To see how this has occurred, we need to think about the options that can be used by a company (the Parent Company) when it wants to invest in operations in a different country. Broadly speaking, there are three ways of doing this as follows. First, it can simply sell its products to customers in that foreign country. This is simple and straightforward in concept, but assumes that the Parent Company can sell to customers in Europe, Asia and elsewhere without having business operations in the local country. One example of this would be manufacturing products in the home country and selling to an unrelated distributor in a different country. Profits earned by the Parent Company are taxed by the tax authorities of the Parent Company while the profits of the local distributor are taxed by its local tax authority.
Second, it can set up a stand-alone operation in the foreign country, sourcing materials, manufacturing, and marketing products without any transactions with the US headquarters. In this case, the Parent Company is a pure investor, and its only interest in its foreign subsidiary is that of an investor. The Parent Company therefore does not earn any business profits from transacting with its foreign subsidiary, but may receive income from dividend repatriation or from the subsequent sale of the foreign entity. One example of this would be setting up a manufacturing subsidiary in the foreign country that that had no transactions with the Parent Company.
Third, It can adopt something of a hybrid model, setting up a foreign affiliate to carry out business in the foreign country, and then also engaging in certain transactions with its foreign subsidiary. This is a hybrid in which the Parent Company is both transacting directly as in (1) above but also is acting as an investor as in (2) above. The relative importance of its role as a supplier/customer of its foreign subsidiary and its role as an investor will vary depending upon whether the intercompany transactions (i) account for only a minor share of the costs/revenues of the Subsidiary (e.g., the parent sells the subsidiary a minor component that accounts less than 10% of its total cost of production) or (ii) account for a significant share of the costs/revenues of the Subsidiary (e.g., Parent Company sells finished goods to the Subsidiary, which engages in only limited wholesale distribution activities).
Note that the taxing rights of the two countries vary depending upon which of the three above alternatives are used. Under alternative (1), profits earned by the Parent Company are taxed by the tax authorities of the Parent Company while the profits of the local distributor are taxed by its local tax authority. Under alternative (2), the foreign subsidiary earns all of the business income associated with the sale of products in the foreign country, all of the income is subject to tax by the foreign jurisdiction, and none of it is subject to tax in the US. This too makes sense, as all of the productive activity takes place in the foreign country. Parent Company is subject to tax by its local tax only when it reports income on its investment in Subsidiary (e.g., when dividends are repatriated or there is a gain from the sale of the foreign subsidiary).
Finally, under alternative (3) the income that results from the overall business activity in the foreign country is split between the Parent Company and Subsidiary based on their relative contributions to that activity. Parent Company reports and is taxed on business income realized from its transactions with Subsidiary, and therefore reports income from, for example, sales of tangible products to Subsidiary. Subsidiary treats its purchases from Parent Company as a cost, and therefore its profits are now dependent upon the prices charged in these controlled transactions. By requiring the prices charges in the controlled transactions are set at the same level as they would be in uncontrolled transactions, setting prices at arms’ length levels leaves both Parent Company and Subsidiary with the same profits as they would have earned, had they transacted with third parties. It also leaves Parent Company in the same position as an investor in Subsidiary as it would have been, had the two related companies been transacting with third parties.
Starting in the late 1980s and early 1990s, as certain tax authorities and in particular the US became more focused on transfer prices, two concerns emerged with the use of the transactional pricing methods. The first was related to the availability of information — while finding a reliable measure of the price that charged in uncontrolled transactions was often possible in the case of commodity product, finding a reliable measure of a comparable price charged between two third parties became much more difficult when the intercompany transaction involved products or intangibles the were not commodities. As a large share of intercompany transactions consisted of such differentiated products, there were significant practical limitations associated with the inability to find data led the introduction of profit-based methods.
The second concern was more conceptual. Given that MNE’s presumably were formed to take advantage of what can be broadly termed as “integration efficiencies” — the collection of legal entities organized into a single MNE could expect to be worth more/generate higher profits than they would if each operated individually – the profits of the MNE might be greater than the sum of the profits of the individual legal entities. If so, what should happen to these excess profits at arm’s length?
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