With the gradual growth of world trade, the opening and expansion of markets, and the growing trend of M&As, we can expect the effects of intra firm transactions, and thereby Transfer Pricing (TP hereafter), to grow in the future.

3. Incentives for using Transfer-Pricing as a Instrument

As the definition of TP, on a broad level, suggests the concept includes a MNC and its subsidiaries in one or more countries and their respective tax levels. This makes possible the deliberate or accidental use of the involved tax systems. A major consideration of the MNC in its international trade is the income tax effect (Moffett et al, 2003), this being the effect on the subsidiary of the corporate taxes in the host country. This effect can either be diminished or increased. This can be illustrated in the simplified example given below.

5. A Simplified Example

In MNC “A” the headquarter is in Austria and “B” is the subsidiary in Belgium. “A” produces its goods in Austria and exports them for sale in Belgium. The cost of production of one unit is, say, € 100 and this is charged to the subsidiary. The subsidiary will market and price the product – according to their marketing strategies – in Belgium at, say, € 200,-. After expenses this leaves € 80,- as profit in Belgium. With Belgian corporate taxes being 40 % there is € 48,- left as profit. However, taxes in Austria are only 20 % and this motivates “A” to charge a higher price to “B”.  In the future the product will cost “B” € 180,- and the profit of  € 80,- will be located in Austria liable to a tax of 20 %.

“A’s” new pricing decision results in only € 16,- corporate tax per production unit and is hence a saving of € 16,- raising profits to 64,-. From the Austrian point of view the tax income has risen by € 16,-.

The example illustrates how common TP is, as this could be almost any good consumed by the average consumer on any given day. And what the economic rationale is for circumventing high taxation in foreign markets. In addition it highlights the obvious loss of the host nation Belgium     (€ 32,-) and the gain of Austria (€ 16,-). Another topic is how Austria and Belgium would react to adding the Cayman Islands into the equation.

In the Abusive Transfer Pricing scenario Belgium is the looser and this is in essence what has produced the ALP. Since even Austria would eventually suffer from a MNC pulling out its profits, many countries have agreed on this principle creating some mutual insurance against abusive TP. The principle states that the related parties in their internal transactions cannot deviate in price from what would be common for independent parties. In other words, the subsidiaries of a MNC must trade with each other on the terms of the market.

There are several issues concerning this topic. The first one is the topic of moving profits around so that the MNC pays taxes in the country where the tax level is the lowest. It is apparent that the MNC will transfer its profit to a country where the tax level is the lowest in order to pay as low a tax as possible. Whether this is morally right or wrong, is a subject that will be left for others to discuss.

Off-shoring is a very important issue that concerns the “Cayman Islands” part of the example. Some would argue it does not matter where a tax is being paid in the world and at which tax level. The problem is if profits are moved to places in the world (like the Cayman Islands) where there is no tax collection at all, because by doing this, the profit of the MNC is not contributing to any country and thereby taking the role as a “free rider” of the global society. To some extent it could be argued that the tax that MNC pay is in fact their contribution to the country in which the MNC operates. The society is thus returning infrastructure and educated labour. Consequently, the problem is not so much where the tax is being paid, rather than the MNCs moving their profits to tax havens.

Fundamentally, it is legal to plan where which share of taxes should be paid as long as the tax statements reflect the economic reality of the company (Larsen et al, 2004). However, willing manipulation securing the corporation as a whole the most beneficial – read, lowest – tax burden is unlawful and can be termed abusive TP.

6. The Main Uses of Transfer-Pricing

Basically there are two broad categories for the use of TP. The first category has to do with the relevant pricing of goods, services and intangibles. Example of the latter could be financial, technological and managerial expertise, or in broad terms knowledge. A MNC might for instance need to transfer new knowledge to its subsidiaries. Obviously the R&D unit at headquarters has invested a lot of time and resources on this intangible asset. Here the MNC faces the problem of allocating costs over the spectrum of the firm. This is problematic not just for the MNC but also for the relevant tax authorities, since it can be very difficult to find the “right” price for the intangible and as well as for the tax authorities to see the logic in that particular pricing. The second category has more to do with the reasons behind the transfers. It could be hedging for risk, the relocation of funds (e.g. to safeguard the MNC against the blocking of funds by foreign governments), the allocation of cost (as in the case of cost of new technology, charging one subsidiaries to another thus dividing mutual costs between the units of the MNC) or just plain tax evasion. The difficult part in both categories is handling or justifying transfers of the intangibles, that is where most of the misunderstandings and possibilities for exploitation begin. Intangibles are sold by the company to its constituent divisions at usually disputable internal prices. In any one firm, internal trade may involve core or strategic activities as well as outsourceable activities, thus making it difficult to affirmatively discern, at least from existing empirical studies, any valid reasons for internalising trade in the first place (Emmanuel, 1994, 1997).

7. The Main Motives for Setting Transfer-Pricing Policies

According to surveys made by Ernst and Young (1997, 1999), MNC have two motives for setting TP policies, internal and external. In the survey, of more than 500 tax- and finance directors of major MNCs, a majority saw the main priority for TP as maximising operating performance. Financial efficiencies, another internal motivation, also scored high. There were external motivations addressed in the survey: optimising tax arrangements and preparing TP documentation in preparation for a tax audit, these ranked about 25% as top priority. The result of this survey (1997) and another one two years later (1999), indicates that MNCs continue to see TP as means for internal allocation but not as means for tax reduction. This seems to contradict the common interpretations that TP is used mainly as a tool to lower corporate taxes, although to be critical the source of the survey could be biased due to work relations in the area of accounting (Ernst & Young work for and market their expertise to MNCs).

