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.