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ASSOCIATED ENTERPRISES
ARTICLE 9
(1) Where -
(a) An enterprise of a Contracting State participates directly or indirectly in the
management, control or capital of an enterprise of the other Contracting State, or
(b) The same persons participate directly or indirectly in the management, control or
capital of an enterprise of a Contracting State and an enterprise of the other Contracting
State,
and in either case conditions are made or imposed between the two
enterprises in their commercial or financial relations which differ from those which would
be made between independent enterprises, then any profits which would, but for those
conditions, have not so accrued, may be included in the profits of that enterprise and
taxed accordingly.
(2) Where a Contracting State includes in the profits of an enterprise of that State - and
taxes accordingly - profits on which an enterprise of the other Contracting State has been
charged to tax in that other State and the profits so included are profits which would
have accrued to the enterprise of the first-mentioned State if the conditions made between
the two enterprises had been those which would have been made between independent
enterprises, then that other State shall make an appropriate adjustment to the amount of
the tax charged therein those profits. In determining such adjustment due regard shall be
had on the other provisions of. the Convention and the competent authorities of the
Contracting States shall, if necessary, consult each other.
52. Scope
Article 9 of the OECD Model provides how the transactions between the associates and
affiliates of an enterprise is to be interpreted, to look upon them as if these were
between two independent enterprises and to work out profit thereafter, which represents
the amount which should have accrued to one of the enterprises, but by reason of
imposition of conditions amongst themselves could not have so accrued. It enables the
authorities of the Contracting States to 'rewrite the accounts of the enterprises if as a
result of the special relations between the enterprise, the accounts do not show the true
taxable profits arising in that State'. 'Rewriting'
is authorised if because of the subsistence of special relationship between the two
enterprises transactions between them have taken place not on normal open market
commercial terms; but otherwise.
Similar treatment has been provided with respect to dividends, interest and royalties
under Articles 10, 11, 12 respectively of the UN Model. Such provision attempts at
prevention of shifting of price or profits by multinationals from the country of high tax
to a country of low tax.
No country would wish that it be defrauded of revenue which is legitimately due to it,
through manipulations, falsification, suppression or omission of the normal effect of
transactions. Defrauding involves two elements, namely, deceit and injury to the deceived.
The act to deceit is meant to induce one to believe that thing is true which in fact is
false. and which the person practising deceit knows it to be so or believes it to be not
true. Injury is the economic loss. A benefit or advantage to the deceiver will always
cause loss to the deceived.
Reduction of profits artificially through manipulation of prices, is the deceit practised
on the country by causing injury to its revenues. This could have been possible - as has
now been recognised by all countries and such recognition is found expression in tax
agreements between them if any or in their absence in their tax codes or in the judge-made
laws - by virtue of close relations between the parent and subsidiary companies or
related, controlled and associated enterprises. Many international transactions are not
questioned. Isolation of transactions between the associated enterprises that are not at
arm's length has always been posing problems to each country. There is awareness amongst
the countries for checking this malpractice.
Extending cooperation to each other in checking an anomalous and fraudulent practice of
transfer pricing, stems not from a common goal but from parallel objectives. Almost all
tax agreements world over contain a provision to the effect that where -
(a) an enterprise of a Contracting State participates directly or indirectly in the
management, control or capital of an enterprise of other Contracting State; or
(b) the same persons participate directly or indirectly in the management, control or
capital of an enterprise of a Contracting State and an enterprise of the other Contracting
State,
and in either case conditions are made or imposed between the two independent enterprises,
then any profits which would but for those conditions, have accrued to one of the
enterprises, but by reason of those conditions, have not so accrued may be included in the
profits of that enterprise and taxed accordingly.
The conditions precedent for the imposition of a charge are:
- Participation of an enterprise or persons in the management, control or capital of
another enterprise.
- Imposition or creation of conditions between them in their commercial or financial
relations for suppression of profits.
The extent to which the charge is created is the difference between the amount of profits
which would have been made had there been no such conditions and the one which have been
made because of these conditions.
