2. Literature Review

In empirical researches, Ernst and Young surveyed 393 multinational enterprises in 12 countries in 1997, the results showed that: driving factors of parent companies to carry out transfer pricing are not only tax optimisation, other factors are also important in a larger extent (E&Y, 1997). In 2002, Ernst and Young surveyed more than 200 multinational enterprises of 22 countries’ again, and this investigation showed that transfer pricing is the main problem of international tax revenue at all time (E&Y, 2002)

2.1 Basic Concepts and Functions of Transfer Pricing

2.1.1 The Basic Concept of Transfer Pricing
This so-called transfer pricing, refers to internal transaction value of a group’s internal institutions or between affiliated enterprises which provide product, service and property mutually. According to Model Convention for the Avoidance of Double Taxation with Respect to Taxation Income and on Capital of Organisation for Economic Cooperation and Development (2003), the definition of transfer pricing of multinational enterprises refers to prices when affiliated enterprises of multinational companies transfer good, intangible assets or providing services. At present, the concept has been accepted by most countries’ tax authorities (including customs).

The Organisation for Economic Cooperation and Development (OECD) defined many important terms such as “advance pricing” and “arm’s length principle” in OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2009. However, the OECD did not define “transfer pricing” in the Guidelines. It is only in preface of the guidelines paragraph. 11, it refers to “Transfer prices are the prices at which an enterprise transfer physical goods and intangible property or provides services to associated enterprises” (Hardari, 2009. pp32)”. And “transfer pricing issues originally arouse in dealing between associated enterprises operating within the same tax jurisdiction” (OECD, 2009)”. Lipton (1990) once defined transfer price as what is used to describe prices for purchasing or selling goods and services in the affiliates and groups within a multinational enterprises. In order to avoid distortion, prices must be the fair market prices. However, due to various reasons, prices of internal transaction within multinational enterprises may be higher or lower than the fair market prices. The method of invoicing is often being used, and this method is also known as the “transfer pricing abuse”.

Transfer pricing can occur within a country, also it can occurs between countries as well. The latter condition refers to two institutions in two countries but within a same legal enterprise (within a multinational company group), that is, corporation with its branches, or two subsidiaries, or two affiliated corporations’ internal prices, which belong to the same enterprise as well.

2.1.2 Functions of Transfer Pricing
From the perspective of optimising tax burden, Horst (1997) and Copithorne (1971) respectively established model of Horizontal Integration and model of Vertical Integration, which discussed how enterprises determining the transfer pricing (Eden, 1985). Bond (1984) demonstrated that multinational enterprises use transfer pricing to transfer income and minimise global tax burden is feasible. Ghosh and Crain (1993) established a mathematical model to demonstrate how multinational enterprises determine transfer pricing when American enterprises’ corporation tax, foreign tax and tariffs changed.

From the perspective of management control, Rutenberg (1970) used differences between income tax and import tax as variable to testify that, parent company can take advantage of liquid assets to manipulate different subsidiaries’ profit, overhead expenses and royalties transferring. Eden (1998) expanded the above models; he considered the risk of exchange rate in the model, and considered both Horizontal and Vertical transfer within the parent companies. He pointed out that in dynamic changes, transfer pricing shall be establish between the lowest and highest boundaries, rather than taking transfer pricing for fixed value as described in the previous two models. Lall (1973) though parties of joint venture tend to use transfer pricing to increase profits of their own enterprises, which would be detrimental to the interests of partners of the Hosts. In order to protect the lawful rights and interest, local partners will actively participate in the decision-making of transfer pricing. Therefore, local partners play a role of supervisor, which would limit behaviours of transfer pricing of their foreign partners. Researches show that, in countries that may occurs currency devaluation, multinational enterprises will reduce liquid assets in their branches. This is method is widely adopted by affiliated enterprise and non-affiliated enterprise, in order to reduce exchange losses.

2.2 Motivations of Transfer Pricing
Through transfer pricing, multinational companies realises its international business strategies and global profit maximisations. The motivations of multinational companies of the transfer pricing is divided into two aspects, one is for tax reason and one is not (Smullen, 2001). Motivations of transfer pricing can be analysed from two aspects as following.

2.2.1 Motivation Not for Tax Reason
(1) Internal trading needs of multinational companies. In various subsidiaries between affiliates and parent companies, there are often a lot of goods flows, for example: technology, capital and labour, and these internal transactions need transfer pricing as measure.

