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Transfer pricing helps tax avoidance, says GAO study

By Joanna Faith

US corporations are using transfer pricing regulations to move profits out of the country to avoid paying federal income tax, said a report from the US Government Accountability Office (GAO).

"If a company is earning profits in the US, it should have some taxable income," said John Taylor, a US tax partner at the law firm Allen & Overy in London said. But, he added, moving profits to another jurisdiction to avoid taxes is a legitimate activity.

"The scenario of large companies using transfer pricing to avoid US tax is rare. If they were that stupid they would stand out," he said. "And they would caught by the IRS."

The research, requested by US senators Byron Dorgan and Carl Levin, also said that both US companies and foreign companies doing business in the US are avoiding all income tax obligations to the federal government despite sales totalling $2.5 trillion.

The GAO analysed samples of corporate tax returns from the Internal Revenue Service's (IRS) Statistics of Income to compare the age, size and industry as well as the tax liabilities of foreign-controlled domestic corporations (FCDC) and US-controlled corporations (USCC) including those reporting zero tax liabilities between 1998 and 2005.

It says in 2005 28% of large foreign companies doing business in the US paid no taxes even though they reported $372 billion in gross receipts that year.

But the report failed to acknowledge that companies such as General Motors did not pay income tax as they made a loss in 2005.

"The report is misleading," said Taylor. "Companies in the start up phase, experiencing a downturn or incurring losses may not be profitable for a while, so may not pay taxes for a while," he said.

"Senator Dorgan calls this a shocking indictment of the current system but if there are companies losing money or not making a profit, it's not a problem of the tax system," Taylor said.

The GAO did not attempt to determine whether corporations were abusing transfer prices or how any such abuse explains differences in the reported tax liabilities of FCDCs and USCCs.

The GAO is an independent, nonpartisan agency that works for Congress. Often called the congressional watchdog, the GAO investigates how the federal government spends taxpayer dollars.

Singapore to review its transfer pricing rules

By Joanna Faith

The Inland Revenue Authority of Singapore (IRAS) is assessing how well taxpayers are complying with the country's transfer pricing guidelines that were issued in 2006 by carrying out a transfer pricing consultation (TPC) programme.

The IRAS hopes to identify potential problems and areas of improvement in TP practices by implementing field visits in which taxpayers will be expected to present details of each related party transaction, how they are priced and any third party comparable information that has been used.

Before field visits take place, the IRAS will send out questionnaires to selected taxpayers who have or appear to have a significant amount of related party transactions, especially with overseas parties, over a period of time. The IRAS will carry out field visits based on the questionnaire responses.

Penny Wong from Transfer Pricing Associates in Singapore does not think the consultation will make the IRAS more aggressive but said it is a step in the right direction in enforcing TP regulations.

"Because Singapore doesn't have an active audit system most companies are not proactive in preparing transfer pricing documentation," she said. "The TPC will incentivise companies to be more proactive and protect their regional and global transfer pricing positions."

New states join Arbitration Convention

Romania and Bulgaria have joined the European Commission's Arbitration Convention. The two EU member states acceded to the process on July 1.

The convention was established in 1995 to resolve tax disputes between EU member states. Countries invoke the convention to bring an end to long running disputes between authorities about the tax liability of enterprises on transfer pricing issues.

A lengthy list of transfer pricing disputes have remained unresolved for many years and the European Commission wanted to create an effective mechanism to limit deliberations over cases. Multinational companies had complained that they were unable to achieve a final settlement of their tax liabilities while tax authorities were negotiating cases. Patrick Leonard, tax partner at KPMG in Bucharest, said: "The authorities are taking an increasing interest in transfer pricing. There have been no high profile cases here such as the GlaxoSmithKline hearings in the US and Canada. Nevertheless, Romania has recently introduced new transfer pricing documentation rules and the transfer pricing environment is becoming more developed.

"I am sure that the accession to the Arbitration Convention for Romania and Bulgaria is unlikely to have an immediate impact. However, it is a positive move. As the transfer pricing environment becomes more sophisticated, cases will become more complex and more contentious. There will be a need for the convention at a later stage."

