Transfer Pricing and Its Potential Effect on Tax Revenue

The corporate tax rate in the United States of America is 38.90%, second highest of any country in the world, and far and away the highest when comparing to other countries with similar economic status (Trading Economics). This may come as a surprise, as it seems you cannot turn on your television without hearing about how major corporations and the “one percent” are exploiting the general public and hoarding all of our countries wealth. The truth is large corporations pay an effective tax rate that is higher than more than 99% of citizens who file income tax returns in the United States each year. Despite this, statistics from 2015 show that corporate taxes only accounted for around 11% of the federal tax revenue generated in the United States that year (Trading Economics). In 1952 corporate taxes accounted for 33% of federal tax revenue generated during the year (McBride). Many people point to these statistics as support that large companies are fleeing the country for more favorable tax rates in similarly developed countries. Whether this is true or not, almost all major multi-national corporations have incorporated different techniques into their business operations to make sure they are not paying more income tax than is required. One of these techniques that many international companies employ is transfer pricing.

A transfer price is the price charged by a parent company to a foreign subsidy for an intercompany transaction. When compiling the corporation’s financial reports to meet outside reporting standards, these transactions are eliminated as the financial results of the subsidiary are combined with the parent, but for tax purposes the financials are not consolidated causing the intercompany transfers to remain (McKinley). These transfers directly affect how taxable income is spread throughout the organization, and can have real consequences on how much tax a multi-national corporation ends up paying. The latest and most substantial example of transfer pricing action that came under scrutiny was the 2006 case of the IRS v. GlaxoSmithKline for a dispute that took place from 1989 through 2005. In this case, the U.K. based Glaxo claimed that the drugs and marketing plan created to distribute them was developed outside the United States, causing the price charged for the product to be lower as more of the “value” of the transaction was assigned to the parent company as opposed to its U.S. subsidiary. The IRS argued that much of the marketing plan for the drugs distributed was created by the companies U.S. subsidiary meaning that the “value” was created within the United States, which would require that the U.S. subsidiary claim a much higher gross profit margin. In the end, GlaxoSmithKline was required to use an alternative method when distributing profits amongst the subsidy and parent company which required the company to pay a back tax payment of $3.4 billion dollars (McKinley). This example illustrates how much taxable income can be altered through transfer pricing, and also the leeway given to companies when deciding on the most appropriate transfer pricing method.

Due to the dollar amounts of potential tax savings, and also the potential losses that could be caused by a misguided transfer pricing allocation method, transfer pricing has become a huge focus of multi-national corporations. According to Ernst and Young’s 2010 Global Transfer Pricing Survey 66% of companies reported undergoing a recent transfer pricing audit; up 14% from the survey taken only three years earlier in 2007 (McKinley). Corporations aren’t the only ones who are taking notice to transfer pricing either. Governments have begun to develop special audit task forces that focus on corporation’s compliance with laws that apply to how transfer pricing should be handled. As evidenced in the example of GlaxoSmithKline cited earlier, it is not only the country that holds the headquarters of a corporation that has to worry about tax revenue being improperly diverted through transfer pricing, but also the country that holds the companies foreign subsidiary. This point alludes to the potential for a conflict of interest between two countries governments as generating revenue from taxes is usually one of the most discussed topics within a countries political landscape.

This brief overview of transfer pricing was meant to highlight one of the many ways large corporations have used the gray area of tax law to try and lessen their overall tax burden. Although it looks like transfer pricing will be around for years to come, the potential for abuse could be discouraged through widespread tax reform within the United States. This could be accomplished by lowering tax rates applied to large corporations who choose to maintain the parent company’s headquarters in the United States, as well as removing some of the ambiguity of selecting the appropriate economic method. With the recent leadership changes in the United States government hopefully some progress can be made in tax reform to retain major corporations headquartered in the United States, and possibly encourage some to return.

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