Monday, March 11, 2013

Profit-Shifting and Transfer Pricing

Mr Kang is diplomatic in not pointing out Malaysia’s own situation, but this article in today’s paper takes a highly educational look into the mechanics of profit shifting and transfer pricing, and a potential solution to the problem (excerpt; emphasis added):

Reining in cross-border profit shifting

A RECENT statement by George Osborne, the British Chancellor of the Exchequer, was given wide media coverage in the United Kingdom and elsewhere when he said that he wanted to see “international action” taken against multinational companies which engaged in “profit shifting”...

...The case of Amazon highlights how profits are “shifted” and the international tax rules that are in play.

Amazon revealed to the UK's Parliamentary Committee that all its European sales, including those to UK customers, are made by its affiliates in Luxembourg.

Its UK affiliate operates the order fulfilment, customer support and logistics services and earns a margin for these services. Since these are low-margin businesses, the profits earned by [sic] the UK entity are understandably low.

The bulk of the profits from its substantial sales volumes are attributable to the Amazon affiliates in Luxembourg, a low-tax location.

Amazon's business model thus exploits fully a number of key international tax rules.

The first is the “separate entity” principle, which treats a company within a global group as separate and distinct from other companies in that group...

...The separate entity rule, therefore, has the perverse effect of permitting the fiction of separate businesses.

The second is the arm's length rule, which operates to complement the first rule. It requires that transactions between companies in a group are made at arm's length i.e. as if they are made with third parties.

Amazon had not been accused of breaking the law so that they would have adhered to these rules in arriving at profits for each of its entities in the United Kingdom and in Luxembourg. Having done so, “it is difficult if not impossible to challenge the attribution of low profits to Amazon UK and high profits to Amazon Luxembourg” in the words of Sol Picciotto, an emeritus professor at Lancaster University and adviser to the Tax Justice Network, an activist group calling for greater transparency and fairness in tax systems...

...The global spread of these rules stems in part from the process of globalisation as well as the realisation that transfer pricing is a zero-sum game. Transfer pricing issues are really issues involving the split of taxes between two countries one where the selling company is located and the other where the buying company is; both being companies in the same group

…It is also a reason why multinational companies find it incumbent on them to play by these rules, but in a way which benefits them.

They do this by locating subsidiaries in low-tax jurisdictions (the Amazon model) and justify this by claiming that they have a responsibility towards their shareholders legally to reduce the taxes their companies pay...

...Professor Picciotto, clearly thinks not and through the Tax Justice Network, strongly advocates the adoption of Unitary Taxation to replace the current international system. The unitary system first came into the limelight in the late 1990s and is still part of the California state tax system.

Under unitary tax, a company operating a business line globally, as in the Amazon example, will have to report a single set of worldwide consolidated accounts to each country where it has a business presence. The overall global profit is then apportioned to the various countries according to a weighted formula reflecting say payroll, assets and sales. Each country will levy tax on its part of the world-wide profit so carved out...

Pace BNM’s press announcement last week and the GFI reports, it’s clear from the above that a part of the “illicit” capital flows from Malaysia are perfectly legitimate and legal, just not ethical, exploitation of loopholes in international tax law.

Given the vested interests involved, I wouldn’t expect a whole lot of progress any time soon – neither the multinationals involved nor the countries benefiting from tax shifting would stay passively on the side-lines while international tax reform takes root.

Would unilateral adoption of unitary taxation help? Perhaps, though without multilateral acceptance and cooperation, it would be difficult to enforce.

Looking at this and other global problems, I can’t help thinking that there will come a time when the logic of having global monetary and fiscal authorities will outweigh concerns over sovereignty and feelings of nationalism. We’re nowhere near that solution though, and we’ll just have to muddle through as best we may in the meantime.


  1. some observation :

    1) japanese fc told me water naturally flow downhill. unless the tp investigator poccess good product knowledge, otherwise very hard to make comparison pricing.

    2) that is also y hk n spore become a trade centre, due to lower tax.