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Double tax treaties and transfer pricing in India

KR Girish and Rohit Jain, of TP Week correspondent KPMG in India, look at the impact of double tax treaties and transfer pricing

A. List of countries with which India has comprehensive tax treaties
1. Armenia	38. Namibia
2. Australia	39. Nepal
3. Austria	40. Netherlands
4. Bangladesh	41. New Zealand
5. Belarus	42. Norway
6. Belgium	43. Oman
7. Brazil	44. Philippines
8. Bulgaria	45. Poland
9. Canada	46. Portugal
10. China	47. Qatar
11. Cyprus	48. Romania
12. Czech Republic	49. Russia
13. Denmark	50. Saudi Arabia
14. Egypt	51. Singapore
15. Finland	52. Slovenia
16. France	53. South Africa
17. Germany	54. Spain
18. Greece	55. Sri Lanka
19. Hungary	56. Sudan
20. Iceland	57. Sweden
21. Indonesia	58. Swiss Federation
22. Ireland	59. Syria
23. Israel	60. Tanzania
24. Italy	61. Thailand
25. Japan	62. Trinidad and Tobago
26. Jordan	63. Turkey
27. Kazakhstan	64. Turkmenistan
28. Kenya	65. UAE
29. Korea	66. UAR (Egypt)
30. Kuwait	67. Uganda
31. Kyrgyz Republic	68. UK
32. Libya	69. Ukraine
33. Malaysia	70. USA
34. Malta	71. Uzbekistan
35. Mauritius	72. Vietnam
36. Mongolia	73. Zambia
37. Morocco

In today's global trade and services environment, a country's national policy cannot ignore its international economic orientation. Double tax avoidance agreements help to create an environment of fiscal certainty which encourages trade and investments between countries, thereby influencing a country's economic relations with other countries.

Indian tax treaties – objectives and overview

Section 90 of the Income-tax Act, 1961, empowers the central government of India to enter into agreements with foreign countries with the following stated objectives:

1. For granting relief in respect of:

   • income which has been subject to tax in two countries; or

   • income-tax chargeable in two countries to promote mutual economic interests, trade and investment;

2. for the avoidance of double taxation;

3. for exchange of information for the prevention of evasion or avoidance of income-tax in India or the other country; or

4. for recovery of income-tax under the laws of the two countries.

In exercise of the powers available under section 90 of the Act, the central government has entered into quite a large number of tax treaties with various countries. On an overall basis, as also stated above, mutuality of relief, equitable treatment of taxpayers, resolving of conflicts and exchange of information are the primary purpose of the Indian tax treaties. Indian tax treaties can broadly be categorised into (a) comprehensive treaties and (b) limited treaties. While comprehensive treaties cover almost all the sources of income, limited treaties are typically aimed to avoid double taxation related to income derived from operations of aircraft, carriage of cargo and freight.

A list of the Indian tax treaties is provided below. In addition to the tax treaties mentioned in the Annexure, tax treaties with Mexico, Senegal, Myanmar and Luxembourg are yet to be notified for coming into force.

Some of the relevant trends in Indian tax treaties have been very briefly summarised below:

• India's tax treaties with developed and industrialised countries typically cover all sources of income arising out of inflow of technology, industrial equipment and direct investment in India. On the other hand, the tax treaties with developing countries are typically structured to encourage flow of technology, equipment and professional services which India is capable to transfer or offer.

• Some tax treaties (such as Mauritius, Cyprus, Netherlands and Singapore) contain favourable capital gain tax clause for making investments in India. Considering the attractive treaty provisions, such jurisdictions have become favourite for routing investments into India.

• The Indian government discourages treaty shopping and misusing favorable jurisdictions for avoiding taxes in India. In this context, it would be relevant to note that the India-Singapore tax treaty was amended by way of a protocol in 2005 to provide that for claiming the beneficial treaty provisions, a Singapore resident company (which is investing into India) should not be a shell/conduit company with no real business in Singapore. Similarly, India-UAE treaty was amended in 2007 to include a limitation of benefit clause. It is understood that India is also in discussion with the authorities of Mauritius and Cyprus on this aspect.

Section 90 of the Act provides that where a tax treaty exists, the provisions of the Act will apply if they are more beneficial to the taxpayer. As a corollary, the provision of the tax treaty would be applicable if the same are more beneficial than the corresponding provision of the Act.

These provisions clearly bring out the relevance of the tax treaties, especially where the tax treaties are restricted in scope as compared to the domestic law, and results in relief to the non-resident tax payer.

Detailed statutory framework for transfer pricing was introduced in India with effect from April 1 2001 with a view to provide for computation of reasonable, fair and equitable profits and tax in India for multinational companies. The basic intention underlying the new transfer pricing regulations is to prevent shifting out of profits by manipulating prices charged or paid in international transactions.

