Transfer pricing for the rest of us.
Keywords: transfer pricing, tax avoidance, intangibles, arm's length principle, profit allocation
Suddenly, transfer pricing is in the headlines [Economist 2013; Wall Street Journal 2014], Major corporations have been asked to speak with legislative bodies and explain their transfer pricing systems or are identified by non-governmental organizations as engaging in "transfer pricing"--as if it were not an acceptable practice [Budu Addo 2012], How did transfer pricing suddenly become a major policy issue? And why are economists involved? This article aims to shed light on this issue and help explain the role economists play in this field.
1. How Did We Get Here?
Long a topic of academic research, transfer pricing has nonetheless at times been only a peripheral issue in policy circles. However, in the wake of the Great Recession, corporate taxation moved into the spotlight as tax authorities sought ways to bolster tax revenue in response to declining taxable profits and skyrocketing budget deficits. With less profit to tax, authorities were motivated to renew enforcement. More recently, tasked by the governments of the G20, the Organization for Economic Cooperation and Development (OECD) has been leading the charge to address corporate taxation with its Base Erosion and Profit Shifting (BEPS) project. One of the focal points of the BEPS effort is transfer pricing.
What is transfer pricing? In the context of international corporate taxation, transfer pricing is the pricing and valuation of goods, intangibles, services, and financial instruments transferred amongst members of the same enterprise. Jack Hirschleifer's "On the Economics of Transfer Pricing"  set out the basic theoretical foundation for pricing goods transferred within a company. However, his analysis did not consider the impact of transfer pricing on taxes and differing taxing jurisdictions. While corporations have many legitimate economic reasons for intra-company transfer prices that appear to differ from prices they may charge externally, tax authorities are concerned with transfer pricing, for among other reasons, because it is a potentially good source of additional revenue. One calculation by researchers in a 2006 paper estimated that in tax year 2004 transfer pricing activity contributed to $5.5 billion in lower U.S. corporate tax revenues [Bernard, Jensen, and Schott 2006]. Collecting this tax would only have raised corporate tax revenue by 0.5 percent in 2004; but in a time when there is widespread concern about budget deficits and future debt burdens, optics are an important driver of priorities even if the actual amount of tax recaptured is a small percentage.
To illustrate transfer pricing in practice, consider this simple example: a company manufactures a product in Country A and sells the product to its subsidiary in Country B for sale to customers in Country B. The intercompany sale price--the transfer price--from Country A to Country B determines the share of profit realized in each country. The lower the transfer price, the lower the profits of Country A and the higher the profits of Country B. Following this example, it may seem logical to conclude that if corporate tax rates were the same in all countries, the impact and significance of transfer pricing would be minimal because the amount of total taxes paid would be the same regardless of where the profit was earned. However, this conclusion oversimplifies the reach of transfer pricing. First, within a company there may be non-tax-related competing interests in transfer prices--for example, if management compensation is driven, in part, by profit allocations. Second, even if the tax rates in Country A and Country B in the previous example were the same, the tax authorities in Country A and Country B would still have great incentive to argue for a higher or lower transfer price to maximize their respective tax revenues. Lastly, in reality corporate tax rates vary significantly across countries, with some countries not taxing corporate profits at all and others, like the United States, taxing them at a rate of 35 percent or higher. The combination of the aforementioned factors illustrates the significance of transfer pricing for both taxpayers and tax authorities alike.
Another key consideration is the stakeholders impacted by transfer pricing. In 2012, the World Bank published data that showed a few large companies dominate export markets in developed countries with the top 1 percent often accounting for more than half--sometimes nearly 80 percent--of total exports [World Bank 2012], Further, the U.S. Census Bureau  published data that indicated in 2013, 41.6 percent of U.S. total goods trade was between related parties. While these statistics consider only a slice of transfer pricing (excluded are services and intangibles), they illustrate the fact that the primary stakeholders for transfer pricing are a small number of large multinational corporations. So significant is transfer pricing in global trade that the OECD [Love 2012] estimates that 60 percent of today's world trade takes place within a multinational enterprise.