There are three market justifications for internalising trade that prevail in the business literature (Mehafdi, 2000): 1) savings on transaction costs (Coase, 1937 in Williamson, 1975) as to avoid uncertainty in transit, 2) a product's unique features or the degree of asset specificity (Williamson et al, 1995) for example brands or secret formulas like Coca-Cola, and 3) the ownership-location-internalisation paradigm, which emphasises market imperfections for justifying FDI (Casson, 1987, Dunning, 1988, Hill, 1998). Underlying these arguments is the pursuit of economic growth and profit maximisation, which constitute the main raison d'etre for MNCs, when under pressure from the capital markets for short-term financial results. The abundant TP literature, both theoretical and empirical, is mostly anchored in the mass production era and does not question this raison d'etre. It takes the volume of internal trade for granted and focuses instead on the pricing aspects, not the harm that TP policies might cause within and outside a company. Elaborate theoretical models developed by Eccles (1985), Spicer (1988) and Emmanuel and Mehafdi (1994) are largely couched in these terms as well. It is more in this area than in the hearsay that TP gets the fair unbiased treatment it deserves as a necessary and helpful instrument at the disposal of the international manager.

4. The Nation States Search for Regulatory Measures

This section will provide the fundamental issues concerning regulations in international tax systems. First addressed will be which authority the MNC’s unit should answer to, which portion of incomes belongs to this authority and how that portion is valued. Then, the attention will turn towards the appropriate method of ensuring that transactions are occurring at fair market prices, namely the ALP. Finally, an instrument to deal with disputes between governments and MNCs is examined: The Advance Pricing Agreement.

8. The Motivation to Create Disincentives to Abusive Transfer Pricing

Although international institutions and alliances, among them the OECD, have fought for more standardisation, in lengthy and what often seems to be unproductive meetings it seems extremely difficult to agree on multilaterally binding tax agreements (cand.mer.jur. thesis, must look it up). Persistent non-compliant behaviour by many MNCs and the loss of billions in tax revenue has prompted many countries and regulating bodies to adopt stringent laws to curb TP abuse and the resultant misrepresentation of taxable profits. Investigations by tax authorities of offending companies usually result in substantial TP adjustments (e.g. additional taxes) and hefty penalties (Moshe’s Ethics Article).

There are three distinct types of taxation problems concerning the global reach of MNCs: That is jurisdiction, allocation and valuation (Eden, 2001). That is which jurisdictional government has the right to tax the MNCs’ income, and can the MNC use different jurisdictions to hide profits and reduce taxes. How should resources be allocated among different jurisdictions, and do MNCs do themselves justice in valuing their intra-firm transfers.

1. Determining the Jurisdictional Boundaries for Taxation

Before discussing appropriate TP regulations, definitions of jurisdiction must be clear. The principle of inter-nation equity calls for an equitable allocation of the international tax base between different countries. The apportionment of the taxable income is considered to be equitable if every country has the right to tax all profits having their source within its borders.

If the individual countries have varying rules, the transaction between associated companies – e.g. the HQ and its foreign subsidiary – makes possible the deliberate or unwilling use of the different countries tax systems. In this way the income tax effect mentioned earlier can be diminished or increased. However, it is in accordance with general taxation principles to plan in which jurisdiction taxes are paid as long as the tax statements reflect the economic reality of the company (Larsen et al, 2004).

2. Establishing the Allocation of Income Creation

The source of profits is defined as the location where the profits are created. It stems from the principle of economic allegiance. It implies that the country within whose borders the realisation takes place is entitled to tax those profits, as this country contributes to the generation of profits by providing its legal and economic system (Picot et al, 1996). In order to determine the profits’ source and, thus, the profit-creating factors, the supply-approach is predominantly accepted.  According to this approach, the source of income is situated where the factors of production of the company generating that income operate.

3. Feasibility and Valuation in Tax Assessment and Collection

Feasibility is an inherent limitation to taxation and is the next criterion. Implying that a tax system, has to be enforceable in practice and, thus, has to have the capacity to achieve its basic objectives. Feasibility of a tax system also includes cost effectiveness, please consult Figure X, page X for an illustration. The requirement of a feasible system of international corporate taxation is of high importance, as it constitutes the basis for the achievement of several other objectives of international tax law. With an extreme effort it would be possible to determine the claims for every profit or even transaction, but it is hard to do so with a reasonable effort and thus impracticable in reality.

The issue of feasibility – above in the context of the tax authorities – is mirrored in the context of the MNC. Here conducting a proper valuation depends to one part on the willingness of the MNCs to asses and price by an approved standard. To the other part, on the feasibility of tracking and pricing, every single transaction within the network of the MNC and particularly the costs incurred by such scrutiny.  

In the absence of financial reporting regulations, companies will continue to keep their TP policies under wraps and prevent a direct observation of their non-tax aspects. This is a known obstacle to empirical TP research (Emmanuel et al, 1994). A further disincentive is the amount of sensitive information being made “semi-public” in the hands of the tax authorities. In conclusion, the valuation objective faces three challenges: 1.) the ability of tax authorities to monitor with reasonable effort an acceptable level of intrafirm trade, 2.) the equivalent problem from the MNC’s view and finally 3.) the reluctance and lacking tradition of MNCs in disclosing all relevant financial figures relating to their TP.

As a response to the challenges in the question of jurisdiction, allocation and valuation, tax authorities in most countries have implemented the guidelines set forth by the OECD to their own legal tax framework. This will be the focus of the next section.

