Internal pricing for maximum returns takes on heightened risk as governments crack down on creative tax-avoidance maneuvers.
Take any hard-pressed Asian CFO into a corner and ask him or her about top concerns, off the record: Chances are that transfer pricing—the work of setting prices on goods sold between related entities in a corporate family—will be high on the list.
Corporations depend more and more on emerging markets returns at the same time that cash-strapped governments in those markets are cracking down on tax avoidance. The increasingly urgent need for Asian governments to grow tax revenue has precipitated new interest in the arcane science of transfer pricing.
“As regional growth tapers off, getting a fair share of tax take is now a hot topic here,” says Alan Morley, a Singapore-based expert in global risk and compliance and managing director of consultancy Adsideo. “Governments are tightening the rules, putting new pressure on CFOs to balance innovation and risk.”
In the past, many jurisdictions lured foreign investors by offering favorable corporate tax rates. Now starved for revenue and egged on by populist anticorruption movements, those same governments are realizing they might find revenue by putting large multinational corporations (MNCs) under a microscope.
And it’s not just in Asia. Emerging markets are merely following the example of the EU, which recently tackled Apple, Starbucks and Microsoft for tax schemes that may have been legal but didn’t hold up in the court of public opinion, highlighting another issue: the risk to reputation.
“Regardless of whether or not a company’s transfer pricing conduct is or was technically legal,” Morley says, “its reputation is at risk when its tax practices are publicly called into question.” In Europe, Facebook and Amazon face huge bills and significant reputational damage. For CFOs across the globe, using transfer pricing to maximize returns in an era of increasing financial scrutiny and draconian penalties is causing major headaches.
Leeway To Game The System
In theory, corporations must publish accounts—and pay tax—in every sovereign territory in which they operate. Their tax liability is calculated on all transactions, including those between their own subsidiaries. Total tax is the sum of all the duty they pay in all the territories where they operate. Average tax rate, much ballyhooed by analysts, is their average tax across all their operations. The lower the average tax, the more profit they return to shareholders.
“When a UK-based subsidiary of [pharmaceuticals giant] GSK, for example, buys something from a French-based subsidiary, determining a price for that transaction is transfer pricing,” explains Morley. Those intramural trades—across national boundaries but within the same group—comprise 60% of international trade, according to his estimates, and because the trading entities are related, there is leeway enough to “game” the price to lower tax bills. “The stakes are high,” he adds. “Getting it wrong [is] a big risk.”
Many see the shift to greater scrutiny across industry sectors as an inevitable consequence of increased scrutiny of financial services firms, particularly in the wake of Swiss bank BSI’s debacle in Singapore—where it was cited for 41 offenses, heavily fined, and then shut down altogether. Offending banks are regularly fined and forced to undertake extensive risk mitigation programs that require drilling down into sometimes-revealing data.
“These initiatives are now bearing fruit,” Morley notes. “The knowledge the financial institutions have acquired through this process has persuaded wily governments to look at other industries with a view to stopping funds slipping away to lower-tax jurisdictions.”
A Key Weapon In Market-Share Battles
In Asia financial supply chains are especially complex, and the range of tax regimes makes smart calibration profit-critical. Talk to a CFO here and it is not uncommon for him or her to be finessing entities in dozens of jurisdictions.
Rajesh Bhambhani is one such CFO, responsible for transfer pricing for Sivantos Asia, a Singapore-domiciled manufacturer of devices for the hearing-impaired that operates in more than 20 markets globally. A transfer price, he asserts, should match either what the seller would charge an independent, arm’s-length customer, or what the buyer would pay an independent, arm’s-length supplier. Determining this is not as easy as it sounds, because comparable transactions for reference may not exist and tax authorities often give conflicting advice.
“Since we are a global business and supply to 26 countries we have constant concerns. We need to have a working knowledge of all those geographies as well as local advice in market,” he says. “It’s complicated, to say the least.”
Because transfer pricing is a tool to maximize profit, he says, CFOs are under pressure to deliver the optimum solution for shareholders. Yet they must be careful not to steal profit from one company to build another. “As a general rule, ask yourself what is the basis for your operation: Are you adding value to the product, or is it simply an artificial invoicing entity?” he says. “If you have a genuine value-add operation developing and making products in, say, Singapore, it makes sense to report most of your profit in Singapore. But if you’re simply creating an artificial transaction to offset tax—watch out!”
Bhambhani sees jurisdictions becoming more vigilant about getting “a fair share of tax” and acknowledges some industries are “especially egregious” in creative accounting. He cites the media industry, saying Asia-based entities take product developed elsewhere but sell it out of Singapore and report most of the revenue there, with no justification other than tax benefits.
Australia, Indonesia and other resource-rich jurisdictions have also recently launched inquiries into the mining industry, which according to Bhambani has “played fast and loose” with transfer pricing. “Major mining companies have consistently exploited transfer pricing mechanisms to keep profit artificially out of Australia,” he says.
Governments Get Smart
Estimates vary as to how much tax revenue is lost by governments as a result of transfer mispricing, but Global Financial Integrity in Washington, DC, estimates it is several hundred billion dollars annually. “Unsurprisingly, there is a lot of momentum towards greater scrutiny,” says Morley. “Expect things to get difficult for companies that flagrantly abuse the available opportunities.”
Morley points to new documentation requirements and increased audit exposure as a sign of this developing issue. “You don’t have to look far to read about substantial and strictly enforced penalties. At the time of going to press, Facebook faces nearly $8 billion in additional taxes based on an IRS challenge to transfer pricing agreements between its Irish and other subsidiaries.
There is overwhelming evidence that jurisdictions, especially in developing markets, are modernizing their tax mechanisms. In China, commentators wonder how infrastructure, healthcare and military commitments will be funded, given that they are projected to grow much faster than GDP, which is struggling to reach 7%. Increases in value-added taxes are one answer, but “change to transfer pricing and increasing scrutiny of corporates, above all foreign ones, are squarely in the sights of the regime,” according to Morley.
This means risks for dishonest and honest players alike—not just to shareholder returns but to reputation. “Watch this space,” says Morley. “With these sums at stake, this issue will not go away.”