Transfer Pricing Evasion

Is the Arms Length Principle a conduit for tax evasion ?

Posted on May 6, 2015 · Posted in General

UBSBy Moses Kulaba

In recent years the concept of arms length principle has become controversial in tax debates. The core of the discussion revolves around the fact that in this interconnected digital globalised economy the concept has become a conduit for tax evasion as multinational companies manipulate prices to achieve a tax advantage. This article critically discusses the concept of Arms length principle and showing how this is dealt with in Tanzania’s Income Tax Act to control manipulation of Transfer prices

 The arms length principle of transfer pricing states the amount charged by one related party to another for a given product must be the same as if the parties were not related. An arm’s length price for the transaction is therefore what the price of that commodity would be on the open market[1] According to the Arm’s length principle the conditions of cross border transactions between different parts of multinational enterprises should not differ from those which would be agreed between independent firms i.e they should not be distorted by the control relationship that exists between them[2]. From the above descriptions, it is evident that the concept of Arm’s length arises where there are transactions between related parties. The Arm’s length principle is therefore used in determining whether the companies or related entities are engaging in transfer pricing or mispricing arrangement through manipulation of their prices to achieve tax avoidance or evasion purposes.

 By definition, transfer pricing refers to an economic term which refers to the valuation process for transactions between related entities or parties. Transfer mispricing occurs when the prices between related or associated companies is not under the arms length principle.  A transfer pricing arrangement is said to occur whenever two or more business (whether corporations or not) which are owned or controlled directly or indirectly by the same people trade with each other. The term is used because if the entities are owned in common they might not fix prices at a market rate but instead fix them to achieve another purpose[3] In some literature transfer pricing refers to the allocation of profits for tax and other purposes between parts of a multinational corporate group[4].

 Consider a profitable UK computer group that buys micro-chips from its own subsidiary in Korea: how much the UK parent pays its subsidiary – the transfer price – will determine how much profit the Korean unit reports and how much local tax it pays. If the parent pays below normal local market prices, the Korean unit may appear to be in financial difficulty, even if the group as a whole shows a decent profit margin when the completed computer is sold. UK tax administrators might not grumble as the profit will be reported at their end, but their Korean counterparts will be disappointed not to have much profit to tax on their side of the operation. This problem only arises inside corporations with subsidiaries in more than one country; if the UK Company bought its microchips from an independent company in Korea it would pay the market price, and the supplier would pay taxes on its own profits in the normal way. It is the fact that the various parts of the organisation are under some form of common control that is important for the tax authority as this may mean that transfers are not subject to the full play of market forces.

The arms length principle therefore aims at achieving two major objectives; protecting a country’s tax base against shifting of profits abroad or offshore and secondly minimizing the risk of tax disputes and room for double taxation which could arise if two countries in which the multinational has operations take different opinions as to what constitutes a ‘fair’ market price. Under the arms length principle, the conditions of commercial or financial transactions between different parts of a multinational enterprise should not differ from those which would be made between independent enterprises in comparable circumstances. If the principle of arms length is not taken into consideration, in effect economic double taxation could arise if the same amount of profits is being taxed in two different jurisdictions which have a divergence of opinion as to what constitutes a fair market price.

The arms length principle therefore becomes important for governments in ensuring that taxable profits of multinational enterprises are not artificially moved out of their jurisdiction and that the tax base and volume of profits reported by multinational companies in the country reflect the economic activity undertaken therein.  It is also important for ensuring that the potential for ‘double non taxation’ is minimized where multinational companies escape being taxed in both jurisdictions where there operations are located as either resident or nonresident entities

For the tax payers, and in this case the multinational companies, the arms length principle is vital in reducing the risk for economic double taxation that may arise as a result from a dispute between two countries on the determination of the arms length remuneration or price for their cross border transactions with associated parties.

 Transfer prices are useful in so many ways and the motivation to engage in price manipulation can be tempting and irresistible. Transfer pricing can help an MNC to identify those parts of the enterprise that are performing well and not so well. It can also help MNEs avoid double taxation. Take the example of a French bicycle manufacturer that distributes its bikes through a subsidiary in the Netherlands. The bicycle costs €900 to make and it costs the Dutch company €100 to distribute it. The company sets a transfer price of €1000 and the Dutch unit retails the bike at €1100 in the Netherlands. Overall, the company has thus made €100 in profit, on which it expects to pay tax[5].

