INTRODUCTION
Transfer Pricing – Defining the Issue
A Transfer Price is simply the price that two
related persons negotiate between each other for the
supply of goods or services.
A general assumption that is often made because
of that relationship is that the Transfer Price that
results from the negotiations will be affected by
that relationship, in other words, it would be
different from the price derived from two unrelated
parties trading at arms length.
As global trade continues to grow substantially,
so too has the interdependence between multinational
enterprises (MNEs) and national economies. The World
Trade Organization data of 2003 estimate that 45% of
export trading in monetary terms relates to
subsidiary trading. MNEs were estimated to be in the
vicinity of 65000 entities with over 185000
subsidiaries and at least two thirds of MNEs are
usually rooted or controlled by a head or parent
company with the decision on how the overseas
entities are structured being largely determined by
global tax considerations. The usual corporate
structure by a resident company based in any part of
the world in setting up operations overseas is
through an overseas branch or an overseas resident
subsidiary.
Regardless of the choice of structure of
the MNE what is evident would be the direct
relationship or association between Parent or Head
Company and the overseas branch or overseas
subsidiary. For the MNE, what is critical is not the
profitability of any particular component or branch
in isolation but the overall group or enterprise
profitability. MNEs may therefore be indifferent as
to which jurisdiction it pays tax but at the same
time mindful of its overall profitability after
worldwide taxation.
In the absence of a Transfer Pricing legislative
regime, there is the real threat of MNEs using
transfer-pricing techniques to artificially achieve
minimum taxation within such jurisdiction. There is
no global tax system in place and different tax
rates and rules between states provide a potential
incentive for MNEs to manipulate their Transfer
Prices to recognize lower profits in states with
higher corporate tax rates and vice versa.
MNEs have been buying out or amalgamating with
other MNEs to control all aspects of the supply at
goods or services. We can examine some of the goods
and services that accounts for the major spending of
a Caricom consumer and look to see trends in its
supply.
Food - MNE control the seeds, the fields, the
fertilizer, the raw products, the final product and
the distribution of almost all processed foods.
Advertisement is changing the eating habits of the
world to processed foods.
Fuel -MNE control the
exploration, extraction, refining and the
distribution of Petrol or Liquid gas.
Telecommunication - MNE control the equipment to
transmit, computer, telephone and the cost of the
transmission.
Pharmaceutical, electricity, travel,
hotels and vehicles
The distributions of almost all
the above are under the control of the MNEs.
Business Policies are also designed in a way that
almost all businesses are being controlled by MNEs.
Formerly some Groceries, Good Outlets and Pharmacies
at the retail end were owned by individuals and
small family concerns. Recent trends have shown that
these businesses are unable to continue to exist
with competition from the MNEs.
In Trinidad and
Tobago, traditionally MNEs controlled hotels, and
goods and services in the Oil Industry. There seems
to be a marked increase of MNEs operating retail
outlets in the supply of furniture and appliances,
groceries, prepared meals and motor vehicles. Almost
all items in these retail outlets are being supplied
from related parties within a group.
Transfer
Pricing will probably present the most challenges in
the future of Tax Administration since traditional
methods of business and consequentially auditing are
changing because of these trends.
CURRENT PROVISIONS IN TRINIDAD AND
TOBAGO - ANALYSIS AND REVIEW
The anti-avoidance
provisions within the local legislation that are
applicable to transfer pricing issues prior to 2006
are:
1. Sect.10 (1) (b) of the Income Tax Act that
places a 1% limitation on the deductibility of
outgoings and expenses in respect of management
charges.
2. Sect. 67 of the Income Tax Act that
gives the Board of Inland Revenue the power to
disregard any transaction that is in its opinion
artificial or fictitious.
These provisions provide
certain anti-avoidance measures. Section.67 is
largely governed by the operative words “fictitious”
and “artificial.” “Fictitious”: in the context of
the legislation, refers to a transaction in which
those who are ostensibly the parties to it never
intended it to be carried out; in other words it is
a sham.¹ “Artificial” in the context of the
legislation has a broader net than “Fictitious”:
Leading local precedents such as Z Estates Ltd.² and
Myerson Co. Ltd.³ have established the specific
features of a transaction that is within the realm
of artificiality.
These features are:
1. The transaction is not one
that is arm’s length in that one party has control
over the other.
2. The transaction is one that does
not make commercial sense, in that it is unnatural
and not one which would be expected in circumstances
of persons acting freely and independently of each
other.
