IT IS no secret that the global economic crisis has driven tax avoidance to the top of the agendas of G8/G20 countries.
In this respect, one of the most common expedients used by multinationals to lower their effective tax rate is mispricing transactions between affiliated companies, so that revenues are allocated to the entities within the group which are resident in low-tax jurisdictions.
Since tax administrations all over the world claim that their revenues are severely affected by this practice – according to the Chinese government, “tax evasion through transfer pricing accounts for 60 per cent of total tax evasion by multinational enterprises” – it comes as no surprise that transfer pricing has become one of the hottest tax topics in recent years.
Corporate executives also acknowledge that the likelihood of being challenged by tax authorities on transfer pricing is extremely high nowadays, as proved by some famous recent cases of transfer pricing audits.
In this respect, the OECD has recently delivered seven draft recommendations to fight tax avoidance by multinationals, which form part of a larger ‘tax base erosion and profit shifting’ (“BEPS”) project.
This project will close next year and aims to ensure that profits are taxed where economic activities are performed and value is created.
In summary, the OECD’s recommendations are to:
1. neutralise hybrid mismatch arrangements through new model treaty provisions;
2. realign taxation and relevant substance to prevent the abuse of tax treaties;
3. ensure that transfer pricing outcomes are in line with value creation, especially in the key area of intangibles;
4. increase transparency for tax administrations and certainty for taxpayers through improved transfer pricing documentation and country-by-country reporting;
5. address the challenges of the digital economy;
6. facilitate implementation of the BEPS actions through a report on the feasibility of developing a multilateral instrument to amend bilateral tax treaties; and
7. counter harmful tax practices.
Not surprisingly, two out of the seven proposals concern transfer pricing (namely, transfer pricing aspects of intangibles and transfer documentation).
This initiative – which is clearly one to be welcomed – should, nevertheless, be followed by further coordinated action of academics, tax administrations and taxpayers.
Given the grey area surrounding transfer pricing, academics and transfer pricing experts should work hard to create a transfer pricing culture, not only by studying this topic and contributing to the creation of an extensive set of guidelines, but also by stimulating a fair and constructive dialogue between multinationals and tax administrations. Serious efforts should also be made to promote thorough and uniform knowledge of transfer pricing among judges and tax court members.
Taxpayers and tax administration will, of course, need to play their part.
On the one side, multinationals should strive to create a culture of compliance, putting ethics before other interests and ceasing to consider transfer pricing as a tax planning tool to reduce their overall effective tax rate.
On the other side, tax administration and governments should put themselves the taxpayers’ shoes and understand that some of the most important principles on which international tax law is currently based are no longer consistent with the way enterprises are organised in today’s global economy.
There are, in fact, several elements of the predominant structures and practices of multinationals that clash with international tax law rules.
For instance, the growth of digital services – where business can be conducted across various jurisdictions without a company having a physical base there – and the increasing importance of intangibles – which by their very nature can be easily shifted – are all real-life trends that can give rise to situations for which traditional tax concepts are no longer suitable.
Another example of a traditional tax concept that should be ‘updated’ to keep pace with reality is the notion of permanent establishment. In fact, given its current definition, the application of this concept to matrix-type organisations may lead to wrong results.
This is because the development of global organisations and technologies has dramatically changed the way multinationals are structured, allowing the creation of teams composed of employees of companies resident in different countries (so-called matrix-type organisations).
Despite these technological improvements, the concept of permanent establishment has not significantly changed over the years.
Consequently, it could happen that a taxpayer is charged with having an undeclared permanent establishment abroad just because it has a cross-border functional structure.
This is a clear example of what should not happen. Being challenged for adopting aggressive tax planning is well deserved; being challenged for keeping abreast of business trends is simply unacceptable.
Stefano Simontacchi, managing partner and head of the transfer pricing practice at international law firm Bonelli Erede Pappalardo