But when the Dutch company is audited by the Dutch tax administration they notice that the distributor itself is not showing any profit: the €1000 transfer price plus the Dutch unit’s €100 distribution costs are exactly equal to the €1100 retail price. The Dutch tax administration wants the transfer price to be shown as €900 so that the Dutch unit shows the group’s €100 profit that would be liable for tax. But this poses a problem for the French company, as it is already paying tax in France on the €100 profit per bicycle shown in its accounts. Since it is a group it is liable for tax in the countries where it operates and in dealing with two different tax authorities it cannot just cancel one out against the other. Nor should it pay the tax twice[6].

But transfer pricing can be done for purposes of hiding profits and evading or avoiding taxes in all countries, especially if the profitable or parent company is located in a low or no tax jurisdiction, where all transactions from other subsidiaries are routed or re-routed. It is for this purpose that transfer pricing arrangements need to be countered by ensuring that related parties engage in transactions at arms length.

Much as the Arms length principle sounds to be easy, its determination and application on a consistent and coherent basis is a complex process which requires governments and tax bodies to have strong legislative regimes and administrative infrastructure. The resources to enforce the transfer pricing rules and regulations are also very important. For this reason, the transfer pricing rules have been crafted within the transfer pricing regulations, embodying the Arms length principle which is endorsed by the OECD and the UN Model Tax Conventions.

 Treatment of the Arms length principle in the Tanzanian Income Tax Act to control manipulation of Transfer prices

 Tanzania does not have a separate Transfer pricing law but the Arms length principle has been dealt with in the transfer pricing provisions and General Anti Avoidance provisions embedded in the Income Tax Act Cap 332 RE-2012. The Income tax Act follows the OECD and the UN Model Tax Convention rules which require that transactions between related parties should be at Arm’s length.  The ITA recognises the existence of transfer pricing and gives extensive powers to the commissioner to re-characterise or make adjustments to transactions between related parties or associates.

 Section 33 (1) of the Income Tax Act requires that in any arrangement between persons who are associates, the persons shall quantify, apportion and allocate amounts to be included or deducted in calculating income between the persons as is necessary to reflect the total income or tax payable that would have arisen for them if the arrangement had been conducted at arm’s length. The ITA further gives extensive powers to the commissioner under section 33(2) to re-characterise or make adjustments to transactions between related parties or associates who fail to  comply with section 33(1). These include the powers to re-characterise the source and type of income, loss, amount of payment or apportionment and allocation of expenditure , including income from a domestic or foreign permanent establishment as defined under section 71(2) of the ITA.

 The ITA also deals with the arms length principle by tackling income splitting arrangements which could be undertaken by related parties to achieve tax objectives. Section 34 provides that where a person (including corporations as juristic persons) attempts to split their income with another, the commissioner may by notice in writing adjust amounts to be included or deducted in calculating the income of each person or re-characterise the source and type of any income, loss or amount or payment to prevent any reduction in tax payable as a result of the splitting of income. The ITA further clarifies that the income in 34(1) includes a reference to transfer, either directly or indirectly, between persons and associate of the persons of amounts to be derived or expenditures to be incurred. In furtherance of the Arms length principle, the Commissioner is required under 33(4) to use the market in determining whether the person is seeking to split income.

 The ITA tackles any tax avoidance arrangements under section 35 by providing the commissioner with powers, where in his opinion he is of the view that an arrangement is a tax avoidance arrangement; he may by notice in writing make such adjustments as regards to ones liability to tax or lack thereof.   Tax avoidance arrangement is defined to include any arrangement one of the main purposes is to avoid or reduce liability of any person to tax for any year of income. Normally manipulation of prices between related parties seek to achieve reduction of the profit or tax liability in one jurisdiction and maximising profits in another jurisdiction which has a low tax rate. This provision seeks to deal with any avoidance arrangements of this nature.

 The income tax under section 12 deals with the arms length principle by tackling potential manipulation of prices between related parties through thin capitalisation by restricting interest on the debt to equity ratio of 7:3.  Thin capitalisation describes the process of financing a company with a high proportion of loans rather than shares. It is used by transactional corporations to reduce the business profits of a subsidiary in a relatively highly taxed location since the interest on loans is usually allowed as a deduction against profit[7].

 Section 54 of the ITA tackles dividends distributed by a resident corporation to its share holders by subjecting it to withholding tax and under section 54(2) another resident corporation  to another corporation is subjected to  a tax at  a rate provided for under the first schedule of the ITA the corporation receiving the dividend which holds 25 percent or more of the shares in the corporation distributing the dividend controls, either directly or indirectly, 25 percent or more of the voting in the corporation. Section 57 restricts dividend stripping.

