[Paper Review] Transfer pricing manipulation, tax penalty cost and the impact of foreign profit taxation

Alex Augusto Timm Rathke|Munich Personal RePEc Archive (Ludwig Maximilian University of Munich)|Aug 16, 2015

Corporate Taxation and Avoidance3 citations

TL;DR

This paper analyzes how transfer pricing manipulation is influenced by tax enforcement, market price uncertainty, and foreign profit taxation. It finds that home country taxation of foreign profits reduces profit shifting incentives, but the limited tax credit rule—though widely used—is less efficient than alternative approaches.

ABSTRACT

This paper analizes the optimal level of transfer pricing manipulation when the expected tax penalty is a function of the tax enforcement and the market price parameter. The arm's length principle implies the existence of a range of acceptable prices shaped by market, and firms can manipulate transfer prices more freely if market price range is wide, or if its delimitations are difficult to determine. Home taxation of foreign profits can reduce income shifting incentive, depending on the portion of repatriation for tax purposes. We find that the limited tax credit rule tends to be a less efficient measure, nonetheless it is the most widely adopted rule by countries, so to spark the perspective of more powerful approaches for taxation of foreign profits.

Motivation & Objective

• To examine how tax enforcement and market price variability affect firms' incentives to manipulate transfer prices.
• To assess the impact of home country taxation of foreign profits on income shifting behavior.
• To evaluate the efficiency of the limited tax credit rule in curbing transfer pricing manipulation.
• To compare the effectiveness of different foreign profit taxation rules in reducing base erosion and profit shifting (BEPS).

Proposed method

• Models transfer pricing manipulation as a function of tax enforcement and market price range, using a principal-agent framework.
• Incorporates expected tax penalties that depend on the likelihood of detection and the severity of sanctions.
• Analyzes the arm's length principle as a constraint on transfer prices, with price ranges determined by market conditions.
• Evaluates the incentive effects of different foreign profit taxation regimes, particularly the limited tax credit rule.
• Uses comparative statics to assess how changes in enforcement and tax policy affect optimal manipulation levels.
• Derives conditions under which home taxation reduces profit shifting, depending on the repatriation tax rate.

Experimental results

Research questions

• RQ1 How does the width of the market-based transfer price range affect firms' incentives to manipulate transfer prices?
• RQ2 What is the role of tax enforcement in shaping the expected penalty cost of transfer pricing manipulation?
• RQ3 How does home country taxation of foreign profits influence the incentive to shift income to low-tax jurisdictions?
• RQ4 Why is the limited tax credit rule widely adopted despite its inefficiency in reducing BEPS?
• RQ5 Under what conditions does foreign profit taxation effectively reduce transfer pricing manipulation?

Key findings

• A wider market price range for transfer prices increases firms' ability to manipulate prices without detection.
• Higher tax enforcement reduces the expected penalty cost, thereby discouraging manipulation, but only up to a point.
• Home taxation of foreign profits reduces income shifting incentives, especially when the repatriation tax rate is high.
• The limited tax credit rule is less efficient than alternative taxation rules in curbing profit shifting, despite its widespread adoption.
• The arm's length principle provides a binding constraint only when market price ranges are narrow or clearly defined.
• The paper suggests that more powerful taxation mechanisms—such as global intangible low-taxed income rules—could be more effective than the current standard.