Lecture 3-4 Flashcards
What is understood by the concept of Arm’s length principle (ALP)?
ALP := Transactions between related parties (controlled transactions) shall follow terms and trades that would be charged if these transactions are agreed upon by independent parties (uncontrolled transactions).
•Need to adjust transfer prices for tax purposes whenever prices would not be settled between independent parties
•Market price relevant for taxable transfer price
•Problem: market prices / third-party prices not available/observable
Please name the OECD Transfer Pricing methods that determine if controlled transactions are done at arms length price.
•Standard OECD methods: ‘one-sided’ comparison
1) Comparable Uncontrolled Price (CUP) Method
2) Cost Plus (CP) Method
3) Transactional Net Margin (TNM) Method
4) Resale Price (RP) Method
•New, two-sided approach: Transactional Profit Split (TPS) Method
→TPS Method originally recommended in OECD BEPS Action 1 for digital economy (before proposal for partial formula apportionment)
What is the main idea of Comparable Uncontrolled Price (CUP) Method?
Main idea is to use Price comparison in internal trade vs. uncontrolled transactions with third parties to determine if company is dealing at arm’s length in controlled transition. (Market prices are used)
Coming closest to idea of ‘dealing at arm’s length’ at marketprices
OECD recommending to use CUP Method whenever possible
In particular appropriate for trading firms
What is the idea behind Cost Plus (CP) Method?
Basis for transfer price: determines direct and indirect costs and apply a a mark-up which is determined by a transaction to unrelated third party.
Very popular method, not related to market prices
Suitable for industrial companies (although OECD recommending CUP Method for R&D)
What is the idea behind Resale Price (RP) Method?
The main idea is to use gross profit margin deducted from price charged by reseller to third parties so that remaining value is giving transfer price
Margin compensating for functions and risk of reseller
Based on market prices and suited for distributors
What is the idea behind Transactional Net Margin (TNM) Method?
Allocating profit in transaction according to specific business ratio such as, e.g., profit-to-sales ratio
Focus on net profit indicator
Effectively checking how much profit shifted, relative to uncontrolled transaction
What is the idea behind Transactional Profit Split (TPS) Method?
Determining profit ratio (i.e., share in transactional profits) according to split of transactional profits on unrelated parties in comparable transactions
In practice, division of transactional profit following allocation keys
Two-sided approach for highly integrated transactions (e.g., digital economy)
TPS Method originally recommended in Action 1 for digital economy (before proposal for partial formula apportionment)
How do firms bypassing transfer price regulation?
Production costs and value of firm-specific intermediate goods private information of MNCs
Often unclear what comparable unrelated transactions should be
⇒Leeway to bypass and interpret regulation
Popular trick:
1) split intra-firm trade in sub-transactions over n affiliates documenting that n−1 affiliates being at arm’s length
2) remaining affiliate must be at arm’s length as well, no matter how high (rather: low) remaining profits
⇒‘Walras’s Law of Transfer Pricing’
How to capture regulation and costs in a formal model?
Strict range of acceptable transfer prices
1) tax authority setting a range of transfer pricesG∈[G, ̄ G]
2) MNC choosing price within the range
⇒Replacing constraints on HTP/LTP in basic model by ̄ G/G
→Usually leeway in pricing as firm-specific arm’s-length range unclear
→Transfer pricing in intangibles most attractive
⋄usually no comparable transactions with third parties
⋄arm’s-length price and method unclear (OECD BEPS Action 1)
How does the MNC determines transfer pricing and what is the effect of transfer pricing in CUP-M and TNM-M?
MNCs determine their transfer pricing position by balancing marginal tax savings against marginal cost of tax planning. Whether abusive transfer pricing affects investment and economic activity on the intensive margin depends on the shape of the tax planning costs.
CUP Method, increasing the volume of internal trade and investment allows for improving tax avoidance by mitigating the tax planning costs.
Under the Transactional Net Margin Method in contrast, tax avoidance does not have any effect on economic activity on the intensive margin.
What is the effect of abusive transfer pricing using intangibles?
Intangibles (e.g., patents) prominent tool for income shifting as low costs and difficult to control
For abusive transfer pricing in intangibles under any of the OECD standard transfer pricing methods, host countries only experience revenue losses, but do not benefit from increased investment and economic activity on the intensive margin. Also sales-dependent royalty payments only trigger ‘lump-sum shifting’.
What are the evidence from transfer pricing studies?
As indirect evidence on income shifting, meta studies report a semi-elasticity of profits with respect to taxes of 0.8 (which is compatible to other findings of a 10% loss in corporate tax revenue). The effect caused
by transfer pricing (0.65) is four times higher than the one from financial mechanisms (0.15). Direct evidence from French export datasuggests that intra-firm prices decrease by 1.2% per 10% increase in the taxdifferential. Shifting to tax havens is the driving force. The dominance of low-tax countries
and big firms indicate the presence of fixed costs of shifting.
What is the relationship between Minority Ownership and Transfer pricing?
Minority ownership acting like implicit tax on MNC profits
⇒Shift income to affiliate with highest after-tax-after-ownership rate
⇒Minority ownership under CUP method inducing higher transfer price
G ito exploit minority shareholders besides tax authorities
⇒Minority ownership under TNM method inducing higher incomeshift-
ingP ito exploit minority shareholders besides tax authorities
There is no qualitative effect on investment from this behavior.
What does the Modigliani-Miller Irrelevance Theorem state?
Starting point: perfect capital market
⋄same set of securities at competitive, fair prices for all investors and firms
⋄no transaction costs, no bid-ask spread, no (distortive) taxation
⋄cash-flows of real investment independent from financing decision
Modigliani/Miller: irrelevance of capital structure
⋄real investment (cash flows) determining value of firm
⋄financing decisions without influence on firm value
Intuition:
⋄law of one price / value additivity
⋄separating cash-flows into parts not affecting overall value
→irrelevant how pizza/cake getting sliced
⋄private investors able to reproduce all leverage decisions
•But: corporate taxation not neutral with respect to financing decisions
Definition of debt tax shields. (under assumption of no costs)
The debt tax shield is defined as the tax savings generated by the deductibility of interest expenses on debt.
⇒Without any other costs, full debt financing (E=0) optimal