B. List of countries with which India has limited tax treaties
1. Afghanistan	9. Pakistan
2. Bulgaria	10. People's Democratic Republic of Yemen
3. Slovakia	11. Russian Federation
4. Ethiopia	12. Saudi Arabia
5. Iran	13. Switzerland
6. Kuwait	14. UAE
7. Lebanon	15. Yemen Arab Republic
8. Oman

The Indian tax treaties do not directly provide guidelines on the subject of Transfer Pricing. However, typically, article 9 (associated enterprises) and article 27 (mutual agreement procedure) of the Indian tax treaties provide some guidance on transactions with associated enterprises and are relevant.

Typically, the Indian tax treaty provisions dealing with 'associated enterprise' provide for an adjustment to profits where transaction have been entered into between associated parties (parent and subsidiary or companies under common control) other than on arm's length terms. These provisions broadly provide as follows:

• Right to tax profits in transactions entered into on other than arm's length terms

The Indian tax treaties gives right to a state to tax the profits accruing, on an arm's length basis, to an enterprise of that state, in a situation where the transactions are not on arm's length basis.

• A corresponding adjustment in the other state

Though there may be exceptions, the tax treaties typically provide that if the afore-mentioned adjustment in the first state results in economic double taxation of the same profits (which have also been charged to tax in the other state), the other state shall make an appropriate adjustment to relieve the double taxation. Further, for the purpose of determining the adjustment, the competent authorities of each state shall consult each other, if required.

The treaties do not clarify or discuss the procedure to be followed for claiming the corresponding adjustment. However, one may refer to the technical explanation, though not binding on the Indian tax authorities, to the India-US tax treaty as issued by the Treasury Department of the US. The technical explanation provides that in case an adjustment is made in one state on the basis of the arm's length principle, the other state would be obligated to make a corresponding adjustment to the tax liability of the enterprise in its state. It further provides that if a corresponding adjustment is made, it needs to be implemented pursuant to the mutual agreement procedure (MAP).

There are some Indian tax treaties which do not contain direct provisions relating to making of a corresponding adjustment in the other state. These treaties include India's treaties with Belgium, Finland, France, Germany, Italy and Norway. One needs to see how a corresponding adjustment can be claimed in the other state under such tax treaties.

Broadly speaking, the treaties generally provide that:

• Where a resident of a state considers that the action of one or both the states would result in taxation not in accordance with the tax treaty, the resident may approach the competent authority of the state in which he is a resident; and

• The competent authority shall endeavour, if it is not itself able to arrive at an appropriate solution, to resolve by mutual agreement with the competent authority of the other state.

In addition to the above, the provisions also typically specify the time limit within which a taxpayer can move an application for initiating MAP, and that the conclusions reached through the proceedings can be implemented irrespective of any time limits or procedural limitations in the domestic law of the states.

In the context of a MAP proceeding, it may not be out of place here to mention that the Indian and the US competent authorities have entered into a memorandum of understanding (MoU) which provides that tax demand would be kept in suspension during the pendency of MAP. The suspension would however be dependent upon various conditions, which include furnishing of a bank guarantee of an amount equal to the amount of tax under dispute and interest accruing thereon as per the provisions of the Act. A similar MOU also exists with UK.

The Indian tax authorities have generally been aggressive in the administration and implementation of the transfer pricing provisions under the Act. This has resulted in significant tax demand being raised upon Indian subsidiaries of various multinational companies.

Though the Indian subsidiary companies, suffering the transfer pricing adjustment, are currently in appeal before the higher authorities, a few of the multinational (parent) companies, as an alternative dispute resolution mechanism, have invoked provisions relating to MAP, through the competent authorities of their state. The direction in which such proceedings would move is something that is yet to be seen.

In this connection, it may be relevant to note that the Central Board of Direct taxes (CBDT) has recently issued a circular, extending the applicability of the MoU to Indian resident entities during the course of the pendency of the MAP invoked by a resident of US. Accordingly, if an Indian subsidiary of a US company suffers a transfer pricing adjustment and the US company has initiated proceedings under MAP, the Indian subsidiary can seek a stay of the demand raised upon it, till the MAP proceedings are concluded. The stay of the demand would however be subject to the conditions included in the MoU (such as furnishing of bank guarantee).

