Transfer Pricing, Mispricing & Trade Misinvoicing: Are They Alike?
THESE DAYS, three terminologies are frequently invoked by our public officials. They are transfer pricing, transfer mispricing and trade misinvoicing. All three are often placed in the same lengthy sentence, particularly in relation to the loss of state revenues.
Consequently, the impression arises that these three terminologies—transfer pricing, transfer mispricing and trade misinvoicing—are similar concepts, all detrimental to revenues, represent conduct of equally serious severity and are interchangeable. Is this correct?
If not, the confusion and public misunderstanding in viewing these three matters may lead to serious consequences. For instance, generalising policy solutions, law enforcement treatment and so forth.
Understanding Transfer Pricing
Any attempt to define transfer pricing should properly begin with an understanding of the internalisation theory (Rugman, 2006). Internalisation theory explains why and how multinational enterprises are established. The theory departs from the thesis concerning the importance of collective organisation among parties that are mutually dependent, with a view to obtaining a more optimal advantage or return.
Internalisation theory constitutes a development of the theory of direct investment and industrial organisation, which rests on the assumption of the existence of market imperfections (or failures). When the market is under an imperfect condition, market participants (firms) must incur additional costs to address various transaction barriers in the open market. For instance, to obtain certainty of quality supply, to gather information on market conditions, to ensure innovations and so forth.
Consequently, all business activities of a firm—including cross-jurisdictional transactions—will become more efficient if there is a genuine effort to manage costs that previously could not be fully controlled by the firm. Coase (1956) termed these costs transaction costs or external costs.
As such, what is the strategy for managing such costs? The approach is to replicate the workings of the market and business functions within an organisation under a single common control (Caves, 2007). The organisation of multinational enterprises is generally conducted through three schemes (Eden, 1998; Li and Paisey, 2005), namely vertical integration, horizontal integration and conglomeration. Rather than transacting with market participants in the open market with high uncertainty risks, multinational enterprises replicate the workings of the open market through transactions with affiliated parties that offer greater certainty and guarantee synergies.
Over time, transactions with affiliated parties that initially emerged as a response to market imperfections subsequently became entrenched as competitive advantages of a multinational enterprise. This is especially so with a focus on the three advantages commonly referred to as the OLI paradigm, namely ownership, location and internalization (Dunning, 1993).
The growing dominance of internal transactions conducted between entities in a special relationship clearly gives rise to a further consequence: transfer pricing. From this perspective, we may conclude that transfer pricing is a neutral term and a logical consequence of the multinational enterprise business model that generally operates and transacts across jurisdictions.
Understanding Transfer Mispricing
Unfortunately, the term transfer pricing is often connoted as something negative and carries a 'pejorative' meaning, namely profit shifting (taxable income) from one company within a multinational enterprise group to another company within the same multinational enterprise group in a country with a lower tax rate. This is conducted in the context of reducing the total tax burden of the multinational enterprise group.
The 'pejorative' meaning, in fact, refers to what is known as transfer mispricing, the manipulation of transfer pricing or abuse of transfer pricing. Transfer mispricing may be defined as a transfer price policy set above or below opportunity cost in the context of avoiding government control and/or engaging in activities that exploit regulatory differences between countries, particularly in relation to tax rates (Eden, 2003). In short, transfer mispricing is the activity of setting a transfer price to be 'too high or too low' with the intention of reducing the amount of tax payable (Darussalam and Septriadi, 2008).
For state revenue purposes, tax authorities across various jurisdictions may well suspect and classify transfer pricing schemes as mere tax avoidance. Imagine if every tax authority in various countries held the same 'suspicion' and possessed unlimited authority over tax corrections and/or law enforcement in the area of transfer pricing. A situation of economic double taxation would arise and would ultimately distort flows of international investments and trade (Darussalam, Septriadi, Kristiaji, 2013).