9. How to regulate Transfer Prices – The Arm’s Length Principle

The OECD guidelines consist of eight chapters. Being the most central chapter, the ALP is an inseparable part of TP. As the word guidelines indicate countries are not obliged to adhere to them. Yet, there is a widespread consensus on these guidelines and in particular the ALP. Thus, the ALP is the tool most widely used to assess whether a MNCs transactions between countries are occurring at fair market prices.

“The arm’s length principle requires that compensation for any intercompany transaction shall conform to the level that would have applied had the transaction taken place between unrelated parties, all other factors remaining the same (Coopers et al, 1993)”.

In the ALP the various entities of a MNC are considered to be independent companies, who are obliged to follow the arm’s length terms in their internal controlled transactions. OECD describes and recommends six different methods which are all in compliance with the ALP. These six methods listed below can be divided into two main groups (Eden, 2001):

The transactional methods seek to compare the prices based on the information sales price or profit on a comparable transaction between two independent companies. The profit-based method, on the other hand, sets prices: a) according to the sizes of the profit, which an independent company would achieve through a comparable transaction, or, b) by how the total profit in a transaction is split between independent companies.

The OECD guidelines do not recommend one specific method, since each has its own strengths and weaknesses. Rather, the MNC is expected to follow the method which applies most appropriately. In general, the transactional methods are best suited to the ALP, since they focus on the individual transaction. However, the profit-based methods are most widely used, since the proper conditions for applying the other methods are not always present – or at least, rather hard to determine. Again, it is an issue of feasibility.

A fundamental prerequisite for meeting the ALP is that it is possible to find a common ground for comparison in a similar transaction between two independent parties. A MNC’s controlled transaction can be comparable with the dependent company’s similar transactions with independent parties.

It is in the area of comparability that the major pitfalls concerning the applicability of the ALP are encountered. The problem is that often there is no market to compare against, or, factors create discrepancies that distort the market comparability. These factors could be instances of highly specialised goods in certain stages of production, or in the case of patents, brands and know-how (JI – yes, what then, Doc?). Especially the latter two factors are subject to much controversy, since MNCs and tax authorities can have very varying interpretations of the value of these. Even the OECD acknowledges that there are numerous situations where transactions are not comparable (Larsen et al, 2004). This again refers to the feasibility problems described above.

Additionally, the ALP falls short of capturing the fair market prices falls in other cases. The fact that the OECD guidelines view the subsidiaries of the MNC as separate entities, does not take into consideration the potential economies of scale achieved by being part of a MNC. Furthermore, the uncertainties surrounding know-how and R&D can create situations where entities within an MNC might agree to a transaction price, which independent companies would not agree on. An example could be the sale of a product with a high uncertainty regarding its future sales potential.

The above mentioned issues merely cover the tangible physical products. When including intangibles such as technology, licensing, royalties and services it is evident, that the issues become much more complex.

In spite of the obvious shortcomings of the ALP, the OECD remains firm in recommending this principle, as it is the closest one can get to free market terms. Thus, this classical second-best option remains the most widely used tool adopted by national tax authorities.

5. Advanced Pricing Agreements

The growing numbers of regulations in the area TP leads to a situation were countries implement different methods to prove the practice of the ALP. Those differences can easily lead to law suits against MNCs alleged of tax evasions. Law suits, in nature, are expensive and time consuming for both parties. Governments try to solve that problem by setting up advanced pricing agreements (APA).

10. The Applications and Mechanisms of APAs

Vogel and Brem (2002) define: “TP, in general, and the use of profit-based methods, in particular, often leave the taxpayer and the tax authority with legal uncertainty. Advanced pricing agreements (APAs) are an agreement between the taxpayer [read, MNC] and the tax authority and, in a bilateral or multilateral case, between the competent authorities of the jurisdictions involved to reduce this uncertainty”. Thus, the APA includes a pre-approval by the involved parties of the terms of TP.

Borkowski (2000) clarifies the motive for APAs: ”The APA is an alternative dispute resolution process that can reduce the number of TP cases requiring legal resolution in governmental courts, saving both time and money for the MNC and for the tax authority”.

The APAs contain a formula to split the taxable profits between the involved countries: "A method to allocate the global profits of a multinational group on a consolidated basis among associated enterprises in different countries on the basis of a predetermined formula" (OECD TP Guidelines). According to the OECD the final APA must include the duration of the agreement, and also which arm’s length method will be used.

The OECD encourages APAs (Hobster, 2002) and most members have adopted APAs as a way to solve bilateral TP disputes with MNCs that generate taxable income in their territory (Borkowski, 2000). As a result, the number of executed APAs is increasing dramatically (Brem and Vogele 2002).

6. The Different Roles: the MNC, the Government, the EU, the OECD & the Public

TP practices, rules and regulations are influenced by different authorities and entities. This section will list the main forces that influence TP issues along with their motives and the mechanisms.

The MNC: The goal of the MNC is to maximise shareholders’ wealth. TP is a tool in the hands of managers in the process of conducting business. It can be used as a control tool, that is by controlling the profit of a subsidiary, especially were the wages of the subsidiary management depends on financial results. More important, TP has become such a big issue since it is a tool used for tax evasion. Eden (2001) defines it very clearly: “TP manipulation – as distinct from TP – is the over or under-invoicing of related party transactions in order to avoid government regulation […] or to exploit cross-border differences in these rates (for example, shifting deductible expenses to the high tax location and revenues to the low tax location in order to reduce overall corporate tax payments)”.