There should be accrual of profits in the first instance and that such accrual must be
suppressed to some extent because of the conditions imposed or created on account of the
closeness of the enterprises. If profits cannot be accrued at all or are not deemed to
accrue such closeness will have no relevance. The expression 'profit' is associated with
the words ‘which would but for these conditions, have accrued to one of the
enterprises, but by reasons of these conditions, have not so accrued'.
53. Associated enterprises
Associated enterprises for purposes of this Article may mean an enterprise of a
Contracting State or the same persons when participate directly or indirectly in the
management, control or capital of an enterprise of the other State, so that conditions are
made or imposed between the two enterprises in their commercial or financial relations
different from those which would be made between independent enterprises.
53.1. Management - Management means administration, control
etc. It may mean an executive authority, a term
often employed as correlative of decisions making.
53.2. Control - To control means to exercise power over the
functioning and the policy of the enterprise. The power to regulate or to exercise
directing influence over the activities of an enterprise means exercising the controlling
power. The process by which the activities of an organisation are conformed to a desired
plan of action would tantamount to exercising control. The expression 'control' means the
possession, direct or indirect, of the power to direct or cause the direction of the
management and policies of a person whether through the ownership of voting securities by
contract or othenvise. The relation whereby one or more corporations or other persons
possess the power to choose at best a majority of the members of the Board of Directors of
another corporation. The power is usually a direct one, evidenced by the ownership of a
majority of the other's outstanding shares of voting capital stock, but an equally
effective control may be of an indirect type: the possession of less than half of the
voting stock (e.g, 20 per cent) may be sufficient to ensure the domination of the meetings
of stockholders provided there exists, to the necessary degree, any one or more of the
following conditions:
- Continued ability to obtain proxies from other stockholders.
- Ownership of voting stock by subsidiaries, officers, employees' nominees or other
persons having subordinated interests.
- In activity of passive stockholders who do not attend stockholders meetings and do not
give proxies.
- Possession of a lease or other contracts which carries with it the virtual ownership or
exclusive use of assets without any formal ownership of capital stock.
Occasionally instances are found where, although a majority ownership of capital stock
exists, there is no domination of the other company's policies and hence no effective
control, as where ownership is temporary where a strong, self-sufficient management is in
the saddle or where the other company is an obliger under a lease or contract of the type
mentioned in the preceding sentence.
53.3. 'Control and management' - Control and management
means the controlling and the directive powers, 'the head and the brain' as it is
sometimes called. It means de facto control
and management and not merely the right or power to control and manage. Thus, if an enterprise could participate in the management, control
and the capital of another enterprise so as be able to influence direct its policy or
management or functioning, or its transactions in such a manner as to secure the maximum
tax benefits, the question of re-writing of their accounts will arise.
The illustration of such a relationship is found in dealings between a subsidiary and its
principal. A subsidiary is a business enterprise which is controlled by another
corporation. Its shares are owned by the controlling company (holding or parent company).
A subsidiary differs from a branch of the parent company in that it has its own corporate
entity and its own corporate character. The parent company forms a subsidiary either by
purchasing the controlling share of an existing corporation or by setting up a new
corporation and retaining the controlling share of its stock. When all the outstanding
stock of the subsidiary is owned by the parent company, it is called a wholly owned
subsidiary. A foreign company or enterprise may be
engaged in trade or business in the host country through a 'permanent establishment' which
is more generally referred to as a 'branch office'.
The subsidiary or branch office or any other form of entity on which the foreign
enterprise could exercise control and management in respect of its functioning, acts as an
agency for preventing payment of taxes which could be due according to the intention of
the tax authorities and tax legislators. The network of tax agreements shows discrepancies
and loopholes which may induce many an international business enterprise to make use of
the significant tax differentials between countries.
54. General rule of computation of income of associated enterprises and
their deviations
The general rule for the computation of income of a branch office or a subsidiary is in
principle the same as is for the computation of income of a domestic corporation
and no distinction is made between them in regard to deductibility of expenses and
allowability of allowances such as depreciation or investment allowances, carry forward
losses, deductible business expenses. Tax agreements affect the tax treatment of
subsidiaries and branch offices. Some rules are deviated which concern (a) dealing at
arm's length, (b) deductibility of expenses which are attributed to the branch office; and
non-deductibility of certain payments such as royalties and interests, and (c) taxability
of income which is attributed to the branch office. Article 9 deals with (a) above viz,
dealing at arm's length.