 The ITA under section 56 (2) restricts in case of change of ownership of more that 50% deduction of losses as per section 19(1) incurred before the change of ownership and thus making it difficult for related parties acquiring ownership  or merging to form new entities from claiming deductions as a way of escaping tax liability

 The ITA also uses a hybrid approach in combining both the source and residence principles in determining income for taxation purposes. This is reflected under sections 66-68 of the ITA. Section 69 of the ITA identifies sources of payments subjected to taxation. Under section 71 in calculating the income of a domestic or foreign PE is treated separately from the owner

 Weakness of the ITA in dealing with Arms length principle and possibility for manipulation of prices

 Tanzania does not have of a separate law on transfer pricing and therefore detailed guidelines on transfer pricing can be dealt with.  For example the US transfer pricing law  provides extensive guidelines and requires that the ‘best method’ rule be used to determine which transfer methodology must be appropriate for determining the arms length price of a given price. The official definition of the arms length standard as applicable in the US is found under section 482-1(b) of the transfer pricing regulations in which it states that in determining the true tax payable the Arms length price is used. South Africa has also developed extensive transfer pricing rules and guidelines.

 The ITA also provides generous exemptions and allowable expenses as provided under articles 15 and article 145 relating to the Mining operations. The allowable expenses and exemptions work contrary to anti transfer pricing efforts. These could potentially used as conduits for transfer pricing. This therefore means that for the Income Tax Act to be strong and effective in dealing with the Arms length principle and manipulation of transfer prices other measures have to be undertaken.  These include;

 There is need for revision of Transfer pricing rules and development of clear guidelines to deal with manipulation of prices.  Recently there have been attempts by the Tanzania Revenue Authority to deal with this. The scope of their operation is still limited.

 There is need for revision and cancellation of Double Tax Treaties (DTTs) or (DTA) to avoid potentials for ‘Double Non Taxation’ through MNCs located in tax havens and safe harbours which could be used as loopholes for channelling profits.

 Strengthened legislative regime and enforcement

 There is need to strengthen the legislative regimes, closing legal, policy and operational gaps that prevent or facilitate manipulation of prices transfer. Domestically there is need to harmonise the laws and plug any loopholes for transfer price manipulation. Tax crimes are serious crimes and need to be pursued as such. This also includes expansion of the ambit of tax crimes to include transfer pricing and to make transfer price a predicate offence. Currently, transfer pricing is not recognised as a tax offence as the commissioner is given the powers to investigate and correct or make any adjustments arising from transfer pricing. This encourages multinational companies to take chances in engaging in transfer pricing. By making transfer pricing a predicate offence means that a jurisdiction has to consider it in Customer Due Diligence (CDD) and Anti Money Laundering (AML) enforcement and cooperation as agreed by the G20 leaders at Cannes summit in 2011. The Financial Action Task Force (FATF) recommends that both individuals and companies committing illegal tax evasion and professionals facilitating it are held to account for their insidious activities[8]. This should be the Tanzanian approach towards price manipulation through transfer pricing

 Increased Interagency collaboration

 There is need for increased interagency collaboration locally and internationally through sharing of information and mutual assistance on tax matters. This calls for signing up to international cooperation arrangements which like the Multilateral Convention on Mutual Administrative Assistance in tax matters. This was one of the recommendations made at the Oslo dialogue: Tax and illicit activities “all take place in climate of secrecy, inadequate legal framework, and lax regulation, poor economic and weak interagency cooperation[9]”. Conducts involving transfer pricing, round tripping and re-invoicing thrive in situations of secrecy. Countering these activities requires greater transparency, more strategic intelligence gathering and improved efforts to harness the capacity of different government agencies to work together to deter, detect and correct such transactions.

 Increased Transparency and automatic exchange of information

 There is need for increased transparency and automatic exchange to information. Transfer pricing thrives under secrecy. There is need for increased transparency and access to information amongst nations by individuals and companies operating across borders.  Transparency should also include automatic exchange and declaration of beneficial owners (a person who actually has the right to enjoy the income or capital that possession of property might provide) of taxable entities.

 The European Union savings tax directive has already established the principle of automatic information exchange between EU member states and is therefore a welcome step towards a global framework for automatic information exchange given that most tax havens are located within the EU. The OECD-Base Erosion and Profit Shifting (BEPS) approach to avoid double ‘non taxation’ of taxable entities also provides some remedy. The BEPS process recongnises that national laws have not kept pace with global corporations fluid capital and the digital economy leaving gaps that can be exploited by companies who avoid taxation in their homes system and shifting of taxable profits to locations where actual activity does not take place.