3. There is substantial disparity between the
price at which the transaction is carried out and
the fair market value.
4. The circumstances
surrounding the transaction are such that one can
fairly infer that it was a device or arrangement to
reduce or avoid tax by the taxpayer.
The weakness of Section 67 lies in that it is an
anti-avoidance measure that would be activated
mainly through the findings of an audit examination
and there are no mandatory reporting requirements
for MNEs to report to the Board of Inland Revenue in
some form all their controlled transactions. This is
a feature of all transfer pricing legislation
globally with the rapid trend of pertinent
jurisdictions prescribing penal provisions in the
event of non-compliance with reporting requirements.
Another potential deficiency relates to any
adjustment made and the substitution of a fair
market value. The legislation as exists does not
prescribe any specific methodologies for attaining
comparable prices therefore attracting the risk of
an arbitrary price being substituted and this would
affect the validity of such an adjustment.
S.10 (1)
(b) also has it legal obstacles, the International
Computers Ltd. decision which provided that the
proportionate part of certain administrative
expenses incurred by a Head Office and reimbursable
by the branch, were not management charges as
defined by the legislation as they do not relate to
the overall management and direction of the company
and accordingly such amounts were deductible in
full, has led to the avoidance/evasion technique of
creative cost classification.
Ancillary to the head
office allocation dilemma would be the modern trend
of MNEs claiming Research and Development costs and
the obvious challenges it would pose from a
deductibility and branch allocation perspective as
there may differing cross border treatments for this
item. Further there are no legislation in place to
deal with thin capitalization thereby making the
threat of a highly geared subsidiaries being the
recipient of deductions relating to loan interest
payments a distinct possibility for generous profit
write offs.
In 2006 Section 10 (1)b has been amended
to increase the management charges limitation to 2%
in respect of all outgoings and expenses in respect
of management charges. Management charges has also
been redefined to include all charges made for the
provision of management services and charges made
for the provision of personal services and technical
and managerial skills, head office charges foreign
research and development fees and other shared cost
charged by the head office.
The legislation seems to
be drafted to avoid some of the problems encountered
prior to 2006 until the last line. It is unlikely
that the head office will be charging their local
entity any of these management charges.
OECD MODEL
The transfer pricing guidelines
published by the OECD have been adopted with minor
variances by a number of both member and non-member
nations into their domestic legislation as providing
the definitive standard by the MNEs should benchmark
their inter-company prices. The prevailing standard
is the arms length principle.
Article 9, paragraph 1
of the OECD model tax convention provides:- When
conditions are made or imposed between… two
associated enterprises in their commercial or
financial relations which differ from those which
would be made between independent enterprises, then
any profits which would, but for those conditions,
have accrued to one of the enterprises, but by
reason of those conditions, have not accrued, may be
included in the profits of the enterprises and taxed
accordingly.”
It may be noted that there may be
differences among countries as to the definition of
associated enterprises. There may be different
standards dependent on direct shareholding and/or
controlling interest. The OECD model therefore
suggest that for purposes of taxation, the
attributable price of transactions between
associated enterprises (controlled transactions)
should reflect the economic reality of those
transactions through comparison with comparable
transactions between independent enterprises
(uncontrolled transactions).
A major reason why OECD
Member countries and other countries have adopted
the arm’s length principle is that the arm’s length
principle provides broad parity of tax treatment for MNEs and independent enterprises. This is because
the arm’s length principle puts associated and
independent enterprises on a more equal footing for
taxation purposes as it avoids the creation of tax
advantages or disadvantages that would otherwise
distort the relative competitive positions of either
type of entity. In so removing these tax
considerations from economic decisions, the arm’s
length principle promotes the growth of
international trade and investment.
COMPARABILITY
The arms length principle at face
value seems to be a readily available solution to
provide a valuation for controlled transactions.
This would be the case where comparable transactions
between independent entities can be readily
identified. The arms length principle becomes a
major problem where MNEs are involved in
transactions involving goods and services to which
it has a monopoly as would occur for transactions
involving specialized goods and services or unique
intangibles or where enterprises enter into
transactions which independent parties would not
undertake.
Market Price should be the result of
supply and demand. Market Price is closest to arms
length Price but in today’s world is it possible to
say that there is not enough oil in the world to
satisfy the demand. Is the price based on management
and control of the end price by the MNEs or the
interaction of supply and demand of Crude Oil?
A
T-shirt with a Brand name logo sells for so much
more than the same T-shirt without the Brand logo.