Given the magnitude of related-party trade and the desire to minimize disagreement about what the proper transfer prices should be, at least in the tax world, most developed countries have agreed to a common standard, the "arm's length principle." The arm's length principle is found in Article 9 of the OECD Model Tax Convention. It states that transactions between associated entities should be evaluated as if they were selling to an unrelated entity. It treats the members of a multinational enterprise as separate entities rather than as inseparable parts of a single unified business [OECD 2010a]. As such, the pricing of their intragroup transactions should ideally mirror their pricing of comparable transactions with third parties in comparable circumstances.
However, multiple research papers over the past several decades suggest that arm's length pricing is not being followed. Clausing  showed that the United States had less favorable intra-firm trade balances with low tax countries. Further evidence that certain firms may underprice goods in intra-firm transfers to low tax jurisdictions was provided by Bernard, Jensen, and Schott : "After matching related-party sales by a firm to arm's-length sales by the same firm for the same product to the same country in the same month using the same-mode of transport, we find that the average arm's-length price is 43 percent higher than the related-party price. While the wedge for commodities (i.e., undifferentiated goods) averages 8.8 percent, the gap for differentiated goods is 66.7 percent. The difference between arm's-length and related-party prices are higher for goods shipped by larger firms, by firms with higher export shares, and by firms in product-country markets served by fewer exporters."
While the empirical statistics cited above cannot be ignored, there are numerous complicating factors that help explain the price gap. First, the volume of intercompany transactions is generally higher compared to third-party transactions, which can lead to a price discount for the buyer and thus a lower sales price. Second, in practice, related-party transactions are often segmented between the tangible goods price and associated items such as royalties or post-sale services, whereas the royalty/services may be embedded within the tangible goods sales price to third parties. Thus, looking at the tangible goods price in isolation can result in a mismatch and cause the related-party sales price to appear lower compared to the third-party sales price. Lastly, the costs and risks for the seller are generally lower for related-party transactions as compared to third-party transactions, further lowering the related-party sales price. These three factors and others illustrate that directly comparing a related-party sales price to a third-party sales price oversimplifies the matter. Rather, a transaction-by-transaction review in consideration of all the unique facts and circumstances is critical to fully understanding price differences.
As more large multinational companies' cross-border practices are being investigated in high-profile cases, the topic is becoming more popular. According to Google Trends, a tool that tracks how often a particular term appears in the news, "tax avoidance" news stories spiked over the period 2010-14 from prior levels. The spike may be partially attributable to household-name corporations being publicly questioned about their transfer pricing policies.
2. New Data, New Rules
In cases where there are no comparable transactions, or in more nuanced instances of the transfer of intangible assets, there is plenty of room for reasonable people to disagree. Furthermore, economic principles around managerial and economic incentives in multidivisional firms also allow room for interpretation. A growing body of academic work analyzes decentralization of the decision-making processes within the multinational firm and how this influences transfer pricing results [Hyde and Choe 2005]. As data become more detailed, there may be further questions for corporations selling the same good to both intra-firm and external entities for different prices. However, because the arm's length principle cannot always be applied with full precision, it leaves some room for reasonable interpretation; and companies will use that room to structure their transactions and transfer prices to enhance the bottom-line and shareholder value while still complying with tax rules. This can lead to disputes with tax authorities, and in some cases taxpayers find that their transfer pricing positions are not sustainable.
To mitigate uncertainty and potential penalties in the case of a tax authority adjustment, companies have increasingly filed Advance Pricing Agreements (APAs), which are agreements between tax authorities and the taxpayer in regard to future pricing. In 2014, the 1RS released data showing that the number of completed APA applications increased from approximately 80 in 2007 to 111 in 2013 and as high as approximately 140 in 2010 [U.S. Internal Revenue Service 2014a]. Despite the increasing number of completed APAs, the number of transfer pricing adjustments proposed by tax authorities has also increased dramatically. The 1RS released data in 2014 that showed that the total number of proposed tax authority adjustments increased from 100 in 2010 to 266 in 2013 [U.S. Internal Revenue Service 2014b],
It is not unlikely that transfer pricing disputes and proposed adjustments will continue to follow this same trend in the coming years in response to a wave of newly proposed transfer pricing rules. A decade prior, only a few jurisdictions had formal transfer pricing documentation rules in place, as compared to more than 60 countries today [KPMG 2014], The OECD's BEPS project is in many ways a culmination of those efforts. The BEPS project is re-examining many aspects of intra-company pricing, including documentation but also thornier topics such as intangible valuation. The authors believe that BEPS, as well as a host of other forthcoming transfer pricing-related rules, may very well have a measurable impact on the number of transfer pricing disputes going forward.
