The impact of countries' transfer pricing rules on profit shifting

Abstract

PurposeThis study investigates the impact of different transfer pricing rules on tax-induced profit shifting. Existing studies create different enforcement rankings of countries based on specific transfer pricing provisions on the assumption that larger penalties and more extensive information requirements imply higher tax enforcement. This assumption carries limitations related to the impact of transfer pricing rules in different countries and to the interaction of different tax rules. Instead, the authors propose a nonordered segregation of groups of countries with different transfer pricing rules, and they empirically investigate the impact of these transfer pricing rules on the profit-shifting behavior of firms.Design/methodology/approachThe authors apply the hierarchical clustering method to analyze 57 observable quantitative and qualitative characteristics of transfer pricing rules of each country. This approach allows the creation of groups of countries based on a comprehensive set of regulatory characteristics, to investigate evidence of profit shifting for each of these separate groups. Profit-shifting behavior is measured by the variation in the volume of import and export transactions between local firms and related parties located in other countries.FindingsThe results indicate that firms have a higher volume of intrafirm transactions with related parties located in countries with a lower tax rate. This result is consistent with the profit-shifting hypothesis. Moreover, the results show that relevant differences in transfer pricing rules across countries produce different effects on the volume of intrafirm transactions. The authors observe that the existence of domestic transfer pricing rules that override the OECD Transfer Pricing Guidelines may inhibit profit shifting. In addition, the results suggest that the OECD guidelines may facilitate profit shifting. Overall, it is observed that some transfer pricing rules may be more effective than others in curbing profit shifting and that firms are still able to manipulate transfer prices under some tax rules.Research limitations/implications(1) The authors focus on the Brazilian context, which provides a suitable set of profit-shifting incentives for the analysis, since it combines an extreme corporate tax rate, a highly complex tax system, and a unique set of transfer pricing rules. (2) Profit-shifting behavior is captured by the volume of intrafirm transactions. The authors would prefer to observe the transfer price directly; however, this information is not disclosed by firms, for it may represent a limitation to the investigation. Nonetheless, theory shows that the profit-shifting behavior is reflected by the manipulation of both transfer prices and intra-firm outputs.Practical implicationsThe authors find that the volume of intrafirm transactions may decrease or increase, depending on the transfer pricing system of the foreign country (including the tax-differential effect). It suggests that some transfer pricing rules are more effective than others in curtailing the profit-shifting behavior and that firms are still able to find vulnerabilities in current rules and take advantage of them in deploying a profit-shifting strategy.Social implicationsResults provide knowledge about how key differences on transfer pricing rules across countries influence the profit-shifting behavior. The results of the study may have valuable application in solving regulatory mismatches, to eliminate blind spots in transfer pricing rules and thus to contribute to the current review of OECD guidelines and to the global tax reset movement.Originality/valueRecent studies suggest that if tax-avoidance incentives are somewhat weak, it becomes difficult to observe the shifting behavior of firms. The puzzle is to check whether profit shifting is nonexistent under weak incentives or whether this is a matter of methodological limitations. The authors’ analysis is applied to a complex tax background with strong profit-shifting incentives; thus, it allows the authors to obtain robust evidences of the shifting behavior and the effect of different transfer pricing rules.

What We Know So Far about Transfer Pricing: a Bibliometric Analysis

“…Following on from the preceding, in international economic relations many companies often avoid the tax "burdens" of high-tax countries (Matei and Pirvu, 2011;Clausing, 2000) by transferring tax profits to low-tax countries (Rathke et al, 2021;de Mooij and Liu, 2018). The issue of transfer pricing comes even more to the fore when it comes to the economic integration of regions where not only companies but also "countries merge".…”

“…Furthermore, the analysis of Kumar et al (2021) concludes that transfer pricing research needs to be improved in order to use transfer pricing as a strategic tool in companies and not only as a kind of "tax administration strategy" by choosing different methods to calculate transfer prices. According to Matei and Pirvu (2011), but also Göx and Schiller (2006), the facts that should be considered when choosing the best method for determining transfer prices are the following: (a) the prices that depend on the free market of comparable companies/countries (Rathke et al, 2021;de Mooij and Liu, 2018), (b) the actual activity of the related companies involved in the transaction (Weichenrieder, 2009;Desai et al, 2005;Edwards and Weichenrieder, 2004;Clausing, 2000), (c) the accuracy with which we can make adjustments to achieve comparability, d) the totality of the circumstances of the actors involved, e) the actual activities of the various related parties (Matei and Pirvu, 2011), f) the circumstances of the taxpayer's business and market (Rathke et al 2021;de Mooij and Liu 2018;Riedel and Zinn, 2014;Cools, 2005), and (g) the documentation of the taxpayer.…”

Transfer pricing practices in multinational corporations and their effects on developing countries' tax revenue: a systematic literature review

“…In South Africa, a developing country, Wier (2020) provided evidence of profit shifting and calculated that the tax loss attributed to imported goods alone accounted for 0.5% of corporate tax payments. The effects of intangible assets, debt covenants, bonus programs, and tax penalties on the transfer pricing choices made by Indonesian manufacturing enterprises were examined by Pramono Sari et al in 2022. The appropriate level of transfer pricing manipulation and the impact of domestic taxes on foreign earnings on income-shifting incentives are examined by Rathke (2015). Amidu et al (2019) investigate the connections between transfer pricing, profits management and tax evasion in multinational firms with operations in Ghana.…”

Windfall Profit Taxation in Europe (and Beyond)

“…The tax literature has been developed ever since the 1990s, with techniques, rules, and regulations to identify and calculate the fair price (the arm's length price) relevant for tax purposes in every transaction (Rathke et al 2021;Rogers and Oats 2022). The OECD has implemented these techniques in a way to preserve the tax base (for income tax purposes) in each county from the possible aggressive tax planning strategies by multinational enterprises (Riedel and Zinn 2014).…”