 Adopting Unitary and global formulary apportionment approaches to international taxation of MNCs

 The unitary tax and global formular apportionment have been suggested as an alternative model to arms length principle for taxation of multinational enterprises (Mold , 2014). This is an  approach where the income of a group companies is treated as one combined sum subject to tax that is then apportioned to a country for tax to be assessed by applying a formula (formulary apportionment) to determine where it might best be considered to have been earned is a good initiative[10]. The approach was first introduced in the 1980’s by the US such as a tax system to tax multinational activity as measured by employment, sales or assets.  The approach is said to be transparent and the fact that it will make transfer pricing. However the approach has a limitation to the extent that there are difficulties in determining the amount of multinationals enterprises profits to be allocated in a formulary apportioned manner. The international agreement of the formulae to be used sometimes is difficult. Despite these limitations, the approach could be of vital relevance in the future methods towards curbing price manipulation. The approaches coupled with increased inter agency collaboration and global support, this could be a good alternative.

 Ring fencing, Country by Country and project by project measures

 More initiatives like requirements for ringing fencing measures Country by Country Reporting and Project by Project reporting on worldwide operations to curb transfer pricing measures should be encouraged. Tax Information model bilateral agreements (TIEAs) under which territories agree to cooperate on tax matters through exchange of information should be encouraged.

 Increased public education about Transfer pricing

 There is need for increased public education about transfer pricing and the need for responsible corporate citizenry. Citizens and business have to be educated on the importance of paying taxes.  Taxes pay multiple purposes including raising revenue, reprising of goods and services, redistribution of income and raising citizens representation by encouraging participation in democratic processes of the state. The subjects of every state ought to contribute towards the support of government, as nearly as possible, in the proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state[11]’ Taxes have also to be planned in such a way that they are fair and can adequately contribute to financing of public services. Citizens should see the value and the corporate have to see the value of engaging in ethical corporate business.

  The motivation by related parties and multinational companies to manipulate prices to defeat the taxman is becoming a challenge. The challenge is not that the less developed Countries like Tanzania are not interested in corporate investment and business making profits. The problem is that the companies are not paying taxes. As summed with by Hon; Tundu Lissu once summed it up “Companies in the extractive industries are not very good corporate citizens. But this is a sideshow. The real show is the laws that have allowed them to get away with murder.[12]


  • African  Development Bank Group: Economic Outlook 2010: Public Resource, Mobilisation and Aid,  2010
  • Alex Mariage: Secret Structures, hidden crimes: Urgent steps to address hidden ownership, money laundering and tax evasion from developing countries; European Network on Debt and Development (EURODAD), 2013
  • Bank of Tanzania: Economic Quarterly Review Report, November 2013
  • Christian Aid, A Rich Seam: Who Benefits from rising commodity prices, London, Christian Aid, 2007
  • Commission for Africa: Our common interest: Report of Commission for Africa, London: Commission for Africa, 2005
  • Musiba: Reforming the business environment in Tanzania, Tanzania Private Sector Foundation, 2004
  • Morriset: Opening the Gates: How the port of Dar es Salaam can transform Tanzania; World Bank, Dar es Salaam, May 2013
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  • K. Matti and F. Mestrum (ed): Tax Justice, London, 2009
  • L. Ndikumana and J. C Boyce: Africa’s Dubious debts: How foreign loans and capital build a continent; University of Massachusetts Press, 2008
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  • OECD: The Launch of the Oslo Dialogue; A Closing statement by Norway as host and OECD, Oslo, 2011
  • OECD: The Oslo Dialogue: A whole of Government Approach to Fighting Financial Crimes:  A closing statement by Italy, as host and the OECD, Rome, 2012OECD Anti Bribery Convention
  • R. Palan, R. Murphy and C. Chavaneux: Tax Havens: How Globalisation really works,  2009
  • Tax Justice Network; Tax Us if you can, London, 2012


[2] African Economic Outlook report 2014: AfDB, OECD and UNDP

[3]  Tax Justice Network: Tax us if you can, London, 2012


[5] ibid

[6] ibid

[7] ibid

[8] ibid

[9] OECD: The Launch of the Oslo Dialogue; A Closing statement by Norway as host and OECD, Oslo, 2011

[10] ibid

[11] Adam Smith as quoted in ‘ Tax us if you can, Tax Justice Network, London, 2009

[12] Tundu Lissu, M.P. – Tanzanian Parliament remarks at the opening session of the high level transfer pricing seminar, 3-4th  October, 2012, Dar es Salaam