(2) Transfer funds. Generally speaking, multinational companies usually take advantages of interest rate’s differences and capital control difference in various regions or countries where their subsidiaries are located, in order to transfer funds from low interest rate countries to high interest rate countries, or from strict control countries to lose control countries. The principle to transfer funds are mainly considered the safety and efficiency of funds (A1-Saadon and Das, 1996), thus multinational companies are able to recoup the capital outlay and gain profits, allocate and transfer funds free, to realise optimal resources allocation.#p#分頁標題#e#

(3) Adjust profit to, realise strategic objectives. There are basically two kinds of circumstances of multinational companies to adjust profits through transfer price (A1-Eryanl, et al., 1990). One is through transfer price multinational company makes its overseas subsidiaries show higher profit on financial affairs, and then improves the market image of just established subsidiary or other important overseas subsidiary, to support key projects and enhance the competitiveness, and to promote the overall strategies of the company or market target. The other one is according to the needs of multinational companies make their overseas subsidiaries show less financial profit through the transfer price, thus can solve higher distribution of partners’, workers’ demands for higher wages, or related departments’ supervision caused by higher profitably problems.

(4) Establish good financial images. Companies could apply favourable transfer price and false sales to achieve revenue growth or cost reduction, increasing specific associated enterprises’ profitability and competitiveness, or through assets reorganisation, transfer quality assets with lower price to affiliate, to enhance the non-performing assets and improve the financial situation.

(5) Avoid risk. It is mainly aimed at the foreign exchange control, price control, and capital control of the host countries. Most developing countries in order to maintain the balance of international payments would strictly control the free flow of foreign exchange, but restrictions of foreign exchange payments in international trade are relatively loose (Baistrocchi, 2004). Hence, the multinational companies take advantages of transfer price in the form of foreign exchanges to bypass controls, and access to the dividends. Local governments restricts multinational companies in the local economic activities, for the purpose of protecting domestic market and safeguard the lawful rights and interests of the home people, for most of whom will execute market price control policy, and formulate anti-dumping law and anti-monopoly law. Multinational companies use low transfer price to reduce the cost of local affiliates to capture a host market.

2.2.2 Motivation for Tax Reason
Transfer pricing of multinational company refers to the transaction price designated by the internal enterprises of the multinational company. The object of transfer pricing include fixed assets, spare, parts, raw material, semi-finished products, products and other tangible commodities, and payment , patent, trademark, technology, management, consultation, and other intangible items (Chris and Richards, 2003). Due to the relations between internal enterprises is different from the relationship between independent enterprises, the determination of internal price tends to serve the general interest of company group, and to achieve overall tax minimisation is also one of the main motivations of using transfer pricing method.

The most common method of income tax avoidances is that, enhancing commodity transfer price form countries and regions with low rate to countries and regions with high rate, increasing company profits of countries with low rate, and decreasing company profit of countries with high rates, shifting profits of profitable company to company running in a red. Due to the overall interests, multinational companies should make comprehensive consideration, including lower incomes and expenses distribution standards of sales, service, lease, and intangible asset transfer of affiliated enterprises from high rates countries to low rate countries, then shift incomes to a affiliated enterprises in low rate countries as many as possible and distribute expenses to affiliated enterprises in high rates countries. Under the condition of invariable pre-tax profit of a group, the goal of total tax reduction will be achieved. BVI Islands and Cayman Islands, Tonga and other “tax Havens” are famous for their zero tax rate and loose regulatory environments to adjust the tariff level of enterprises. Tariffs are usually proportional tax rate, the average tariff in developed countries is about 3%, and which in developing countries is fact must be considered. Lower transfer prices may reduce the tariffs, thereby reducing the tariffs the multinational companies should pay.#p#分頁標題#e#

Under normal circumstances, for subsidiaries in high tariffs countries, multinational companies sell goods with relative love transfer price to reduce the import amounts, then it reduces AD valorem tariff. According to tariffs imposed by ”AD valorem tax” or “mixed rates”, when multinational companies conduct insider trading, they can use subsidiaries in different countries or regions to lower prices, reduce tax base of goods and total tax amount, thereafter achieve the goal of reducing import tax, so as to achieve the purpose of reducing tariffs

2.3 Methods of Transfer Pricing
From the methods of transfer pricing, Tang (1993) though factors which are the influence methods of transfer pricing mainly include total profits of enterprise, the countries’ tax rate, different tax rules, and limitation rules of profit repatriation in the Host and so on. Yunker (1982) on the other hands though, that methods of transfer pricing connect with overall market situation, product demands, government restrictions and regulations and economic background. Borkowski (1994) and Vaysman (1996) proved that, transfer pricing methods related to tax law and tariff rates, as well as the degrees of difficulty when using these rules.

