Multinationals and misused transfer pricing techniques

Multinational enterprises (MNEs) are responsible for more than 60% of world trade and roughly half of this exchange of goods and services takes place within individual conglomerates (UNCTAD, 1999). International trade is thus largely an activity between different divisions of the same enterprise operating in different jurisdictions. MNEs may take advantage of the different tax regimes, including tax havens to maximise after-tax profits. One way in which multinational enterprises may try to benefit from their international presence is misuse of transfer pricing, e.g. by artificially shifting taxable profits from high tax jurisdictions to low tax jurisdictions. This happens when firms under- or over-invoice for goods, services, intangibles or financial transactions between entities situated in different tax jurisdictions.

African tax authorities may not be able to identify such profit shifting where this occurs and even if they did, they often lack the means and technical capacity to deal with the complexities of the practice. Despite the development of international and domestic guidance, even the world’s most sophisticated tax administrations sometimes have difficulties assessing whether the prices at which multinationals carry out cross-border transactions are manipulated, especially for complex financial transactions and those involving significant unique intangibles. African tax administrations already struggle to collect regular corporate tax beyond a few dozen of the largest companies. Auditing capacity is often very limited and relies mainly on information directly provided by the multinationals. Not to mention that the dispute resolution process in any disagreement with a trans-national enterprise can be very costly.

Improper transfer pricing is an international problem that affects developed and developing nations alike. The main beneficiaries are assumed to be tax havens and the multinationals. While there are no solid figures measuring the size of the problem, a number of studies have tried to approximate its magnitude. Kar and Cartwright-Smith (2008) estimate that total trade mispricing in 2006 was more than USD 500 billion. Hollingshead (2010) reckons that the amount of tax revenue lost by developing countries to misuse of transfer pricing averaged between USD 98 billion and USD 106 billion annually from 2002 to 2006. In Africa, a yearly average of USD 3.8 billion would have been lost between 2002 and 2006. Again, these figures must be treated with some caution since they are based on models for assessing the loss of tax revenues which are still being developed. 

Taxing natural resources

Vast extractable natural resources – oil, gas and minerals – are already an essential revenue source for many African nations. But the African Development Bank’s 2007 African Development Report highlighted the widely held belief that African countries get less money from resources than many other countries in the world. There is evidence that African countries are not maximizing the tax revenue they obtain for the resources (Keen and Mansour, id.). It is difficult to obtain a clear picture, however. Contracts are often subject to strong confidentiality clauses by the companies, governments, investors and banks involved. There is little transparency and disclosure. Corruption is often blamed for this secrecy. Corruption and secrecy feed off each other. But there is more than corruption involved. Governments argue that they cannot make all details of the extractive industries public and that they have limited influence on companies. Countries compete for the scarce managerial and technical skills needed for resource extraction (Di John, ibid.). Yet, shortages of legal and negotiation skills play a major role in driving down tax revenues from natural resources.

Tax preferences creep-up

Tax preferences – also known as tax incentives – grant preferential tax treatment to specific taxpayer groups, investment expenditures or returns, through targeted tax deductions, credits, exclusions or exemptions. Governments may cite various arguments for the use of tax incentives, such as addressing different types of market failures, attracting foreign firms (e.g. Comoros, Cameroon) or stimulating exports (e.g. Namibia). Tax preferences are also used to increase or decrease the progressivity of the taxation system or to benefit some groups over others for political reasons. In Sudan, for instance, a high proportion of civil servants are exempt from paying taxes, undermining the country’s tax base.

Tax preferences are difficult to target and may not yield intended outcomes. Significant tax revenue losses and other unforeseen effects may result instead. Inefficiencies and inequities can also arise where tax relief is targeted to specific groups over others for political reasons. Indeed, tax preferences can undermine the tax base, revenues, and fiscal legitimacy when granted arbitrarily. For example, tax preferences granted to powerful and rich potential tax payers place more of the tax burden on people with less economic and political clout. African governments also lose a significant amount of revenue from corporate income tax exemptions, though the cost is hard to estimate given their often arbitrary nature (Keen and Mansour, id.). Yet corporate income tax and other tax revenues are essential for funding infrastructure, education, and expenditures underpinning good governance, which investors repeatedly identify as key considerations when making investment location decisions. Finally, the consequences of exemptions granted to aid-funded goods, services and personnel are also debated by donors and recipients (Box 3).

Countries should therefore use tax incentives with care. This includes explaining the rationale for their use and reporting tax revenues foregone by tax incentives (tax expenditure reporting) for transparency and the integrity of the tax system, while at the same time guarding against erosion of the tax base needed to fund economic development.