Transfer pricing regulation and taxation of royalty payments

• Published date: 01 February 2018
• Author: Steffen Juranek,Dirk Schindler,Guttorm Schjelderup
• Date: 01 February 2018
• DOI: http://doi.org/10.1111/jpet.12260

Received: 22 March 2016 Accepted: 14 May 2017

DOI: 10.1111/jpet.12260

ARTICLE

Transfer pricing regulation and taxation

of royalty payments

Steffen Juranek1Dirk Schindler2Guttorm Schjelderup2

1NorwegianSchool of Economics, NoCeT

2NorwegianSchool of Economics, NoCeT,

andCESifo

Weare grateful to participants at the confer-

enceon TaxCitizenship and Income Shifting at

NotreDame Global Gateway London, Japanese–

NorwegianWorkshop on Public Economics in

Bergen,Skatteforum (tax forum) of the Research

Councilof Norway in Halden, and Research Sem-

inarat the Max Planck Institute for Innovation

andCompetition in Munich, as well as two anony-

mousreferees and Francis Bloch (the Editor), for

valuablecomments. Financial support from the

NorwegianTaxAdministration and the Research

Councilof Norway is greatly appreciated.

SteffenJuranek, Norwegian School of Economics,

Departmentof Business Economics and Manage-

mentScience, Helleveien 30, 5045 Bergen, Nor-

way(Steffen.Juranek@nhh.no). Dirk Schindler,

NorwegianSchool of Economics, Department

ofAccounting, Auditing and Law, Helleveien 30,

5045Bergen, Norway (Dirk.Schindler@nhh.no).

GuttormSchjelderup, Norwegian School of Eco-

nomics,Department of Business Economics

andManagement Science, Helleveien 30, 5045

Bergen,Norway (Guttorm.Schjelderup@nhh.no).

The digital economy is characterized by the use of intellectual prop-

erty such as software, patents, and trademarks. The pricing of such

intangibles is widely used to shift profits to low-tax countries. We

analyze the implications of different OECD methods to regulate

transfer pricing and the role of a source tax on royalty payments for

abusive transfer pricing. First, we show that under the traditional

transfer pricing methods mispricing of royalty payments does not

affect investment behavior.In contrast, the TransactionalProfit Split

Methodthat is promoted by the OECD for evaluating firms in the dig-

ital economy triggers higher investment in order to facilitate higher

profit shifting. Second, royalty taxation is effective in reducing (such)

abusive profit shifting, but always reduces investment. Third, a roy-

alty tax rate below the corporate tax rateleads to overinvestment in

a tax system with allowance for corporate equity (ACE).

1INTRODUCTION

The rapid evolution of technology, especially digital and e-commerce arrangements, pose a significant challenge to

countries’ tax systems. Royalty payments are often linked to the digital economy because they represent remunera-

tion of intellectual ideas in the form of intangible assets. Google, for example, charges its affiliates royalties for the use

of its search engine. The income stream from these arrangements is paid to Bermuda, using a “Double Irish sandwich.”

Other digital companies have been accused of using the same setup to shift profits to low-tax jurisdictions. The lack of

market parallels for intangibles poses a problem for tax authorities because it is difficult to determine what the arm’s

length price is. Multinational companies therefore have substantial discretion in setting their royalty fees.

In particular,the OECD (2015a) is concerned that the traditional methods to evaluate transfer pricing, such as the

Comparable Unrelated Price Method (CUP),will no longer be applicable, because observable comparable transactions

are rapidly ceasing to exist. The reason for the latter is the digital economywith its integrated global value chains and

Journal of Public Economic Theory.2018;20:67–84. wileyonlinelibrary.com/journal/jpet c

2017 Wiley Periodicals,Inc. 67

68 JURANEK ET AL.

TABL E 1 Taxeson royalty payments for European countries, Canada, and the United States, 2015

Country

Corporate Tax

Rate (in

percent)

Source Taxon

Royalty

Payments(in

percent) Country

Corporate Tax

Rate (in

percent)

Source Taxon

Royalty

Payments(in

percent)

Austria 25.0 20.0 Latvia 15.0 0.0

Belgium 34.0 25.0 Lithuania 15.0 10.0

Bulgaria 10.0 10.0 Luxembourg 29.2 0.0

Croatia 20.0 15.0 Malta 35.0 0.0

Cyprus 12.5 10.0 Netherlands 25.0 0.0

Czech Republic 19.0 15.0aNorway 27.0 0.0

Denmark 23.5 25.0 Poland 19.0 20.0

Estonia 20.0 10.0 Portugal 29.5 25.0a

Finland 20.0 20.0 Romania 16.0 16.0

France 38.0 33.33bSlovenia 17.0 15.0

Germany 30.2 15.0 Slovakia 22.0 19.0a

Greece 29.0 20.0 Spain 28.0 24.0

Hungary 20.6 0.0 Sweden 22.0 0.0

Ireland 12.5 20.0 U.K. 20.0 20.0

Italy 31.4 30.0 Canada 26.5 25.0

Iceland 20.0 20.0 U.S. 40.0 30.0

a35.0 if payment to a tax haven;b75.0 if payment to a tax haven.

Source: Corporate tax rates:Eurostat (2015, p. 144); Royalty taxes: Deloitte (2015).

its tendency to generate quasi-monopolies. Therefore, the OECD (2015a,b) wonders whether the TransactionalProfit

Split Method is a suitable (alternative) method to analyze global value chains where parties makeunique and valuable

contributions, e.g., in the form of intangible assets. This method is not well analyzed yet, and the OECD has announced

further research on its applicability until the end of 2017 (OECD, 2015a, p. 92).

The problem of establishing arm’s length prices and suitable transfer pricing methods is exacerbated by empirical

evidence suggesting that multinationals hold their intellectual property in low-tax jurisdictions as part of their global

tax-saving strategy.1Theintellectual property has often been developed in a high-tax country, but is transferred to an

affiliate offshore. The location of the patent provides multinationals with an incentive to shift profits to the tax haven

affiliate by overinvoicingthe transfer price on the intellectual property to high-tax affiliates.

An instrument to counter such profit shifting to tax havens is a source tax on royalty payments. It allows the tax

authorities to capture some of the revenue loss due to abusive royalty rates. Unfortunately,such a tax has its down-

sides as well.2One such is that firms may be discouraged from investingin high-tax countries. Interestingly, the OECD

(2015a,b)reports do not discuss source taxes on royalty payments. Nevertheless, many countries impose them, as Table

1 documents with an overview of royalty and corporatetax rates for a selection of OECD countries.3

Inthis paper, we take up the concerns by the OECD, provide an analysis of different transferpricing methods, includ-

ing the TransactionalProfit Split Method, and their interaction with royalty taxation. First, we analyze the implications

of different transfer pricing methods for intangible assets on profit shifting and investmentincentives. In a second step

1See,e.g., Mutti and Grubert (2009), Dischinger and Riedel (2014), and Karkinsky and Riedel (2012).

2The disadvantages of source taxes on royalty payments are discussed in detail by the latest Norwegian TaxCommittee. See their report NOU (2014,

chapter7.3).

3Royaltypayments within the European Union are exempt from the source tax due to the EU Interest and Royalties Directive, and many bilateral tax treaties

includea source tax reduction.