Nowadays, the international business taxation faces a lot of problems, one of the most importantbeingthe problem of allocating the taxable profits of a multinational enterprise (abbreviated MNE) to jurisdictions where subsidiaries and permanent establishments are located.
The OECD approach to international profit allocation is based on separate entity accounting and the transfer prices of inter-company transactions that take place within MNEs.
It is already known the fact that the transfer pricing for inter-company transactions is determined according to the arm’s length principle. According to OECD, the determining pointof the approaching of transfer pricing is a comparison between the transfer prices of a controlled transaction and the market prices of an uncontrolled transaction.
Often, direct price comparability fails if companies possess specific assets that are not traded in markets. In this case, the assessment of transfer pricing must rely on some other type of market-related data.When is granteda leeway in the assessment of transfer prices for intra-firm transactions, MNE have the opportunity to shift profits to low-tax jurisdictions via transfer pricing. Also, companies can allocate internal resources in terms of investments to low-tax jurisdictions to improve profit shifting opportunities.
Starting from the hypothesis that MNEs successfully shift profits to low-tax countries, the research of the specialists in the fieldindicates that profit shifting impacts resource allocation within MNEs. In high-tax jurisdictions, profit shifting reduces the tax revenues. Nevertheless, profit shifting cushions the negative effects of high profit tax rates on internationally mobile capital investments.
A hightax jurisdiction might wish to tolerate a certain amount of international profit shifting to support its attractiveness as an investment location and to preserve comparatively higher profit tax rates. In particular, larger countries with many firms operating nationally might consider such tax policies attractive and thus might tolerate transfer pricing rules that give firms some freedom of movement.
Important efforts are made by the Transfer Pricing Guidelines in order to reduce tax planning opportunities for MNEs. Since market prices for internal transactions are rarely respected, the Transfer Pricing Guidelines suggests other criteria: additional rules are designed to allocate the MNE’s total profit from internal transactions according to performed economic functions.
However, fair allocation of the total profit of an integrated firm according to economic functions or involved factors of production is impossible and as a result, this approach is economically undetermined. Beyond the theoretical weaknesses, the main advantage of the OECD approach is its time-honored international acceptance.
The result of the effort to assess transfer pricing may be perceived as fair in terms of the international distribution of the tax base. Moreover, the transfer pricing methods allow vast discretionary powers. Although the OECD regulations are designed to safeguard comparability by considering a transaction individual facts and circumstances, the result is a pseudo-accuracy that allows for considerable leeway.
Tax authorities may follow different approaches and thus expose MNEs to the risk of double taxation. Moreover, both compliance costs for MNEs and enforcement costs for the tax authorities are presumably high. These costs are obviously driven by the increasing complexity of integrated companies and the documentation requirements that tax authorities impose on MNEs to keep track of internal transactions.
From this perspective, recent amendments to the Transfer Pricing Guidelines may not be a step in the right direction. The new guidelines have abolished priority rules for the different methods of assessing a transfer price and thus give MNEs and tax authorities even more discretion.
Consequently, an aspect to be considered is reducing comparability requirements and relying on a small set of easily observable and measurable factors to apportion profits and assess transfer prices. In this case, the starting point is a standardized transaction-based apportionment method, which combines a fixed standard profit margin with the apportionment of residual profits to points of sales. Decreasing the complexity of the current transfer pricing rules is expected to significantly reduce compliance and enforcement costs and double taxation risks.
Those companies that invest in several countries with different profit tax rates may engage in international tax arbitrage. Multinational enterpriseswould be able to exploit tax rate differences through their choice of investment location and the financial structuring of investments. Given their investment and financing decisions, they also can shift the tax base in locations with low taxon transfer pricing. Several empirical studies have investigated whether multinational enterprises manipulate transfer pricing to reallocate taxable profits and reduce tax payments.
The profit-shifting opportunities associated with separate entity accounting can stimulate the creation of a taxable arrangement in low-tax countries. The firms have a strong incentive to relocate economic functions thattrigger the assignment of taxable profits. Relocated economic functions should be mobile if relocation costs are small and productivity is unaffected by location-specific characteristics.
Very important, service operations and intangible property are candidates for activities of base-shifting. Excepting their mobility, business services and intangible property are specific for some firms. Consequently, comparability might fail, and application of the arm’s length principle is difficult in these particular cases.
Thus, a company may find two benefits from base shifting. If at least some of the expected profits can be shifted, a combination of the host country’s tax rate and the tax rates imposed at the MNE’s other locations determines investment decisions. Reducing the effective tax level triggers additional investments at high-tax locations.
Multinational enterprises operating in a high-tax country have lower capital costs in comparison to domestic competitors. Consequently, profit-shifting opportunities stimulate international merges and acquisitions and encourage domestic firms to become multinational.