International Taxation scores as one of the most exciting categories of tax with several key emerging issues, having gathered traction and interest especially owing to the rise of tech-multinationals and the super-mega rich wealthy persons behind them. What’s even more interesting is that they often seem to pay little to no tax. This has been brought to global attention owing to the aggressive tax strategies employed companies such as Google and Amazon, which have often landed them in trouble with governments.
The first part of this article reviews the most common strategy employed by multinationals, Transfer Pricing. Let’s get to it.
Transfer Pricing.
Of primary focus in international tax planning is the reduction of tax liability by reducing the world-wide effective tax rate thereby increasing after-tax profits which in turn results in more cash and liquidity for the companies … rather, the shareholders.
The underlying principle in transfer pricing, involves a multinational corporation (main) operating in a high tax jurisdiction, setting up an associate company in a low tax jurisdiction. The associate company then charges the main company an expense, this can be in the form of royalties, management fees, training costs, right to use intangible assets fee amongst others. The effect is increased costs for the main company leading to little or no profits in the high tax jurisdiction, while transferring most of the funds to the low tax jurisdiction where the high profits end up with little to nil taxes.
** You can view the tax rates of different nations and territories here … some with 0% tax rates.
Transfer pricing can also work in a 3 or more states set-up, where you have two high tax jurisdictions (the production state and the market state) with a low tax jurisdiction in between (Tax Haven). To illustrate this, assume a multinational operating in the emerging cashew-nuts markets in Senegal where corporate tax rate is 25%. It costs $1,000 to produce a crate of cashew-nuts in Senegal. Their primary market is in Australia, where the standards corporate tax rate is 30%. The market price for a crate of cashew-nuts in Australia is $4,000. The multinational sets-up an associate company in the Cayman Islands, where the corporate tax rate is 0%.
The Senegalese entity then sells the crate of cashew-nuts to the Cayman associate at cost, $990, leaving $10 profits in Senegal. The Cayman associates sells the crate to the Australian entity at $3,990, leaving $3,000 profits in the Cayman Islands. The Australian entity finally sells the crate of cashew-nuts at $4,000 leaving profits of $10 in Australia.
Effectively, they pay taxes on the crate to the Senegalese government of $2.50, 0.00$ to the Cayman territory and $3.00 to the Australian government. The effective corporate tax rate is (0.001%) despite primarily operating in tax jurisdictions with corporate tax rates of 25% and 30%. The crate doesn’t even physically pass through Cayman Islands.
Globally, transfer pricing is of key concern for governments who are now fully aware of its limiting ability on collecting tax from multinationals. Though still legal, tax laws have been effected as interventions against aggressive transfer pricing employed by multinationals and cap any resulting negative fallout. The United Nations has deployed the UN Transfer Pricing Manual while jurisdictions have implemented into their internal tax laws the Arm’s Length Principle. The ALP is also stipulated in the UN and OECD Model Tax Conventions
The Arm’s Length Principle is an international convention that compares the charges on transactions between related entities the prevailing market rates for the same transaction. It guides that transactions between related parties should be conducted at the market rate or as through such a relationship didn’t exist.
Kenya has effected the Arm’s Length Principle in the Income Tax Act, Section 18: Ascertainment of gains of profits of business in relation to certain nonresident persons. It holds that a transaction between a non-resident and a resident or its permanent establishment that results in no profits or less than ordinary (market) profits, then the gains of such a transaction, for tax purposes shall be deemed to be the amount that might have been expected had the transaction occurred between independent persons dealing at Arm’s Length Principle.
This section has been amended by the 2021 Finance Act defining a multinational entity as ‘a group that includes two or more enterprises which are resident in different jurisdictions’ and the ultimate parent entity ‘means an entity that (a) is resident in Kenya for tax purposes; (b) is not controlled by another entity; and (c) owns or controls a multinational enterprise group.’