3. Economists in Transfer Pricing
Economics has long been a key element of transfer pricing. The IRS considers economics so critical that an "Economic Analysis" is one of 10 required items in a qualified penalty protection report [U.S Internal Revenue Service undated]. Why is economics so important to transfer pricing? Since intercompany pricing should reflect arm's length pricing, and true arm's length pricing is shaped by particular market forces at a particular time, a full understanding of an arm's length price requires a full understanding of the market forces and how they may shape the price for a given transaction at a certain point in time.
Many major U.S. transfer pricing court cases involve testimony by economists engaged by both the IRS and the taxpayer as expert witnesses. Economists analyze the internal and external market environment of the transactions in question, identify potential comparables to price the transaction, and develop adjustments to account for differences between the internal transaction and the external comparables. One example of such adjustments is the widely used "working capital adjustments." These adjustments are meant to account for differences in payment terms between the tested internal transaction and the external, comparable transaction [OECD 2010b], Economists have developed many other adjustments based on the specifics of a particular case, such as foreign exchange adjustments, asset intensity adjustments, and location savings adjustments,
The arm's length principle has been in place for some time, but the OECD's recently released BEPS proposal further emphasizes economic considerations to support profit allocations. The authors believe the most striking examples are: BEPS Action 8--Intangibles, Action 9--Risk and Capital, and Action 10--Other High-risk Transactions. These initiatives intensify the focus on a thorough economic analysis, in the context of intangibles, by unambiguously divorcing contractual ownership of an intangible asset from a claim on the same intangible's profit [OECD 2014], If implemented, taxpayers would be required, through an economic analysis, to show that profit allocations are aligned with the location of key functions such as research and development. This could have far reaching implications for where research and development is conducted and where GDP is recorded.
In step with the OECD, the IRS is also emphasizing economic considerations. In the recently released Audit Roadmap, IRS field examiners are encouraged to identify audit risks using the follow criteria: "If indications are that the tax result claimed by the taxpayer is at odds with common sense and economic reality--'too good to be true'--chances are it is a good candidate for further scrutiny" [U.S. Internal Revenue Service 2014c].
As a result, economists, especially those with a background in financial and business economics, play an even more central role in the interpretation and application of the arm's length principle. Both tax authorities and tax advisors employ economists to help solve the transfer pricing puzzle. The IRS even has a Senior Transfer Pricing Economist to provide guidance on complex issues involving the arm's length principle.
4. In Closing
Transfer pricing has been thrust into the spotlight. All signs indicate that in the near term, the spotlight will become larger as transfer pricing disputes continue. Lastly, while popular opinions may have recently shifted as a result of certain external forces, transfer pricing itself is not a practice devoted to minimizing taxes. For the business economist, a career in transfer pricing combines the practical application of basic economic principles with business consulting; it is an interesting area of business economics that the authors believe will continue to grow over the next decade.
Bernard, Andrew B., J. Bradford Jensen and Peter K. Schott. 2006. Transfer Pricing by U.S.-Based Multinational Firms. NBER Working Paper 12493, National Bureau of Economic Research, August, http://www.nber.org/papers/ w 12493.
Budu Addo, Emmanuel. 2012. Effects of Transfer Pricing beyond Tax Revenue Loss: A Threat to Economic Development. Actionaidusa.org, http://www.actionaidusa. org/sites/files/actionaid/effects_of_transfer_pricing_beyond_tax_revenue_loss-5-12-11.pdf (accessed December 9, 2014).
Clausing, Kimberly A. 1998. The Impact of Transfer Pricing on Intrafirm Trade, NBER Working Paper No. 6688, August, http://www.nber.org/papers/w6688.
Hirschleifer, Jack. 1956. "On the Economics of Transfer Pricing." The Journal of Business, 29(3): 172-184.
