journal of international tax

Nama : Ridwan Tri Atmojo (26212325)

               Riszki Indra Septian (26212482)

                                         

Tax Reforms and Evidence of Transfer Pricing

                                                                 Deborah Swenson

                                                                        2000

BACKGROUND

While tax reforms have generally reduced corporate tax rates globally, continued international tax differentials are an enduring feature of the global fiscal environment. In this context, multinational firms can reduce their worldwide tax payments by shifting income from highly taxed jurisdictions to more lightly taxed locations. While income shifting can be accomplished through the reallocation of real activities, it can also be attained by shifting reported income, as occurs when firms manipulate their transfer prices on international transactions. While a few studies have examined transfer pricing directly, there is little evidence or consensus about the actual level of transfer pricing activities.

Since research on tax incentives and the behavior of multinational firms typically relies on publicly available data, data limitations generally force researchers to focus on indirect evidence of income shifting.  Most papers choose proxies such as reported income, tax payments, and intra-firm exports, and have found that cross-country and cross-time variations in these variables are consistent with income shifting incentives. Other work has shown that multinational firms have changed their real activities such as foreign investment, or altered their location of debt in response to tax incentives. However, while this line of research provides evidence from economic aggregates that is consistent with tax-induced income shifting, this line of research can not determine whether tax-induced transfer price manipulation played a major role.

This paper turns to individual product-level data to determine whether transfer-pricing incentives havep layed a significant and measurable role in the movement of U.S. import product prices. If firms use transfer prices to manipulate income, reported customs values should rise and fall with changes in tax incentives. I study the years 1981 to 1988 since they capture a period when the U.S. and many of its trade

partners changed their corporate tax rates. In general it is difficult to measure the effects of tax reform, since any year to year variation in aggregate data may be caused by changes in the underlying macroeconomic environment rather than changes in taxes. In this study I manage to avoid this problem, because I identify tax effects by examining fine product-level transfer prices in a framework that controls for corporate tax incentives, and cross-product tariff variation. The cost of shifting income out of the U.S. through artificially raised transfer prices differs across products according to U.S. tariff rates. I utilize these cross-product tariff differences to distinguish the responsiveness of reported transfer prices to transfer pricing incentives.

This paper proceeds as follows. In the next section, I explain how corporate taxes and product tariffs influence transfer-pricing incentives. I then develop a simple model that shows how multinational firms select their reported transfer prices based on tariff rates and tax considerations. In the third section, I use regression analysis to measure the response of product level prices to tariffs and taxes. In the fourth section I measure the implied penalties associated with transfer pricing and describe the economic implications of my results. A brief conclusion follows.

PURPOSE

for studies the reported transfer prices for a set of products imported into the U.S. from Canada, France, Germany, Japan and the U.K. between 1981 to 1988. Tariff variation across products creates incentives for the underpricing or overpricing of affiliated firm transactions that may either complement or detract from general tax-induced income shifting motives.

ANALYSIS TOOLS

Taxes, Tariffs and Income Shifting Incentives

The foreign affiliates of multinationals commonly import goods from their parent firm. These imports arise because the affiliate acts as a distributor, or because the affiliate imports intermediate inputs from its foreign parent and assembles them in the host country. The discussion that follows assumes that firms base their production and sourcing decisions on market opportunities and relative production costs.

When multinationals set transfer prices for intra-firm transactions they may seek to maximize their expected world income by manipulating the reported transfer prices upward or downward. The direction of manipulation depends on the tax system governing the multinational, differences in tax rates between the home and affiliate locations, and any relevant product tariffs. When firms select a transfer price, they must consider the integrated effect of taxes and tariffs, since Internal Revenue Code Section 1059A states that the tax cost of imported goods is not to exceed their customs value. This effectively means that firms are required to select a single reported price for tax and tariff purposes.

To see how taxes and tariffs influence the firm’s pricing decision, consider the tax linkages between a foreign parent firm and its U.S. affiliate. The firm can shift taxable income out of the US and in to its foreign parent country by reporting artificially elevated transfer prices. If the U.S. tax rate is higher than the tax rate in the home country, this strategy reduces the firm’s worldwide tax payments since taxable income is transferred from the U.S. to the lower tax parent country. However, as the firm uses overstated transfer prices to shift income out of the U.S, it becomes liable for additional US tariff payments on the incremental elevation of transfer prices. If the tariff rate is especially high, all tax benefits associated with shifting may be more than offset by the new tariff payments. Further, income-shifting costs, penalties, and the fear of detection may all reduce the degree of transfer price manipulation selected by the firm.