The processes to determine transfer price are highly confidential and a extremely complex work. Products implementing transfer pricing are basically divided into two segments, one is tangible goods, and other is intangible goods. In the process of valuation of the goods, referring to different types of goods, multinational companies use different methods of transfer pricing.

For transfer pricing of tangible commodity, companies usually adopt two pricing systems. One is adapting internal cost plus higher (or lower) parts, and the other method is applying external market price plus higher (or lower) parts.

The intangible commodity prices do not have reliable pricing bases; its pricing strategy mainly depends on two factors: one is the ability to grasp information, the other one is the ability to bargain during negotiations. Transfer pricing strategies of multinational enterprises mainly apply these following kinds: through controlling transaction prices of intermediate products such as spare parts, and semi-finished products, in order to influence the cost of subsidiaries; and through controlling sales prices of overseas subsidiaries’ fixed assets or duration of service, to affect the costs of subsidiaries; to provide loans and adjusting interest, to affect the costs of subsidiaries; through transferring intangible assets such as patent, trademark, proprietary technology, the name of manufacturer, charging royalties, and to influence the costs of subsidiaries and profit; through service fees such as technology management, advertising, consultation, to influence the costs and profits of overseas companies; through products sales to give overseas companies with higher or lower commissions or kickback, or using transportation systems, insurance system, controlled by the parent company to collect high or low transportation fees, loading and unloading expenses, insurance fees, to influence the costs and profits of overseas companies.#p#分頁標題#e#
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2.4 Regulations of Countries for Transfer Pricing
At present, many countries and regions in the world formulate relevant taxation systems; the United State is one of the earliest countries to establish transfer pricing taxation. S482 of the Internal Revenue Code (IRC) of the US in 1954 and its detailed rules formulated in 1968, regulated how to adjust unreasonable transfer pricing of affiliated enterprises. After the United States, Holland, Japan and other countries successively formulated relevant laws to restrict transfer pricing of multinational enterprises to prevent the national tax evasion.

In 1996, America issued detailed rules of penalty clause of transfer pricing s6662(e) of IRC. The core meaning is that if any taxpayer uses reasonable transfer pricing method accurately, and provides relevant documents, he or she will not be punished for any other reasons, but only charged for excessive transfer pricing. According to different degree, penalties are divided into two levels: if the amount of profits equal to or more than 500 million dollars, or equal to or more than 10% of total adjusted incomes, or transfer price equal to or 2 times higher than normal trade prices and equal to or 1/2 times lower than normal trade prices, companies shall be fined 20% of evaded tax amounts; if transfer prices equal to or 4 times higher than normal trade prices, or equal to or 1/4 times lower than normal trade prices, shall be fined 40% of evaded tax amount *baker and McKenzie, 1997)

Such a punishment in fact indicates an important though, that is, emphasizes the right to handle enterprises’ own affairs, even with transfer pricing. For general transfer pricing, taxation authorities may be adjusted, but with no punishment. Only for excessive transfer pricing, its purpose is in accordance with tax evasion, penalties shall be implemented.

In Australia, if state tax bureau identifies tax evasion, penalties is 50 % of re-estimate tax amounts, if tax evasion is not main purpose of transfer pricing, penalties is 25%, tax authority which can be decided whether to cancel penalties according to companies’ cooperative attitudes (Australian Taxation Office, 1997, 1998).

In France, if companies cannot answer the requirements of tax authorities perfectly, it shall be fined five thousand francs. If tax authority chooses to recalculate taxes revenues, it shall produce higher overall costs. The results of postponing taxes are imposed 0.75% interests monthly. Additionally, if the tax authorities have a bad impression of companies, may lead to impose 40% to 80% for insufficient tax revenues (OECD, 1995).

UK Tax authority indicates that if the companies fail to provide supporting documents under survey, dereliction of duty of tax companies will be defined, and when adjusting transfer pricing punishment mechanism shall be triggered automatically. If there are enough documents to testify the arm’s length standard of transfer pricing, punishments shall be avoided. According to the cooperation degree of tax companies and violation scales punishments differ. If companies did not reflect the fair price and were accused inconsistent with the facts, will not only impose insufficient taxes of companies and interests, for malice and dereliction of duty, the company will be fined up to 100% penalties. This punishment may be reduced, like America, UK does not have Safe Harbour Provisions, which is that UK laws do not indicate what can be prevented from punishment within which scope (International Tax Review, 1997)#p#分頁標題#e#