54.1. Arm's length and shifting of profits - On a commercial
basis, dealing with or as though dealing with independent, unrelated persons, competitive,
straightforward; involving no favouritism or irregularity; is an arm's length purchase. A
buyer and a seller both free to act, each seeking his own best economic interest and
agreeing on a price, are said to have an arm's length relationship. Transactions between
affiliated companies are not ordinarily recorded (or regarded by outsiders) as being at
arm's length even though expressed in terms of market value. The aim of the doctrine of arm's length is to curb the tendency of
shifting profits from one jurisdiction to another.
In order to maximise profits, the multinational enterprises have been resorting to
techniques of shifting profit from arising or accruing to a place where it suffers less
tax than it would have suffered if its arising or accrual would not have been interrupted.
Various devices are adopted for this purpose; some of them have now acquired in the
international tax world a distinct nomenclature:
- Income splitting
- Transfer pricing
- Treaty shopping
- Royalty and technical fee
- Capitalisation and loan financing
54.1-1 Income splitting The multinational companies (MNCs)
operate in a number of countries. So that the combined tax effect on their income should
be minimal, they resort to devices known as tax fragmentation or income splitting. Tax
fragmentation involves spreading of income as if arising in number of countries, so that
each constituent is subjected to differing tax considerably less than what would have been
the treatment, the sum total of which is tax consequence had the transaction been taken as
composite one whole in one country. Similarly, income-splitting consists of dividing one
composite contract into a number of separate contracts which may be spread over a number
of countries in such a manner that the bulk of the profits arise in a low-tax rate
country. This is usually practised in a contracting business. The profit is assessable in
the country where such contract is undertaken whilst the sale of equipment supplied as a
part of the contract arises in another country. A contract for work may involve sale of
goods if there is an independent term in the said contract for the sale of any specific
goods. This is possible where not only work is to be done but the execution of work
requires material to be used. Thus, the execution of work is performed in one country and
the sale of goods required for such execution, in the other. The contract agreed upon is
thus divisible. The composite contract by arrangement is split up into many constituents
mainly two, one for the sale of goods and the other for work and labour. The term
income-splitting is adopted to distinguish the practice from transfer pricing.
- Splitting of a contract - Where not only work is to be done but the execution of
such work requires material to be used, may take one of the three forms:
- The contract may be for the work to be done for remuneration and for supply of materials
used in the execution of the work for a price.
- It may be a contract for work in which the use of materials is accessory or incidental
to the execution of work.
- It may be a contract for supply of goods where some work is required to be done as
incidental to sale.
Where the contract is of the first type, it is a composite contract consisting essentially
of two contracts, one for the sale of goods and 'the other for work and labour. The second
type of contract is clearly a contract of work and labour not involving the sale of goods.
The third type is a contract for sale where goods are sold as chattels and some work is
undoubtedly done, but it is done only an incidental to sale. No difficulty arises where
the contract is of the first type because it is divisible and contract for sale can be
separated from the contract for work and labour and the amount payable under the composite
contract can be apportioned between the two. The real difficulty arises where the contract
is of the second and the third type, because in such a case it is always a difficult and
intriguing problem to decide in which category the contract falls. The dividing line
between the two types of contract, is somewhat hazy and 'thin partitions do their bounds
divide'. But even so the distinction is there and it is yew much real and an ingenious
exercise has to be performed for distinguishing one from another.
A contract for works can be said to involve sale of goods if there is an independent term
in the said contract for the sale of any specific goods by one party to the other for
money consideration and not merely an incidental transfer of title to some goods as
ancillary to the performance of work or service.
A question often arises whether a contract is a work contract or a contract for sale, if
in under-taking the contract the contractor uses some material. The primary test is
whether the contract is one the main object of which is transfer of property in a chattel
as a chattel to the buyer, though some work may be required to be done under the contract
as ancillary or incidental to sale, or it is carrying out of work by bestowal of labour
and service and materials are used in execution of such work. The primary difference
between a contract for work or service and a contract for sale of goods is that in the
former no property in the thing produced as a whole vests in the person performing work or
rendering service. In the case of a contract to sale, the thing produced as a whole has
individual existence as the sole property of the parity who produced it sometime before
delivery and the property therein passes only under the contract relating thereto to the
other party for price.