Multinationals that are headquartered in high tax territorial countries face reverse tax incentives; they may decide to report artificially low transfer prices as a means of shifting income into the U.S. This is due to the fact that territorial firms pay taxes on income based on the location of earnings; income generated at home is taxed exclusively at home, while foreign earned income is taxed only abroad.  As these firms reduce their worldwide tax payments, they enjoy the added bonus of lowered tariff payments that complement the strategy.  I combine these ideas to create a simple model that describes how multinational firms set their transfer prices.

Empirical Evidence of Transfer Pricing

While the transfer-pricing hypothesis is straightforward, there is little empirical evidence to quantify the economic importance of this method of income shifting in firm activities. To fill the void, I study the prices of U.S. imports from Canada, France, Germany, Japan, and the U.K. since these countries were some of the biggest foreign investors in the U.S., and their activity created an infrastructure of parent firms and U.S. affiliates which could manipulate transfer prices. Ideally, I would study the reported prices for individual firm intra-firm product sales. Since such data are not available, I am instead studying reported product prices by country. The sample covers 1981 to 1988 because these years involved frequent tax changes in the U.S. and abroad and cover years when U.S. tariff rates were changing.13

The fundamental price variable in the data set is based on U.S. Department of Census trade data collected at the fine TSUSA product-level. The TSUSA category system, or Tariff Schedule of the United States Annotated, is used to classify products for tariff purposes – all products within a particular TSUSA category face the same tariff rate. While the Census data do not report prices, they do report the annual value of imports for each TSUSA item by country, and the corresponding annual quantities of these imports. As a result, I construct reported prices by the formula PR ic = [(Custom’s Value of Product i imports from country c)/(quantity of product i imported from country c)].

The identification of transfer pricing is based on the TPI variable. As is demonstrated in the previous section, the definition of the TPI is, TPI = (τf-τh)-TARf(1-τf) if the investor is headquartered in a territorial country, or for investors headquartered in a residential country whose rate of tax is less than or equal to the U.S. corporate tax rate. For all other residential investors, the TPI = - TARf. In sum, the relevant TPI depends on the form of taxation in the multinational’s home country, and on tax rates in the U.S. and the multinational’s headquarters location.

Transfer Pricing and Penalties.

Since the benefits of transfer price manipulation are attenuated by potential costs of shifting, I explored whether transfer pricing costs and penalties explain the small economic magnitude of the transfer pricing estimates. To estimate the implicit magnitude of transfer pricing penalties and costs, I applied nonlinear least squares estimation techniques to the pricing formulas in section 2 which show that the reported price for each product, parent country and year (subscripts i, c, and t)

To implement this procedure, I assume that the price ratio for arm’s length prices piht/pimt is determined by overall quality differences between countries, and by macroeconomic factors. This implies that I can proxy the ratio of arm’s length prices for each country pair with the ratio of arm’s length prices for all products sold. 22 The resulting estimating equation relates the ratio of reported prices to the average over all products ratio (by country-year pair), and the tax-tariff-penalty functions derived in section 2. I use non-linear least squares, since reported prices are a non-linear function of the tax, tariff and penalty components.

Conclusion

This paper studies the reported transfer prices for a set of products imported into the U.S. from Canada, France, Germany, Japan and the U.K. between 1981 to 1988. Tariff variation across products creates incentives for the underpricing or overpricing of affiliated firm transactions that may either complement or detract from general tax-induced income shifting motives. In my examination of the data I discover that reported prices rise when the combined effect of taxes and tariffs provides an incentive for firms to overstate their prices. While the results are statistically significant, they are economically small, implying that a 5% decline in foreign tax rates causes the reported price of affiliated firm imports to rise by 0.024%. Because transfer price manipulation is predicated on the actual flows of goods among countries, this method of moving income may be more costly than other methods of income shifting. While the manipulation of intra-firm trade transfer prices represents one potential avenue for income shifting, my evidence from trade transaction prices suggests that the manipulation of product transfer prices is not generally responsible for large movements in reported income.

