Assistant Professor, Widener University School of Law. I would like to express my appreciation of Lily Batchelder, Associate Professor of Law and Public Policy, New York University Law School and Professor Frank McClellan of Temple Law School for their willingness to read this Article in draft and for their many helpful comments and suggestions. I am also grateful to Erin Daly of Widener Law School for her support and encouragement and to Brett Norton, of Widener Law School Class of 2010, my research assistant, for his excellent work. Finally, I would also like to thank William Baresel for his excellent work as an Articles Editor.
The United States and the rest of the world are in the throes of a global economic crisis unlike any since the Great Depression. 1 Governments all over the world are facing huge budgetary deficits. 2 For instance, the U.S. budget Page 601 deficit for 2009 is predicted to be $1.7 trillion. 3 These desperate budgetary situations are forcing governments to introduce or strengthen their transfer pricing guidelines as a means of getting their fair share of taxes from multinational enterprises ("MNE"s).
At a recent international tax conference held by Washington University, U.S. Internal Revenue Service ("IRS") Commissioner Douglas Schulman declared that the IRS would take a hard-line approach to U.S.-based MNEs amid the current world economic crisis. 4 He stated, " U.S. multinational corporations shopping for the best tax deals across the globe will come under increased public scrutiny back home." 5
Even China, which used to be lax about transfer pricing rules, recently released regulations that require taxpayers to prepare transfer pricing documentation in support of their related party transactions. 6 In addition, many developing countries, like Ghana, Uganda, Thailand, and the Philippines plan to augment their transfer pricing regimes. 7 "This means that lower profits, losses, or any business restructuring can expect close scrutiny." 8
For example, in September 2006, the pharmaceutical drug maker GlaxoSmithKline PLC ("GSK") paid $3.4 billion to the federal government to settle abusive transfer pricing allegations. 9 In dispute was the amount of taxes owed under the transfer pricing method used by GSK from 1989 to 2005. 10 This was the biggest tax settlement in U.S. history. 11 The payment, which amounts to about 40 percent of the company's operating cash flow, is an indication of the regulatory risks that MNEs face as governments around Page 602 the world scrutinize their intercompany transactions. 12 The GSK case is also a vivid example of the current ongoing disputes between MNEs and governments in both developed countries like the United States and developing countries like Ghana.
Transfer pricing occurs when a corporation trades internal goods, services, or intangibles and constitutes the easiest way of relocating income and expenses among its various entities. 13 Most government transfer pricing regulations require that related parties-typically units within the same company that are located in different countries and tax jurisdictions-charge each other at arm's length or the going-market-rate for services. 14 The requirements are intended to prevent companies from using intracompany charge-backs to evade taxes by inflating or deflating the profits of a particular unit. 15
The MNEs account for 60 percent of all global trade. 16 An estimated 70 percent of this trade is between associated enterprises. 17 A 1999 study by the Joint Committee on Taxation of Economic Issues in International Taxation reported that intracompany sales between U.S. parent companies and their foreign subsidiaries are a significant portion of the U.S. merchandise export and import sales. The committee noted:
For instance, in 1994 U.S. [MNEs] shipped $136.1 billion of goods to their foreign affiliates, a figure representing 26 percent of U.S. merchandise exports in 1994. In addition, foreign affiliates of U.S. multinational enterprises shipped $113.4 billion of goods to their U.S. parent enterprise, a figure Page 603 representing 17 percent of U.S. merchandise imports in 1994. 18
Multinational companies structure themselves to minimize worldwide taxation. This is perfectly legal. However, transfer pricing constitutes abusive tax avoidance when entities artificially increase or decrease the price of goods and services to shift income and/or expenses between entities for tax avoidance purposes. The U.S. Government Accountability Office ("GAO") reported that inaccurate transfer pricing allowed approximately 72 percent of foreign corporations and 55 percent of foreign controlled corporations to avoid U.S. income tax for at least one year between 1998 and 2005. 19 An executive summary estimates that transfer pricing abuses accounted for $53 billion in U.S. tax losses in 2001. 20
According to a 2007 report by the U.S. Department of the Treasury, many U.S.-based companies moved their operations from the United States to jurisdictions with lower or nominal taxes, called "tax havens," to avoid paying U.S. taxes. 21 Eighty-three of the 100 largest U.S. companies had foreign subsidiaries in tax havens. 22 For example, General Electric cut its U.S. taxes drastically by moving its exports to offshore subsidiaries, which in turn sold them to their customers around the world. 23 Pepsi-Cola has over seventy subsidiaries in tax havens. 24 Dell moved patents on intellectual property developed in the United States to subsidiaries in Ireland where no taxes are Page 604 charged on royalties. 25 According to Senator Carl Levin of Michigan, such abuses cost the U.S. government about $100 billion annually. 26 The Obama Administration is concerned about these abusive transfer pricing practices, so much so that it endorsed a Stop Tax Haven Abuse Act and put the topic on the agenda for the London G-20 meeting that was held on April 2, 2009. 27
This issue has even led some unconventional commentators to voice their concerns over abusive transfer pricing practices. For example, the Pope joined the chorus endorsing the closure of tax havens and abusive transfer pricing schemes. 28 The Pope issued an encyclical on March 18, 2009, calling for the closure of all tax havens. 29
With such a robust cast of business and economic leaders calling for reform, the problem is now one of how best to address and eliminate tax havens and abusive transfer pricing schemes. The United States, with its sophisticated and aggressive administrative tax enforcement mechanisms, fails to prevent abusive transfer pricing schemes resulting in an estimated $40-70 billion. 30 Thus, it is doubtful that developing countries, like Ghana, can circumvent these schemes to recover any tax revenue at all.
This conclusion is supported by a 1974 study conducted by Constantine Vaitsos regarding overpricing by MNEs in four industries in Colombia: pharmaceuticals, rubber, chemicals, and electronics. 31 The study found that overpricing by foreign firms was greatest in pharmaceuticals, such that reported profits constituted 3.4 percent of the effective returns, 14 percent of royalties, and 82.6 percent overpricing. 32 Another study in Colombia estimated that the weighted average of overpricing for a wide range of pharmaceutical imports between 1967 and 1970 was 155 percent of the arm's length price. 33 Page 605
A similar study in Ghana also indicates that MNEs do take advantage of the opportunities to manipulate transfer prices. 34 It is estimated that the amount of money that the world's poorest countries lose from abusive transfer pricing schemes is more than the development aid they receive annually. 35 U.S. researcher Raymond Baker estimates that up to $500 billion in capital flows out of developing countries through transfer pricing abuses. 36
To the extent that transfer pricing abuses occur-in both developed and developing countries-they result in revenue losses and a drain on foreign exchange reserves. However great a problem transfer pricing abuses are in developed...