It is therefore that a common standard is required as a global consensus. Such a standard must be capable of classifying what constitutes transfer mispricing and what does not as well as what constitutes tax avoidance and what does not. It must also serve as a tool to prevent double taxation on cross-border transactions. This is because the transfer pricing issue is fundamentally a dispute over the allocation of tax between governments (G2G).
That standard refers to the arm's length principle (ALP or prinsip kewajaran dan kelaziman usaha/in Indonesian). The ALP underlines that the authority of tax authorities to perform corrections is only permitted when the price or profit derived from a transaction between related parties is not comparable to a transaction conducted with or between independent parties. In short, an uncontrolled transaction is the benchmark of a transaction considered at arm's length or compliant with the ALP (Owens, 2005).
Historically, this concept was first introduced in the Carroll Report (1933), adopted by the League of Nations and promoted by the OECD. The OECD embedded the ALP in Article 9 paragraph (1) of the Model Tax Treaty, which subsequently became the reference for drafting and negotiating tax treaties globally. The elaboration of the ALP was subsequently set out in detail through the OECD Transfer Pricing Guidelines, published in 1979, 1995, 2010 and 2022.
Kindly note that the OECD Transfer Pricing Guidelines are fundamentally soft law and non-binding. Nevertheless, the majority of transfer pricing provisions in various countries are influenced by or fully reference those guidelines. Indonesia is no exception, where the application of the arm's length principle in transactions influenced by a special relationship is stipulated under the Minister of Finance Regulation (MoF Reg.) 172/2023.
Understanding Trade Misinvoicing
Unlike transfer mispricing, trade misinvoicing departs from a field of discussion that is relatively more negative. The term trade misinvoicing is associated with illegal conduct, driven by efforts to avoid levies in international trade and can be conducted not only by affiliated parties.
Literature citing trade misinvoicing is generally associated with the topic of illicit financial flows (IFF). According to Baker (2005), IFF is defined as money that is illegally earned, moved, or used that crosses an international border. Examples include funds sourced from corruption, conducted through large-scale gold smuggling or used to finance terrorist activities.
IFF is generally undertaken through various methods, including illicit tax and commercial practices, categorised into two activities, namely (i) illegal tax, which generally refers to tax evasion that is inherently illegal and classified as a criminal matter, and (ii) aggressive tax avoidance, which is legal in nature and falls within the administrative sphere (UNODC, 2020).
It is important to note that trade misinvoicing constitutes part of the illegal tax family. Whereas, transfer mispricing constitutes part of aggressive tax avoidance. Nevertheless, trade misinvoicing and transfer mispricing both constitute part of IFF schemes (Collin, 2019).
Trade misinvoicing itself is defined as a method of moving funds illicitly by deliberately incorrectly declaring the value, quantity and/or type of commodity when conducting international trade transactions (Global Financial Integrity/GFI). Trade misinvoicing is deemed the most dominant IFF method.
The most commonly used research method for calculating trade misinvoicing is trade mirror statistics (Marur, 2019). In simple terms, this method identifies and assesses the amount of the discrepancy between a country's recorded exports to a counterparty country and that counterparty country's recorded imports. As an illustration, Indonesia's recorded rice export figures to Thailand would be compared with Thailand's recorded rice import figures received from Indonesia.
Although widely used, this method is not without criticism (Nitsch, 2017). The principal criticism lies in the oversimplification of the assumption that any discrepancy arising is used as an indication of trade misinvoicing. In reality, such discrepancies may arise from technical factors, such as differences in exchange rates, differing calculation methods between countries, non-integrated data between ports, particularly in archipelagic nations and so forth. As a result, the value of trade misinvoicing findings is potentially overestimated.
Trade misinvoicing is generally driven by several factors, such as money laundering, tax and customs evasion, seeking certain incentives and exploiting gaps in capital control regimes (Celasun and Rodrik, 1989; Chalendard, Raballand and Rakotoarisoa, 2016). Fairly common methods include over-invoicing or under-invoicing the value of exports or imports.
