Multinational enterprises (MNEs) wield immense power, not only in terms of business operations, but also in their ability to exploit international tax rules.
One of the most commonly used tax avoidance strategy is manipulation of transfer pricing. While transfer pricing itself is legal and necessary for intercompany trade, its abuse is costing countries billions annually in lost revenue.
This article explores how MNEs manipulate transfer prices, with a focus on the role of tax havens and conduits and the impact especially on developing countries.
Understanding transfer pricing
Transfer pricing rules are grounded in the arm’s length principle. However, since the transfer pricing rules are anything but an exact science, they create opportunities for MNEs to engage in transfer mispricing.
Transfer mispricing arises when MNE group members transact at manipulated prices, with the intention of shifting profits into low tax jurisdictions. This manipulation often hinges on overpricing and underpricing strategies and is amplified through the use of tax havens and conduit jurisdictions.
Generally, tax havens are jurisdictions that offer zero or low taxes, financial secrecy, and minimal regulatory oversight to attract foreign investment while conduit jurisdictions are intermediary countries that facilitate flows of capital or income between operating affiliates and the tax havens.
MNEs set up holding or finance companies in such jurisdictions, rather than where the actual economic activity takes place, to benefit from extensive double taxation treaty networks; tax exemption of certain types of foreign-sourced income; and zero or low withholding taxes.
The tax havens have emerged and flourished largely due to international tax competition, where countries compete to offer more favourable tax regimes in the hope of attracting mobile capital inflows.
How MNEs manipulate transfer prices
MNEs use transfer pricing as a vehicle to shift income to jurisdictions with lower tax rates to reduce their effective tax rates by exploiting loopholes in the tax systems as follows:
Mispricing intra-group sales of tangible goods
An MNE may overprice or underprice goods sold between affiliates to move profits. For instance, goods may be sold by an affiliate in a high tax jurisdiction at below market prices to an associated enterprise in a tax haven which then resells to third parties at market prices thereby suppressing profits in the high tax jurisdiction and recording higher profits in the low tax jurisdictions.
Interest payments
MNEs often arrange loans between group enterprises and set high interest rates. The interest payments made by affiliates in high tax jurisdictions are tax deductible, reducing taxable income, while interest income is earned in the low tax jurisdictions.
MNEs with head offices or regional hubs located in low tax countries often charge their subsidiaries “management” or “technical” or “consulting” fees in return for centralised services. The fees are often set at levels that drain profits from the jurisdictions with high tax rates where the subsidiaries are located.
Royalty and license fees
The valuation of unique intangibles is inherently difficult. MNEs often assign ownership of valuable intangibles to shell entities in tax havens and charge exorbitant royalties or license fees to operating subsidiaries in high tax jurisdictions to shift income to the tax havens.
Cost sharing arrangements
MNEs manipulate cost contribution arrangements to disproportionately burden affiliates in high tax jurisdictions by over-allocating shared costs to them and shift the income to low tax jurisdictions.
Why it matters
The manipulation of transfer pricing disproportionately hurts developing countries which lose an estimated $100 billion annually. This loss of revenue limits the ability of such countries to invest in education, health, and infrastructure.
Conclusion
Transfer pricing manipulation remains a leading tax avoidance channel used by MNEs. Tax havens, in turn, serve as vital conduits for such schemes, enabled by weak transparency, low tax rates, and regulatory arbitrage.
While legal in form, the schemes undermine tax fairness and weaken public finances, especially in vulnerable economies.
In the next article, we will continue to unpack BEPS strategies deployed by MNEs to reduce their tax liabilities.
*Vilipo Muchina Munthali is the managing consultant at Swift Resources, an international tax and transfer pricing consulting firm that specialises in developing, implementing, and defending transfer pricing policies for both local groups and multinational enterprises. Feedback: vilipo@swiftmalawi.com