The same item could be sold at different countries
for vastly different prices. There are many factors
that determine what is an arm length price and many
of these could be discounted if the parties affected
wish to challenge the basis of arriving at an arms
length price. Probably the arm has became too global
in its grasp.
The substitution of a Transfer Price
is not an exact science but at the same time a price
should not be applied arbitrarily. Where
transactions between associated enterprises and
independent parties are not identical all
economically relevant differences that may affect
the Transfer Price need to be examined.
Factors to be considered in determining
comparability and the analysis of each case include:
1. Characteristics of property and services.
2.
Functional Analysis.
3. Contractual Terms.
4.
Economic Circumstances.
5. Business Strategies.
6.
Transaction Structure.
7. Multiple Year Data.
8.
Losses.
9. International Set Offs.
10. Government
Policies.
The United States Tax Administration is
involved in gathering data for comparable
transactions and has many administrative challenges.
For certain industry sectors it involves outsourcing
experts in analyzing certain transactions. Other
countries eg Brazil and the Netherlands use
discounting and indexing techniques as well as
factoring the effects of inflation.
There is the
need for proper training of pertinent staff in
dealing with comparable transactions so as to reduce
the risk of matters being lost at litigation due to
arbitrarily imposed transfer pricing on the part of
the Tax Administration. There are challenges for
both taxation administrators and MNEs in obtaining
adequate information to apply the arm/s length
principle. This arises because the principle usually
requires the evaluation of uncontrolled transactions
and the business activities and strategies of
independent enterprises and to compare these with
the transactions of associated enterprises. That
process would entail a substantial amount of data.
There would also be inherent risks associated with
deficiencies or incompleteness of accessible data or
interpretation problems; other information if it
exists may be difficult to obtain because of its
geographical location or of the parties to whom it
may have to be acquired and there may also be
reluctance to disclosure for confidentiality
concerns. Despite these hurdles, the arm’s length
principle remains the universal benchmark in
governing the evaluation of Transfer Prices among
associated enterprises. The principle remains
theoretically sound and provides the closest
approximation of the workings of the open market in
the case where goods and services are transferred
between associated enterprises.
A departure from the
principle would be abandoning the sound theoretical
basis on which it is based and be perceived as a
sort of renegade action to the international
consensus that may create risks of double taxation.
Based on its adoption in many countries there is
also a substantial body of common understanding
between MNEs and tax administrators. There has also
been the emergence of no realistic or legitimate
alternative to the arm’s length principle and the
arm’s length principle has been widely endorsed by
both OECD and CIAT.
PRICING METHODS
All jurisdictions have
essentially the same pricing methods. However, there
may be differences in relation to whether a MNE has
discretion in choosing a pricing method or whether
dependent on industry sector and approval from the
relevant taxation authorities, a particular method
is mandatory.
The main pricing methods are:-
1.
Comparable Uncontrolled Price Method (CUP method).
This method is usually applied to intangibles,
transfer of commodities and loans, provision of
financing.
2. Resale Price Method. This method is
usually applied to distribution of finished
products.
3. Cost Plus Method. This method is
usually applied to the provision of services,
transfer of semi-finished goods and long-term buy
and sell arrangements.
4. Comparable Profits Method.
5. Profit Split Method This method is usually
applied to transactions involving integrated
services provided by more than one enterprise.
6.
Comparable Profit Split Method.
7. Residual Profit
Split Method.
8. Transaction Net Margin Method. This
method is usually applied to the provision of
services, distribution of finished products where
the resale price method cannot be adequately applied
on the transfer of semi-finished goods.
ADVANCE PRICING ARRANGEMENTS (APA)
An advance
pricing arrangements (APA) is an arrangement that
determines in advance of controlled transactions, an
appropriate set of criteria for the determination of
transfer pricing for those transactions over a fixed
period of time. An APA is formally initiated by a
taxpayer and would require negotiations between the
taxpayer, one or more associated enterprises and one
or more tax administrations.
In jurisdictions that
have transfer-pricing legislation, the modern trend
has been to introduce the option of advance pricing
legislation. In the local context, APA may not be
initially introduced in the short term because of
the unpredictability of the world Price of Oil and
Gas.
The advantages of an APA are as follows:
1.
Facilitates tax certainty.
2. APA’s are prospective
relating to future transactions, there has also been
little need to audit the years comprising the term
of the APA.
3. An APA is reached after extensive
processes whereby a review of submission of MNE is
undertaken following discussions. The tax
authorities are thus able to fully appreciate the
MNE’s operations.
