Country by country reporting

Country by country reporting is being held up as the solution to so many international tax woes. But could someone please tell me quite how it does so?

Tax should be paid where the economic substance of the activity takes place. That\’s the mantra isn\’t it?

It\’s just that I\’m not really sure what that means.

Take for example this little international business I know about. I\’ve changed the country names, the product name and the margins but the substance of the following is true.

OK, first purchase in Tajikistan some low grade europium oxide. Purchase at $1,000 per kg.

Ship it to Warsaw where it is upgraded to high grade europium oxide. This costs $1,000 per kg raising the value to $2,000 per kg.

Then ship it to Canada where it sells for $3,000 per kg.

Now, yes, I can see that the whole process creates value of $2,000 per kg. But what I find very difficult to understand is how we\’re going to allocate that over the different places.

For there\’s a fourth location involved as well. Tunisia. Where resides the information about how to put this all together. The intellectual rights if you wish.

Just about no one other than the man in Tunis knows how to do this. They don\’t know where to get the low grade oxide. They don\’t know where to get it refined. They don\’t know who in Canada is willing to pay for it.

Quite literally (put it this way, the Canadian factory hasn\’t asked for a competitive bid for europium oxide for a decade, let alone received any unasked for approaches) no one else knows how to put this process together.

OK, so where is the economic substance of this series of transactions? I can see that the original purchase gets taxed in Tajikistan. I\’m not sure at all about the $1,000 on the upgrade in Warsaw. For that wouldn\’t happen at all without the involvement of Tunis, so surely some of that value should be allocated there?

And the next $1,000. That\’s not value added in Canada, is it? Or Warsaw? So does it get taxed in Tunis? The place that created this rise in value?

Or does it go entirely the other way around? $1,000 in Tajikistan, $1,000 in Warsaw and $1,000 in Canada? But then what of the value added by Tunis? Where, given the proprietary nature of the knowledge involved in all of this, arguably the real economic substance is taking place.

Note that that there is nothing taking place "offshore". No special structures, no hiding anything. It\’s just that I cannot see any hard and fast rules about where the value is added, where the economic substance resides.

So I\’m not sure what benefit there is to country by country reporting.

OK, so this might be a strange example but it\’s one that I know of, a real world example.

Where should this be taxed? What hard and fast rules can we use to decide amongst Tajikistan, Warsaw, Canada and Tunis?


7 thoughts on “Country by country reporting”

  1. If the processing is done by independent corporate bodies then each stage of the chain naturally has a profit. There’s no problem here, so..

    ..if the processing is done by subsidiaries then subsidiaries are supposed to charge each other an arms-length price for the service or product, and then each subsidiary reports its profits, even if its customers were in the same group of companies. What’s the big deal? This is what happens today.

    For some things it’s easy to determine the arms-length price. For others, it’s not, and there is a need to root out the cooking of transfer prices. So what? That’s what we do today (even to the point of the tax authorities hiring domain experts to go grubbing around software source code to dig out metrics to support or attack a particular price).

  2. Knowing the relevant authorities, I would say each of those countries would want about half the money, leaving a total tax burden of about $6,000.

  3. How about governments buggering off from the productive end of things and taxing consumption, at source, and not giving a flying stuff about whether the people two doors down were ‘unfairly’ competing? It would be cheaper, it would be fairer, it would make more revenue and it would be a stick in the eye for Richard Murphy and all his grasping lackwitted confreres. That’s a win-win-win-win situation.

  4. Well there are two separate questions.

    The first is how you allocate the economic substance for taxation purposes – at present this is done through transfer pricing, ie each of the subsidiaries must pay the ‘arm’s length’ or market price for the goods and services it procures from another. These are all internal transactions within the group, but they allocate the profits between subsidiaries. A more effective way would be to use formulary apportionment, the system applied for allocating economic activity across more than one US state, on a global level. But evidently that’s a way off.

    The second question is how do you check that the prices being used inside the company really are arm’s length prices. There are all kinds of incentives to manipulate these prices, and hence shift profit around. That’s where country-by-country comes in, not as a silver bullet, but as a smoking gun.

    Tim adds: Well, I see what you’re saying in general. But I’m asking about specifics. For example, in this example, that $3,000 price in Canada is about 50% of what anyone else would charge for the same product of the same purity. So if we have to use arms length prices anywhere along the chain then the tax will be on arms length prices….which are higher than the actual prices being charged. No, not because there’s anything being hidden in the chain, but because the chain itself is producing the item cheaper than anyone else does. That’s the whole reason that the chain exists of course, because it can indeed produce something a great deal more efficiently (or cheaply) than the use of arms length prices allows.

    Which takes us right into Coasean territory. Why does a firm exist in the first place? Why isn’t everything done as a series of arms length transactions? What possible value is there in having an organisation with overheads etc rather than multiple independent players? Coase’s answer was of course that there are transaction costs. Where those transaction costs are higher than the costs of having the single organisation then the single organisation you’ll get. But where they’re lower then the independents bound by contracts you’ll get.

    But by insisting that corporations are taxed on arms length prices you’re now insisting that they be taxed on their very reason for existence. Those transaction costs which they exist to be more efficient than.

    Hmm, I think I’m beginning to get a glimmer of why this country by country argument, at arms length prices, fails in economic theory. For it ignores the very reason that we have integrated firms in the first place. Transaction costs.

    And that still doesn’t deal with the allocation of economic substance over the various stages involved.

  5. But arm’s length prices are what are currently used by tax authorities! Yes, there is sometimes a problem defining them, but there is a whole OECD transfer pricing manual.

    I think the point is that, while you rightly argue that lower transaction costs result in lower transfer prices, it’s still possible to identify a floor below which a product is clearly mispriced. The OECD definitions of arm’s length price uses interquartile ranges, giving quite a wide variation in costs. Also, the evidence shows that much profit shifting takes place through overpricing, not underpricing, which your argument doesn’t address.

  6. Pingback: Country by country: a case study | called2account

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