A Negotiation-Based Model of Tax-Induced
Transfer Pricing
CBT Summer Symposium, Oxford
Johannes Becker (with Ron Davies, UC Dublin)
University of Münster
25 June 2014
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
1 / 13
Motivation
Evidence
Robust empirical …nding for MNEs:
An increase in a location’s tax rate reduces the reported pro…ts (per capital
unit) of the a¢ liate in this location (ceteris paribus).
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
2 / 13
Motivation
Evidence
Robust empirical …nding for MNEs:
An increase in a location’s tax rate reduces the reported pro…ts (per capital
unit) of the a¢ liate in this location (ceteris paribus).
Evidence for pro…t shifting:
E.g. Huizinga & Laeven (2008), Weichenrieder (2009), Dharmapala & Riedel (2013)
etc.
Meta-study by Heckemeyer & Overesch: pro…t semi-elasticity w.r.t. tax rate of 0.8.
Main drivers are …nancial policy (internal debt) and transfer pricing (including
licencing), but no consensus on relative importance.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
2 / 13
Motivation
Evidence
Robust empirical …nding for MNEs:
An increase in a location’s tax rate reduces the reported pro…ts (per capital
unit) of the a¢ liate in this location (ceteris paribus).
Evidence for pro…t shifting:
E.g. Huizinga & Laeven (2008), Weichenrieder (2009), Dharmapala & Riedel (2013)
etc.
Meta-study by Heckemeyer & Overesch: pro…t semi-elasticity w.r.t. tax rate of 0.8.
Main drivers are …nancial policy (internal debt) and transfer pricing (including
licencing), but no consensus on relative importance.
Evidence of transfer pricing:
Comparison of pre-tax pro…ts and EBIT: e.g. Heckemeyer & Overesch (2013).
VAT by industry: Bartelsman & Beetsma (2003).
Import/export price indexes: Swenson (2001), Clausing (2003).
Prices of individual cross-border transactions: Bernard, Jensen & Schott (2006).
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
2 / 13
Motivation
Evidence
Robust empirical …nding for MNEs:
An increase in a location’s tax rate reduces the reported pro…ts (per capital
unit) of the a¢ liate in this location (ceteris paribus).
Evidence for pro…t shifting:
E.g. Huizinga & Laeven (2008), Weichenrieder (2009), Dharmapala & Riedel (2013)
etc.
Meta-study by Heckemeyer & Overesch: pro…t semi-elasticity w.r.t. tax rate of 0.8.
Main drivers are …nancial policy (internal debt) and transfer pricing (including
licencing), but no consensus on relative importance.
Evidence of transfer pricing:
Comparison of pre-tax pro…ts and EBIT: e.g. Heckemeyer & Overesch (2013).
VAT by industry: Bartelsman & Beetsma (2003).
Import/export price indexes: Swenson (2001), Clausing (2003).
Prices of individual cross-border transactions: Bernard, Jensen & Schott (2006).
Explanation
Standard approach: Concealment Model.
Our approach: Negotiation Model.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
2 / 13
Concealment Model
Concealment model (following Allingham & Sandmo 1972)
True transfer price q .
MNE may choose q 6= q , at a concealment cost of c = c (q
of concealed mispricing, detection probabilites and …nes.
q ), based on a story
After-tax pro…ts (with π: pre-tax pro…ts, t1 ,t2 : tax rates):
(π
q ) (1
t1 ) + q (1
t2 )
c (q
q )
Pro…t-maximizing transfer price implied by equality of marginal return and marginal
cost:
t1 t2 = c 0 (q q )
Prediction: The higher the tax di¤erential jt1
Johannes Becker (WWU Münster)
Negotiation Model
t2 j, the larger is jq
q j.
25 June 2014
3 / 13
Concealment Model
Pro…t maximum at
t1
t2 = c 0 (q
Prediction: The higher the tax di¤erential jt1
Tax rate
difference
q )
t2 j, the larger is jq
q j.
