Pricing policies have failed to solve cross-border tax problems.
In the past, a question that every multinational manufacturing or trading company had to settle for itself was: where, in what proportion, shall we take the profits? Its decision was never entirely free, of course. Since all governments tax profits, they too had an interest in the matter. Thus the question for companies resolved itself into another: how can we arrange our affairs so as to minimise taxation, and at the same time avoid antagonising host governments? In July the OECD published a set of guidelines on transfer pricing, but whether these have simplified the issue - or muddied the waters - is by no means sure. The US has long argued that the tax should be based on its own system of 'split profits'. Australia has since adopted a US-style transfer pricing system, and Mexico is likely to follow suit. Most other nations continue adhering to the principle of 'arm's length' pricing, and it is this which is embodied in the OECD guidelines.
The trouble with arm's length prices is that they are open to possibly self-serving judgments on the part of companies, and are frequently hard to substantiate. Countries as diverse as Japan, Korea, Poland and New Zealand have increasingly been challenging the transfer prices declared by companies, demanding verification that these are indeed, genuinely, arm's length. 'Even the Inland Revenue is becoming increasingly aggressive in this area,' says Jim Marshall, head of international tax at KPMG. There's nothing surprising in all this. 'International groups must expect to have their pricing policies reviewed by the tax authorities of the countries in which they trade, and must be prepared to document and defend those policies.' But what, in practice, can companies do? Nicholas Dee, director of taxation at SmithKline Beecham, identifies two possible strategies. First, 'Make sure that what you do is defensible in both tax jurisdictions, and then be prepared to defend it robustly'. A great deal of corporate representation went into the OECD guidelines, he points out. And the US Internal Revenue Service has now made clear its requirements on companies' supporting documentation.
The alternative strategy is to reach prior agreement with the relevant taxation authorities. 'Advance pricing agreements' make it possible to clear pricing policies with the relevant tax authorities before any challenge is made. 'Any corporate taxpayer with cross-border transactions may approach the US Internal Revenue Service and seek an APA,' explains Marshall. The system has been enthusiastically received in the US by companies such as Apple Computer. The UK authorities seem less keen, however. 'The Inland Revenue is more cautious and has issued only four or five, none of them to a manufacturing company.' John Hobster of the Inland Revenue's international division confirms that the APAs issued so far have all gone to the financial services sector. 'The case for extending APAs outside the financial sector is not, we feel, proven,' he adds. After all, if UK companies are conforming to the OECD guidelines, there should in theory be no requirement for APAs. 'We (at the Inland Revenue) will obviously defend our position where necessary but have found that transfer pricing issues can generally be resolved amicably, thus avoiding the adversarial situations that can arise in other countries.' But that is not much help to businesses wishing to minimise the risk of a protracted transfer pricing dispute. There's one glimmer of hope, though, according to Dee. 'There's nothing in the rules to stop a UK company's US subsidiary going for a unilateral US APA.' This assumes that, once a transfer pricing formula has been accepted in the US, the UK authorities will fall in with the agreement.
But with most other countries even less inclined than the UK to set up APAs, this clearly falls a long way short of a global solution. 'Businesses have a clear interest in seeing an equitable structure of interlocking tax regimes,' says Peter Welch, chairman of WSP Group, the consulting engineers. As head of the Unitary Tax Campaign, Welch played a vigorous role in support of Barclays' 17-year long struggle against California's unitary tax law, which called for the bank to pay state taxes based on a proportion of its worldwide profits. California was ultimately forced to back down, Welch points out. If companies want a similarly satisfactory outcome in the transfer pricing battle, 'they will have to invest resources' to bring it about.