Evaluating International Tax Reform

INTRODUCTION

Much of the current structure of U.S. taxation of foreign income dates to the early 1960s, and, remarkably, so too does much of current thinking on the desirability of taxing foreign income. The U.S. regime of taxing foreign subsidiaries of American multinational corporations was put in place in 1962, and despite numerous modifications in subsequent years, the system used by the United States to tax foreign income has been broadly unchanged since the early 1960s. American individuals and American corporations owe tax to the U.S. government on their worldwide incomes, but are entitled to claim credits for income taxes paid to foreign governments. Taxpayers are permitted to defer U.S. taxation of unrepatriated foreign income earned by separately–incorporated foreign subsidiaries, though this deferral is limited. Every political season in the United States brings new issues and controversies, typically including tax legislation that has foreign provisions. Proposed U.S. legislation in 2003 illustrates this trend, with three major legislative initiatives directed at those inclined to change the taxation of foreign income. This flurry of interest reflects not only the importance of international taxation to modern economies and the unsettled nature of the U.S. tax treatment of foreign income, Evaluating International Tax Reform Mihir A. Desai Business School, Harvard University, Boston, MA 02163 and NBER, Cambridge, MA 02138 James R. Hines Jr. Business School, University of Michigan, Ann Arbor, MI 48109-1234 and NBER, Cambridge, MA 02138 NATIONAL TAX JOURNAL 488 but also fundamental uncertainty over what constitute desirable attributes of systems of taxing foreign income. Economic theory offers three benchmarks for assessing the desirability of tax systems and reforms. The concepts of “capital export neutrality” (CEN) and “capital import neutrality” (CIN), introduced by Richman (1963), and which she refined in Musgrave (1969), are mainstays of the welfare analysis of international tax reform. These principles characterize tax systems directed at maximizing global welfare, while “national neutrality” (NN) is characteristic of home–country tax systems directed at maximizing home–country welfare. The purpose of this paper is to describe new methods of evaluating the desirability of taxing foreign income, and to use these methods to consider current U.S. international tax reform proposals. The analysis introduces capital ownership neutrality (CON), the principle that world welfare is maximized if the identities of capital owners are unaffected by tax rate differences, and national ownership neutrality (NON), the principle that national welfare is maximized by exempting foreign income from taxation. The second section of the paper motivates the emphasis on ownership that is central to CON and NON and that is missing from standard welfare frameworks. The third section describes CON and NON, drawing attention to the very small change in assumptions that distinguishes them from standard welfare benchmarks. The fourth section evaluates current international tax reform proposals according to these alternative welfare frameworks. The fifth section is the conclusion.

THE IMPORTANCE OF OWNERSHIP TO THE WELFARE ANALYSIS OF FDI

 It is common practice in analyzing the desirability of international tax rules to posit that foreign investments by multinational firms from different countries are equally productive. In contrast, CON and NON put differences between owners at the center of the welfare analysis of international tax rules. In order to consider the appropriate role of ownership in evaluating international tax rules, this section considers evidence on the role of ownership in determining patterns of foreign direct investment (FDI) and on the effects of tax rules on ownership.

Ownership and FDI

Since Hymer (1976), the literature on foreign direct investment starts from the observation that FDI is driven by the needs of firms in markets, and therefore represents something much more than the transfer of net savings between countries. Caves (1996), who offers an excellent survey of this literature, notes that the intuition that multinational firms are merely conduits for capital to arbitrage differences in rates of return between countries has been found to be “neither satisfying theoretically nor confirmed empirically” (p. 26).In its place, economic models of multinational behavior have emphasized a transaction–cost approach whereby multinational firms emerge because of the advantages conferred by joint ownership of assets across locations. These advantages are understood to stem from proprietary assets that are best exploited under common ownership. The most common manifestation of this framework for explaining foreign direct investment in the international business literature—Dunning’s eclectic paradigm—emphasizes how ownership, localization, and internalization (OLI) are the fundamental determinants of foreign direct investment.1 Specifically, multinational firms are thought to engage in foreign direct investment when ownership confers specific advantages relative to arms–length relationships, so activities are most profitably undertaken within the firm. An obvious implication of this approach is that multinational firms differ in the proprietary assets (e.g., brands, production processes, patents) they can exploit and that these differences are critical to understanding the patterns of FDI and the productivity of these firms.2 In addition to differences in business practices contributing to the possible importance of ownership, scholars are paying increasing attention to differences in institutions (e.g., legal regimes) and the ways in which these variables can influence firm outcomes. These country–level differences would provide another reason to expect ownership to be associated with different patterns of FDI and the productivity of that investment.3 The modern property rights approach to the theory of the firm, as developed in Grossman and Hart (1986) and Hart and Moore (1990), suggests that the prevalence of incomplete contracts provides a rationale for particular configurations of ownership arrangements. The ability to exercise power through residual rights when contracts are unable to prespecify outcomes provides an economic rationale for when ownership is important. Such settings are particularly likely to characterize multinational firms investing abroad. Desai, Foley, and Hines (forthcoming) analyze the changing ownership decisions of multinational firms, finding that globalization has made firms more reluctant to share ownership of foreign affiliates, given the higher returns to coordinated transactions inside firms. The costs and benefits of ownership appear to be central, and increasingly so, to the choice between investing in a country and serving the same market with arm’s–length transactions. It is useful to consider the importance of ownership with reference to a specific example. Consider the establishment of an automotive manufacturing plant in a large emerging market. Why might the productivity of this plant differ depending on whether a local or multinational firm owns it? One can easily imagine that the multinational firm may be more productive given the ability to extend a global brand or to transplant proven production processes to the emerging market. Similarly, the ability to integrate this plant within a worldwide production process or to use expatriates with related experience in similar markets could also have important productivity consequences. Finally, the ability to use incentive contracts tied to equity where minority shareholders have protections could similarly lead to productivity differences. While this example emphasizes a productivity advantage for the multinational firm, the more general point is that ownership is likely to be associated with significant productivity differences. Recent evidence illustrates the degree to which foreign direct investment represents transfers of ownership rights rather than reallocations of property, plant, and equipment between countries. Table 1 categorizes foreign direct investment into the United States, as reported by Anderson (2002), as either the establishment of new entities or the acquisition of preexisting entities. These figures suggest that the vast majority of FDI in the United States over the last decade represents transfers of ownership rights rather than greenfield

