Mr Potato Head International transfer pricing might not win any awards for Sexy Topic of the Year, but it's what's at the heart of the debate around low corporate tax payments by the likes of Starbucks, Amazon, and Google. To explain why, consider Mr Potato Head: Let's say Mr Potato Head is owned by Toy Corp, USA (for the avoidance of doubt - we're making this up for the purposes of this example). Additionally assume that he's assembled on US soil with locally sourced parts. He's exclusively sold to the domestic market. In such a simple scenario, all of the revenues and costs of Toy Corp would arise within US borders and the Internal Revenue Service would no doubt receive its fair share of tax. Let's take over the world Things can quickly get complicated when Toy Corp launches foreign operations. Say Toy Corp wants to branch out to the European market. To assist this, the company opens a subsidiary in the UK. Now imagine that most of the world's plastic nose trading occurs in Switzerland. After being purchased by Toy Corp's Swiss employees, the raw noses are shipped to the Netherlands for painting. Also worth mentioning - the blueprints for manufacturing Mr Potato Head (potato body plus parts) are "owned" by another Toy Corp company. That one is in the Cayman Islands. Given that the blueprints are in the Carribean, the noses are purchased in Switzerland and then painted in the Netherlands, plus the marketing for Mr Potato Head is handled mostly by the US corp, how should the tax accounts of the Toy Corp subsidiary in the UK be compiled? Some potential line items: £10.0m Mr Potato Head sales (£3.0m) Manufacturing costs in the UK (£2.5m) Other UK cost of sales, e.g. salaries (£0.5m) Purchase of noses from Dutch Toy Corp (£1.0m) Royalty payment to Cayman entity (£0.4m) Marketing costs paid to US Toy Corp £2.6m Taxable income in UK The £5.5m of costs in the UK are uncontroversial. Becoming more tax efficient The next three line items are where transfer pricing come in. If the Dutch entity - that itself buys raw noses form the Swiss entity - pays lower tax, then one can see how it's in the overall interests of the Toy Corp group to claim that the final noses are expensive. Expensive noses mean lower UK tax liability, and more revenue in a country (the Netherlands) where the tax suffered is lower. The company ends up with more cash overall and higher profits at the group level through such maneuvering. The same goes for the royalty payment to the Cayman entity, which is paid because that entity owns the blueprints for Mr Potato Head. The UK entity is using that intellectual capital. As for the marketing costs, that's sending money to a higher tax jurisdiction, so not as potentially tax efficient. But hey, can't get everything right! That would look bad. Inspectors call Given all of this, if you were investigating how aggressive Toy Corp is being with its tax planning, you'd probably ask yourself these sorts of questions: Does Toy Corp have genuine operations in the Netherlands, Switzerland, and the Caymans, or are those just shell entities? Does Toy Corp UK pay a fair ("arms length") rate for the noses? One would be particularly curious to get good answers to these questions if Toy Corp UK was in fact making a loss for tax purposes. It could well be that Toy Corp UK's tax accounts are a genuine reflection of its costs of doing business. Imagine the market clearing rate for noses is £3.0m, but the UK entity only paid £2.0m to the Dutch entity. This could be harmful to the Dutch entity if it then can't meet its costs, and the UK entity is going to get taxed more than its fair share, possibly causing it to lose ground to competitors in the British toy market. Competing with tax rates Transfer pricing should allow entities to be taxed fairly on their operations in each country in which they do business. But, well... some countries do effectively compete for business activity to be done within their borders with tax incentives. Companies, quite rationally, respond to that and can go quite far with it, while still very much landing within legal boundaries. Maximising profits is part of one's fiduciary duty to the owners (shareholders) of the company after all. The taxman's burden All in all, it becomes a huge task for local tax authorities to establish whether companies within their remit are setting prices for inter-group transactions appropriately. This is very difficult as it often requires expert knowledge of a given industry and market. It's not possible to say whether Toy Corp UK is paying its Dutch entity too much without knowing something about the Mr Potato Head's noses market. These are some of the potential signs that a company's transfer pricing should be investigated, as per an OECD report on "Dealing Effectively with the Challenges of Transfer Pricing," published in early 2012: In addition to its work on transfer pricing, bringing together tax authorities across the globe, the OECD has also been at work on a broader, related topic: base erosion and profit shifting. This should sound familiar (from a November 20, 2012 announcement) ... There is a growing perception that governments lose substantial corporate tax revenue because of planning aimed at eroding the taxable base and/or shifting profits to locations where they are subject to a more favourable tax treatment. Civil society and non-governmental organisations (NGOs) have been vocal in this respect, sometimes addressing very complex tax issues in a simplistic manner and pointing fingers at transfer pricing rules based on the arm's length principle as the cause of these problems. Cough, cough. Beyond this perception based on a number of high profile cases, there is a more fundamental policy issue: the international common principles drawn from national experiences to share tax jurisdiction may not have kept pace with the changing business environment. Domestic rules for international taxation and internationally agreed standards are still grounded in an economic environment characterised by a lower degree of economic integration across borders, rather than today's environment of global taxpayers, characterised by the increasing importance of intellectual property as a value-driver and by constant developments of information and communication technologies. For example, some rules and their underlying policy were built on the assumption that one country would forgo taxation because another country would be imposing tax. In the modern global economy, this assumption is not always correct, as planning opportunities may result in profits ending up untaxed anywhere. Good news! This has reached the upper echelons as an area deserving of considerable attention: The G20 Leaders meeting in Mexico on 18-19 June 2012 explicitly referred to "the need to prevent base erosion and profit shifting" in their final declaration. This message was reiterated at the G20 finance ministers meeting of 5-6 November 2012 whose final communiqué states "We also welcome the work that the OECD is undertaking into the problem of base erosion and profit shifting and look forward to a report about progress of the work at our next meeting." As for next steps: The OECD will deliver a progress report to the G20 in early 2013 on actions to tackle the issue of BEPS [base erosion and profit shifting], including strategies to detect and respond to aggressive tax planning and ensure better tax compliance. Can't come soon enough. That Mr Potato Head looks a shifty fellow.