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Australia's AAT hands down final decision in Roche ruling

Stuart Edwards of PricewaterhouseCoopers, Australia, believes courts will favour traditional transactional transfer pricing methods rather than bottom line profits methods in the wake of the landmark Roche decision.

On July 22 2008, Justice Downes, president of the administrative appeals tribunal (AAT), handed down his final decision in the transfer pricing case Roche Products Pty Ltd vs the Commissioner of Taxation [2008] AATA 639. In the final decision, the adjusted assessments totalled A$42.55 million ($40.3 million) ((as compared to the earlier preliminary decision of A$58.74 million ($55.6 million)). The reduced amount of the adjustments to assessable income arise from recalculations of gross profits across several years, including some increases, leading to amendments to the preliminary adjustments and one year where the time limit for amendment had passed and hence no adjustment was possible.

One new element to the decision is that the AAT has increased assessments in some years over and above those that the Australian Taxation Office (ATO) had originally sought. This illustrates the power of the AAT to stand in the shoes of the commissioner with the ability to exercise all his powers.

Since the reasons for the Roche decision have remained unchanged, the outcome reinforces the view that the courts are likely to prefer the traditional transactional transfer pricing methods (and analysis), rather than bottom line profits methods that the ATO and taxpayers have most often relied upon.

Interestingly, Justice Downes' comm-ented that one of the problems with profit methodologies is that: "... when applied to transfer pricing, it inevitably attributes any loss to the pricing." He went on to say: "...it is certainly true that there are companies which make losses for reasons other than the prices for which they acquire their stock."

This reinforces, for taxpayers, the importance of carefully analysing and recording (on a contemporaneous basis) the reasons why their performance falls short of industry norms (should this be the case) and the value of reconciling their performance to commercial factors rather than just addressing pricing.

On the other hand, the ATO can be expected to more vigorously evaluate and appraise the price setting process and policies of taxpayers. At the same time one expects that the ATO will more rigorously search out the most relevant transactional data held by the taxpayer, be that held in Australia or by overseas related parties. One expects that ATO personnel will also address more comprehensively, than has traditionally been the case, the commercial reasons for a taxpayers operating performance.

It is also noteworthy that the evidence given by the former Roche Australia managing director (for more than 20 years) was seen as valuable by Justice Downes; accordingly, taxpayers would be well advised to evaluate, on a timely basis, how the evidence of such former employees may potentially influence a case.

There is much about the Roche decision that can only be said to be well balanced in its reasoning and argument. Personally, however, I struggle with that part of the decision where Justice Downes concludes that 40% is the "...bottom of any range..." of possible gross margin outcomes that should be achieved from arm's length pricing by Roche.

Justice Downes proceeds to apply this (40% floor) to each of the eleven years in dispute.

The manner of application of the resale price method by Justice Downes has all the hallmarks of the application of a Clayton's type profit based methodology (contrary to his reasoning, albeit at the net rather than the gross margin line). This is so as there is no apparent consideration given to the quantum of the gross margins derived on individual product lines (and reasons for lesser or greater margins than the 40%); one imagines commercial factors at play here too. In addition, there appears to be less than due regard paid to the evidence led by the former managing director that the federal government's effective price controls over ethical pharmaceutical products generally limit gross margins to 30%. The question this poses is whether some within the ATO may seek to argue that taxpayers selling ethical pharmaceutical products should derive a gross margin, on average, of no less than 40%. It is to be hoped this will not be the case but that remains to be seen.

Interestingly, there is obiter dictum in the Roche decision with effect that the double tax agreements of which Australia is signatory do not confer power upon the commissioner to assess income tax, rather they allocate taxing power as between the treaty partners. The transfer pricing provisions enshrined within division 13 of the Income Tax Assessment Act confer the power to tax.

What will also be interesting going forward is a consideration of the possible impact of the Roche decision having regard to the present OECD review of the application of the transactional profit methods. In particular, whether or not the status of profit methods, as methods of last resort for use in applying the arm's length principle, will continue to be maintained in chapter III of the 1995 transfer pricing guidelines.

I suspect that if the OECD guidelines are amended to place the transactional net margin method and the profit split method on an equal footing with the traditional transaction methods it is likely that the ATO may then seek some minor amendments to division 13 of the Income Tax Assessment Act so that the focus is not on prices or consideration alone but also upon the net operating result of the business.

The parties had until August 19 2008 to lodge an appeal.

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