Marginal cost of
concealment
t‘1-t2
t1-t2
q-q*
Johannes Becker (WWU Münster)
q‘-q*
Negotiation Model
Deviation from true
transfer price
25 June 2014
4 / 13
Concealment Model
Pro…t maximum at
t1
t2 = c 0 (q
Prediction: The higher the tax di¤erential jt1
Tax rate
difference
q )
t2 j, the larger is jq
q j.
Marginal cost of
concealment
t‘1-t2
t1-t2
q-q*
q‘-q*
Deviation from true
transfer price
Concealment model is empirically successful,
now THE model of tax-induced transfer pricing.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
4 / 13
Motivation
But practitioners quibble:
1
No such thing as the ’true’transfer price...
... rather a set of accepted methods of calculating transfer prices, e.g. the
comparable uncontrolled price method, the cost plus method, the transactional net
margin method etc.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
5 / 13
Motivation
But practitioners quibble:
1
No such thing as the ’true’transfer price...
... rather a set of accepted methods of calculating transfer prices, e.g. the
comparable uncontrolled price method, the cost plus method, the transactional net
margin method etc.
2
Nothing to conceal.
Yes, there is tax-induced transfer pricing, but it is more about choosing the adequate
pricing method.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
5 / 13
Motivation
But practitioners quibble:
1
No such thing as the ’true’transfer price...
... rather a set of accepted methods of calculating transfer prices, e.g. the
comparable uncontrolled price method, the cost plus method, the transactional net
margin method etc.
2
Nothing to conceal.
Yes, there is tax-induced transfer pricing, but it is more about choosing the adequate
pricing method.
3
At least large …rms are frequently audited, concealing does not make sense.
Illegal mispricing is unattractive and, actually, occurs rarely (few court cases etc.).
When transfer prices are audited and adjusted, there are usually no …nes.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
5 / 13
Motivation
But practitioners quibble:
1
No such thing as the ’true’transfer price...
... rather a set of accepted methods of calculating transfer prices, e.g. the
comparable uncontrolled price method, the cost plus method, the transactional net
margin method etc.
2
Nothing to conceal.
Yes, there is tax-induced transfer pricing, but it is more about choosing the adequate
pricing method.
3
At least large …rms are frequently audited, concealing does not make sense.
Illegal mispricing is unattractive and, actually, occurs rarely (few court cases etc.).
When transfer prices are audited and adjusted, there are usually no …nes.
If this is true, how can a positive relationship of tax di¤erentials and low tax
location’s pro…ts be restored?
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
5 / 13
Explaining the facts
Concealment model
Larger tax di¤erential increases the incentive to manipulate transfer prices.
Higher expected …nes are accepted.
If audits are certain, no pro…t shifting.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
6 / 13
Explaining the facts
Concealment model
Larger tax di¤erential increases the incentive to manipulate transfer prices.
Higher expected …nes are accepted.
If audits are certain, no pro…t shifting.
Negotiation model
Larger tax di¤erential increases incentive to manipulate (potential) negotiations by
preparing high-quality report.
High-quality report provides arguments used by low-tax country.
Mutual Agreement Procedures (MAP, OECD TP guidelines) serve as a threat.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
6 / 13
Explaining the facts
Concealment model
Larger tax di¤erential increases the incentive to manipulate transfer prices.
Higher expected …nes are accepted.
If audits are certain, no pro…t shifting.
Negotiation model
Larger tax di¤erential increases incentive to manipulate (potential) negotiations by
preparing high-quality report.
High-quality report provides arguments used by low-tax country.
Mutual Agreement Procedures (MAP, OECD TP guidelines) serve as a threat.
Both models
Better outside options lead to more favorable transfer prices.
If high tax country increases its tax rate, pro…t shifting is allowed to increase.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
6 / 13
Model analysis
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
7 / 13
Negotiation Model
Setup
Three countries with index i : low-tax country (l ) and high-tax country (h) and a
third country.
In…nitely-lived multinational …rm with production sites in countries l and h.
