draining development.pdf - Khazar University

Tax Evasion and Tax Avoidance: The Role of International Profit Sharing 119IRS regulation 482 stipulates that this method can only be applied touncontrolled transactions (see section 1.482-1e, iii [C]), which meansthat only transactions between unrelated parties can be taken intoaccount in assessing whether or not a transfer price is acceptable. Transactionswithin multinational firms must be excluded. The reason isthat transactions between unrelated parties are more likely to reflectundistorted prices. Effectively, the IRS approach compares transactionsbetween unrelated firms to transactions between related firms. In contrast,Pak (2007) applies the price filter method to all transactions, includingtransactions between related parties. This is fundamentally different.An approach that uses a method consistent with IRS regulation 482 isapplied in a study of trade mispricing by Clausing (2003). This studyfocuses on U.S. external trade, however, not on developing countries inparticular. Clausing (2003) compares the prices in trade transactionsbetween related parties with the prices in transactions between unrelatedparties and shows that the differences are significantly influencedby tax rate differences. For instance, in transactions between related parties,the prices of exports from low-tax countries to high-tax countriesare higher than the prices in transactions between unrelated parties. Thissuggests that multinational firms try to reduce the taxes they have to payby manipulating transfer prices.Of course, one could argue that mispricing is also likely to occur intransactions between unrelated parties. For instance, an exporter locatedin a low-tax country and an importer in a high-tax country could agreeto increase the price of the transaction. This agreement could include aside payment that the exporter makes to the importer. Such a paymentwould have to be concealed from the tax authorities. If this happens, theapproach used in Clausing (2003) systematically understates the impactof tax differences on profit shifting through transfer pricing. However, amere price manipulation in a transaction between related parties ismuch easier than a price manipulation, combined with a concealed sidepayment by which the importer would participate in the tax savings.Profitability and profit shiftingAs mentioned above, a second approach to measuring income shiftingdirectly considers the profitability of firms and asks whether the profitabilitypattern observed may be explained as a result of income shifting.