    3) govt know, but the politics of full employment might outweigh tax income.

    4) it seem country with communist sys in the past have better control, for instance vietnam n china, due to lots of red tape n rigidity when selling to inter-co.

    1. HuaYong,

      On the last, China appears to be the biggest victim of capital flight in the world - the scale dwarfs Malaysia's.

  2. Well, Hisham - what's stopping Malaysia from becoming a "low tax" regime?

    I don't know if you have been reading the commentaries or following the debate in the Singapore Parliament about the republic's Budget 2013, but it's clear that the Singapore Government, despite all the concerns voiced by MPs about inequalities (of which the Gini coefficient is one indicator) and the perceptions that social mobility is freezing up and that meritocracy may have to be tempered, is not about to tamper with Singapore's low-tax regime (corporate tax rate of 17 per cent and a top marginal personal income tax rate (on incomes exceeding S$320,000 per annum).

    So, is Malaysia "shooting itself in the foot" with it's current tax regime?

  3. Sorry, I meant to write "a top marginal personal income tax rate....of 20 per cent.

    1. Jasper, given inertia, it won't be enough to just match lower tax rates elsewhere, you have to go lower still. But then it just becomes a race to the bottom and you can't go below zero. Corporate tax rates everywhere are already at historical lows.

      There's also the role of corporate tax breaks for certain categories of expenditure, tax holidays for FDI, etc etc. The effective tax yield on corporations is just a little over 10% in Malaysia, nowhere near the marginal rate of 25%.

      Of course, you could take the position that corporate tax itself is inefficient, since it constitutes "double" taxation of income when it's finally distributed. In that case, the most efficient tax rate would be zero.

      As for inequality, if Singapore doesn't see the need for raising marginal tax rates, they're just going to have to live with high inequality and reduced social mobility.

  4. I've done a bit of work related to transfer pricing and it seemed like the rules on how you value imported goods - and thus the tax and profit recognition rules - were so strict as to leave nearly no leeway for us to manage the profit sharing process. But perhaps Australia by design requires very strict rules and enforcement on transfer pricing, as they have one of the highest tax rates in the world.

    This issue seems like a legal and enforcement issue, not an economic structural issue inherent in having global companies. At least from what I've seen, having proper laws (and if they are followed) eliminates this problem nicely. As I recall it, the imported content had to be declared at the cost value plus a markup in the mandated range to make it an arm's length transaction. If Amazon UK is bringing in books across the border not at cost+small markup value but instead valuing them full retail price, that would explain why Amazon UK only declares a tiny profit (they would only make money on distribution). I would say their laws are illogical and need reforming. If they were forced to declare the value of the imported content at cost+10% markup, say, then majority of their profit would be recognized within the UK itself and thus taxed there.

    Sure, some companies will try to cheat on the cost declaration part, but all you need to do is make the penalties lucrative enough for the government to pursue (Toyota here is on the hook for a billion dollars in penalties for transfer pricing violations, they've paid a quarter million so far and are trying to dispute the rest)

    1. aetherfox,

      You're absolutely right, it's a question of regulation and enforcement. In Malaysia's case, the trade price discrepancies only lie with a handful of other countries but not others. For example, Malaysian trade to and from Japan and the US are recorded at almost identical values, and the discrepancies can be explained by CIF costs. Trade with China and Singapore on the other hand...

    2. Hisham

      You have piqued my curiosity!

      What, exactly, are you saying when you wrote "Trade with China and Singapore on the other hand...."?

      Are there some "unwritten" rules in operation here?

      And it can't be entirely coincidental that China and Singapore are consistently ranked among Malaysia's top 5 trading partners.

      Can it?

      More to the point - who benefits from this?

      On a related note - don't the bilateral Double Tax Agreements (DTAs) that Malaysia has entered into cover this issue of transfer pricing?

    3. Jasper,

      Both the US and Japan are also consistently among Malaysia's top 5 trade partners, yet we don't see the discrepancy in trade numbers like we see with Singapore or China.

