African and developing countries are losing billions in tax revenue because of hidden or under-reported cross-border trading between different branches and subsidiaries of multinational companies.
The Africa Tax Outlook, released this month, compiled by the Africa Tax Administration Forum, warns that critical low tax revenue is undermining African economies.
The UN Conference on Trade and Development (Unctad) estimated that 60 percent of international trade happens within, rather than between, multinational companies. Different branches and affiliates of the same global company trade goods, services and pursue financial transactions called “controlled transactions”.
The practice of transfer pricing happens when affiliates of the same company in different countries trade with each other. When the global company put a price on the trade between its affiliates and subsidiaries, it is called “transfer pricing”.
More frequently, the prices of goods, services and financial transactions between the affiliates and subsidiaries of global companies are falsely dropped or hiked to shift profits between countries in a bid to escape paying taxes.
The price of trade, services and goods between subsidiaries of companies are supposed to be set at the rate that the open market would have charged. However, subsidiaries and affiliates of global companies often set very low rates for goods, services and trade between in order not to pay taxes.
Companies shift goods, services and money to subsidiaries and affiliates in countries where the tax rate is lower. Companies also use transfer pricing to either overprice imports or underprice exports to bypass limits developing and African countries set on companies repatriating their profits.
Many global companies shift their income away from where it is generated to countries where the tax rates are lower. More recently the UK settled with Google to get the company to pay £130m ($170m) back in lost transfer pricing taxes.
The Organisation for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines states: “Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions”.
Unctad argues that moving profits out of African and developing countries lowers the countries’ GDP, because it reduces the profit part of value-add (which GDP measures) to the economy. Furthermore, the shifting of profits also reduces the amount of capital available in the developing or African country for reinvestment in productive activities.
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A 2015 report by the OECD on Base Erosion and Profit Shifting (Beps) estimated that revenue lost through Beps was estimated at $100bn to $204bn a year, or 4 to 10 percent of global corporate income tax (CIT) revenues.
The OECD and G20 have, as part of their Beps initiative, set out 15 measures to tighten transfer pricing documents requirements. The OECD has developed a 15-point action plan to ensure that profits of companies are taxed at the point where the economic activities creating the profits are achieved and where the value is generated.
The OECD and the UN Tax Committee have pushed for the “arm’s-length” principle in which companies must pay a fair share of tax in the countries where they generate their profits.
In the “arm’s length principle”, one compares the payment from cross-border transactions within the multinationals with the payment from transactions made between independent companies in roughly similar circumstances.
The UN has also published a transfer pricing practice manual for developing countries, which uses the “arm’s length principle”.
The UK more recently criticised Google and Amazon for alleged transfer pricing. Australia has passed transfer pricing laws which compels companies to pay their “fair share” of tax.
The onus is on the developing or African country governments to regulate transfer pricing – and not on the developed country from where the global company originates.
Many developing and African countries do not have the capacity or the resources to monitor and regulate transfer pricing.
China has also introduced transfer pricing laws which compel companies investing there to adhere to the same transfer pricing rules as operating within the EU.
Brazil has introduced transfer pricing laws which set price limits for deductible cost linked to inbound trade between company subsidiaries and minimum income limits for outbound trade.
Nevertheless, some African countries, such as Kenya, Tanzania, Uganda and South Africa, have more recently tightened laws to police transfer pricing. South Africa set up a tax review committee under the leadership of Judge Dennis Davis (the Davis Committee) to look at tax reforms, including tightening transfer pricing rules.
Last December year the South African Revenue Services (Sars) issued a draft rules to tighten transfer pricing, based on the OECD’s transfer pricing guidelines. The rules compel global companies to keep more detailed and compulsory records of their transfer pricing transactions if the companies have a consolidated turnover of over R1 billion.
The OECD has proposed that to deal more effectively with transfer pricing, countries must compel companies to have a “master file” with standardised information about the subsidiaries, affiliates and entities of the global company; a “local file” which sets out the transactions at the country level; and a comparative country level report which sets out the allocation of income and taxes paid and the extent of the operations.
The African Tax Administration Forum has identified transfer pricing as a critical issue for African countries.
South Africa in July 2013 set up a tax review committee, headed by Judge Dennis Davis (the Davis Committee) to including looking at transfer pricing. The South African Revenue Services (Sars) has increased its monitoring of transfer pricing and have instituted regular transfer pricing audits.
Kenya, Uganda and Tanzania have also recently introduced transfer pricing laws, based on the OECD’s transfer pricing guidelines or the UN’s Transfer Pricing Manual, to stop revenue lost through foreign companies shifting costs between affiliates to avoid paying tax.
In 2008, the UN Committee of Experts on International Co-operation on Tax Matters said developing and African countries faced “tension” between “enforcing their legitimate taxing rights while ensuring open, transparent, investment-friendly and fair environment for investors. The skills and informational gaps in many developing countries exacerbate these difficulties.”
In practice, the “arm’s-length principle” is not easy to implement. A report by researchers from Christian Aid pointed out that companies can organise their business in such a way that “allocates risk and value to minimise tax liabilities”.
Multinationals have vast resources compared to African and developing countries to make seemingly valid arguments for their pricing structures or obscuring them. For another, it is also very difficult to allocate the price of intangibles such as how brand value should be appraised.
The UN Committee of Experts on International Co-operation in Tax Matters has pointed out that many developing countries lack “comparable data for calculating costs or resale prices of goods and services”.
South African Finance Minister Pravin Gordhan said African countries needed to focus on increasing the capacity and integrity of tax and customs agencies, as well as on strengthening tax legislation to better deal with the abuse of tax.
Many African countries lack appropriate transfer pricing laws, and if they do have, they may not have the resources to implement them. African countries will need to co-operate by collectively insisting that multinationals do country-by-country reporting of activities, and exchanging tax information and sharing capacity.