Nevertheless, there are in fact many other schemes, such as ghost shipments (declaring the import of certain goods when the goods never arrive), false misclassification (declaring the export of commodity X when commodity Y is actually being exported), quality misinterpretation (declaring the import of a commodity X at low quality when it is, in fact, the highest quality), carousel trade (import-export activities that merely call at many ports without unloading cargo) and so forth. One thing is certain: each of these methods presents different prevention challenges.
Are the Three Interchangeable?
Based on the foregoing discussion, we may conclude that the three terms must be viewed, interpreted and treated differently.
Transfer pricing is the activity of determining a transfer price conducted between related parties in a multinational enterprise group. Transfer pricing is a logical consequence of the internalisation and integration conducted by multinational enterprises in the context of achieving economies of scale, synergies and at the same time, reducing uncertainty in the open market. At this point, there are no legal consequences arising from transfer pricing practices.
Transfer pricing conducted between related parties may only be declared as transfer mispricing where there has been a violation of the arm's length principle (ALP). Pursuant to both the OECD Transfer Pricing Guidelines and MoF Reg. 172/2023, the testing of the application of the ALP must be conducted in stages and is relatively complex. This ranges from industry analysis, comparability analysis, the selection of a transfer pricing method, to the use of an arm's length range.
From the perspective of legal concepts, legal interpretation and comparative studies, transfer mispricing is classified as tax avoidance, which is legal in nature but contrary to the intent behind the legal instrument (Forstater, 2018). Accordingly, the legal treatment of transfer mispricing falls within the administrative sphere, unless there are other accompanying acts that give rise to criminal liabilities.
Further, transfer mispricing is not trade misinvoicing. Both are part of illicit financial flows (IFF) and have an impact on the 'leakage' of state revenues. However, the two have crucial differences and are not equivalent (GFI, 2019; UNODC, 2020).
Transfer mispricing occurs when a price recorded in an official document (invoice) is a price agreed upon between the transacting parties, but is not at arm's length compared with a transaction conducted between independent parties. According to the UNCTAD (2016), transfer mispricing will not produce a discrepancy between export and import records because both use the same agreed price and are officially declared by both parties. Nevertheless, the declared price does not necessarily satisfy the ALP.
As an illustration, take a commodity with a fair market value of USD150. Due to the existence of a special relationship between the exporter and the customer, the export price of the commodity may be set in a manner that does not fulfil the arm's length principle (ALP), at USD130. That agreed price is subsequently outlined in the official document (invoice) at the same value, namely USD130. Accordingly, although there is a difference between the controlled transaction price and the market price (USD130 < USD150), the agreed transaction price is the same as that listed in the invoice (USD130 = USD130).
On the other hand, a trade misinvoicing scheme in the context of pricing is where the price recorded in the invoice differs from the price agreed between the seller and the buyer.
As an illustration, take a commodity with an international market price of USD150. The exporter and the customer in another country subsequently agree on a negotiated price of USD130. In the official export documents, the exporter records USD100 as the price of the commodity. Accordingly, there is a discrepancy between the price recorded in the export documents and both the agreed price and the international market price (USD100 < USD130 < USD150).
This conceptual distinction is even affirmed by Global Financial Integrity (GFI), as a party focused on mainstreaming IFF issues. Although frequently used interchangeably, the two must be viewed as separate matters.
Unlike transfer mispricing (as one form of tax avoidance), trade misinvoicing involves an effort to report the value, quantity and type/quality of a commodity incorrectly in customs documents/transactions. The two also require different solutions. This is because trade misinvoicing is illegal tax evasion, whereas transfer mispricing is legal tax avoidance.
In conclusion, transfer mispricing is clearly not the equivalent of trade misinvoicing. Confirmation of this matter can be found in "Illicit Financial Flows, Trade Misinvoicing, and Multinational Tax Avoidance: The Same or Different?" written by Maya Forstater (2018). Based on analysis from the perspective of definitions, historical review, measurement methods and the legal sphere, she concludes that transfer mispricing differs from trade misinvoicing. (dik)