      The differential between reported exports and imports between Japan and Malaysia is on the order of about 10%, which is consistent with estimated CIF costs (carriage, insurance, freight i.e. the cost of transportation). The US numbers are similar, though a little higher (as are Europe's).

      The discrepancy with China however (which is somewhat closer) is on the order of 40%-50%. Singapore is even closer still, yet we have reported discrepancies in the region of 20% or so.

      I don't think it should cost 20% of the value of a shipment to cross the causeway, when it only costs 15% to ship it to America or Europe.

      These trade discrepancies form the bulk of what GFI is calling illicit capital outflows (94% of illicit outflows in Asia based on their calculations), and why Malaysia is reported as being third in the world to suffer from them.

      DTA's do regulate transfer pricing practices, but there are lots of loopholes.

      Close them and you might lose FDI...leave them open and you lose tax revenue. Damned if you do, damned if you don't.

    4. Hisham

      It may just be that the US and Japanese Customs and tax authorities are doing a better job of "policing" imports and exports across their borders.

      And, maybe, they come down like a ton of bricks on businesses and companies that transgress on their tax laws.

      I am not entirely sure why closing the loopholes and strictly enforcing the tax laws should result in a loss of FDI. After all, businesses and companies, especially MNCs, look for countries which are politically stable and where there is a clear and transparent rule of law, plus supportive infrastructure and policies.

    5. Jasper,

      I've been told by a tax expert that tax regulation also plays a part as far as the US and Japan are concerned - the explanation was technical and I don't honestly understand the significance.

      Be that as it may, another potential reason is that trade with those countries are primarily in finished goods, while trade with Singapore and China are primarily intermediate goods. That's speculative though and doesn't help explain Europe, as Malaysian trade with Europe is also largely in intermediate goods.

      As for FDI, it's an interesting question and one I've looked at before. The determinants vary greatly depending on the type of FDI and the sector.

      For example, stability and governance don't appear to matter for primary sector FDI, but are crucial for tertiary sector FDI. Investors in secondary sectors look for cheap labour and undervalued exchange rates, but investors in tertiary sectors look at just the opposite. There's no one-size-fits-all menu of policies and characteristics that would satisfy all investors.

      In this context though, I'm thinking of FDI competition - if all other things are equal, would you prefer a country with lax tax regulation, or stricter tax regulation? Insofar as there is little to differentiate Malaysia from other countries in the region, enforcing stricter tax rules may drive foreign investors towards Indonesia or Thailand - not that they need much excuse.

    6. Hi, Hisham

      To pick up on your point, are there any studies that correlate a country's FDI with it's headline or effective tax rates?

      In the Asean context, it's Malaysia, Singapore, Indonesia and Thailand that have attracted the bulk of inward FDI measured over the past 10 years.

      Yet these countries' tax rates vary considerably from one another.

      I am wondering if the FDI story is more complex than a straightforward tax angle? And that political stability, infrastructure, rule of law and consistent policies are equally, if not more, important.

      I mean, if MIDA is out there competing against, say, Singapore's EDB, what would persuade a MNC to put a high-value investment in Malaysia? Tax? Politics? Infrastructure? Rule of law? Consistent policies? Availability of skilled manpower? Low wages?

      This is crucial, because the ETP cannot simply be about throwing ringgit around and hoping that foreign investors will bite.

    7. Jasper,

      I'll have a look, but a quick review tells me its a lot more difficult than it sounds. For one, you have to be able to separate the impact of differential marginal tax rates from other determinants of FDI. Second is that inward FDI tends to have a different time-varying tax structure, which makes comparison difficult. Correlation on its own would not be a smoking gun.

      On the other hand the structure of FDI itself can give pointers.