2.5 　Governing procedure of transfer pricing in UK

(a) Existence of transfer pricing laws/guidelines
Schedule 28AA of ICTA 1988　refers to the legislation of transfer pricing in UK． There are two key statutory requirements as follow:
In making their own assessment of their taxable profits, taxpayers are always required to use the length transfer prices.
With Art 9 of the OECD Model Tax Convention and the OECD’s Transfer Pricing Guidelines, the rules about transfer pricing， as matters of law, have to be construed consistently．

(b) Transfer pricing scrutiny
When they will conduct a transfer pricing audit, HMRC has issued guidance．“HMRC” , the most recent guidance, approach to compliance risk management for large business, which was published in March 2007, as part of the 2006 Review of Links with Large Businesses．HMRC sets out its approach in it, stating that, in response to risk, it will vary its activities more clearly, thereby enquiring for low risk customers, increasing the intensity and effectiveness of interventions for high risk customers and reducing significantly the number of checks．

HMRC expects that the majority of its engagement take place in real-time for low risk businesses， as issues arise．HMRC will not expect to repeat the full risk process for two to three years，or even longer, if a customer is at low risk．it is likely that several meetings will be necessary each year, for the highest risk businesses ,with annual risk reviews．

And there are some factors as reasons for initiating an audit in the Initial guidance:
? The existence of tax haven entities in the group but outside the controlled foreign corporation rules， which are profitable despite the absence of significant activities carried out in their locations.
? The UK’s company possesses the resources to generate high-margin profits yet produces only a routine low-margin profit．
? When there is no obvious prospect of super-profits in later years, poor performance over a number of years need to justify the risk of continuing losses.
? In the United Kingdom, profit margins are lower than in the group generally and there reasons to believe that this should not be the case.
? Royalty or management fee payments that do not appear to make commercial sense and which substantially impact on the UK bottom line.
? Cost-sharing arrangements have been introduced．
? In any period, changes in intra-group contractual arrangements purport to adjust the risk profile.

(c) Definition of related party
In relation to a body corporate, the concept of control is based on ICTA 88， sec 840: “Control”， means the power of a person to secure:
? By means of the holding of shares or the possession of voting power or in relation to that or any other body corporate.
? By virtue of any power conferred by the articles of association or other document regulating that or any other body corporate.#p#分頁標題#e#

To this definition, there are two important additions:
? In determining whether parties are controlled, attribution rules (ICTA88/S755D (5)-(9)) trace control relationships through a number of levels．
? With a UK and non-UK party, where the UK party has an interest of at least 40%, the 40% test (ICTA88/S747(1A)) will be applied to joint venture companies.

(d) transfer pricing penalties
Under schedule 20 Para 20 of FA1998, a tax-related penalty can be imposed on a company of up to the amount of the tax understated where:
? A return is made which is not in accordance with the arm’s length principle.
? We can see that the return was submitted negligently or fraudulently by the taxpayer, and negligently or fraudulently by the taxpayer.
? United Kingdom tax is lost as a result．

(e) Advance pricing agreement (APA)
Between taxpayers and the UK tax authorities, the legislation essentially provides for legally binding written agreements．After 27th July 1999, These are available for accounting periods ending．

In the legislation, two kinds of APA are outlined:
? The “bilateral” type， where there is a double taxation treaty, and the tax authorities of the relevant treaty partner country are also involved．
? The “unilateral” type， in which only the taxpayer and HMRC are involved (including UK to UK transactions).

If the situation does not seem to complex enough to justify their use of the resource, HMRC sees APAs as resolving complex transfer pricing issues and can decline to consider an APA．Thus, HMRC encourages applications for bilateral APAs wherever this is possible．

Advance Thin Capitalisation Agreements (ACTAs) also can be used to resolve potential thin capitalisation problems．Without having to seek relief through double taxation treaties, unilateral ACTAs would allow taxpayers to gain certainty．

3. Methodology
3.1 Introduction
This paper is divided into four parts. The first part introduces the reason of why choose topic of transfer pricing. The second part is literature review, which begins with concept of transfer pricing, then introduce its motivations and methods, as well as various countries' regulations for transfer pricing. The third part is specific case study about multinational enterprise, and how the tax department deals with the transfer pricing problems. The forth part is suggestion, which based mainly upon the third part, combing with the theories of literature review, and putting forward corresponding policy recommendations.