Hyde, Charles E. and Chongwoo Choe. 2005. "Keeping Two Sets of Books: The Relationship between Tax and Incentive Transfer Prices." Journal of Economics, Management and Strategy, 14(1): 165-186.
KPMG, 2014. KPMG's Global Transfer Pricing Review, http://www.kpmg.com/global/en/issuesandinsights/articles publications/global-transfer-pricing-review/pages/default .aspx (accessed December 9, 2014).
Love, Patrick. 2012. Price Fixing, OECD Insights, http://oecdinsights.org/2012/03/26/price-fixing/ (accessed December 9, 2014).
Organization for Economic Cooperation and Development, 2010a. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Section 1.6. July.
--, 2010b. Comparability Adjustments, Centre for Tax Policy and Administration, July, http://www.oecd.org/ tax/transfer-pricing/45765353.pdf (accessed December 9, 2014).
--, 2014. Guidance on Transfer Pricing Aspects of Intangibles, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing.
The Economist, 2013. The Price Isn't Right (February 16).
U.S. Census Bureau, 2014. US Goods Trade: Imports and Exports by Related Parties 2013, http://www.census.gov/ foreign-trade/Press-Release/2013pr/aip/related_party/rp13.pdf (accessed February 26, 2015).
U.S. Internal Revenue Service, 2014a. Announcement and Report Concerning Advance Pricing Agreements, http:// www.irs.gov/pub/irs-drop/a-14-14.pdf (accessed February 26, 2015).
--, 2014b. Internal Revenue Service Large Business and International Division Competent Authority Statistics, http://www.irs.gov/pub/irs-utl/2013USCAStat.pdf (accessed February 26, 2015).
--, 2014c. Transfer Pricing Audit Roadmap, http://www .irs.gov/pub/irs-utl/FinalTrfPrcRoadMap.pdf (accessed December 9, 2014).
--, undated. The Section 6662(e) Substantial and Gross Valuation Misstatement Penalty, http://www.irs.gov/pub/ irs-apa/penalties6662_e.pdf (accessed December 10, 2014).
Wall Street Journal, 2014. EU Tax Probe Targeting Transfer Pricing, But What Is It? (June 11).
World Bank, 2012. World Bank Database Shows Export Markets Are Dominated by Big Firms, http://www.worldbank.org/en/news/press-release/2012/05/24/worldbank-database-shows- export-markets-are-dominated-bybig-firms (accessed February 26, 2015).
Disclaimer: This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax advisor.
CONSTANCE L. HUNTER, THOMAS HERR AND MARCUS HEYLAND *
* Constance Hunter is the Chief Economist of KPMG, LLP. Her work focuses on how economic factors impact asset prices and business performance worldwide. She works closely with the firm's leadership and clients to identify inflection points, risks and opportunities that arise in the constantly evolving economic landscape. She has held numerous positions in asset management over the past 20 years, including Chief Investment Officer and Chief Economist for the past 10 years. She graduated with an M.A. in Economics and Sociology from New York University and with a Master of International Affairs from Columbia University's School of International and Public Affairs.
Thomas Herr leads KPMG's Transfer Pricing group in Philadelphia. He has 20 years of experience advising businesses on intragroup transfer pricing policies, transfer pricing planning opportunities, and business and intangible valuation issues. He has provided transfer pricing and valuation service across a broad range of industries. His work has focused on intangible-related issues, such as licensing arrangements, contract IP development arrangements, cost sharing arrangements and intangible sales. Herr has a Master's in International Relations from Johns Hopkins University's School of Advanced International Studies, a Master's in Economics from the University of St. Gallen, and is a member of the CFA Institute.
Marcus Heyland is a senior associate in KPMG's Transfer Pricing group in Philadelphia. He has experience in performing transfer pricing and valuation services for mid-size and large international corporations across an array of industries and has assisted clients on a variety of transfer pricing planning opportunities. He has a B.A. in finance from the University of Iowa's Tippie College of Business.
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|Comment:||Transfer pricing for the rest of us.|
|Author:||Hunter, Constance L.; Herr, Thomas; Heyland, Marcus|
|Date:||Apr 1, 2015|
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