      Hard to do a table in a comment, but these are the inward FDI ratios for the main ASEAN countries in 2011 (as % of ASEAN FDI, all figures from UNCTAD):

      MY 10.3
      ID 16.2
      SG 54.9
      TH 8.2

      By type:
      MY 22.4
      ID 32.1
      SG 22.3
      TH 2.8

      MY 14.6
      ID 17.7
      SG 45.2
      TH 15.4

      Retained Earnings
      MY 4.9
      ID 10.9
      SG 68.6
      TH 6.8

      That last number for Singapore is no typo. As a percent of global FDI, Singapore garnered 49.5% of the world total in retained earnings.

    8. Hisham

      I am not entirely surprised by the stats you've put up.

      They basically show that Singapore has "punched way above it's weight" over the other "big 3" Asean economies.

      As for "retained earnings", I would suggest that it's got everything to do with Singapore's tax structure, network of bilateral Double Tax Agreements and a host of bilateral and multilateral Free Trade Agreements (FTAs).

      And because several MNCs have chosen to locate their regional or global corporate treasury operations and cash management functions in the republic.

      I sometimes wonder if Malaysia has missed the boat here. After all, a country that's a world leader in Islamic finance should have spotted and latched on to these other opportunities, right?

    9. Jasper,

      All tax havens "punch above their weight". That's the whole point of that retained earnings number - it's a huge red flag. The number one global destination of inward FDI is the United States, and China is second i.e. the usual suspects. Yet profits from FDI are distributed completely differently.

      I haven't examined the outward flows yet, but I suspect they are similarly skewed, which would be a marker for "round-tripping" of FDI, which is akin to money laundering.

      It certainly does have everything to do with Singapore's tax structure and probably just as important, banking secrecy laws. Having regional or global HQs in a tax haven also allows the use of inter-company capital markets, which creates one more channel for tax evasion (interest margins on inter-company loans).

      To be fair, Malaysia and other East Asian countries have benefited from tax competition, not just Singapore. None of the countries in East Asia, with the exception of Japan, levies a capital gains tax. That's certainly a big factor for portfolio flows, and to a lesser extent to FDI.

      BTW, Malaysia has approximately the same number of DTAs as Singapore, and only slightly less FTAs, though I don't see the relevance of the latter in this context.

      In case you're wondering, only greenfield FDI has clear benefits for economic growth and development through capital investment, employment and technology transfer.

      The effect of M&A FDI has occasionally been positive but can also be negative, because it involves simultaneous investment and divestment.

      Retained earnings don't appear to convey any benefit at all, especially since it involves no cross border flows of actual capital - it's just an accounting entry.

      So far, most of the papers I've scanned on this issue talk about the same thing - it's bloody hard to figure out the impact of taxation on FDI. Part of the problem is that there is no such thing as a single tax rate. A second issue is that every single one I've seen uses aggregated FDI data, not the dis-aggregated data that's now (sparsely) available.

  5. Yeah (hic)......the linked paper does not touch on tax/fdi, more on governance, pluralism, voice (whatever that means...hahahahaha). I was more "besotted" by the "professor's" glib talk about non - tax angles at 4.55pm.

    Must make it a point to attend his eminence's lecture series, if any......perchance he delivers one at NUS's Lee Kuan Yew's School of PUBIC Policy .hohohohohohohohoho....sledding we go...hohohoho

  6. "Slush money", "FDI round-tripping"...

    Blah, blah and blah.

    Why not round off the "trifecta" and add in "money laundering"?

    It would be so simple, except for a pesky little mote called "hard evidence".

    Which, let it be known, has yet to be produced, FATCAs, "white lists", "grey lists" and "black lists" notwithstanding.

    And that must be a laugh-a-minute, seeing as how Hong Kong and Singapore are both doing pretty ok.

    Just today I read that the Malaysian government is "institutionalising" the IFF (illicit financial flows) task force and setting up a Central Asset Management Corporation.

    I wonder if the government has just cottoned on to the fact that Malaysia does have "illicit financial flows".

    Now, let's hypothesise and ask where these "illicit" funds land up?

