A critical analysis of the profit based methods for satisfying the comparables test in UK transfer pricing regulations
The arm’s-length principle (ALP), the transactions taken place between unrelated parties acting at an arm’s length in competitive markets, is used by income tax authorities to determine transfer pricing, the pricing of goods, services and intangibles transferred between affiliates of a multinational enterprise (MNE), and is an important international tax issue for a number of reasons. First, globalization creates integrated businesses with enormous cross-border transfers whilst corporate income tax systems remain nationally based. Second, governments insist that globalization provides MNEs with more opportunities to manipulate transfer prices and reduce taxes than in the past, thus the need for tighter regulation. Third, there is an increased desire amongst tax authorities faced with tight fiscal situations, to protect and enhance their revenue base encouraging stricter regulation of MNEs. Profit is seen as only one of the many goals that motivate the behaviour of MNEs and the newly introduced profit based methods of transfer pricing has increased the reliance on comparables significantly. As the number of specified methods was increased and the hierarchy of acceptable methods was replaced by either the best method rule or the method of last resort, taxpayers are expected to document their transfer pricing policies. The documentation has to be contemporaneous and available upon request. The methods newly introduced by the Organization for Economic Cooperation and Development’s (OECD, 1995), Transaction Net Margin Method (TNMM), and US Internal Revenue Service’s (IRS, 1994) Comparable Profit Method (CPM), vary in relation to their application and views in controlling for function and risk when developing comparables. This suggests a degree of discretion may be exercised under different regulations that may be detected through ownership and tax. This study attempts to identify the level of discretion provided under both OECD (TNMM) and US IRS (CPM) methods. It is also tests the scope of ownership effect on the reported profit of Japanese-owned companies and US-owned companies compared to their UK counterparts. Finally this study examines whether the reported tax expense has changed subsequent to tax policy changes, specifically the latest UK transfer pricing regulations introduced in 1998 corporation tax self-assessment. The empirical analysis confirms differences between OECD and US IRS profit ranges and variations between profit level indicators (PLIs). Foreign-owned Japanese and US companies are also found to exhibit low profitability compared to UK companies. This research discovered low performance among a high number of the Japanese-owned companies with operating losses when compared to their UK counterparts and offers evidence of the low tax expenses reported by foreign-owned Japanese companies.