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Published in: International Tax and Public Finance 2/2024

06-12-2022

Tax havens and cross-border licensing with transfer pricing regulation

Authors: Jay Pil Choi, Jota Ishikawa, Hirofumi Okoshi

Published in: International Tax and Public Finance | Issue 2/2024

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Abstract

Multinational enterprises (MNEs) have incentive to reduce tax payment through transfer pricing. The incentive is stronger when MNEs own intangibles, because it is easy to transfer them across countries. To mitigate such strategic tax planning, the OECD proposes the arm’s length principle (ALP). This paper deals with technology patents as an example of intangibles and investigates how the ALP affects MNEs’ licensing strategies and welfare in a model with a tax haven. The ALP may distort MNEs’ licensing decisions, because providing a license to unrelated firms restricts MNEs’ profit-shifting opportunities due to the emergence of comparable transaction. Interestingly, the termination of licensing in the presence of the ALP may worsen domestic welfare if the (potential) licensee and the MNE’s subsidiary do not compete in the domestic market but may improve welfare if they compete. The results under ad valorem royalty are in distinct contrast with those under per-unit royalty.

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Appendix
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Footnotes
1
Tax havens include Ireland, the Netherlands, Luxembourg, Switzerland, Singapore, the Bahamas, Barbados, Bermuda, and the Cayman Islands, among others.
 
2
The BEPS project was proposed by OECD in 2012 to limit the risk of tax avoidance by MNEs. In particular, 15 action plans were stipulated as international taxation rules. Currently over 135 countries and jurisdictions are collaborating on the implementation of the BEPS actions. For more detailed information, see the following web page: https://www.oecd.org/tax/beps/
 
3
Many countries have taken the OECD’s transfer pricing guidelines very seriously. In fact, some countries have renewed their law based on actions of the BEPS project. For example, Australia incorporated the OECD’s transfer pricing guidelines in its transfer pricing law. Section 1 Foreign Tax Code in Germany defines the main aspects of the German interpretation of the ALP. The UK also has enacted the OECD guidelines in its law. For more details, see the following web site: https://www2.deloitte.com/global/en/pages/tax/articles/beps-action-implementation-matrices.html
 
4
See https://www.oecd.org/tax/beps/beps-actions/action8-10/
 
5
One of the most famous examples of profit-shifting through intangible assets is the “Double Irish with a Dutch Sandwich” conducted by Apple, Google, and Facebook, among others. It was reported that Google saved at least $3.7 billion in taxes in 2016 using this method (https://www.irishtimes.com/business/economy/double-irish-and-dutch-sandwich-saved-google-3-7bn-in-tax-in-2016-1.3343205).
 
6
For empirical evidence of location choices for intangible assets, see Dischinger and Riedel (2011), Karkinsky and Riedel (2012), and Griffith et al. (2014), among others.
 
7
See the Financial Times (https://www.ft.com/content/d6a75b56-215b-11e8-a895-1ba1f72c2c11).
 
8
In the case of intangibles, the CUP method is often called the comparable uncontrolled transaction method.
 
9
The TNM method is explained in Sect. 2.3. The OECD proposes three different additional methods of exercising the ALP: the cost plus method, the resale price method, and the transactional profit split method.
 
10
An APA is a prior agreement between a tax payer and tax authorities on the method of calculating arm’s length prices for transactions between the taxpayer and its related parties. For details, see https://www.irs.gov/irb/2017-15_IRB. The comparable profits method is mainly used in the U.S. to calculate appropriate transfer prices. Basically, these two methods are the same, with the only difference being that the TNM method deals with investigations based on transaction units, whereas the comparable profits method investigates firm-level transactions.
 
11
See https://www.nta.go.jp/english/MAP-Report/2020.pdf.
 
12
Behrens et al. (2014) and Choi et al. (2020) also show that transfer pricing regulations may harm consumers and worsen welfare in different contexts.
 
13
We observe a number of cross-border licensing within an industry. For example, Fujifilm Corporation licensed its technology to produce antiviral drug called Avigan to an Indian and a UAE’s pharmaceutical company, Dr. Reddy’s Laboratories Ltd. and Global Response Aid in 2020. In addition, in 2021, Novavax Inc and Takeda Pharmaceutical Company Ltd. concluded their contract on the use of intellectual property rights for the production of vaccination of COVID-19. Ishikawa & Okubo (2013) also list many other examples of cross-border licensing to rival firms. For example, Samsung Electronics Co. Ltd. used to enter a lot of licensing contracts with Japanese and European firms.
 
14
Transfer pricing of tangibles has also been explored from different aspects. See Schjelderup and Sørgard (1997), Auerbach and Devereux (2018), Mukunoki and Okoshi (2021), and Kato and Okoshi (2022), for example. Studies that explore actions of the BEPS project other than transfer pricing include Gresik et al. (2017), Haufler et al. (2018), and Agrawal (2021), among others.
 
