Papua New Guinea Law Reform Commission
LAW REFORM COMMISSION
PAPUA NEW GUINEA
TRANSFER PRICING MANIPULATION
REPORT NO. 12
The Honourable John Yaka MP
Minister for Justice
On 26 March 1976 the then Minister for Justice, the Honourable N. Ebia Olewale MP, required the Law Reform Commission to enquire into and report to him on: "(a) the current state of the law in regard to contracts, commercial transactions, creditors rights and hire-purchase, corporations and business organisation, and any related economic legislation; and (b) the changes needed in these laws if the economy is going to develop in the direction specified by our Constitution." Under this reference we have enquired into the area of transfer pricing manipulation.
We recommend the establishment of a small-scale, practically orientated task force in the Office of Taxation to supplement the existing methods of controlling transfer pricing manipulations in Papua New Guinea.
Joseph Aisa, Acting Chairman
Father Cherubim Dambui
Pastor Timothy Palitu
On 26 March 1976 the then Minister for Justice, N. Ebia Olewale, forwarded to the Law Reform Commission a reference requesting the Commission to review the economic laws in Papua New Guinea. The area of transfer pricing manipulation was selected as being a matter of considerable importance to economic development.
An Inter-departmental working group was established in 1977 to consider the broad nature and extent of the problem. Later that year a request was made by the Government of Papua New Guinea to the United Nations Centre on Transnational Corporations to provide an expert to examine and report on the effectiveness of existing legal and administrative controls on transfer pricing and profits manipulation in Papua New Guinea. Dr. Panayotis Roumeliotis visited Papua New Guinea in December 1977 and his report "The Transfer Pricing Control System in Papua New Guinea and Proposals for its Improvement" was completed in August 1978 and circulated to interested government agencies and individuals in September 1978.
Work on the project was resumed in March 1980. This resulted in the completion of Occasional Paper No. 12 "Transfer Pricing manipulations in Papua New Guinea" in August 1980. It recorded the detailed views of interested government agencies and individuals on the extent of known transfer pricing manipulations, the adequacy of existing controls and the possible approaches to control.
Views on this latter paper were solicited during 1981 and in September 1981, Mr. Alasdair Finnie, Acting Principal Legal Officer, presented a paper entitled "Transfer Pricing Manipulations in Papua New Guinea" at the Waigani Seminar on "Trade, Investment and Development in the Pacific". As a result of views expressed to the Commission during 1981 by interested agencies the paper advocated the establishment of a task force in the Office of Taxation as a method of supplementing the existing control measures of individual departments over transfer pricing manipulations.
Reaction to this proposal has been generally favourable and accordingly the establishment of a task force is again recommended in this report.
The task force will not provide a complete answer to the problem, but for a small financial outlay it has considerable potential for saving substantial revenue presently being lost by Papua New Guinea.
What is transfer pricing manipulation?
Transfer pricing manipulation is the practice of obscuring the actual value of transactions so as to generate the most profit for the businesses involved. Manipulations are effected by juggling book keeping entries relating to goods, services, and loans. They can be effected not only through the artificial setting of prices in transactions between businesses but also through variations in the actual and declared quality and quantity of goods and services.
Global taxation liabilities, international competition and the effects of exchange controls can be substantially reduced by these methods. Internationally, transnational corporations have been commonly associated with transfer pricing manipulations because of their dominant position in the market place for particular products and services, and because they have more opportunities, through their world-wide networks of related companies, to carry out transactions at prices different from those between businesses independent of each other. However, such manipulations are not confined to transnational corporations. Any two companies conducting business together can decide to arrange to transfer the profits from their transactions into tax havens.
In Papua New Guinea transfer pricing manipulation occurs in its simplest form when imports sent by a transnational parent company to its related company in Papua New Guinea are deliberately overpriced. Similarly, it takes place exports when are intentionally undervalued in order to shift profits made by a subsidiary in Papua New Guinea to the home country of the transnational corporation or to a tax haven like Hong Kong.
Why does it occur in Papua New Guinea?
