Pros and cons of using the arm’s length principle

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Transfer pricin

What is transfer pricing?

The definition of TP which is given by the OECD is that TP is the price used for transfers of goods, services and intangibles within MNEs (OECD TP guidelines, 1995). TP is defined by the Swedish tax authority as the prices which are used for border-crossing transactions performed between related parties (Skatteverket, 2010).
The first research concerning the subject of TP started with the seminal article that is written by Hirshleifer in 1956 and ever since then the research within the subject of TP has expanded widely. Hirshleifer’s article can be said to be the marking of the beginning of both corporations and academic concern within the subject of TP (Borkowski, 2001). According to Hirshleifer (1956) the problem of TP is important due to that such prices affect, the rate of return on investment by which each division is judged, the level of activity within divisions and the total profit that is achieved by the firm as a whole.
TP is a subject that has received attention during the recent years, this can be shown by the fact that during 1998 only five countries around the world had regulations concerning TP and demands of documentation of TP in their legislations. Only seven years later this number had risen to approximately 40 countries which had corresponding regulations (Riley and Ingram, 2008). One reason for why TP has gotten this attention during the recent decades even though it always has existed is that the influence and penetrating power of MNEs has increased drastically during the same time. Estimations have been made that somewhat around 70 percent of all trades around the globe is between businesses in relationship (Skatteverket, 2010). There are several reasons to the increasing growth in the world trade and why TP became an important issue, MNEs desire to expand their production by taking cheaper labor costs into account and the increased demands from lesser developed countries for wider ranges of goods and services from more developed countries. Another factor behind this expansion is the universal increase in the use of technology, especially computer systems that have resulted in a vast array of information being accessible in seconds (Adams et al., 1999).

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Advance pricing agreementsSpring 2011 Alm and Ehrstedt

There are mainly three reasons why corporations pay much attention to TP compliance, these are, the risk of double taxation, risk of significant consequences, both financial and reputational, in the case of non-compliance and the potential penalties (Cools and Slagmulder, 2009). Double taxation is a big risk of using TP, this since corporations are forced to follow not only the taxation regulation in their home country but also the regulation in the host country. These two regulations are most likely different and might therefore also be conflicting with each other (Eden, Dacin and Wan, 2001). One example on how double taxation can be a risk is that not all countries that the same business operates in, has the same tax rate. Therefore some associated businesses might agree on prices on another basis besides the arm’s length principle. This can be done solely to shift profits from a high-tax jurisdiction, such as Italy, Malta, Germany and Norway (based on corporate taxes during 2009), to a low-tax jurisdiction, such as Cyprus, Bulgaria, Estonia and Latvia (based on corporate taxes during 2009), and losses in the opposite direction. However, such manipulations of TP are constrained by tax regulations (Borkowski, 1997). Due to the risk of decreased tax incomes, governments of high tax jurisdictions have formulated new tax laws to make tax manipulations more difficult to achieve (Halperin and Srinidhi, 1996). TP used on transactions performed between different parts of a MNE which are located in the same country, does most often not imply any specific problems. This since most problems of TP arises due to cross-border transactions, such as double taxation and non-taxation.
Due to this problem tax authorities can perform unilateral adjustments of the TP to ensure that their country get what they consider to be their fair share of tax revenues (Terra and Wattel, 2008). If a business is practiced in more than one country and the different parts of the business are strongly integrated, than it can generate national difficulties when the taxable result shall be finalized. This is so since the taxable result shall be finalized in a way that contributes to a fair allocation between the concerned countries. Due to this it is desirable that the tax authorities develop a well functioning co-operation and a mutual vision on the TP area to prevent from unnecessary conflicts between the concerned countries. By doing so each concerned country can practice their right to tax the profits that can be said to be originated from each respective country and also the risk of double taxation will decrease (Skatteverket, 2010).
In a survey conducted by Ernst and Young (2010) it is shown that the pharmaceutical industry is found to view TP as their most important tax issue, followed by the technology and biotechnology industries. This might be the case since tax authorities normally target industries which have a high value, portable intellectual property and which generates high margins. Industries such as telecommunication and banking and capital markets, on the other hand, which are known not to have such high levels of cross-border transfers do not have such high concern with TP (Ernst and Young, 2010).

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1 Introduction
1.1 Background
1.2 Problem
1.3 Purpose and research questions
1.4 Delimitation
1.5 Outline
2 Method
2.1 Research approach
2.2 Data collection and analysis of secondary data
3 Transfer pricing
3.1 What is transfer pricing?
3.2 Swedish law
3.3 Swedish accounting standards
3.4 IFRS/IAS
4 Arm’s length principle
4.1 The principle in general
4.2 Pros and cons of using the arm’s length principle
4.3 OECD
4.4 Swedish Income Tax Act (1999:1229)
4.5 Tax surcharges
4.6 An example of the arm’s length principle
5 Pricing methods
5.1 What pricing method shall be applied?
5.2 Traditional transaction methods
5.3 Transactional profit methods
6 APA
6.1 Definition
6.2 History of APA
6.3 Advantages of APA
6.4 Disadvantages of APA
6.5 Article 25 OECD model tax convention
6.6 Unilateral APAs versus Bilateral APAs
7 Regulation of APA
7.1 OECD TP guidelines
7.2 European Union Joint Transfer Pricing Forum
7.3 APA legislation in Sweden
7.4 APA legislation in Germany
7.5 APA legislation in the Netherlands
7.6 APA legislation in the U.S.
8 Analysis
8.1 APA legislation within the scope of Europe
8.2 European APA legislations compared to U.S. APA legislation
8.3 What will the Swedish APA legislation imply for Swedish MNEs?
8.4 Will the advantages outweigh the disadvantages?
9 Conclusion
10 Further research
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Advance pricing agreements The concept and its implementation in Swedish tax law

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