It is, therefore, necessary in every case to find out whether in essence there is any
agreement to work for a stipulated consideration. If that were so, it would not be a sale
because even if some sale may be extracted that would not affect the true position. The
nature and type of the transactions are important and determinative factors. What is
necessary to find out is the dominant object. Mere passing of property in an Article or
commodity during the course of performance of the transaction in question does not render
the transaction to be transaction of sale. Even in a contract purely of work or service,
it is possible that Articles may have to be used by the person executing the work and
property in such Articles or materials may pass to the other party. That would not
necessarily convert the contract into one of sale of those materials. In every case, it
has to be found out what is the primary object of the transaction and the intention of the
party while entering into it. In order to constitute a sale, it is necessary that there
should be an agreement between the parties for the purpose of transferring title 'to goods
which, of course, presupposes the capacity to contract and, that it must be supported by
money consideration, and that as a result of the transaction, the property must actually
pass in the goods. Unless all these elements are present, there would be no sale. Thus, in a contract for repairing a coat the
parties cannot be regarded as having entered into a contract for the sale of thread which
was stitched into the coat and which thereby became part .of coat in the process of
carrying out repairs.
- Splitting of engineering contracts - By splitting the several operations carried
on by an establishment in connection with his main business, the person cannot be said to
have established separate units or establishment. If any establishment carrying on the
business of engineers and engineering contractors which is exclusively engaged in building
and construction industry, such activity forms part of the building and construction
activity.
In order to discharge effectively its functions as engineers and engineering contractors
engaged in building and construction industry, an establishment has to maintain a workshop
or workshops where the works of smithy, welding, cutting, carpentry, etc., are carried on.
Without these operations it is not possible for any person to carry on satisfactorily the
work of building and construction industry. The reason for taking this view is obvious. An
establishment exclusively engaged in running a hospital does not cease to be an
establishment exclusively carrying on the said business merely because it sets up a
pharmacy section for preparing and compounding medicines to be used exclusively by the
patients at its hospital. Similarly, an establishment which is exclusively engaged in
providing shipping transport facilities does not cease to be an establishment exclusively
carrying on the said business merely because it sets up an on-shore workshop for effecting
repairs exclusively to its own ships. Such illustrations may be multiplied. The point
which is made out by these illustrations is that where an establishment is engaged
exclusively in carrying on a particular type of business by setting up any place of work
with a view to carrying on the work of repairs, etc., to the tools, equipment, vehicles,
etc., used in its business or to carry on any other activity which is essential for its
business effectively and which is not used to carry on the work for the benefit of any
third party but utilised exclusively for the business of the establishment, such
establishment does not cease to carry on exclusively the business in which it is engaged.
It cannot also be said that the establishment has commenced to carry on another industry
by setting up of such a place of work.
- Splitting of transactions without economic contents not permissible - The
transactions may be split into a series of such "transactions" so that each may
be looked upon as an independent source of income; though in substance the entire series
is nothing but in substance constitutes one composite transaction. By fragmenting the
transaction income is also fragmented so as to appear arising in different jurisdictions.
Till recently such arrangement could have been permissible, as a person is master of his
own affairs who could arrange them in a manner most suitable and beneficial to him.
The doctrine that every man is entitled if he can to order his affairs so as that the tax
attracted under the appropriate statute is less than it otherwise would be, as propounded
by Lord Tomlin in IRC v. Duke of Westminster and
as followed in India in CIT v. A. Raman & Co.,
CIT v. B. M. Kharwar and some other cases, has
long back been given a befitting burial in the W. T. Ramsay Ltd. v.
IRC IRC v. Burmah Oil Co. Ltd. and McDowell & Co. Ltd. v. CTO.
In India Justice Desai of Gujarat High Court recorded a sign of departure from the
principle in Wood Polymer Ltd., In re. and
Bengal Hotels (P.) Ltd, in re., by refusing to
accord sanction to the amalgamation of companies as that would lead to avoidance of tax.
The departure was completed by the Indian Supreme Court in the case of McDowell & Co.