The information is mainly obtained by the way of reading related reports. It is one of the most effective ways to learn new knowledge. It is not only to analyze the companies’ reports, but also those governments'. However, it is not enough. I also should pay attention to comments in the newspapers and websites. This information will give me impartial views.#p#分頁標題#e#

3.2 Validity and Reliability

In order to understand how the transfer pricing mechanism works, I have read a lot of literatures about concept of transfer pricing, functions of transfer pricing, motivations of transfer pricing of multinational enterprises, transfer pricing methods, etc. Such as: Tang (1993), Yunker (1982), Borkowski (1994) and Vaysman (1996), though the process to determine transfer price is a highly confidential and complex work.

Only understanding what methods used for transfer pricing, can help us to understand pricing mechanism more profoundly. And then, I will focuses on transfer pricing regulation system used in the whole world, combing with specific situation of application of multinational enterprises' transfer pricing.

In order to achieve the object, I will deeply study the case of GSK on transfer pricing. In the case, I make the hypothesis that, in the traditional regulatory system, multinational corporations can always find loopholes in the area of transfer pricing. Thus, there are many ways to regulate multinational enterprises for government. Moreover, based on the case, I will focus on a new understanding to transfer pricing of intangible assets, the economics function of Subsidiaries of multinational corporations and the remaining or residual profit split method applied in regulation of transfer pricing.

3.3 Research approach
In this paper, the theoretical analysis will be based on the previous studies and the transfer pricing case- GSK, which is openly criticized and punished in the newspapers. Through the analysis of the theory of transfer pricing and the review of the relevant research in domestic and international area, combined with the practical case in multinational companies, we are here try to build a systemic analysis framework for distinguishing the rules of financial fraud both for companies and governments.

Case Study method is based on the market reality and the typical case, through specific analysis to make access to specific marketing conditions and marketing process in order to find a solution to marketing problems. Case Study, Survey Study and Multi-Site Case Study are major social science research methods. The principle of Survey Study is to control environmental conditions, by causing changes in the independent variables to observe the changes in the dependent variable, so as to establish the relationship between variables.

Compared to the normal methods of investigation and research, firstly, Case Study method’s advantage lies in its depth. Based on the detailed description, it can reveal the underlying cause behind the case. Secondly, Case Study needs people to collect abundant information. That information is often ambiguous, and even conflicting with each other. It is beneficial for researchers to break thseir habitual thinking, resulting in a new perspective and new theory. Thirdly, the research of Case Study provides certain conditions for more mature studies and more accurate measurement in the future. Finally, when compared to those methods which based on completely self-explanatory, the theory or conclusion derived from Case Study can be more practical. #p#分頁標題#e#
3.4 Limitations of this paper
There are two gaps of this paper: First, for the multinational transfer pricing is confidential, it is difficult to obtain the public transfer price data, thus we cannot make the empirical research, making some of the conclusions of this article cannot be tested by empirical.

The second is that: we ignored any moral hazard; we assumed that the manager is risk neutral. If the moral hazard (such as the non-visible behaviour, risk aversion and uncertainty, etc.) is taken into account, then the business will face the balance between provisions of an effective incentive and minimize the managers` need for risk. For instance: In order to obtain more benefits, different division managers may deliberately exaggerated or reduced to the headquarters of the data, the performance of risk averse and risk preferences is quite different. The study of the impact of this area is also a future research direction of transfer pricing.

4.2 The GSK transfer pricing event
September 11, 2006, the United States Bureau of Internal Revenue Service, hereinafter referred to as "IRS", announced the successful settlement transfer pricing tax dispute with the U.S. pharmaceutical giant GlaxoSmithKline (GlaxoSmithKline Holdings Inc. & Subsidiaries, hereinafter referred to as "GSK"). GSK has to not only pay 3.4 billion U.S. dollars to the IRS in taxes, but also give up 1.8 billion U.S. dollars deserved tax refunds. In response, IRS revoked the company's tax evasion charges. This is the largest case of transfer pricing adjustments in U.S. history.

There is an agreement between the IRS and GSK, which is a conclusion to the dispute dating back to the 1980s and involves adjustments to GSK's tax years from 1989 to 2000. To ensure the proper reporting of taxable income, the Tax Court of transfer pricing case concerns to require that related parties engage in transactions at arm's length. Then, the IRS and GSK have also reached agreement for tax years from 2001 to 2005 with respect to the transfer pricing issues arising in the area of multinational business.

In years 1989-2000, the Tax Court dispute for intercompany transactions between certain of its foreign affiliates and involves GSK, refers to various GSK’s pharmaceutical products. The value of GSK's marketing and other contributions in the U.S. plays a very important role for profitably in the group of GlaxoWellcome. Thus, GlaxoWellcome has to cooperate with the IRS for the U.S. market. Under the settlement agreement, over 60% of the total amount has conceded by GSK for the years pending in Tax Court.