Taxation and Ownership of FDI

Do taxes influence the level and ownership of FDI? Home–country taxation has the potential to affect the ownership of foreign assets by changing after–tax returns and thereby inducing the substitution of one investment for another. As a general matter, investors from countries that exempt foreign income from taxation have the most to gain from locating their foreign investments in low–tax countries, since such investors benefit in full from any foreign tax savings. Investors from countries (such as the United States) that tax foreign profits while providing foreign tax credits may benefit very little (in some cases not at all) from lower foreign tax rates, since foreign tax savings are offset by higher home–country taxation. These relative tax incentives therefore create incentives for investors from countries that exempt foreign income from taxation to concentrate their investments in low–tax countries, while investors from countries that tax foreign income while providing foreign tax credits have incentives to concentrate investments in high–tax countries. There is considerable evidence that patterns of foreign investment respond to incentives created by home–country tax regimes. Hines (1996) compares the location of investment in the United States by foreign investors whose home governments grant foreign tax credits for federal and state income taxes with the location of investment by those whose home governments do not tax income earned in the United States. Investors who can claim credits against their home–country tax liabilities for state income taxes paid in the United States should be much less likely than others to avoid high–tax states, and the behavior of foreign investors is consistent with this incentive. Hines (2001) compares the distribution of Japanese and American FDI around the world, finding Japanese investment to be concentrated in countries with whom Japan has “tax sparing” agreements that reduce home country taxation of foreign income. Recent empirical work indicates the extent to which ownership decisions of U.S. multinationals are affected by tax incentives. Desai and Hines (1999) measure the extent to which American firms shifted away from international joint ventures in response to the higher tax costs created by separate “basket” provisions of the Tax Reform Act of 1986.5 Altshuler and Grubert (2003) and Desai, Foley, and Hines (2003) demonstrate that American multinational firms increasingly use “chains of ownership” for their foreign affiliates, including intermediate ownership by affiliates located in countries that exempt foreign income from taxation, to facilitate deferral of home country taxation. The National Foreign Trade Council (1999) argues—through case study examples of the foreign flag shipping, life insurance, and oil and gas pipeline industries—that tax rules have altered the positioning of U.S. firms relative to multinationals from different countries leading to changes in ownership patterns within these industries. And Desai and Hines (2002) analyze dramatic ownership reversals in which U.S. multinational firms expatriate by inverting their corporate structure, reconfiguring their ownership as foreign corporations in order to reduce the burden imposed by U.S. tax rules. These and other cases indicate that ownership

 CONCLUSION

The welfare principles that underlie the U.S. taxation of foreign income rely on the premise that direct investment abroad by American firms reduces the level of investment in the United States, since foreign competitors are assumed not to react to new investments by Americans. It follows from this premise that the opportunity cost of investment abroad includes foregone domestic economic activity and tax revenue, so national welfare is maximized by taxing the foreign incomes of American companies, whereas global welfare is maximized by providing foreign tax credits. If, instead, direct investment abroad by American companies triggers additional investment in the United States by foreign companies, which is likely in a globally competitive market, then entirely different prescriptions follow. National welfare is then maximized by exempting foreign income from taxation (NON), and global welfare is maximized by harmonizing the taxation of foreign income among capital– exporting countries (CON). It is tempting to think of international tax differences as influencing the location of economic activity rather than determining the ownership of assets around the world. In fact tax systems do both, but given the central importance of ownership to the nature of multinational firms, there is good reason to be particularly concerned about the potential for economic inefficiency due to distortions to ownership patterns. Tax systems that satisfy CON ensure that the identities of capital owners are unaffected by tax rate differences, thereby permitting the market to allocate ownership rights to where they are most productive. Proposed and pending international tax reforms in the United States have the potential to affect national and global welfare. In order to evaluate these tax reforms properly, it is necessary to consider their implications for patterns of capital ownership throughout the world.