product manufacturing. If this company builds a foreign subsidiary, it is denoted as an integrated multinational enterprise.
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taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such internal transactions,2 the arm’s length (AL) regulation of Internal Revenue Code (IRC) §482 requires the calculation of a firm’s transfer pricing to be comparable to a transaction with an independent party. If the transfer price reported by the firm deviates far from the tax authorities’
expectation, the firm may face a penalty according to IRC §6662.3 The penalty could be either 20% or 40% of the underpaid amount of tax. In Argentina, the amount of the penalty may even be up to 400% of the underpaid tax (Ernst & Young International Ltd., 2012). IRC proposes three methods for estimating the AL price:4 (1) Comparable uncontrolled price; (2) Resale price: the price at which the good is resold by the affiliate is reduced by overhead and profit; and (3) Cost-plus approach: an appropriate profit is added to the cost of the manufacturing affiliate. European Commission indicates that current corporate tax systems in EU Member States were conceived in the 1930s, when cross-border trade was more limited, business models were simpler and products were tangible. As business activities evolve, the present rules no longer work in a globalized, digital, mobile business environment. This out-of-date system is inefficient and creates opportunities for MNEs to use sophisticated tax-planning schemes to escape taxes. For prohibiting MNEs from tax arbitrage via transfer pricing among related foreign affiliates, the Ministry of Finance in Taiwan announced that the scope of tax audit will be broaden in 2016.5 The following circumstances will be listed in the higher priority.6
1. The gross profit ratio, operating profit ratio and net income before tax ratio are below the industry average.
2. The parent or headquarters reports profit on the global consolidation level, but the local affiliate reports loss or much less profit than the industry average.
3. The enterprise reports significant fluctuations of profit over the transaction year and
2 adopt from : https://www.law.cornell.edu/uscode/text/26/482
3 adopt from : https://www.law.cornell.edu/uscode/text/26/6662
4 See Eun and Resnick (2014, p. 510)
5 Source: http://www.chinatimes.com/newspapers/20150916000017-260202 (2015.09.28)
6 Source: EY, 2012 Transfer pricing global reference guide, Taiwan, Audit risk/transfer pricing scrutiny.
http://www.ey.com/GL/en/Services/Tax/International-Tax/Transfer-Pricing-and-Tax- Effective- Supply-Chain-Management/2012-Transfer-pricing-global-reference-guide---Taiwan) (2015.11.10)
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the two years preceding.
4. The enterprise fails to disclose related party transactions in accordance with the related party transaction disclosure requirements.
5. The enterprise fails to determine whether its related party transactions are within an arm's length range and fails to prepare documents in accordance with the Transfer Pricing Guidelines.
6. The enterprise has significant or frequent controlled transactions with related parties in tax havens or low tax jurisdictions.
7. The enterprise has significant or frequent controlled transactions with related parties entitled to tax incentives.
8. Any other transaction fails to meet the arm's length requirements in accordance with the Transfer Pricing Guidelines.
The transfer pricing rules and regulations, arm’s length pricing methods, and penalties in major countries are summarizes as Table 1.1.
Table 1.1 Transfer Pricing Guide of Major Countries (2015)
Country Tax law Arm’s length
pricing methods Transfer pricing penalties
OECD
Articles 9 and 25 of the OECD Model Tax Convention.
comparable uncontrolled price (CUP), resale price method (RPM), cost plus (CP), profit split method (PSM), transactional net margin method (TNMM)
Depends on local law. However, the OECD transfer pricing guidelines recognize that promoting compliance should be the primary objective of civil tax penalties.
United States
Section 482 of the Internal Revenue Code.
comparable uncontrolled price (CUP), resale price method (RPM), cost plus (CP),
comparable profits method (CPM), profit split method (PSM)
The penalty is equal to 20% of the under-payment of tax attributable to that substantial under-valuation.
The 20% penalty is increased to 40% of the underpayment in the case of a gross valuation
misstatement with respect to either penalty. Reg. §1.6662-6(a).
United Kingdom
Taxation (International and Other Provisions) Act 2010 (‘TIOPA 2010’) Part 4, formerly Taxes Act 1988, Schedule 28AA, as amended. The legislation is based on the arm’s length principle (ALP) as stated in Article 9 of the OECD Model Treaty, and is expressly stated to follow OECD Guidelines.
comparable uncontrolled price (CUP), resale price method (RPM), cost plus (CP), profit split method (PSM), transactional net margin method (TNMM)
For returns due after 1 April 2009, penalties are linked to the
behavior that gives rise to the error: if reasonable care was taken - no penalty; careless behavior - minimum 0 % and maximum 30
%; deliberate careless behavior - minimum 20 % and maximum 70
%; and deliberate and concealed error - minimum 30 % and
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Table 1.1 Transfer Pricing Guide of Major Countries (2015)
Country Tax law Arm’s length
pricing methods Transfer pricing penalties maximum 100 %. If there is no additional tax liability due to losses or availability of UK group relief, a penalty charged at a discounted rate of the gross adjustment may still apply.
Germany
Section 8 para. 1 and 3 Corporate Income Tax Act ; Section 4 para. 1 Income Tax Act ; Section 1 Foreign Tax Code ; Section 90 para. 3 and section 162 para. 3 and 4 General Tax Code.
comparable uncontrolled price (CUP), resale price method (RPM), cost plus (CP), profit split method (PSM), transactional net margin method (TNMM)
A penalty of 5 % to 10 % of the income adjustment will be assessed, with a minimum surcharge of €5,000 if
documentation is not provided or if the documentation is essentially unusable. In case of delayed submission of documentation, the surcharge may be up to €1 million, with a minimum of €100 per day.
Japan
Article 66-4 of the Act on Special Measures concerning Taxation.
comparable uncontrolled price (CUP), resale price method (RPM), cost plus (CP), profit split method (PSM), transactional net margin method (TNMM)
Japan does not have specific transfer pricing penalties. The ordinary penalty is 10 % to 15 % of the additional tax (35 % for concealment of facts). The delinquency tax rate is the lower of 7.3 % and 4 % plus the special discount rate for commercial bills at the central bank.
Korea
Law for Coordination of International Tax Affairs (LCITA).
comparable uncontrolled price (CUP), resale price method (RPM), cost plus (CP) , profit split method (PSM), transactional net margin method (TNMM)
10% - 30% penalty for
under-reported taxable income.
Taiwan
Articles 43-1 of Taiwan Income Tax Law.
comparable uncontrolled price (CUP), comparable uncontrolled transaction (CUT), resale price method (RPM), cost plus (CP), comparable profits method (CPM), profit split method (PSM)
Substantial adjustments made by the tax authorities based on the transfer pricing guidelines will trigger a penalty of up to 200 % of underpaid taxes under Article 110 of Taiwan’s Income Tax Law.
Source: Merged from
1. http://www.uhy.com/wp-content/uploads/Global-Transfer-Pricing-Guide-January-2015.pdf (2015.09.28) 2. https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Tax/dttl-tax-transfer-pricing- country-guide-2015.pdf (2015.09.28)
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