    And let's play along and ask how much of these funds are "washed" and round-tripped back into Malaysia as legitimate portfolio investments and FDI?

    Maybe the powers-that-be could provide us with some answers, seeing as how we need some light relief from the incessant politicking!

    And here's a quote from today's Singapore Business Times: "The attorney general (Abdul Gani Patail) said that the approach taken by the task force is not to put the evaders in jail, but to facilitate them to pay up the taxes owed to the government over the years, adding "We are not going to kill the goose that lays the golden eggs as we understand that it may affect future tax revenue collections and jobs. We are playing the role of a financial expert, advising them how to settle their default payments.""

    Wow - "goose", "golden eggs", "financial expert" - so many concepts for this simple mind to grasp!

  7. This comment has been removed by a blog administrator.

  8. Counterpoint to that questionable Malaysian garbage you quoted:

    "At least another $5 billion is likely to be collected from continuing cases involving accounts at banks in Switzerland, India, Israel, Hong Kong, Singapore and elsewhere, according to estimates from lawyers who are tracking the various probes.The number of confessions is expected to rise sharply from the current total of 38,000.

    "The government has no intention of letting up in its relentless pursuit of wealthy Americans with secret accounts offshore, and soon it will have even more tools to work with" as a new law goes into effect, said Mark Matthews, .............."

    Hahahahahahahahahahahahahahahahahaha (breathe) they say once a loser forever an effing, F%^&*(#g loser....hahahahahahahahaha....keep tuning up the delusion and enjoy......(ROFLMAO)

    1. Drum roll acknowledge Singapore's continued listing as money laundering haven numero uno by no less than the US State Department itself:

      an accolade every bit as worthy as fraudulent unsolicited Triple A ratings and Transparency International (TI) awards (which strangely overlooks even the US State Department red flags....hahahahahahahahahahahaah)

      Maybe for the second year running, the left hand of the US enforcements agencies does not know what the right hand of US diplomacy is doing, as a well known propessor kangkung bin kailan aka Jaja Buntut aka JB likes to claim like all good pretentious codswalloping cognoscenti wankers love to do:

      "Money laundering continues to pose a serious global threat, with 64 countries fitting the criteria for “major money laundering countries,” the State Department said in the second part of its annual International Narcotics Control Strategy Report (INCSR), released this week.

      Those countries ranged from such financial powerhouses as the United States, the United Kingdom, Switzerland, and Singapore to offshore hubs like the British Virgin Islands, the Bahamas, and Cyprus. Finally, the list also included countries without relatively low financial activity but high laundering risk due to robust drug networks and shoddy law enforcement."

      And where there is money laundering, there is murder too:

      For nothing is sacrosanct for immoral Mongoloids......

  9. Watch the language, or I'm going to start using the delete button with extreme prejudice.

  10. Dei come-on lah blog owner, don't let your sense of impartiality be clouded by race pride or some other effing reason. There was nothing remotely obscene in that comment with even any "offending portions" blanked out.

    Sheesh ...sometimes I wonder if economists have a warped perspective of the world. OIC, they are goldfishes trapped in that proverbial bowl further crippled by the distortion the laws of refraction inevitably produce.

    Quit highhorsing around and moderate with perspicuity......if not might as well shut down the comments section....Perhaps taking a leave outta Rocky Bru might do wonders.Now that's a blog owner who knows what blogging and free exchange of views is all about...

  11. One, I'm not Rocky, and this isn't Rocky's Bru. My blog, my rules.

    Two, I wanted to block out the offending part of the comment, but Blogger doesn't play nice that way (no comment editing). So the whole comment had to go. For that, apologies.

  12. it, Joe, apologia accepted. Its no skin off mah nose, if that's the way thy wind blow, soft spots for Singapork notwithstanding (LOL). But things cannot be simply chiseled and easeled away at convenience, if only we could, right?:

    so have a few laughs for in the end, no matter how we suffocate it, truth has infinite number of lives to outlast a scaredy cat's nine....hahahahahahahahaha