There are various reasons for transnational corporations engaging in such manipulations. Because of significant company tax rate differences between Japan and Papua New Guinea, there are strong incentives for Japanese parent transnational corporations to under-invoice primary export commodities to minimise Papua New Guinea revenue controls such as corporation tax, royalties and export duties.1 The motive to evade or minimise taxes may not necessarily be so important for transnational corporations of other countries of origin because of Papua New Guinea's slightly lower rate of company tax. But this disincentive to manipulate transfer prices will also depend on the extent to which tax credits are permitted in their countries of origin. 2
Non-tax factors probably play an equally important role in the motives for transfer pricing manipulations. For example, transnational corporations in Papua New Guinea may be anxious to maximise their returns on investment in the supply of capital equipment and in providing loans and technical and management services. They may also wish their subsidiary to record a lower profit in Papua New Guinea to resist the introduction of price controls, or discourage potential local investors taking up their options to buy shares3. On the other hand, funds may simply be required to finance investment in a subsidiary located elsewhere.
Another possible motive is that the interest rates for the investment of surplus capital in Papua New Guinea may be considered too low. Anxiety about potential tightening up of exchange controls or a devaluation of the kina may provide further incentives to manipulate transfer prices. Transnational corporations may as a risk-minimisation strategy consider it preferable to remit their profits out of a developing country into related companies in developed countries. These other non-taxation motives can clearly result incidentally in evasions of Papua New Guinea's revenue controls.
What is the present extent of transfer pricing manipulation in Papua New Guinea?
No-one knows the precise extent of transfer pricing manipulation in Papua New Guinea. It is often very difficult to detect and many technical government agencies simply do not have the resources to control and monitor it effectively.
Some of the known examples of transfer pricing manipulation and the sources of information are as follows:
It seems that transfer pricing manipulations occur most frequently in areas where international market prices cannot be obtained easily and where vertically integrated transnational corporations dominate a market. The incidence of known transfer pricing manipulations is highest in respect of fish and log exports. There are few known instances of manipulations concerning copper and copper concentrates, coffee, cocoa, copra and copra oil exports. This probably reflects the availability of easily ascertainable and competitive international prices for these commodities. But examples have been recorded occasionally when either competition and /or control mechanisms have been inadequate. The difficulty of ascertaining a wide range of production and other costs means that the incidence of a transfer pricing manipulations in respect of imports is largely unknown. Nearly every government agency contacted has expressed concern about possible manipulations. These agencies are beginning to question the high level of some management fees, interest rates on loans and the prices paid for capital equipment, especially when supplied through related companies. They have strong suspicions that overcharging is taking place but they lack the information, expertise and staff to carry out detailed studies.
How adequate are the existing control measures and how should they be improved?
Occasional Paper No. 12 recorded various government agencies' and individuals' views on this aspect in some detail. 4 It concluded that although the existing legal, administrative and other controls at each agency's disposal to monitor and control transfer pricing manipulations are considered in general to be adequate, their enforcement has been rare and unsystematic. The major constraint on effective control is the shortage of staff, and particularly specialist expertise, to administer both formal legal provisions and departmental procedures.
There is also growing recognition of the need to adopt competitive methods to establish accurate market prices and trends so that regulatory controls can be applied more effectively. In the fisheries sector steps have been taken over the last year to implement a competitive approach to transfer pricing control. The Papua New Guinea Fish Marketing Corporation Proprietary Limited was established to act as a fish broker on the world's fish markets, arranging sales of Papua New Guinea's fish on a commission basis. It commenced operation on 22 July 1980 and has been working steadily to improve overall prices for fish exports. Although no detailed statistics have yet been prepared, it appears that export fish prices have improved as a result of its use of the right to purchase up to 25% of a fishing company's catch on a first refusal basis. This has been operating in an informal way to date, but it is expected that optional purchase agreements formalising this arrangement will be signed shortly by each fish exporting company. In return the State agrees to consider favourably the granting of fishing and export licences to these companies. The Corporation also expects to begin supplying the Fisheries Division regularly with market prices for fish so that minimum guideline export prices can be fixed monthly.
In the forestry sector progress has been slow and no final selection of the competitive options has been made. It does appear however that a choice will probably be made between the establishment of a wholly state owned forest products export marketing agency and a joint marketing venture between the government and an established international forest products marketing agency (without close end-user connection).
