A great letter in this morning’s FT from a tax lawyer demonstrates not one but two points about the transfer pricing of royalty fees. The first is the way in which companies game the system:
The role of the tax expert was to identify the highest level of royalty that could be defended in attritional correspondence with the Inland Revenue. The lawyer’s role was to reach for the intellectual property precedents and draft licensing agreements, which bore the imprimatur of arms-length contracts although they were in reality no such thing.
Sometimes discussion of transfer pricing by campaigners obscures the difference between the blatent use of prices that are much lower or higher than should be permitted (this is true ‘transfer mispricing’, which is more akin to fraud) and the more common manipulation of prices to get the best tax position possible within the ‘arm’s length’ range.
The letter’s author, in common with many tax professionals, recognises the latter practice as quite a normal and undisputed type of tax planning. This rather contradicts the adjacent letter from Michael Devereux of Oxford University, which takes Starbucks as a “case in point” of how, “[c]laims that particular companies are exploiting loopholes are typically based on scant information, and sometimes appear to be based on a misunderstanding of the tax system.”
The second point is a more conceptual one:
In Starbucks’ case, it might be that the UK company pays the “top end” royalty and sustains the vast bulk of expenditure needed to sustain the brand. In that case, the UK tax-paying entity would be paying twice over, which could be the end that its tax advisers intend.
Interestingly, this is one of the areas in which China has decided to tweak the OECD’s transfer pricing guidelines, as the UN tax committee’s Chinese member explained in Geneva last week. He used the example of the shampoo brand Head & Shoulders, owned by the US multinational Proctor & Gamble, which also sells it in China. Under a typical transfer pricing arrangement, P&G would be able to have its Chinese subsidiary, which distributes Head & Shoulders in China, pay large royalty fees for the use of this successful international brand.
But here’s the catch: the brand has no value to most Chinese people, who don’t know what ‘Head & Shoulders’ means. The Chinese subsidiary will have to invest a lot to establish and, in the words of the FT’s correspondent, ‘sustain’ the brand before it has any practical value. China has decided to correct the way transfer pricing works to take this into account.
Martin Hearson 
Devereaux’s letter is also interesting for apparently endorsing the FT’s editorial suggestion that formulary apportionment might be the way forward. Do you think he’ll be blogging for TJN in the near future?!
I interpreted “a reform that allocates taxes on profit according to where sales are generated” as VAT, which tends to be Devereux’s position. In which case he’s saying “you could use formulary apportionment or, ironically, throw out profit tax and just use VAT.” The main issue for development would then be less the progressivity of VAT, and more the fact that most multinationals’ sales take place in the developed world.
I’m not so sure either. I agree it’s tightly worded, but value-added isn’t profits, which is what he says? So I think national progressivity may be less of an issue (pace the argument that all profit taxes are passed onto shareholders or consumers).
The bigger point which interested me is that it highlights how when we talk about formulary apportionment we often gloss quickly over what formulas would look like. The letter reminded me that in practice the formula would be just of much of an international power struggle as TP or source/residence taxation, and we’d be fighting off formulas that were internationally regressive. E.g. a formula based on sales which could potentially decimate tax bases of countries dominated by extractives industries, and would be ripe for commissionaire-type structures?
Mike, that’s precisely my concern about advocating a global approach to formulary apportionment. Hard to imagine developed countries agreeing to a settlement that tipped the balance in others’ favour compared to the status quo. Advocates should be careful what they wish for.
That said, the OECD guidelines are full of guff about how you couldn’t do formulary because you’d never reach a global agreement…but I think the same applies to transfer pricing. There has been no global agreement, OECD just became a de facto global standard.