Deterring Transfer Pricing Abuse: Changing Incentives As a Practical Alternative to a Global Tax Regime

Washington University Global Studies Law Review Volume 10 Issue 4 2011 Deterring Transfer Pricing Abuse: Changing Incentives As a Practical Alternative to a Global Tax Regime David A. Osborne Washington University School of Law Follow this and additional works at: https://openscholarship.wustl.edu/law_globalstudies Part of the Comparative and Foreign Law Commons, and the Taxation-Transnational Commons Recommended Citation David A. Osborne, Deterring Transfer Pricing Abuse: Changing Incentives As a Practical Alternative to a Global Tax Regime, 10 WASH. U. GLOBAL STUD. L. REV. 813 (2011), https://openscholarship.wustl.edu/law_globalstudies/vol10/iss4/6 This Note is brought to you for free and open access by the Law School at Washington University Open Scholarship. It has been accepted for inclusion in Washington University Global Studies Law Review by an authorized administrator of Washington University Open Scholarship. For more information, please contact . DETERRING TRANSFER PRICING ABUSE: CHANGING INCENTIVES AS A PRACTICAL ALTERNATIVE TO A GLOBAL TAX REGIME I. INTRODUCTION Recent tax scandals have involved individuals hiding money in offshore accounts, hopefully never to be discovered by the U.S. Internal Revenue Service (“IRS”). This conduct is clearly illegal. Multinational businesses, however, have been avoiding taxes by moving money internationally for decades. The difference between a company’s tax avoidance procedures and illegal tax evasion is that these multinational businesses have become very adept at remaining within the letter of the law in various nations when shifting income. Transfer pricing is a practice whereby companies use transactions between different corporate units to shift income between jurisdictions for the purpose of reducing the company’s overall tax burden.1 An international company can theoretically choose to pay income taxes in the country of its choice by shifting income from one unit of the company located in a country with a relatively high corporate income tax rate to another unit located elsewhere with a lower tax rate. As might be expected, the “high tax” countries are not content to stand idly by as their tax base erodes out from underneath their feet. The United States, as one of the relatively higher-tax countries, has enacted a variety of laws and regulations to try to ensure that international companies accurately apportion their income among the countries where they conduct business.2 1. See BLACK’S LAW DICTIONARY 1309 (9th ed. 2009). The following is an example of how a transfer pricing scheme might work: [A] company . . . that makes widgets [creates] a subsidiary, S1, to perform the actual manufacturing in high-tax country A. The widgets cost $60 to produce. S1 sells the widgets for $62 to a related company, S2, which is a resident in tax haven Country B. S2 sells the widgets for $80 to S3, yet another related company residing in the United States. S3 distributes the widgets throughout the U.S. market, selling them to unrelated U.S. customers at an average of $90, after incurring expenses of about $5 per widget. Of the $25 of combined profits per widget, S1 reports and pays taxes on $2 in A. S3 pays taxes on its profit of $ 5 per widget in the United States. S2 reports $18 of the profit and is taxable only in B, which levies very little tax. Julie Roin, Can The Income Tax Be Saved? The Promise and Pitfalls of Adopting World-Wide Formulary Apportionment, 61 TAX L. REV. 169, 181 (2008). 2. The beginning of this long maze of rules can be found at I.R.C. § 482 (2006), which provides the overarching goal of preventing tax evasion through accurately apportioning income between entities that conduct transactions with each other. See discussion infra Part II.B. 813 Washington University Open Scholarship 814 WASHINGTON UNIVERSITY GLOBAL STUDIES LAW REVIEW [VOL. 10:813 While the intended legal framework for transfer pricing is not difficult to define in broad strokes, the actual detailed implementation of the necessary laws and regulations in each nation has proven to be extraordinarily difficult. With billions of dollars at stake, international businesses have a huge financial incentive to find ways to reduce their tax burden while still staying within the letter of various nations’ laws. This Note proposes a change to the jurisdiction of the U.S. Tax Court and discusses why such a change would deter businesses from engaging in overly aggressive tax-avoidance behavior. First, in Part II it provides an initial example of the problem of transfer pricing by explaining how a multinational enterprise, IKEA, uses a carefully planned corporate structure to greatly reduce its tax burden. It then provides an introduction to how one nation, the United States, addresses corporations that shift income between countries. Next, it addresses in Part III how the global tax system might be reformed and whether such reform would effectively prevent tax evasion by allocating income to countries with a lower tax. In Part IV, using the U.S. tax regime as an example, the Note suggests modifications to national tax regimes that will deter transfer pricing abuses, including the requirement that Article III courts, where there is the prospect of a jury as the fact-finder, have exclusive jurisdiction over transfer pricing disputes. The Note concludes in Part V. II. TRANSFER PRICING PERMITS INTERNATIONAL COMPANIES TO AVOID TAXES The concept of an “international tax system” is an illusion. The current reality is one of independent states attempting to tax international activities by casting a net woven from a mixture of each country’s domestic tax laws and bilateral tax treaties.3 Not surprisingly, the lack of a 3. “Basically, there are three sets of international tax rules: (1) the domestic rules dealing with taxation of non-residents, (2) the domestic rules dealing with taxation of residents generating income abroad, and (3) some complementary rules (that are not purely domestic and are mainly found in tax treaties) . . . .” Yariv Brauner, An International Tax Regime in Crystallization, 56 TAX L. REV. 259, 265–66 (2003). An international income tax system usually contains: several layers of rules that apply to transactions and taxpayers independent of each other, but in a certain, rigid order. These sets of rules, in that order, are: (1) definition of “income” subject to tax, (2) measurement of the tax base and transfer pricing rules, (3) classification of types of income, (4) source (and allocation) rules, (5) taxing provisions, including rates and timing, (6) relief of domestic taxation under domestic rules, (7) relief of domestic taxation claiming tax treaty benefits, and (8) means of collection—mainly withholding tax rules. Id. The system is currently made up of about 1,500 bilateral tax treaties. Id. at 292. Although the sheer number of treaties may lead one to believe otherwise, there is already a degree of harmonization https://opensc (...truncated)