The Government: The main interest of the government in TP issues is the corporate taxes collected by the tax service. On the one hand, policies implemented and enforced by legislative bodies aim at attracting as many MNCs as possible to the country, in order to stimulate the economy. Evidence of this is found in the gradual reduction of corporate tax levels in most OECD-countries over the last decades. (Possible place for “newsflash”)This will be explained further in the next section. On the other hand, the government tries to enforce thoroughly the ruling tax legislation and collect the full amount of taxes payable by MNCs. This of course serves to balance and finance the public budget. The balance of these two conflicting factors can be an intriguing one, and each country has its own balance of the two factors. The problem of too high tax levels is illustrated by the Laffer-curve (Beeg et al, xxxx), which illustrates how the tax revenue will decrease when tax levels reach a certain point.

The government does not act in a vacuum. Because of the nature of countries - interdependent, yet competitive at the same time – attempting to attract FDI, they influence and are influenced by tax regimes in other countries. For example, when the corporate tax rate decreases in other EU countries, the Danish government feel urged to apply similar changes in order to remain attractive for MNCs. Ultimately this is a discussion of absolute vs. relative gains.

The OECD: “The forerunner of the OECD was the Organisation for European Economic Co-operation (OEEC), which was formed to administer American and Canadian aid under the Marshall Plan for reconstruction of Europe after World War II. Since it took over from the OEEC in 1961, the OECD vocation has been to build strong economies in its member countries, improve efficiency, hone market systems, expand free trade and contribute to development in industrialised as well as developing countries (, 2004).” The main problems that hinder the optimal functioning of international trade are, traditionally, double-taxation and other tax related problems regarding trade over national boundaries. To try and come up with a solution the OECD made the OECD Model Tax Convention (MTC), in 1963. The outcome on the other hand was that the OECD MTC, did not sufficiently resolve the TP-issue, but focused more on double-taxation; therefore it was necessary to make special TP Guidelines for the OECD countries, the OECD guidelines are published by the Committee for Fiscal Affairs (J. Bunfgaard et al, 2001). The basic principle in the OECD guidelines is that ALP should be used in all inter-company transactions, and tax authorities in the OECD countries have adopted this principle (Eden, 2001), thus making the OECD the most influential international authority on TP issues.

The Public: The main influence of the public on TP issues is creating pressure on the government. The public derives its main source of information on the economy and society from the media. As mentioned before, the media is not per se an independent objective source. Large groups of the general public do not understand the concept of TP and others see it only in the context of tax evasions. The media is also a tool in the hands of MNCs, using their PR and marketing departments to shape the image of the corporation. In the next section we will discuss a case regarding public pressure in Denmark.

Another element to take into consideration is the influence the public has over governments, all the while the government strives to maintain power. When TP issues are being discussed in the media it creates public pressure that may make the government respond. Often, it is more an anxious response to public outrage than a deliberate law or policy. It can be argued that the Danish debate – a detailed description follows – had its roots in poor enforcement rather than a real need for legislative measures.

5. Transfer Pricing in Denmark

From 1999 to 2001 a couple of critical articles in the Danish weekly business Magazine “Mandag Morgen”(MM) dealing with TP issues in Denmark were published. The main point of these articles was that the Danish Treasury is loosing billions of DKK each year due to MNCs alleged abusive use of artificially high internal prices attempting to transfer funds from their Danish subsidiary to more advantageous – in tax terms – units of the MNC (MM, Nr. 21, 2001). This conclusion quickly found its way into the conventional mass media and, thus, contributed in sparking off an unprecedented and widespread debate about MNCs role and behavior in Denmark. Adding to this, in 2002, the Danish broadcaster DR2, which is regarded as a highly reliable, serious broadcaster, launched a program called “The Tax Acrobats”. This programme disclosed that subsidiaries of huge MNCs like Coca Cola, Nestlé and most international oil companies operating in Denmark had not paid tax, or paid very little in a range from 5 to 10 consecutive years. With the amount of publicity a program of this caliber created, the Parliament was forced to address this issue. Within a month the government had worked out a report on issues to assess and determine the extent and proliferation of the possible transfer of “would-have-been” Danish tax revenue to other countries.

This section will depict the current shape of the Danish issues and debate over TP. It will do so by incorporating the issues clarified in the previous sections to Denmark, e.g. apply the theoretical findings to a real life example. How much is the Treasury losing and how is it being estimated? Is it a one-way problem or are funds being funneled via TP into Denmark as well? How much of a factor is the corporate tax rate in these matters, and how has it changed in recent times? What initiatives has the government introduced to hinder any misuse of the rules? Consequently, this brings the attention to the international level to put the Danish issues into perspective vis à vis issues in other selected OECD countries. And what can be learned from other countries dealing with TP-issues. These are some of the issues that will be addressed in the following section.

7. The Danish Debate

It seems like Denmark must be one of the worlds most competitive and difficult markets to operate in. How else can some of the worlds most profitable MNCs have subsidiaries in Denmark with continuous deficits and thus, not paying anything in corporate tax? This seems to be the general reply from MNCs in explaining the lack of tax payments in a series of articles in MM starting in 1999 (MM, Nr. 31 and 32, 1999). The articles display figures from Danish subsidiaries, of large MNCs from Nestlé and Unilever to oil companies like Statoil, Q8 and Hydro Texaco. See figure 5.1 and 5.2. Interestingly, these numbers indicate some quite unprofitable businesses, despite revenues in the billions of DKK. Unilever has lost DKK 127 million on their Danish activities from 1991 to 2000 from revenue of DKK 16 billion, and thus have only paid DKK 2 million in tax. This is quite varying from their average European profits that accounted for 11 % in 1998 (MM, Nr. 31, 1999) Except Shell who has paid DKK 678 million in tax in six years (1995-2000), the remaining four other big oil companies operating in Denmark have altogether paid DKK 70 million out of a revenue of DKK 100 billion.