Four general comments have been made recently to the Law Reform Commission by interested government agencies and individuals on the ways in which control measures should be improved.
First, nearly all agencies contacted consider that controls on transfer pricing manipulation should be exercised primarily on an individual industry basis (e.g. forestry, fish, mining). They also generally believe that a combination of regulatory and competitive controls is necessary to improve their particular sector. The regulatory controls considered range from selective import controls to improvements in existing enforcement and information systems; the competitive measures referred to include the establishment of state marketing corporations and joint government/commercia1 marketing enterprises.
The second general observation was to emphasis the importance of government developing and sustaining skills in the area of negotiations on major development projects. It is believed that by doing so a number of potential areas for transfer pricing abuse could be minimised.
The third comment was to stress the importance of augmenting the day to day monitoring and enforcement of controls on declared qualities and quantities of both imported and exported goods.
Finally, a majority of government agencies advised that there is a need for some centralised and co-ordinated investigation in specialist areas where a particular government agency's resources and expertise are insufficient. It was stressed that such investigations should be specific and practical in nature. It has been suggested that this might be satisfied by establishing a small-scale, practically orientated "task force" within government.
Why should a task force be established?
During discussions held by the Law Reform Commission with relevant government agencies and individuals recently, considerable support was expressed for the idea of establishing a task force as one of the ways of tackling the transfer pricing problem.
It envisages the appointment of a small number of permanent "core" staff to a task force located in government, who with appropriate government officers and consultants would conduct specialised investigations into areas where transfer pricing manipulations are suspected. Nearly all the agencies consulted on the proposal immediately suggested specific areas on which they would welcome assistance. These ranged from the investigation of certain freight, fuel, capital equipment and bulk supply contracts to the validity of particular management services, consultancy fees, loan arrangements and licensing of technology. The opportunity for such a task force to provide an overall coordinating role was also stressed. It could provide government agencies with early warning of changes in the methods and areas of transfer pricing manipulation, particularly after the more obvious forms have been brought under control. Additionally, it could be the natural focus for liaison with international agencies and other governments concerned with transfer pricing manipulation by transnational corporations. 5
How would the task force operate?
The main features of the proposed task force have been discussed in some detail with interested agencies and would be as follows:-
(a) It would be located in the Office of Taxation
There is general agreement that the task force should be located in the Office of Taxation. Its location in the Office of Taxation is preferable to the Bank of Papua New Guinea or the other divisions of the Department of Finance for the following reasons. First, a key element in the successful operation of the task force will be free and ready access to information. Comprehensive powers ark already available to the Office of Taxation to obtain information for income tax assessment and collection purposes from individuals, companies, partnerships and all other government agencies.6 It also has the primary material - specific company, partnership and personal income tax returns -with which to commence most investigations. No other government agency has access to this information.7 Thus, for example, although the Office of Taxation has power to request details of major funds transactions and contracts involving foreign exchange from the Bank of Papua New Guinea, the Bank cannot obtain specific information about an individual corporate taxpayer. Secondly, the Office of Taxation via its Investigation Branch has previous practical experience in carrying out investigations into transfer pricing manipulations, such as its recent study on selected fishing companies which it carried out for the Fisheries Division of the Department of Primary Industry. Thirdly, as Papua New Guinea's major concern with the effects of transfer pricing manipulation is the loss of revenue, the location of the task force in the Office of Taxation will ease liaison with those sections responsible for enforcement and recovery of tax. It should also be remembered that such action under the Income Tax Act enables the recovery of-past losses of revenue. It would also be in the best location to be conversant with and advise on the amendment of taxation mechanisms (e.g. rates of tax, or how it should be imposed) whenever these are necessary to neutralise the advantages of companies shifting methods of manipulating transfer prices. Finally, this location would facilitate the benefits the task force could derive from the Office's links with international taxation developments.
(b) It would have a small permanent core of staff and be assisted by relevant departmental officers.
