Jerry Carter, Vice President of Tax and International Finance at IDEX Corporation and a class of 1988 alumnus, discussed the ethical and practical aspects of transfer pricing in an Ethics Week lecture Monday afternoon at Giovanini Commons in the Mendoza College of Business.
Carter defined transfer pricing as a set of rules that ensure businesses with common ownership transfer goods and services between each other at a fair market rate. He gave a hypothetical example of two companies held by the same owner, one being located in the U.S. and one in Italy. If the U.S. company sells goods to its Italian counterpart, it must do so at fair market value.
Carter said companies often sell cheaply to their counterparts in other countries with lower taxes, so their overall cost decreases and profit is boosted.
“The subject of debate lies in fair market value,” he said.
While there are some standards for establishing fair market value, it is largely left up to the companies themselves to decide what is a legitimate price, Carter said.
If a company uses transfer pricing at a fair market value to simply pay lower taxes in another country, it is not violating any ethical standards or laws, he said. However, if companies arbitrarily lower the selling price of their goods to reduce their tax bill, they are guilty of tax evasion. Transfer pricing requires supporting documentation and a justifiable grounds that it meets the criteria of fair market value, Carter said.
“The number one reason transfer pricing is used for tax evasion is greed,” he said.
Other reasons for unethical transfer pricing include peer pressure from managers and competitors, eagerness to take advantage of tax credits and even patriotism, Carter said. He said Asian companies, particularly those from Japan, often prefer to pay more taxes to their country than to ones where their subsidiaries are located.
Carter cited Toyota Australia as an example: the Toyota Motor Corporation overcharged its Australian subsidiary so that it would pay more taxes to Japan. Toyota ultimately paid the Australian government a $250 million settlement. Similarly, Carter said, British pharmaceutical firm GlaxoSmithKline overcharged its U.S. subsidiary for inventory and eventually paid $3.5 billion in penalties to the IRS.
Carter said what he calls “the cookie jar philosophy” has taken hold at many multinational companies that adopt aggressive tax and transfer pricing strategies in the hope they do not get caught with their hands in the cookie jar.
“At IDEX we don’t subscribe to this at all,” Carter said of “the cookie jar philosophy.” “As you can imagine, it’s hit or miss.”
Tax arbitration is a potential solution to transfer pricing issues, but it requires cooperation between nations, according to Carter. He said India has struggled to agree with the U.S. on tax arbitration, but it is currently trying to reenter discussion on the matter. Another option is advanced pricing agreements that preemptively lay out pricing strategies and gain government approval before being put into action, Carter said.
Carter said that the ethical line between tax avoidance and tax evasion is often murky but must be carefully examined by everyone.
“I don’t ask you to be transfer pricing experts, but it is important to be aware of this topic,” he said.