From an economist’s point of view one would expect such unprofitable subsidiaries to either drastically restructured or even be divested. Advisory tax auditor, Christen Amby, one of the most prominent tax experts says: “When a number of companies display consecutive running deficits of this magnitude, it can only mean that the companies are either driven by poor businessmen or that revenue is consciously funneled out of the country. I assume no one would accuse these companies of being unprofessional (MM, Nr. 21, 2001).” A common explanation of the unprofitability of these companies is that they have invested heavily in various assets. This point is indeed a valid one, since companies’ heavy investments will affect their financial figures. However this will only postpone the payment – not make them disappear, and thus, taxes should figure in future statements. This view is shared by Søren Bo Nielsen, economic advisor and CBS professor, who notes that “...[i]f this does not happen within a five to ten year time horizon, then I would have difficulties relating it to investments (MM, Nr. 25, 2001).” 

8. The Extent of the Problem

One of the most complex issues concerning TP is to measure the extent and proliferation of the abusive TP. Not surprisingly, economists, politicians and companies differ substantially in their various estimations on the subject. In a survey from 1999 of the top 300 foreign and domestic companies operating in Denmark, 46 % of the 67 foreign MNCs had profits lower than the government bond interest rate (MM, Nr. 13, 1999). Interestingly, the number of “below bond rate-profits” was less than 33 % for all 300 Danish and foreign companies.

One of the more qualified attempts to quantify the issue was presented by a group of economic advisors, headed by Søren Bo Larsen, in an article in MM Nr. 21 in 2001. Using figures from 1995-97, it was establish that the income generated within the borders of the country apparently topped the income registered by the Danish tax authorities by DKK 20-40 billion. With a corporate tax rate of 30 % this result in a deficiency of 7-14 billion in the Treasury in those years. However this estimate should be seen with caution, since there are several uncertain variables, for instance Danish individuals not registering their purchase of foreign securities. “But the main part of the explanation of the amount probably refers back to transfer pricing in a broad sense (MM, Nr. 21, 2001)”, Søren Bo Larsen notes.

Representatives from the Ministry of Finance, on the other hand, have indicated that the revenue lost by the Danish Treasury is marginal (K, have to find it…). Indeed they are uncertain that there is even talk of a net loss. They point at the reduction in the Danish corporate tax level, which is currently below the OECD and approximately averaging the EU-level (Politiken, 2004), which would indicate that funds could just as well be transferred into the country instead of funds leaving the country. However, one should also be cautious acknowledging this argument since the abstractness of such an argument makes it relatively inconclusive. Moreover, government politicians can be perceived as biased, in the sense that they have an incentive to defend the existing tax rules and regulations.

9. The Danish Corporate Tax Level

During the last decades Denmark has followed the international trend of gradual corporate tax rate reductions. Thus, the Danish tax rate has fallen 20 %-points from 50 % in 1986 (OECD, 2003) to the current level at 30 %. Two interdependent factors can be contributed to these changes. The main reason for this general trend in the world of corporate tax should be found in the continuous attempts by countries to compete to attract foreign investments. Equally important is the fact that countries, despite drastic tax rate reductions, have been able to avoid reductions in the tax revenues because of increases in the size of the tax base. The latter point has made the former economically feasible. Interestingly, Denmark has gone from being one of the highest corporate tax level countries to being slightly below OECD average. Moreover, Denmark’s current level is substantially lower than several countries in its geographical proximity like Germany (40 %), Holland (35 %) and Belgium (39 %). These countries are some of Denmark‘s principal trading partners. Assuming the often-cited argument that MNCs allocate profits to the most advantageous countries, the corporate tax level would per se not indicate a net outflow of cash. This particular argument suggests that the funds transferred out of the country are offset by an equal – or even higher – amount of ingoing funds. However, only looking at the tax level merely gives an indication, since it excludes other important factors such as the investment milieu, interest rates, depreciation regulations/possibilities etc.

10. Transfer Pricing Center

In 1998 Danish tax authorities were criticised for not handling cases where companies were accused of abusing TP regulations very well. Consequently, it was decided to centralise the top Danish TP experts in one Transfer Pricing Center. Furthermore, new regulations, inspired by the newly ratified OECD guidelines, concerning corporate tax were implemented. The most significant of them being the one on TP, where MNCs now have to provide documentation, that their transactions have occurred in accordance to the ALP. The role of this TP-center is to competent and approving authority in cases of potential abusive behavior concerning TP. Furthermore, they are dialoging in conflicts between Danish subsidiaries in other countries and the tax authorities in that country. After only a few years the TP-center employing 16 tax experts were investigating approximately 200 cases of suspected Danish subsidiaries of foreign MNCs. These cases vary substantially in magnitude – most of them are in the two-digit million DKK scale, but a small handful of companies have received additional tax bills in the three digit million scale (MM, Nr. 21, 2001). Still the pace and results of the TP-center has been criticised from various sides. The reason for this is two-fold. First, the center has experienced difficulties and keeping their employees. The tax experts have become valuable to MNCs and auditing firms, who have been successful in attracting the experts with higher salaries. Thus, only five of the initial 16 employees were still employed after three years of operation. Second, the TP-center has allocated considerable resources in helping Danish MNCs who are facing similar tax demands from foreign tax authorities. Here the MNCs are accused of transferring profits from their foreign subsidiaries to Denmark. Thus, the TP-center assists in assessing their demands and if they are found unjustified, the TP-center might help the MNCs file a case against the foreign tax authorities. If, however, the TP-center agrees with the demands of the foreign tax authorities, they will have to give the Danish MNC a corresponding tax exemption in order to live up to the standards in the OECD Model Tax Convention on double taxation (Hansen et al, 2004 and Eden, 2001). Thus, the TP center plays a crucial role in the interaction between other tax authorities and the MNC in question. It is here that the APA’s mentioned above arise as the obvious tool to prevent or solve disagreements. These agreements are also done by the TP center.

