draining development.pdf - Khazar University

246 Draining Development?to pay US$3.1 billion in taxes related to an assessed income adjustmentbecause of improper transfer pricing and also agreeing not to seek relieffrom double taxation (which is available through the bilateral tax treatybetween the United Kingdom and the United States).A case of windfall profitsConsider the case of a large petroleum company doing business in ahigh-risk country. During a typically turbulent period (in a recess fromopen conflict and in the run-up to a contentious election), the governmentsolicits the assistance of the company’s local subsidiary in buildingan electricity generating station (not normally an activity that the companywould choose) and agrees to pay in barrels of oil (from governmentstocks) valued at the spot-market price (fixed over the term of the contract).14 In the circumstances, the level of conflict escalates; the currentgovernment is removed from power; and the world price of oil rises considerably.For the company, the contract terms yield a windfall: it is ableto sell the in-kind payment for roughly three or four times the fixedvalue set in the contract. In the normal course of business, the local subsidiarysells its local oil production to a foreign-related party (the group’strading subsidiary), which onsells to oil traders or refineries.In a country with ALP transfer pricing regulations, the differencebetween the price set by the contract and the arm’s-length price for localcrude would likely be attributed to the local subsidiary as income. Inturn, the trading subsidiary would be accorded a normal trading profit.In other words, given that the key value-driver in generating this incomewas the local contract and the related business risks assumed by the localsubsidiary, an ALP-consistent allocation of profits would call for thebulk of the total profit to be declared in the source country, and the tradingoperation would earn a return consistent with comparable companies(that provide similar services to third parties).Additional considerations are as follows:• During this time period, the source country had no specific transferpricing legislation, a marginal corporate tax rate of 60 percent, and agenerally weak tax administration.• By contrast, the OECD country where the trading subsidiary resideshad a highly competent tax administration (which would certainly