15
For example, royalty payments within the EU are exempted from the source tax.
 
16
In Sect. 4, we consider the case in which the goods are substitutes.
 
17
According to practitioners, decision making on transfer pricing is centralized in almost all the MNEs in Western countries. See (Mori (2014), p.410).
 
18
Our qualitative results do not depend on the MNE’s full bargaining power assumption. If the licensee has some bargaining power, the royalty rate would be lower and the MNE will have less incentives to license its technology. Nonetheless, the overall qualitative effects would be intact. In addition, if the licensing contract is a two-part tariff, the bargaining power by the licensee will only affect the lump-sum component and the royalty rate would be the same independent of the relative bargaining power of the MNE and the local firm.
 
19
Even if the foreign tax rate is higher than the domestic one, the analysis in this subsection would not change with the assumption that the MNE establishes a shell company in the domestic country and transfers its patent to the shell company.
 
20
In the presence of the external licensing, \(\pi _{y0}^{{}}\) equals firm Y ’s revenues because there is no FC for production.
 
21
In reality, it is often observed that intellectual property rights (IPRs) are transferred within a firm free of charge or at low prices. For example, when Google used a tax avoidance scheme, the Double Irish with a Dutch Sandwich, the headquarters transferred its IPRs to its Irish subsidiary at an extremely low price (see Saez and Zucman, 2019).
 
22
Some existing literature such as Peralta et al. (2006) and Yao (2013) considers cases in which the ALP completely eliminates the opportunity of profit-shifting. In our model, however, the MNE still enjoys some profit-shifting because the ALP makes the royalties equal between related and unrelated firms and a part of profits are shifted to the shell company. This is based on the assumption that the MNE can relocate the patent without any costs. Although such reallocation of technologies into tax havens is restricted and costly by current anti-tax avoidance measures such as the European exit tax and the modified nexus approach, the MNE can avoid such measures by relocating the intellectual property rights ex ante. The incentive of relocation ex ante is theoretically analyzed and supported by Sharma et al. (2021). See also footnote 21.
 
23
According to the Internal Revenue Service, the most frequently used PLI is operating margin (i.e., the ratio of operating profits to sales) which accounts for 67%. There are several other measures of the PLI, such as belly ratio and return on assets or capital employed, which accounted for 33%. On service transactions, the comparable profits method or the TNM method was used in 76% of the cases. The most commonly used PLI was the operating margin (43%).
 
24
Once an APA is made, the tax authorities neither adjust nor audit the pricing of specified transactions under the agreed to transfer pricing method for 3 to 5 years. In Japan, 133 APA applications were submitted in 2019. See https://​www.​nta.​go.​jp/​english/​Report_​pdf/​2021e.​pdf
 
25
As explained in above, this reference firm is not necessarily in the same industry or the potential licensee. For example, in March 1999, the Japanese national tax tribunal made a decision on arm’s length royalty based on 23 transactions as comparable transactions which included different countries and products. See Fujieda and Tsunoda (2020).
 
26
The domestic country may benefit from knowledge spillovers caused by licensing, which are beyond the scope of this paper.
 
27
We set \(A=B=a=b=1\) and \(c_{y}=\frac{1}{10}\) in Figs. 2 and 3.
 
28
See Appendix A for the proof.
 
29
Figures 4, 5, 6 are drawn with \(c_{y}=\frac{1}{1000}\) and \(A=a=1\).
 
30
This case is somewhat similar to the case explored in Choi et al. (2020). In fact, some of their results are applicable here.
 
31
Strictly speaking, the optimal price is less than \(c_{y}\) if \(c_{y}\) is sufficiently high. With Eq. (13), this is the case if \(c_{y}>B/2\). We assume away this case.
 
32
This tax-adjusted MC for the MNE is \(-\frac{t\upsilon _{x}}{1-t}<0(=c_{x})\) and is known as the perceived marginal costs in the literature. See Choi et al. (2018) for example.
 
33
Note that in the absence of the ALP, the Cournot duopoly equilibrium in the domestic market arises if and only if \(c_{y}<\frac{A(1-t)}{2-t}\).
 
34
\(\frac{A(1-t)}{2-t}>\frac{A(2-t)}{7-5t}\) if and only if \(t<\frac{1}{2}\).
 
35
Regarding the patent box, see Haufler and Schindler (2020), for example.
 
36
The following parameter values are set: \(A=1\), \(a=1\).
 
37
The following parameters are set: \(A=1\), \(a=1\), \(t=\frac{3}{10}\), and \(F= \frac{1}{500}\).
 
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Metadata
Title
Tax havens and cross-border licensing with transfer pricing regulation
Authors
Jay Pil Choi
Jota Ishikawa
Hirofumi Okoshi
Publication date
06-12-2022
Publisher
Springer US
Published in
International Tax and Public Finance / Issue 2/2024
Print ISSN: 0927-5940
Electronic ISSN: 1573-6970
DOI
https://doi.org/10.1007/s10797-022-09770-w

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