The fact that considerable resources are being allocated to assist Danish subsidiaries in foreign countries supports the view presented earlier in the section that considerable profits are being transferred into Denmark as well.

This two-edged role of the TP-center can, from the Danish tax authority’s point of view, be seen as a way of “profit maximisation”. To support that, research shows that government resources spent on TP-issues indeed provide the highest return in terms of tax payments. A UK-report shows that one GBP spent controlling TP-issues provides a return of GBP 240,-, whereas VAT-control for example only came back 10 fold (MM, Nr. 32, 1999). See figure 5.3. (ibid)

Clearly, this indicates that there is indeed a sound rationale from the Danish tax authority’s point of view, to introduce initiatives like the TP-center followed by tighter regulations on TP-issues.

11. Denmark vis à vis other OECD Countries

Since TP per se is international, assessing Denmark’s rules and regulations necessitates a comparative study of other countries’ ruling tax systems. In a survey published for the Danish Parliament (Regeringen 2002, Redegørelse om TP), the TP-center investigated the regulations in nine other OECD countries. The results showed that Denmark varied from most others countries, but not more than other countries varied among each other. In Denmark companies have a duty to disclose all material facts concerning internal transactions, but these facts need not be very detailed. The other countries in the survey either had this duty, but with very detailed specification, or did not have a duty to disclose all material facts. Concerning the duty of documentation Denmark again found itself in the middle with one group of countries not having this duty, and another group having much more comprehensive criteria. In Denmark the burden of proof lies with the tax authorities as is the case in Holland, Portugal, Japan and Germany, whereas in USA, Canada and Australia this burden lies with the companies, meaning that they have to prove that they have followed the ALP etc. In conclusion, Denmark is clearly in the “midfield” of the group of countries, and have more comprehensive regulations than some of the other countries in some of the three above mentioned factors. But what the government report does not mention is that all the other countries have at least one factor where they have tight regulations, whereas Denmark seems to be in the middle of all of the factors. Thus, the Danish regulations could be characterised as generally weak, which is a significant issue in the attempt to control the behaviors of MNCs.

6. Conclusion

Evidence from this paper and its underlying research – mapping the difficulties surrounding the concept of TP – suggests that a viable solution is not within easy reach. However, the need for international convergence and cooperation in cross-border taxation begs for multilateral settlement.

TP has always been a controversial issue in every forum it has been discussed. Nevertheless, we would like to outline our conclusions:

1. TP influences inflows to a country as well as outflows.
2. Observing the trends in international business (growth of international trade, transnational strategies adopted by MNCs), the significance of TP can only increase.
3. The complexity of taxing MNCs appropriately will increase, especially where the traded goods are intangibles like services, technologies and managerial experience.
4. The OECD has the most significant influence on TP issues around the world, in member states as well as in other countries. The OECD guidelines have led to substantial progress, being a benchmark to many legal frameworks. But still a lot needs to be doneblabla
5. Governments around the world will have to change regulations and continuously adapt to the ever changing international business environment, looking for the optimal balance between attracting FDI and contributing to the financing of the public budget.

On a more philosophical stroke, it is interesting to see the TP issue clashing with the century old concepts of nation states with their sovereign borders and laws: The challenge is thus to combine a geographically and legally limited entity with the ever-accelerating internationalisation of MNCs.

MNCs are becoming more and more transnational, with each plant distributed according to its highest value adding location. This type of organization is configured as a network of sister affiliates with an intrafirm two-way flow of goods, services and intangibles. The physical assets and management capabilities are distributed internationally, but are interdependent (Bartlet et al, 2003).

12. International Taxation in the Future

We would like to suggest a possible principle – based on the works of Lorraine Eden (Eden, 2001) - that might be used as inspiration in a future regulatory body. The principle will be presented in a simplistic form, well aware that the realisation of such a suggestion is far from simple. The overall aim is to eliminate the incentive of abusive TP behaviour as it is known today, and to create some simple and standardised regulation, thus reducing the high financial costs for both MNCs and tax authorities. This undoubtedly calls for international cooperation. The idea is to establish a Global Tax Authority (GTA) that is to collect the tax of a MNC for its global corporate profits, instead of the individual subsidiary’s national profit as it is done today. The taxes will be charged and allocated according to the relative sales revenues generated by the subsidiary in each country. This principle needs exemplification:

 

MNC “Big” operates in Denmark, Germany and Norway. Its R&D centres, production facilities and management are spread among those countries. “Big’s” total sales are $390 million: $50 million in Denmark, $300 million in Germany and $40 million in Norway.

These sums appear after deduction of the VAT from the sales revenue, since VAT are funds that are transferred directly to the local tax authorities. The total corporate profit as it is shown on the income statement is $55 million. Hence, the profit that relates to Denmark is 55 x (50 / 390) = $7 million. The tax liability for the Danish tax authority is the Danish corporate tax rate (30%) times the related profit, thus; 30% x 7 = $2.1 million.