Ltd. (supra). Lord Brightman in Furhiss v. Dawson
stated that the formulation of Lord Diplock in Burmah Oil Co, Ltd. (supra) expresses the
limitations of the Ramsay principle. ' First, there must be preordained series of
transactions; or, if one likes one single composite transaction. This composite
transaction may or may not include the achievement of a legitimate commercial (i.e.,
business end. Secondly, there must be steps inserted which have no commercial (business)
purpose apart from the avoidance of a liability to tax 'no business effect'. If those two
ingredients exist, 'the inserted steps are to be disregarded for fiscal purposes. The
court must then look at the end result. Precisely have the end result will be taxed will
depend on the terms of the taxing statute sought to be applied.
- A series of transactions if preordained is a single composite transaction - For
rejecting a device aimed at saving the tax the formulation of the law veers round two
concepts. First, there should be preordained series of transactions, i.e., one single
composite transaction, and the other, there must be steps inserted which have no
commercial purpose apart from the avoidance of tax liability. A question arises what does
the expression 'preordained series of transactions' means: whether it means the
transaction intended to have effect as part of a nexus or series of transactions or as an
ingredient of a wider transaction intended as a whole.
The revenue authorities might heavily rely upon the decision of the Indian Supreme Court
in McDowell & Co. Ltd's case (supra) and of the House of Lords in Furhiss
case (supra) in rejecting an assessee's all attempts at saving the tax if he is
entitled to do so legitimately, on the basis that the transactions were preordained or
were inserted with a view to avoiding tax, without making a serious attempt to understand
the implication of the expression 'preordained series of transactions'. While interpreting
this expression they may tempt to take it as if they are words of an Act. Interestingly
this expression has been subject-matter of discussion in the three English cases, viz, Baylis v. Gregory, IRC v. Bowater Property Developments Ltd. and Craven v.
White, 'Salde LJ summarised the reasoning in striking contrast to
the decision in Dawson as follows :-
"I conclude that two successive transactions, each of which has legal effects, are
not properly to be regarded as a preordainsd series or as a single composite transaction
within the meaning of the first Ramsay condition as stated by the House of Lords unless,
at the time when the first transaction was effected, all essential features (not merely
the general nature) of the second transaction had already been determined by a person or
persons who had the firm intention and for practical purposes the ability, to procure the
implementation of the second transaction."
Thus, the expression 'preordained series of transactions' contemplates that the person has
in contemplation the sequence of transactions when he takes the first step, to follow that
step with the intention of saving tax. If there is no planning without the next step being
arranged or the next step was expected but did not in fact materialise or the next step
was one and probable more likely, of the two possible outcomes, that subsequent steps
cannot be said to be preordained series of transactions. If there is an intention to carry
out the next step, that intention of the taxpayer alone should not be the test of whether
there was preordained series of transactions. What is required to be proved is that at the
time of the first transaction it was intended by the taxpayer that the first transaction
is used as conveyancing machinery in order to achieve the final object of saving the tax.
One cannot have a composite transaction unless the second part has been pre-arranged or
preordained at the time of the first. In Ramsay & Dawson the reasoning had been
that there is no difference between series of steps which are followed though as part of
an arrangement which falls short of a contract and a series which are carried out under
the contract. By the same reasoning a quasi-contract in the absence of one of the parties
being identified cannot be said to be an arrangement through a contract. If there is an
uncertainty and difficulty in practice about the next step, it is very difficult to tax
the income at the first stage on the basis that second stage is bound to happen. The Court
of Appeal in the aforesaid decisions, therefore, pointed out that preordained series of
transactions or a single composite transaction cannot be taken to be the one where the
next step has not been arranged or has not in fact materialised or the next step is one
and probably the more likely of the two possible outcomes.
The Indian Supreme Court in LIC v. Escorts Ltd.
observed that merely the form cannot control the Acts, the Rules or the directions. Only
under the following circumstances tax avoidance can be inferred:
- There is no economic or other significant reason which could justify the transaction.
- The existence of the intent to avoid tax can be clearly established.
- Acts leading to its occurrence are unusual or artificial and give rise to the situation
where the letter of the tax regulation does not apply but differs so little from a
situation provided for under the regulations that the purpose and the spirit of the
regulations would be frustrated if it were to be declared inapplicable.