4. A review is normally conduced
by the MNE of its operation and a variance analysis
conducted to compare actual and forecasted results
with the necessary adjustments made relative to
differences in results.
5. There are savings on both
side in relation to time and costs for the years
under the APA.
6. APAs are usually negotiated by
both parties under a spirit of compromise as
distinct from the adversarial nature that features
in audits and subsequent proceedings.
7. In the case
of multilateral APA, the MNE would minimize the risk
of double taxation.
8. An APA may provide a viable
solution to resolve a complicated and protracted
audit situation.
Despite the obvious advantages of an APA there
are certain challenges inherent to it, as follows.
1. There may be reluctance on certain MNEs to apply
for APA as too much information on its affairs would
be brought to the attention of the taxation
authorities.
2. The negotiation of an APA is time
consuming.
3. There may be some uncertainty in
future projections and reliability of databases.
4.
Skilled personnel in projections may have to be
outsourced.
5. It may place a strain on existing
resources as tax administr4ators would have to
divert resources earmarked for other purposes.
OECD has stated in their Transfer Pricing
Guidelines that the success of an APA program is
dependent on the care taken in determining the
proper degree of specificity of the arrangement
based on critical assumptions, the proper
administration of the program, and the presence of
adequate safeguards to mitigate the risks of
possible pitfalls, in addition to the flexibility
and openness in which all parties approach the
process.
THIN CAPITALIZATION
Thin capitalization arises
in circumstances where companies are highly geared,
that is to say, financed predominantly by debt as
against by equity. In most jurisdictions including
ours, interest on the debt is deductible for
taxation purposes whilst dividend payments are not
so deductible for corporation tax purposes. The
absence of capitalization rules provides the astute
international tax planner to structure local
subsidiaries of foreign enterprises with a high
level of debt capital that ultimately is financed
and in turn payable to the controlling enterprise.
Without getting into too much analysis, it would
appear that in jurisdictions that have thin
capitalization rules, there is a limitation on the
full deductibility of interest expense incurred on
loans from foreign affiliates, if the debt to equity
ratio of the resident company exceeds a certain
ratio. It would appear that the standard acceptable
debt: equity ratio is 3:1. Financing transactions
also present certain spin off issues with connected
enterprises type implications such as in relation to
guarantee fees, finance leases, start up financing
and debt factoring.
CONCLUSION re TRANSFER PRICING
The level of
economic growth and foreign establishments having
branches or subsidiaries within the Caricom
jurisdictions in key sector areas would drive the
necessity of establishing a transfer pricing regime.
The absence of a comprehensive framework heightens
the risk of pricing manipulation practices that
would inevitably erode the tax base. However, since
it would not be too debatable that on the surface,
it appears that there is a need for a more
comprehensive regime to deal with transfer pricing,
there would be the need for a more detailed
feasibility analysis to be conducted. In that regard
an appropriate Tax team should be established to
examine, analyze and evaluate such.
In that regard,
the following activities should be focused on:
1. A
compilation of a database of all MNEs operating in
the jurisdiction with emphasis on their corporate
structure, main business undertakings and linkages
within its group. This database can be compiled from
internal sources and information from the Companies’
Registry.
2. A study of all MNE controlled
transactions with emphasis on pricing and related
factors that determined such pricing.
3. A sector
analysis of MNEs operating within the Region.
4. The
establishment of linkages with CARICOM countries for
the development of comparables.
5. The establishment
of linkages with countries who have had the
experiences of implementing and administering a
Transfer Pricing regime.
6. The establishment of the
competent authority to administer the transfer
pricing program within the jurisdiction. It is
suggested such an exercise be conducted as early as
possible.
CONCLUSION
Other Taxes
The main purpose of
Taxation is to provide revenue to manage a country
and support the needs of the people. Since Transfer
Price could substantially reduce the taxation
collected, another tax that is not based on profits
may be introduced
Value Added Tax. This Taxation may
reduce the problem of Transfer pricing and is easier
to administer.
Airport Tax. Room Taxes. Depending on
the economy, this may be the simplest way to collect
taxes.
Wages and Salaries also support the needs of
the persons in a country. The Government by
introducing Minimum Wages Legislation could ensure
that proper wages and salaries are paid by certain
sectors or as a whole. They can ensure that adequate
pension schemes are introduced to provide for the
future needs of persons. Certain standards of work
environment could also be mandatory in an attempt to
restrict future stress on the Health Sector.
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