If two unrelated companies trade with each other, a market price for the transaction will generally result. This is known as “arms-length” trading, because it is the product of genuine negotiation in a market. This arm’s length price is usually considered to be acceptable for tax purposes.
But when two related companies trade with each other, they may wish to artificially distort the price at which the trade is recorded, to minimise the overall tax bill. This might, for example, help it record as much of its profit as possible in a tax haven with low or zero taxes.
How does World Inc. shift its profits into a tax haven?
For example, World Inc. grows a crop in Africa, then harvests and processes it and transports and sells the finished product in the United States. It has three subsidiaries: Africa Inc. (in Africa), Haven Inc. (in a zero-tax haven) and USA Inc. (in the U.S.).
Africa Inc. sells the produce to Haven Inc. at an artificially low price. So Africa Inc. has artificially low profits – and therefore an artificially low tax bill in Africa. Then Haven Inc. sells the product to USA Inc. at a very high price – almost as high as the final retail price at which USA Inc. sells the processed product. So USA Inc. also has artificially low profits, and an artificially low tax bill in the U.S. But Haven Inc. is different: it has bought cheaply and sold at a very high price, creating very high artificial profits. Yet it is located in a tax haven – so it pays no taxes on those profits. Voila! A tax bill disappears.
The example in the box illustrates how this is done. The “Arm’s Length” principle is supposed to stop this by ensuring that the prices are recorded as if the trades were conducted at ‘arm’s length.’ In practice, it is unworkable in many if not most situations: a lot of multinational corporate tax avoidance happens for this reason.
Consider what has happened in the example in the box with World Inc. These games have not resulted in more efficient or cost-effective production, transport, distribution or retail processes in the real world. The end result is, instead, that World Inc. has shifted its profits artificially out of both Africa and the United States, and into a tax haven. As a result, tax dollars have been shifted artificially away from both African and U.S. tax authorities, and have been converted into higher profits for the multinational.
This is a core issue of tax justice – and unlike many issues which are considered to be either “developing country” issues or “developed country” issues – in this case the citizens of both rich and poor nations alike share a common set of concerns. Even so, developing countries are the most vulnerable to transfer mispricing by multinational corporations.