There is general agreement that the best combination for the permanent core staff of the task force would be an accountant with tax investigation experience and an
economist with a business background in a developing country. Papua New Guinea counterparts would also be selected if expatriates are appointed to these positions initially.
Opinion varies on the ways in which other government officers should be recruited to the task force and the extent of their involvement. Some consider that formal secondments from other departments should be kept to a minimum because of the difficulties of ensuring proper work output and of maintaining adequate security over information being worked on outside the task force's office. Secondments might also create undue friction with other departments and produce less motivated members of the investigatory team. Thus, it is argued that it may be preferable to appoint two additional permanent staff to the task force to carry out the general investigation and analysis work on records and accounts.
The alternative view is that the task force must have access to the specialist expertise already available in government if it is to carry out its work effectively. The precise nature of the particular special study being conducted by the task force would dictate whether the relevant departmental officers would be intensively or only temporarily involved. Formal secondments to the task force would be made (even if temporary) so that the core staff have authority to direct the work programmes of the secondees and thereby ensure that the investigations are completed on time. This proposal would require the agreement of departmental heads, as it would mean the temporary abandonment of the normal vertical reporting lines within each department for those officers engaged on task force work.
The Commission recommends that initially the task force should simply request departmental heads to make individual officers available to take part in specific investigations as required. Granting power to require the release of officers to the task force should not be considered unless this latter method proves unsuccessful.
(c) It would have a budget to recruit consultants.
There is general agreement that specialist help will be needed from consultants on specific investigations. Accordingly, adequate allowance should be made for this in the task force's budget.
(d) It would be subject to the supervision of the Chief Collector of Taxes.
The task force should report to and be supervised by the Chief Collector of Taxes. However it is recommended that the Chief Collector should be required to consult the Assistant Secretary, General Financial Policy Branch, Department of Finance. The Chief Collector is clearly the best person to provide practical advice and supervision over the work of the task force, and the Assistant Secretary of the General Financial Policy Branch is in a good position to ensure that the activities undertaken and priorities being set are consistent with the current general financial policies of government. The Chief Collector, in consultation with the Assistant Secretary of the General Financial Policy Branch, would be responsible for establishing the task force's priorities and for determining the target dates for the completion of particular investigations.
(e) It would have the power to communicate information to other government agencies.
As all officers and consultants connected with the task force will have to take the oath of secrecy and comply with the confidentiality requirements of s.9 of the Income Tax Act, one important issue which has to be resolved is precisely how the results of investigations of the task force can be made known to other agencies. There is obviously no difficulty when solely revenue enforcement action is considered appropriate. Also the results of an investigation can be relayed to other government agencies if it is done on a nonspecific industry basis. But if the task force wishes to relay information about the transfer pricing practices of a specific company so that other control measures can be taken against it there is no current legal way it can do so. It would be most unsatisfactory for other government agencies if following a task force investigation they had to rely on a tax prosecution being taken to court before detailed information about a company's transfer pricing practices would be known to them. In the case of serious transfer pricing abuse being discovered it may also be desirable for quick preventive action to be taken by, for example, the Department of Foreign Affairs and Trade in recommending the revocation of export licences under the Exports (Control and Valuation) Act 1973, or the Office of Forests or the Fisheries Division in recommending the cancellation of forestry or fishing licences, or the Minister for National Planning and Development in recommending the cancellation of the registration of a foreign enterprise.
It is therefore recommended that the Income Tax Act 1959 should be amended as set out in Appendix I of this report..
This would enable the Chief Collector of Taxes to communicate specific information to a minister or government officer when he has reasonable grounds for believing that transfer pricing manipulation has taken place and has resulted, or is likely to result in tax evasion.
Transfer pricing manipulations do not usually excite political or popular reactions because they are generally not visible- they simply involve the manipulation of book-keeping entries. However, manipulations which are not detected can cause substantial long term detriment to a country's foreign exchange reserves and revenue raising process. 8 There are now sufficient examples and suspicions of manipulation in Papua New Guinea to justify concerted action. The extent of manipulation is likely to accelerate in Papua New Guinea as uncertainty about the introduction of stricter exchange controls increases, as further natural resource development projects are commenced and as large scale manufacturing industries involving high volumes of intra-firm trade are gradually introduced.