The proposition cannot be accepted in its entirety that a transaction may be disregarded
for tax purposes solely on the basis that it was entered into without any bona fide
business purposes. A strict business purpose test in certain circumstances would run
counter to the apparent legislative intent which in the modern taxing statutes may have a
dual aspect. Income tax legislation is no longer a device to raise revenue to meet the
.cost of governing community. It is also employed to attain economic policy objectives.
The statute is mix of fiscal and economic policy. The economic policy element of the
fiscal statute sometimes takes the form of an inducement to a taxpayer to undertake by or
redirect a specific activity. Without the inducement offered by the statute, the activity
may not be undertaken by the taxpayer for whom the induced action would otherwise have no
bona fide business purpose. Thus, by imposing a positive requirement that there be such a
bona fide business purpose, the taxpayer might be barred from undertaking the very
activity Legislature wishes, to encourage. At minimum, a business purpose requirement
might inhibit the taxpayer from undertaking a specified activity which the Parliament has
invited in order to attain economic and perhaps social policy goals. Indeed, where the
Parliament is successful and taxpayer is induced to act in a certain manner by virtue of
incentives prescribed by the legislation, it is at least arguable that the taxpayer was
attracted to this incentive for the business purpose of reducing his cash outlay for taxes
to conserve his resources for other business activities. The tax authorities may presume
that tax avoidance was intended if the taxpayer chooses to carry out transaction which may
be regarded as unusual.
Avoidance occurs when the taxpayer takes advantage of a provision of law, the formulation
of which is obscure or incomplete or very complex, so that he can reduce or avoid his
liability while remaining within the limits of the law. If, however, the taxpayer is
acting against the will of the Legislature even if he remains within the literal
interpretation of law he can be said avoiding the tax. The revenue authorities cannot
brush aside any and every attempt of an assessee at saving the tax if that attempt is
sanctioned by the law or hold the assessee guilty of avoidance when the saving is the
result of series of steps which at the time of taking the first step could not be in
contemplation of or devised by the assessee.
54.1-2 Transfer pricing - Transfer pricing is perceived as
device to avoid tax in a jurisdiction where it is due. Intention for such avoidance is
inferred where the transaction is highly structured, is artificial or is otherwise
considered to be an unnatural 'way of achieving an economic or business result. The
affairs and transactions between the related affiliates are arranged or rearranged and are
carried out with the intent or object of tax avoidance. Such arrangements or
rearrangements are devoid of bona fides. The right to transact business in a manner as to
be the most beneficial is abused as to cause harm to the exchequer of the country from
where profit is intended to be shifted. The countries are now alive to the harm caused to
them by the related parties when they exercise their rights in relation to transactions
inter se in a way which is beyond the normal exercise by a prudent man, and are,
therefore, enacting laws reflective of that every person is bound to exercise his rights
and fulfil his obligation according to the principles of good faith. The law does not
sanction the evident abuse of a man's right. It is now accepted world over that contracts
should be interpreted and performed according to the requirement of good faith. A
currently accepted principle is that the exercise of right is misused or abused in such a
manner as to lead to the existence of disproportion between the interests of the injuring
party and those of the injured party (viz, the State's exchequer) that the former could
not have reasonably decided to exercise his right in this way. The concept of the abuse of
rights imposes a reasonable limitations, whether codified or developed through judicial
pronouncements on a person's liberty in order to prevent him from injuring others by
exercising his rights in bad faith.
The MNCs adopt the device of transfer pricing so that the arising or accruing of the
ultimate profit takes place in low rate or no tax country. This is done by transferring
goods between companies within the same group at dictated price so that the profit is
diverted to the desired place. The MNCs may decide to sell goods or services at a low
profit to another or its subsidiary company located in a tax haven country. That another
or subsidiary would sell them at an arm's length price, and the inflated profit is
subjected to little tax.