In each period, output is produced and sold in h at given market price.
Production requires a renewable …xed asset, produced at zero cost in l .
Requires transfer price q̃. Set of generally accepted transfer prices: q, q̄ where
q 0 and q̄ π.
Tax rates: ti 2 [0, 1] with tl < th .
Audit probability equals one.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
8 / 13
Negotiation Model
Setup
Three countries with index i : low-tax country (l ) and high-tax country (h) and a
third country.
In…nitely-lived multinational …rm with production sites in countries l and h.
In each period, output is produced and sold in h at given market price.
Production requires a renewable …xed asset, produced at zero cost in l .
Requires transfer price q̃. Set of generally accepted transfer prices: q, q̄ where
q 0 and q̄ π.
Tax rates: ti 2 [0, 1] with tl < th .
Audit probability equals one.
Firm’s decisions:
1
2
3
4
Variable inputs (acquired in h, therefore neglected).
Transfer price proposal (costlessly changed by authorities, therefore neglected).
Transfer price report: explains and justi…es q chosen in the tax statement. Report
quality is z̃ at convex cost cost C (z̃ ), deductible from the tax base in l .
Stay or leave (after transfer price is …xed).
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
8 / 13
Negotiation Model
Timing
1 – Firm determines
report quality
z
2 – High-tax country
proposes transfer price
q~h
3 – Low-tax country
decides on proposal
accept
not accept
4 – Negotiations
between countries
stay
Pay-offs
leave
Pay-offs
stay
Pay-offs
leave
5 – Firm decides to
leave or to stay
Pay-offs
Figure: Game tree.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
9 / 13
Negotiation Model
Findings:
Transfer prices are determined by one of these:
1
2
3
(quasi-)legal constraints,
…rm’s outside option,
anticipated negotiation outcome.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
10 / 13
Negotiation Model
Findings:
Transfer prices are determined by one of these:
1
2
3
(quasi-)legal constraints,
…rm’s outside option,
anticipated negotiation outcome.
If negotiation determines transfer price (3):
Pro…t shifting takes place even if audit rate is one and outside option is non-binding.
More audits/auditors may not have the expected yield.
Tax rate di¤erential a¤ects transfer prices as in the concealment model.
Bargaining power a¤ects transfer price. Therefore, powerful countries may dislike
introduction of formula apportionment.
Residents’…rm ownership increases pro…t shifting.
Pro…ts positively a¤ect pro…t shifting (note: negatively under (2)).
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
10 / 13
Discussion
Summary: Negotiation Model...
o¤ers an alternative explanation of the tax-rate-pro…t link.
yields a couple of new empirical predictions w.r.t. bargaining power
(operationalization?), ownership and pro…ts.
makes a case against formula apportionment (from the perspective of powerful
countries).
stresses the ‡exibility of the current system (negotiations may take account of wide
range of aspects, e.g. strategic trade considerations).
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
11 / 13
Discussion
Summary: Negotiation Model...
o¤ers an alternative explanation of the tax-rate-pro…t link.
yields a couple of new empirical predictions w.r.t. bargaining power
(operationalization?), ownership and pro…ts.
makes a case against formula apportionment (from the perspective of powerful
countries).
stresses the ‡exibility of the current system (negotiations may take account of wide
range of aspects, e.g. strategic trade considerations).
Synthesis?
In the paper: Negotiation model with infrequent audits.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
11 / 13
Discussion
Some more...
Complexity gives rise to ’individualized’taxation. Exciting …eld for optimal tax
theory empirics? [See also Becker/Davies/Jakobs (2014): The Economics of
Advance Pricing Agreements.]
Social norms? Competent autority representatives (low-tax country):
Will only …ght for …rms that submit ’serious’transfer price reports.
CA representatives stress the repeated game character of negotiations.
’Report quality lowers negotiation cost’vs. ’power of the convincing argument’.
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
12 / 13
Thank you for your attention!
Johannes Becker (WWU Münster)
Negotiation Model
25 June 2014
13 / 13