Transfer Pricing and Tax Implications Transfer pricing © Taxation * Ethics * Corporate governance * Risk management © Business performance Background of transfer pricing Transfer pricing is a method used by some companies to increase profit and lower tax expenses by performing intercompany transactions. Allocation of group-wide taxable income across national tax jurisdictions are directly affected by transfer pricing. Hence, a company’s transfer- pricing policies can directly aftect its after-tax income to the extent that tax rates differ across national jurisdictions. Determining a company’s transfer prices requires identifying where value is created in an organization and transferred across group members. Most foreign tax authorities also specify similar methods to choose from. Transfer pricing gives taxpayer advantages to reduce tax expenses. If the transfer is done to the price of goods and services in a low tax rate, a company would enjoy a tax haven. As a result of this, the company’s profit will be higher. Figure 1 demonstrates the transfer pricing mechanism There have been a number of companies which have misused the transfer pricing mechanism. One of them is Starbucks Coffee. Starbucks’ manufacturing subsidiary in the Netherlands bought green coffee beans from the global buying operations in Switzerland, which is a tax haven, Starbucks then paid inflated price for the beans, allowing Starbucks to shift profit to Switzerland. Later, Starbucks paid royalties to Alki LP in the UK for roasting and blending the formulas. Starbucks then shifted its taxable profit to the UK.118 Integrated Case Studles for Accounting ‘Country A Sales of finished goods MANUFACTURING CountyB HOLDING COMPANY ~~ i Royalties INTELECTUAL Licence PROPERTY COMPANY Country D aes DISTRIBUTOR ces Figure 1 The transfer pricing mechanism Executive summary As the Director of Finance of Apfel, Michael McMonaghan has found out that Apfel might face the transfer pricing regulations risk for tax avoidance. He realized that both subsidiaries in Ireland have been granted undue tax benefits by the Irish government after recalculating the retrospective tax assessments. This had been in contrast with the European Commission state aid rules. He faces an ethical dilemma about the newfound information. There is a discussion between Michael and Rebecca Quin, the Director of Operations of Apfel, about whether there is a need for the changes of operation structure in the two subsidiaries. There is an argument between Michael and Scott Trenton, the representative from Apfel in the United States, about the ethical issues of their current tax practice. Corporate governance practices in Apfel also contribute towards the aggressive tax planning, Michael will have to take some actions as the Director of Finance in order to solve the ethical dilemmas arising from the aggressive tax planning that is legal but unethical. About Apfel Apfel was founded in 1976 with its headquarters located in California, United States. It is a multinational company that specializes in the production of a line of portable digital phones, players, computers, notebooks, operating systems and software. Apfel’s products are sold through its own chain of retail stores in more than §0 countries. Apfel has a strong customer base in the consumer electronics industry especially in Europe and the United States with its unique reputation, Its other main markets are Ireland, Japan, Germany, France, Spain, Canada, UK and Italy Apfel had started its production facilities and operation in Holyhill, Cork, on 23 December 1980. Apfel Sales International and Apfel Operations Europe are two Irish-registered companies that are owned by the ApfelCase 21 Transfer Pricing and Tax Implications 119 J group and controlled by the US parent, Apfel Incorporated. The taxable profits of Apfel Sales International and Apfel Operations Europe in Ireland are determined by a tax ruling granted by Ireland in 1991, which in 2007 was replaced by a similar second tax ruling. This tax ruling was terminated when Apfel Sales International and Apfel Operations Europe changed their structures in 2015. Apfel Sales International is responsible for buying Apfel products from equipment manufacturers around the world and selling these products in Europe. Apfel set up its sales operations in Europe in such a way that customers were contractually buying products from Apfel Sales International in Ireland rather than from the shops that physically sold the products to customers. This way, Apfel recorded all sales, and the profits stemming from these sales, directly in Ireland. Under the agreed method, most profits were internally allocated away from Ireland to a ‘head office’ within Apfel Sales International. This ‘head office’ was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings. There is only a small fraction of the profits of Apfel Sales International that were allocated to its Irish branch and thus subjected to tax in Ireland. The remaining vast majority of profits were remained untaxed via allocation to the ‘head office’. Apfel’s business model Apfel manufactures hardware through contract manufacturers like Foxconn, and with a focus on software integration and the complete user experience Apfel sells its products through the retail channel, playing the role of wholesaler, while also selling directly to consumers through stand-alone retail stores and an online store, by the traditional retail and manufacturer direct business models, respectively. The business model of Apfel can be divided into several important portions including the cost structure and revenue stream The simplified version of Apfel’s business model can be seen in Figure 2. Key Partners Manufacturers Key Activities Value Propositions ‘App store developers Design Design Publishers Software development Convenience/usabilty Cellular service providers Quality contro! Performance Music, television and Manufacturing Brand/Status movie industries Revenue Streams Sale of products Media salesiiicensing Rental and subscription fees Figure 2 Apfel’s business model120 Integrated Case Studies for Accounting ‘Apfel holding company (Apfel Operations Heland, AO!) Aptel Operations Europe (AOE) _— “ Foreign-based companies’ eaeasy — sales income _-"| International (As!) ireland ol ~ Ss Offshore Tita pany | detiton manufacturer | Goods subsidiaries Ching | BEDE ery peers ener Ireland! Singapore J 7 Consumers Figure 3 Apfel’s offshore distribution structure Apfel has two subsidiary entities in Ireland, which are Apfel Sales International (ASI) and Apfel Operations Europe (AOE), that effectively own most of the company’s intellectual property. These two companies earn income from the licensing arrangement that gives intellectual property license to other global Apfel subsidiaries. For instance, when Apfel’s product is sold in China, the Apfel’s Chinese subsidiary must pay the Irish company (ASI and AOE) to reflect the use of the Irish companies’ intellectual property. Case organization and materials ‘Recently, more and more multinational corporations have been in the limelight due to the avoidance of taxation of the profit via various methods. However, the usage of transfer pricing as a method of corporate tax planning had been a prominent issue for the past few years. High-valued companies such as Google, Microsoft and Starbucks have been found guilty of deliberately reducing the payment of the actual assessment of corporate income tax by extensive usage of the transfer pricing mechanism.’121 J Case 21 Transfer Pricing and Tax Implications While reading the local Irish newspaper, Michael McMonaghan was pondering the implications of the similar transfer pricing regulations towards his company as well. As a recently-hired Director of Finance, he believed that ‘Apfel was using the similar mechanism of using transfer pricing as a legal way of reducing the corporate tax assessment. However, as he delved deeper into the financial and tax practices of the company, he found that Apfel had been paying a very low rate of income tax of just 0.005% since 2014. Previously, it had only been assessed at 1% effective corporate tax rate in 2003. This is a huge difference from the Ireland’s tax rate of 12.5%. Michael thought that these practices may have gone too far. After recalculating the retrospective tax assessments for the previous years, he found that both subsidiaries of the Apfel in Ireland, namely Apfel Sales International and Apfel Operations Europe, had been granted undue tax benefits of up to €13 billion by the Irish government. Thus, Michael found himself in a sticky situation where he must decide on what to do next with this newfound information. According to the European Commission, the European Union’s (EU) executive arm, member states of the EU cannot give tax benefits to selected companies as it is illegal under the EU state aid rules. This has prompted Michael to further think along the lines on what are the implications that will affect the stakeholders of all the parties involved. Should he report this information and cooperate with the European Commission, or should he keep silent on the matter? Does the Irish tax authority know about the ‘preferential’ treatment that Apfel had been receiving? What are the ethical dilemmas faced by Michael in relation to this issue? Michael contacted the Director of Operations, Rebecca Quin, about Apfel’s transfer pricing issues. She mentioned that Apfel has had a long history in Ireland. It opened its production facilities in Holyhill, Cork, on 23 December 1980 and became an important part of the local economy. Its corporate structure consists of two subsidiaries: Apfel Operations Ireland (AOI) and Apfel Sales International (ASI). AOI acts as an internal financing company and claims to be a tax residence of Bermuda, a tax haven country. ASI, which has computer manufacturing operations, is an Irish-registered subsidiary of Apfel Operations Europe (AOE). AOE and ASI entered an Irish advanced pricing arrangement back 1991, which was later updated in 2007.122 integrated Case Studies for Accounting After their lengthy discussions about the subsidiaries and its impact on the transfer pricing arrangement in Ireland, it was found that the pricing arrangement between Apfel and Ireland was not supported by an economic assessment and was in part supported by employment considerations. Michael and Rebecca came to a conclusion that something had to be done about Apfel’s operation in Ireland. Should Apfel change its operations and/ or organizational structure? How can it avoid such transfer pricing issues from arising in the near future? Duiing one of the regular boardroom meetings among directors, Michael addressed the issue of the retrospective tax assessment of €13 billion and its potential implications. The representative from the United States to Europe, Scott Trenton, stated that it was a common practice for large corporations such as Apfel to practise transfer pricing due to the huge tax burden. Under the current agreement with Ireland, the arrangement is treated as a state aid from the Irish government. Scott mentioned again that Apfel had done every tax reporting in its subsidiaries all over the wotid in a legal manner and there was nothing wrong with Apfel’s current practice. Michael argued that aggressive tax planning by using transfer pricing will backfire on Apfel in the long run. Besides that, he thought it was necessary to address the ethical issues of aggressive tax planning. Although corporate tax planning is completely legal, it’s not ethical if it’s done aggressively. Of course as a for-profit organization, our main objective is to continuously make profit, and we are allowed to utilize the tax benefits made for us. However, it’s also important that we pay taxes accordingly as we are also using the country’s resources for the operation of our business. Besides, paying tax to the government will also bring back economic growth to the country, and we can further benefit from that as well. Michael: Scott: Michael, you're still new to Apfel. We're currently struggling through hard times. It’s important we utilize all the tax benefits we have in order to cut costs and increase our profit wherever possible. Besides that, our pending lawsuits in other countries are also a contingent liability to us that we need to consider as well. I consider that this issue of retrospective taxation is