We are, indeed, aware of the difficulties and the huge time horizon concerning the implementation of such a bold and ambitious principle. The details of this suggestion are not of great importance. The all important notion is the underlying principle – namely that of a more just distribution of taxes on the basis of the relative sales revenue of each subsidiaries. Basically, it removes a major part of the incentive to transfer profits from one country to another. This will be particularly important concerning the ‘tax havens’, which is one of the most profound sources of abusive TP behaviour. Furthermore, a set of clearer and more standardized regulations makes possible the reduction of expensive and time consuming legal disputes between the MNC and the various tax authorities involved. Evidently, the time and resources required by MNCs, auditing companies and tax authorities to implement such an initiative is not to be underestimated – especially in the shorter run. However, it seems reasonable to assume that over the long run, this cost burden will be lifted somewhat.

One important aspect of this principle is the partial loss of the states’ sovereignty of their own tax regulations. Empirical evidence suggests, as in the case of world trade liberalization or the EU constitution, that the loss of sovereignty is one of most difficult issues for countries to accept. This will, undoubtedly, also be the case in this principle. The countries will be required to accept and conform to the regulations negotiated under the GTA. Another complicating factor is that the national tax authorities will need to have access to financial statements from other countries in which the MNC operates. This, however, is not new phenomena since that is already occurring in certain instances. On the facilitating/positive aspect, the loss of sovereignty is ‘only’ partial. Countries will still be able to attract investments, for example, by offering tax cuts for a certain period. In our “Big” example this could be a Danish 25% tax cut for five years, thus instead of 30% of the relative profit ($ 7 million) the revised tax would be (1 – 0.25) * 0.30 * 7 = $ 1.575 million. This space for incentives is indeed important since this aspect ceteris paribus will make it more tolerable for countries to accept.

Another positive aspect of the introduction of such a principle is that it does not require fundamental changes of the existing OECD guidelines. Thus, it can co-exist with the ALP – in fact, it is likely to ease the burden of the extensive commitment to the ALP, so, that the pitfalls concerning pricing and comparability will not be as profound/evident. Whereas the OECD guidelines focus very much on transaction as such, this principle focuses solely on the profit. Indeed, this is one of the valuable features of the proposed principle.

• The management of a transnational organization is spread around different countries so there is no head quarter that would relate the ownership to one country. (Moshe, do you want elaborate on this and put it into sentences?)

Turning to the more problematic side, the widespread enterprise ownership across borders of the contemporary global business environment is, indeed, an impediment to the principle of a Global Tax Authority. How is a subsidiary that is owned by three different companies in three different countries to be taxed? This is indeed an issue which needs thorough assessment by tax experts, and thus, it is beyond the scope of this paper. However, it is worth mentioning that, as in the case mentioned above, the problem is not unprecedented, since tax authorities are already facing this issue today. The big challenge is for countries to find consensus on the subject.

Are there any other pros or cons that we have not thought of???

Finally, we will turn to the question of who is likely to take on the enormous task of establishing and implementing the GTA. Historically, almost all international initiatives concerning TP have been spawned by the OECD. However, as emphasized elsewhere in this paper, the OECD has no authority to implement regulations to national tax systems. Indeed this “guiding and recommending heritage” could prove to be inappropriate when rules and regulations are the issues to be addressed, which is also noted by other practitioners (need to find source). Interestingly, the EU has been rather silent when it comes to TP issues. Seemingly, this body has had plenty of issues to handle in other areas. The most noticeable initiative is the JTPF (Joint Transfer Pricing Forum) which is merely a forum for discussing the issue (Danish Government Report, 2003).

However, it is in this body that we see the biggest potential for the establishment of a GTA. The reason is to be found in a motivational and an authority context. Firstly, the inclusion of 10 new member states to the EU will have a significant impact on the motivations for transferring profits. The “old” member states have a significantly higher corporate tax rate, than the “new” member states. Thus, acknowledging that there is a TP problem among the “old” members, this will undoubtedly be increased with 10 new member states fiercely – all competing for FDI with attractive low corporate tax levels. This, in our view, would motivate even the slowest and most bureaucratic body. Secondly, the EU has a history of being an international regulating body. This makes the EU more geared in establishing and implementing a GTA. Furthermore, the bargaining power of the EU vis à vis non EU countries (notably the US and Japan) will be higher and more forceful, which is considered necessary if an agreement has to be achieved. Interestingly, the countries that are expected to oppose this principle predominantly, are countries of a “tax haven” character, which are, in essence, not in a position to do anything to prevent it.

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7. Table of References

Books:

• Bartlett, Christopher A., Birkinshaw, J., Goshal, Sumantra. (International edition 2003) Transnational Management: Text, Cases and Readings in Cross-Border Management. McGraw-Hill/Irvin
• Bundgaard, J. and Wittendorff, J. (2001) Armslængdeprincippet og Transfer pricing. Magnus Informatik, København, p. 41-43.
• Casson, M. (1987). The Firm and the Market: Studies on Multinational Enterprise and the Scope of the Firm. Basil Blackwell, Oxford.
• Dunning, J.H. (1988). Explaining International Production. Unwin Hyman, London.
• Eccles, R. (1985). The Transfer Pricing Problem: a Theory for Practice. Lexington Books, Lexington, MA.
• Elliot, J. and Emmanuel, C.R. (2000) International Transfer Pricing. London CIMA publishing.
• Emmanuel, C. and Mehafdi, M. (1994). Transfer Pricing. Academic Press and CIMA, London.
• Feinschreiber, R. (2002) Transfer Pricing Handbook/Transfer Pricing International. Somerset John Wiley Sons.
• Hill, C.W.L.(1998). International Business: Competing in the Global Marketplace. Irwin McGraw-Hill.
• Moffet, M. H, Stonehill, A. I. and Eiteman, D. K, 2003, Fundamentals of Multinational Finance. Pearson Education, Inc., Boston
• Pagan, J. C. and Scott Wilkie, J.: Transfer pricing strategy in a global economy. IBFB Publicat.
• Williamson, O.E. (1975). Markets and Hierarchies: Analysis and Anti-Trust Implications. The Free Press, New York.