- MNCs and transfer pricing - MNC group of taxpayers which are owned or controlled by the
same interest. These are also termed as 'transnational corporations', which expression
means enterprises with either substantive or formal economic activities in more than one
jurisdiction. MNCs have been handling a great portion of the world's trade. Since the
business is conducted within the group, there is a tendency and scope for shifting the
income from one company to another in the same group, though located in different
jurisdictions so that income or profit accrues or arises at a place which suffers least
tax. Transfer of goods or commodities or merchandise or raw materials or stock or services
made at a price which is not dictated by the market but controlled by the consideration of
reducing taxable profits or duties. The market pricing or arm's length pricing is,
therefore, of no relevance. Reduction or profits artificially or causing losses, or
avoiding taxes or customs and excise duties in a specific country through manipulation of
prices is one of the aims and objects of MNCs. Of late, the expression 'transfer price'
has acquired a pejorative meaning which conjures visions of furtiveness, manipulations and
secrecy. Transnational enterprises are not the only entities that engage the transfer
pricing abuses. There are many instances in which local individuals or companies use
transfer pricing to shift artificially profits abroad so as to avoid or evade taxes,
circumvent exchange controls Or reduce the economic exposure arising from political or
economic uncertainties.
Employment of 'transfer pricing' techniques with a view to avoidance of taxes is resorted
to by the Pakistani based subsidiaries and branches of MNCs when they are dealing with
their parents and head offices or with their other foreign subsidiaries or affiliates
which are based in tax haven countries. A tax haven
is a country that has no taxes, or has taxes at low rates, or where these are imposed on
local income and not on foreign-income, or where (though rate of taxes are normal) special
concessions are offered to certain types of income or class of taxpayers.
- Motives for 'transfer pricing' - The strategy of 'transfer pricing' is assumed
with the following main objects:
- To reduce profits artificially so that tax effect is reduced in a specific country.
- To facilitate decentralisation of production so that efforts are directed to concentrate
profits at the state of production where there is no or least competition.
- To remit profits more than the ceilings imposed for repatriation.
- To use it as an effective tool to exploit the fluctuation in foreign exchange to
advantage.
Thus, the main object for resorting to the device of 'transfer pricing' is to appropriate
maximum profits leaving very little for the revenue of the Government, or for the local
participant. How best and dexterously it could be done depends on the tax structure of a
jurisdiction, its exchange control regulations, its political and economic conditions, or
independence on the foreign technology, know-how, skill, expertise. The incentives to
engage in transfer pricing abuses are greater in less developed countries than those in
industrialised countries with risk of detection being less. Pakistan is very popular
country amongst the tax-payers who want to avoid tax. It has all the characteristics
mentioned above.
Tax Saving - Evasion/avoidance of tax is the most important consideration of all
others which motivate transnational corporations to adopt the technique of transfer
pricing. Profit is intended to be shifted to a country where tax burden is less, from a
country where it is heavier resulting in increase the after tax-profits. This is because
of the tax differential being significant, either on account of its structure or of
incentives or rebates. Intra-firm transactions are manipulated by inflation or suppression
of the price of goods, services by overinvoicing or underinvoicing of imports. Intra-firms
transfer of amounts, therefore, are structured. in a manner so that they are deductible by
the payer in a high tax country and are taxed at a very low rate or not taxed at all .in
the country of the payee, Sometimes these amounts are given nomenclature which attract no
tax, because taxes are not levied on such remittances.
Exchange Control and Foreign Investment - The underdeveloped countries lay heavy
restrictions in regard to remittances of profits. But in their eagerness to secure access
to foreign technologies, expertise, technical know-how, capital goods and components for
their industrial development, they are liberal in regard to payment for these technologies
etc. and make favourable and liberal exchange control regulations. Liberal regulations are
made use of, and restrictions in regard to remittances of profits are circumvented, when a
foreign company charges more than the market value as a consideration for imparting
technology, services and other tangibles. For that matter the technique of transfer
pricing is resorted to.
Many developing countries are very sensitive about foreign investment and, therefore,
permit such investment on a restricted scale. The transnational corporations have changed
their investment strategy in those countries. Instead of insisting participation on
hundred per cent equity basis, they drain off the profits through excessive royalties,
technical and management fees, overinvoicing of imported components and underinvoicing of
exports. Such expenditure will result in reducing the profits to the extent of it being
excessive. The profits are thus withdrawn before they are shared by the local
participants, the revenue and finally the transnational corporation, through the transfer
pricing techniques.