something that should not be brought up to the authorities as it will only make us look bad. We don’t want to get into another lawsuit with the government of Ireland. And as far as the agreement goes, we had held up our end of the bargain. ‘We reported everything legally. We're not avoiding tax; we're merely reducing it. Michael was still unsatisfied with the explanation given by Scott. He knew that his argument alone was not enough to convince Scott. He then proposed a corporate governance fortification to address the issue ofCase 21 Transfer Pricing and Tax Implications 123 excessive transfer pricing. He thought that by doing this, he would be able to influence Scott and the rest of the board to convince them that Apfel was currently at a risk of facing a huge lawsuit if it is indicted by the authorities in Ireland. How should he address this? How would he be able overcome the ethical dilemma faced and what are the alternatives that he could use to convince Scott? With all the problems at hand, Michael believed that it was unhealthy for Apfel to continue its practices in this manner. Remembering the article in the newspaper that he had read, he was sure that Apfel was within the authorities’ scrutiny. Juggling his responsibilities at home and at work, he was facing the risk where, in the near future, he could be convicted as well if Apfel was found guilty. He might lose his job due to his failures to alert the related parties. What could he propose to Apfel to do next? Overall, were there any changes that can be made that were within Michael's jurisdiction and powers as a Director of Finance? What were the limitations that he faced? After a long reflection of the issues highlighted in the newspaper, Michael started to summarize the issues which he thought might be relevant to Apfel. These included: * identifying what are the ethical dilemmas faced in relation to the newfound information regarding the ‘preferential’ tax treatment * investigating the challenges faced by the tax authority on the issue of transfer pricing © investigating the actions taken by various stakeholders (the company itself, the tax authority, etc.) in curbing the issue of transfer pricing illegality * considering what are the implications that will affect the stakeholders in curbing the transfer pricing illegality © investigating the causes and the opportunity of applying transfer pricing methodologies * considering whether the company should change its operations or organizational structure to avoid the transfer pricing illegality in the near future © investigating the role of corporate governance policies in determining transfer pricing mechanism used. Contemplating these issues, Michael also concluded that it was important for Apfel to consider its legal and ethical standpoint before making any huge changes to its financial policies, especially in relation to tax assessments and transfer pricing methodologies. He was of the opinion that Apfel must be responsible in abiding by the contract set upon it and it must always notify the tax authorities before making any material steps that would eventually affect how Apfel was being assessed in terms of its tax matters. By having a legal standpoint (fully abiding by the contract without ambiguity), Apfel can protect itself even if it faces any sanctions or legal lawsuits by the authorities. He believed that Apfel was not at risk of facing huge losses in a contingent liability.124 Integrated Case Studies for Accounting Michael also was at the juncture of where the issue of ethics was heavily emphasized whenever it came to transfer pricing and its role as a method to devise comprehensive tax planning. Although tax planning is legal, it would transcend the boundary of ethicality if it was done too aggressively. In the case of Apfel, it had utilized the transfer pricing mechanism way too much until it had reached a point where its tax payment to the Irish government was very small compared to other companies that were incorporated in Ireland (which had to pay at a 12.5% tax rate). There were guidelines that must be followed thoroughly in order to ensure a fair tax assessment and payment by Apfel to the Irish tax authorities. Although the main goal of any profit-based organization is to gain profit by its operation, it should not neglect the responsibilities of paying tax to its host country as well. Now he was even worried about the transfer pricing treatment and concerned about whether Apfel should pay taxes at the stipulated tax rates of the country. He realized that even multinational companies that were spreading their businesses and operations in other countries must adhere to the guidelines provided when it came to cross-border tax practices, whether locally or internationally. This was to ensure fairness between the company and the country itself so that a win-win situation is achieved when it came to tax assessments and payments. Application Questions 1 Should Michael report the newfound information and cooperate with the European Commission, or should he keep silent on the matter? Does the Irish tax authority know about the ‘preferential’ treatment that Apfel has been receiving? What are the ethical dilemmas faced by Michael in relation to this issue? 2 Should Apfel change its operations and/or organizational structure? How can it avoid such transfer pricing issues from arising in the near future? 3. Michael is planning to enhance the corporate governance of Apfel so that Apfel can reduce the risk when it comes to the issue of transfer pricing. How should he propose this? How can he overcome the ethical dilemmas faced and what are the alternatives that he can use to convince Scott? 4 Michael is facing the risk where he could be convicted as well if Apfel is found guilty. He might lose his job due to his failures to alert the related parties. What can he propose to Apfel to do next? Overall, are there any changes that can be made that are within Michael’s jurisdiction and powers as a Director of Finance? What are the limitations that he faces?Case 21 Transfer Pricing and Tax Implications. 125 References Apple Owes Ireland €13 Billion In Back Taxes. (2016). 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