The individual action taken and proposed in the fisheries and forestry sectors is to be commended. However there remains the need for co-ordinated and practically orientated investigations into areas where transfer pricing manipulations are suspected and which are beyond an individual government agency's resources and expertise. This need can be met by the establishment of a task force in the Office of Taxation. It is anticipated that for a small financial outlay, this task force will save substantial revenue presently being lost by Papua New Guinea. If, as proposed it is given power via the Chief Collector to communicate information about specific companies to agencies which have other mechanisms for control of transfer pricing manipulation, the task force will have a most useful deterrent effect on the more serious offenders.
1. Comparative company tax supplied by the Office of Taxation, Port Moresby:
Japan 10-12% for companies importing raw materials; normal rate approximately 35%.
Papua New Guinea 36.5% (48% for companies incorporated outside Papua New Guinea). Also there is, in effect a divided withholding tax of 15% applicable to dividends remitted overseas.
2, P. Fitzpatrick, Law and State in Papua New Guinea, Academic Press, London, 1980, p.219.
See too UNCTAD, Dominant Positions of Market Power of Transnational Corporations: Use of the Transfer Pricing Mechanism, United Nations, New York, 1978, p.25.
LAW REFORM COMMISSION DRAFT
THE INDEPENDENT STATE
OF PAPUA NEW GUINEA
INCOME TAX (AMENDMENT) BILL 1981
No of 1981
Arrangement of Clauses
2. Interpretation (Amendment of Section 4)
3. New Section
4. Access to books etc. (Amendment of Section 365)
THE INDEPENDENT STATE OF PAPUA NEW GUINEA
INCOME TAX (AMENDMENT) BILL 1981
BEING an Act to amend the Income Tax Act 1959 to authorize the communication of information where a taxpayer has engaged in transfer pricing manipulation.
MADE by the National Parliament to come into operation in accordance with a notice published in the National Gazette by the Head of State acting with and in accordance with the advice of the Minister.
The title to the Principal Act is amended by inserting after the words "and collection", the words "and for other purposes".
The long title is amended to ensure the new section 9A falls within the purpose of the Act.
Section 4(1) of the Principal Act is amended by inserting after the definition of "trading stock" the following definition:-
"transfer pricing manipulation' includes the practice of directly or indirectly obscuring the actual value of any transaction whether it relates to goods, services or otherwise:"
3. New Section
The Principal Act is amended by inserting after Section 9 the following section:-
"9A - Communication of information where taxpayer has engaged in transfer pricing manipulation.
(1) Notwithstanding any other provision in this Act, where the Chief Collector has reasonable grounds to believe that a taxpayer has engaged in transfer pricing manipulation, which has or is likely to have the effect of evading liability for taxation under this Act, he, or a person authorised by the Chief Collector, may make a record of, or divulge or communicate only such information acquired or obtained under the provisions of this Act as is necessary to enable any Minister or officer of government, who has responsibility for the administration of any other Act that has application to the taxpayer, to consider whether any action is required to be taken against the taxpayer under such other Act.
(2) Whenever it is practical to do so, the communication of such information under subsection one shall be made only to the Minister or the head of the relevant department of government.
(3) The provisions of Section 9 of this Act shall have no application to any recipient of information under subsection one.
(4) If no action is taken under any other Act, the recipient of information under subsection one shall take all reasonable precautions to ensure such information received from the Chief Collector or a person authorised by the Chief Collector remains confidential. "
Clause I provides the Chief Collector with the discretion to communicate information about a taxpayer to a Minister or government officer in the limited circumstances where he has reasonable grounds to believe that transfer pricing manipulation has occurred and which has, or is likely to have, the effect of evading taxation liability.
4. Access to Books etc. (Amendment of Section 365)
Section 365 of the Principal Act is amended by inserting after the words "purpose may", the words "seize, retain and remove for inspection or".
This section improves one weakness in the present powers of taxation officers. It amends section 365 to enable books, documents and papers to be seized, retained and removed by taxation officers so that they cannot be altered by a taxpayer during the course of an investigation. This would of course have general application and not be confined to the work carried out by the task force.