Top U.S. tax expert in savage attack on transfer pricing rules

Lee Sheppard of Tax Analysts is one of the world's top experts in international tax, as well as being a soccer expert, a formidable intellect, and quite a character.

She has just issued one of the most devastating critiques ever made of the prevailing system for taxing multinational corporations, in a nine-page document entitled Is Transfer Pricing Worth Salvaging? Tax Analysts have kindly given us permission to republish it.

What is the tax problem?, Sheppard asks, in her (fairly U.S.-focused) article.

"In a nutshell, developments in law and planning have enabled U.S. multinationals to deprive the United States of tax revenue, as though it were any other source country."

And the main way they do this is through transfer pricing. The next section is so good it is worth quoting at some length, even if it does require a (very) little advance knowledge of the issues. Our emphasis added:

"Defenders describe it as ‘‘the arm’s-length principle’’ — as though attaining perfection in pricing between fictitious entities would resolve the question of who should pay how much tax where.

Transfer pricing is the leading edge of what is wrong with international taxation. It raises all of the other issues.

The question that needs to be answered is what base Congress wants to tax, now that the international corporate income tax base is largely gone and the U.S. corporate income tax base is seriously at risk. Proposals for territorial taxation would essentially concede what little is left of the international base, while putting the U.S. base at risk.

The purpose of the OECD model treaty was to make life comfortable for American, British, German, and French multinationals by ensuring that the taxation of their operations by host countries is limited by separate company accounting and the permanent establishment concept. Treaties accomplish this task very well — so well, in fact, that many multinationals pay tax nowhere.

Our American readers tend to believe that the OECD model treaty and the transfer pricing guidelines are immutable and permanent fixtures of the tax landscape, rather than clumsy tools that affluent developed countries have used among themselves, to their collective detriment, and seek to impose on developing countries.

The former head of the OECD Centre for Tax Policy and Administration liked to refer to the transfer pricing guidelines as the Bible. There are similarities. Both require a great deal of faith. And the Bible is about as practical a document for tax administrators as the guidelines. Readers, the arm’s-length method did not come down on stone tablets. There is nothing sacrosanct about it."

And, immediately after that:

"The OECD Centre for Tax Policy and Adminis- tration has lost control of the debate. The transfer pricing guidelines are a sorry vestige of a system that will be gone in 10 years."

Astonishing. Then, the very next paragraph:

The OECD cannot justify the results that the current system permits. More rules and more document requirements will send our readers’ kids to private colleges, but continued tinkering will not change the outcomes. More rules will not shore up the corporate tax base in developing countries so their kids can go to school. The problems have reached the public, and opponents ranging from protest groups to governments, are saying no.

We like to think that our recent Helsinki seminar, at which Sheppard was present and provided biting commentary throughout, helped crystallise some of these ideas. (Sheppard also appeared in the powerful film We're Not Broke, which has been making quite a splash across the Atlantic.)

From this introduction, the article then ventures onto somewhat more technical ground, examining in detail what different countries (and groups such as TJN) are up to. Here's her summary of the position of developing countries, and particularly Brazil, Russia, India, and China (the BRICs):

"The polite Western fiction is that the BRICs will be brought along to the OECD view when they have their own multinationals stomping around the world. Ain’t happened, ain’t gonna happen. The BRICs sign the treaties and then do what they want."

The stream of devastating commentary continues:

"India is actively undermining [aspects of transfer pricing rules] . . . Brazil is not going to be brought around to the transfer pricing nonsense. . . . China signs the treaties, offers advance pricing agreements, and then lets local tax officials make their own decisions. . . China wants to reclaim some of the advantages of the 'China price' as taxes.
. . .
The CCCTB [European plans for replacing transfer pricing arrangements with the radical alternative, formula apportionment inside Europe, read more here] is for real."

She has kind words for the Occupy movement, which has started to take an interest in transfer pricing:

"These are your kids. These are bright, energetic, self-starting young people who you would like to have as employees. They are the same class of educated people who protested and stopped the Vietnam War. This is serious."

She explores TJN in the context of country-by-country reporting, to which she is mostly sympathetic: it would, among other things,

"prevent multinationals from telling different stories to different governments."

She cites a slew of media articles on Google, say, or into Apple's tax affairs, though she adds:

"The problem with this method is that while it provides a lay- man’s description of transfer pricing abuses, it contributes to the impression that the problem is just a few bad apples, when every multinational is stripping income out of market countries and into tax haven intangibles holding companies."

Quite so. And she notes from Guardian and ActionAid investigations that even in simple cases, the results are unfair, which

"puts the lie to the argument that tax rules have simply failed to keep pace with a high-tech globalized world."

On the transfer of intangibles to tax havens, a transfer pricing staple, she adds:

"What is the solution? The ultimate, most desirable solution is formulary apportionment to countries where intangibles are used — that is, the location of the ultimate consumer. But some new thinking focuses on incremental fixes to the current system, including clawback of excess profits or re-sourcing of the income from intangibles."

And the well-aimed vitriol continues:

"The frightening thing about the shifting of income from relatively simple manufacturing operations to tax haven principal companies is how cheap it is. Contracts are redrafted, lawyers baby-sit, and a few people are assigned to mind things in Switzerland. The OECD transfer pricing guidelines tell tax examiners to respect these self-serving contracts."

With further quote after further quote:

"The point of the treaty-based international consensus was to make it comfortable for multinationals to romp around the world while paying minimal tax."

and

"A pernicious fiction propagated by the OECD is that the arm’s-length method produces precise results, while all other methods of allocating income are sloppy. The arm’s-length method is illusory.. . . fiction piled on top of fiction"

Can, the big alternative of formula apportionment ever happen? Of course it can:

"Can the United States unilaterally adopt formulary apportionment and expect others to follow? This is the big bogeyman about formulary apportionment. Oh, other countries would never agree! The chief countries that would have to agree — those in Europe — have already agreed to reinstitute formulary apportionment among themselves. The other important countries — the BRICs — have already rejected the arm’s-length method."

She also points out that it is often wrongly assumed that OECD model treaties would need to be changed to accommodate formula apportionment: OECD rules have in fact been misread and do not command transfer pricing approaches. She tackles another bogeyman about formula apportionment: that the formulae used would easily be gamed. No, she explains that it is far harder to move personnel and equipment across borders than it is to shuffle a few numbers in an accountant's workbook.

And for transfer pricing wonks, the article contains much, much more. A final, hopeful note:

"There’s nothing new about the problems discussed in this article. They have been festering for years. What is new is that Europe has turned on the international consensus, and the former voices in the wilderness have entered the mainstream. Public disgust at multinationals being excused from their civic responsibilities is real."

This will be stored permanently on our transfer pricing page, and also on our permanent page on tax treaties.

(Also see Sheppard's earlier, shorter report on transfer pricing.)