International Finance and Mr. Potato Head

Lisa Pollack explains Internatinal Transfer Pricing (with particular reference to the ongoing saga of Starbucks in the U.K.) via that famed mouthpiece - Mr. Potato Head.
Oh, you do know about whats going on with Starbucks in the U.K., right? 
For those who haven't been following the sordid saga, the (extremely) short version is that despite having been in business in the U.K. for 14 years, and making around £400 million/year, they've paid a grand total of £8.6M. Over 14 years.  They get away with it because they do fun stuff like royalties paid to Starbucks Netherlands, coffee purchased from Starbucks Switzerland, and no doubt "Because International Finance".
This is actually a bit more than forum shopping - its basically moving finance widgets around the global chessboard which can be done for good or for evil - and thats what is called Transfer Pricing.
 And this is where Mister Potato Head comes in.  I've excerpted the article below - go read the whole thing at the source...

[...C]onsider Mr Potato Head:

Let’s say Mr Potato Head is owned by Toy Corp, USA (for the avoidance of doubt — we’re making this up for the purposes of this example). Additionally assume that he’s assembled on US soil with locally sourced parts. He’s exclusively sold to the domestic market.

In such a simple scenario, all of the revenues and costs of Toy Corp would arise within US borders and the Internal Revenue Service would no doubt receive its fair share of tax.

Let’s take over the world

Things can quickly get complicated when Toy Corp launches foreign operations.

Say Toy Corp wants to branch out to the European market. To assist this, the company opens a subsidiary in the UK.

Now imagine that most of the world’s plastic nose trading occurs in Switzerland. After being purchased by Toy Corp’s Swiss employees, the raw noses are shipped to the Netherlands for painting.

Also worth mentioning — the blueprints for manufacturing Mr Potato Head (potato body plus parts) are ‘owned’ by another Toy Corp company. That one is in the Cayman Islands.

Given that the blueprints are in the Carribean, the noses are purchased in Switzerland and then painted in the Netherlands, plus the marketing for Mr Potato Head is handled mostly by the US corp, how should the tax accounts of the Toy Corp subsidiary in the UK be compiled?

Some potential line items:

£10.0m Mr Potato Head sales
(£3.0m) Manufacturing costs in the UK
(£2.5m) Other UK cost of sales, e.g. salaries
(£0.5m) Purchase of noses from Dutch Toy Corp
(£1.0m) Royalty payment to Cayman entity
(£0.4m) Marketing costs paid to US Toy Corp
£2.6m Taxable income in UK

The £5.5m of costs in the UK are uncontroversial.

Becoming more tax efficient

The next three line items are where transfer pricing come in. If the Dutch entity — that itself buys raw noses form the Swiss entity — pays lower tax, then one can see how it’s in the overall interests of the Toy Corp group to claim that the final noses are expensive.

Expensive noses mean lower UK tax liability, and more revenue in a country (the Netherlands) where the tax suffered is lower. The company ends up with more cash overall and higher profits at the group level through such maneuvering.

The same goes for the royalty payment to the Cayman entity, which is paid because that entity owns the blueprints for Mr Potato Head. The UK entity is using that intellectual capital.

As for the marketing costs, that’s sending money to a higher tax jurisdiction, so not as potentially tax efficient. But hey, can’t get everything right! That would look bad.

Inspectors call

Given all of this, if you were investigating how aggressive Toy Corp is being with its tax planning, you’d probably ask yourself these sorts of questions:

• Does Toy Corp have genuine operations in the Netherlands, Switzerland, and the Caymans, or are those just shell entities?

• Does Toy Corp UK pay a fair (“arms length”) rate for the noses?

One would be particularly curious to get good answers to these questions if Toy Corp UK was in fact making a loss for tax purposes.

It could well be that Toy Corp UK’s tax accounts are a genuine reflection of its costs of doing business. Imagine the market clearing rate for noses is £3.0m, but the UK entity only paid £2.0m to the Dutch entity. This could be harmful to the Dutch entity if it then can’t meet its costs, and the UK entity is going to get taxed more than its fair share, possibly causing it to lose ground to competitors in the British toy market.

Competing with tax rates

Transfer pricing should allow entities to be taxed fairly on their operations in each country in which they do business. But, well… some countries do effectively compete for business activity to be done within their borders with tax incentives.

Companies, quite rationally, respond to that and can go quite far with it, while still very much landing within legal boundaries. Maximising profits is part of one’s fiduciary duty to the owners (shareholders) of the company after all.