Question

A) Describe the following approaches to adjusting the value of transactions for tax purposes in a transfer pricing environment:

Cost plus approach                                    

Profit split approach                                   

Resale price approach                     

B) Discuss six challenges faced by tax policy makers in developing countries in their efforts to achieve the desired objectives of taxation.                   

Answer 1

A)

Cost plus approach  

With the Cost Plus Method, we focus on the costs of a supplier of property or services in a controlled transaction. Once we know the costs, we add a mark-up. That mark-up should reflects the profit for the associated enterprise on the basis of functions and risks performed. The result is an arms’ length price.

In general, the mark-up in a cost plus method will be computed after direct and indirect costs of production or supply. However, operating expenses of the enterprise such as overhead expenses are not part of the mark up.

The mark-up can be determined in two ways. The first, it can be compared to the mark-up applied by the associated supplier of property or services for comparable transactions with third parties (internal cost-plus method). If such transactions do not take place, the alternative is to look at the cost plus mark-up applied in transactions between third parties (external cost-plus method).

Profit split approach

Associated enterprises sometimes engage in transactions that are very interrelated. Therefore, they cannot be examined on a separate basis. For these types of transactions, associated enterprises normally agree to split the profits.

The Profit Split Method examines the terms and conditions of these types of controlled transactions by determining the division of profits that independent enterprises would have realized from engaging in those transactions.

Resale price approach

The Resale Price Method is also known as the “Resale Minus Method.”

As a starting position, it takes the price at which an associated enterprise sells a product to a third party. This price is called a “resale price.”

Then, the resale price is reduced with a gross margin (the “resale price margin”), determined by comparing gross margins in comparable uncontrolled transactions. After this, the costs associated with the purchase of the product, like custom duties, are deducted.

What is left, can be regarded as an arm’s length price for the controlled transaction between associated enterprises.

B)

1) Increasing Tax Effort

Taxes matter. Not only are they necessary to pay for public services but people talk

about them, complain about them, and try to dodge them when they can. How people react in

turn affects the level and structure of taxation.

2) Assessing Tax Performance

International observers (and aid agencies) frequently ask for assessments of the tax

performance of developing countries. As a rule, what those who ask for such things seem to be

looking for are indicators of performance and output that are comparable over time and across

countries and are preferably simple and quantifiable. With respect to tax ratios, for example, the

aim is usually to provide a basis for assessing which countries are making a real effort to

improve and which are not. If a reliable standard of the level of performance that should be

expected from countries at various stages of development can be established, then the actual

performance of a country, its "effort", may be assessed in terms of how closely it approaches the

standard.

3) Improving Tax Administration

Reaping revenues from tax rate changes (in any direction) requires that tax administration

is effective to at least some extent. Raising revenues through base expansion requires even better

tax administration,. New taxpayers must be identified and brought into the tax net and new

collection techniques developed. Such changes take time to implement. The best tax policy in

the world is worth little if it cannot be implemented effectively. Tax policy design must take into

account the administrative dimension of taxation (McLaren 2003). What can be done to a

considerable extent inevitably determines what is done.

4) Lowering Tax Rates

As noted earlier, the challenge for many developing countries is not so much whether to

increase revenues but rather how to do so. Essentially, there are only three possibilities: raise

rates, expand bases, and improve administration. Raising rates within the existing system is the

most obvious approach, and it is often also the most politically acceptable approach. On the

other hand, it is generally the least economically desirable solution. Raising rates when

traditional tax bases are not expanding, new bases can shift abroad, and administration is weak is

unlikely to increase revenue much.

5) Broadening Tax Bases

No one likes taxes. People do not like to pay them. Governments do not like to impose

them. Unfortunately, taxes are necessary both to finance desired public spending in a non-

inflationary way and to ensure that the burden of paying for such spending is fairly distributed.

Since even necessary taxes impose real costs on society, good tax policy seeks to minimize those

costs. However, tax policy is not just about economics but also reflects such political factors as

the degree of concern about fairness.

6) Assessing Tax Performance

International observers (and aid agencies) frequently ask for assessments of the tax

performance of developing countries. As a rule, what those who ask for such things seem to be

looking for are indicators of performance and output that are comparable over time and across

countries and are preferably simple and quantifiable. With respect to tax ratios, for example, the

aim is usually to provide a basis for assessing which countries are making a real effort to

improve and which are not. If a reliable standard of the level of performance that should be

expected from countries at various stages of development can be established, then the actual

performance of a country, its "effort", may be assessed in terms of how closely it approaches the

standard