Edited Volume:

-     Begg, F. and Dornbusch. (2003), 7th ed: McGraw-Hill Education - Europe, London.

-  Jolly, Adam (2003), 1st edition: ”OECD Economies and the World today”, Kogan Page Limited UK and US, Kogan Page and Contributors.

-    Eden, Lorraine. (2001), 1st ed: Taxes, Transfer, and the Multinational Enterprise, in Rugman, A.M. and Brewer, T.L., The Oxford Handbook of International Business, Oxford University Express Side 12 skal noten laves! + side 15.

-   J. Owens, ‘Tax Administration in the New Millennium*, International Tax Review 2002, p. 126, Commission of the European Communities, Company Taxation in the Internal Markets, SEC(2001) 1681 (Brussels, 2001), p. 263; OECD, Globalisation of Industry. Overview and Sector Reports (Paris, 1996), pp. 29-30.

Journal Articles:

• Vogele, A. and Brem, M (2002). Do APAs prevent disputes? International Tax Review, 14(1): 35
• Coase, R. (1937). The Nature of the Firm. Economica 4, p.386-405.
• Borkowski, S.C. (2000) Transfer pricing advance pricing agreement: Current status by country. The International Tax Journal, 26(2): 1
• Hobster, J. (2002) European transfer pricing: At the crossroads? Journal of International Taxation, 13(7): 55
• Krugman, P. (1997). What should Trade Negotiators negotiate about? Journal of Economic Literature, Vol. 35, 113-120.
• Jacob, Prof. Dr. O.H., Spengel, Prof. Dr. C and Schäfer, A. (2004). ICT and Profit Allocation within Multinational Groups. Intertax, Volume 32, issue 6/7. Kluwer Law International
• Picot, A., Ribbenberger, T., and Wolff, B. (1996). The Fading Boundaries of the Firm: The Role of Information and Communication Technology. Journal of Institutional and Theoretical Economics.
• Spicer, R. (1988). Towards an Organizational Theory of the Transfer Pricing Process. In Accounting, Organizations and Society 13(3), 303-321.

Research Papers: 

• Olsen, P. B. and Pedersen, K., 2003, Problemorienteret projektarbejde, Roskilde Universitets Forlag, Roskilde
• Larsen, H. and Nielsen, J. (2004). Transfer Pricing: Status På Dansk Lovgivning. CBS, Institut for Regnskabsvæsen, Økonomistyring og Revision.

Newspaper articles:

• Ugebrevet Mandag Morgen (1999),”Skattesmæk på vej til globale koncerner i Danmark”, Nr. 31, September 13th.
• Ugebrevet Mandag Morgen (2001), ”Politikere kræver kulegravning af olieselskabernes skatteforhold”, Nr. 25, August 13th.
• Ugebrevet Mandag Morgen (1999), ”Kæmpe regning til Novo Nordisk efter skattesag i Japan” Nr. 32, September 20th.
• Ugebrevet Mandag Morgen (2001),”Transfer Pricing koster statskassen mere end grænsehandlen”, Nr. 21, June 11th.
• Ugebrevet Mandag Morgen (2000), ”De store olieselskabers indtjening et mysterium”, Nr. 19, May 15th.
• Ugebrevet Mandag Morgen (1997), ”Ny skrappere Emma Gad for globale virksomheder”, Nr. 6, February 10th.

Websites:

• http://www.oecd.org

On air Documentary:

        DR – dokumenter (2002) Skatteakrobaterne, video.

Institutional Publications:

-     Danish Government Report. (2003). Redegørelse om Multinationale Selskaber og Transfer Pricing. Regeringen.

• OECD rapports

Various Artists:

-        Emmanuel, C. and Mehafdi, M. (1997). Convergence, Divergence in Transfer Pricing Research: a Forty Year Survey, Paper presented at the 20th Annual Congress of the European Accounting Association, Graz, Austria, April.

-        Ernst and Young. (1997). Global Transfer Pricing Survey. Washington, DC: Ernst and Young International.

• (1999) Global Transfer Pricing Survey. Washington, DC: Ernst and Young International.
• CCH International. (1993) International Transfer Pricing. Bicester Cooper Lybrant

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Problems – what is this all??:

Cand.merc.jur thesis (must look it up in the library (remark by Jacob))

Regeringen: Redegørelse om multinationale selskaber og Transfer Pricing, oktober 2002

 Derived from Told & Skat, 2003: Transfer Pricing . Hvordan fastsættes og dokumenteres prisen, når virksomheder handler internt. (DLJ Kasper, hvad vil du med noten. Pp 8

International Transfer Pricing, Cooper’s and Lybrand, 1993 – Page pending – Page 14

Have to find it” Representatives from the Ministry of Finance, on the other hand, have indicated that the revenue lost by the Danish Treasury is marginal “….. page 22.. everything pending

OECD Economies and the world today, 2003 Page nr pending actually everything is pending this is actually not a footnote.

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