Companies don’t just sell their products to individual consumers, nor do business conglomerates only trade with other conglomerates. A large part of global trade is conducted within corporations – possibly even more than half of all trade.
In principle, affiliates of the same firm should use market pricing when trading with one another. However, the OECD and several courts realised as early as the 1960s that finding market prices may be impossible if equivalent products and services are unavailable on the open market. Consequently, companies were allowed to use specific formulas to set pricing in trade between affiliates.
"In practice, most pricing has been determined in this manner, but when affiliate trade is mentioned, the assumption remains that it is comparable with any market," says Matti Ylönen, who is working on his dissertation on world politics at the Faculty of Social Sciences with the working title The Politics of Corporate Tax Information.
Distorted pricing impacts taxes
According to Ylönen, this practice among affiliates, known as transfer pricing, is actually rarely based on the market prices being impossible to determine. Prices are often distorted to avoid taxes.
Ylönen and his dissertation supervisor, Professor in World Politics Teivo Teivainen, recently received first prize at the Yale University article competition named after Amartya Sen, a Nobel Prize in Economic Sciences laureate and professor of economics at Harvard University. The theme of the competition was illicit financial flows and tax avoidance.
In their winning article, Ylönen and Teivainen focused on affiliate trade and the related tax planning from the perspective of political economic research.
“The idea is for affiliates to figuratively keep each other at an arm's length when trading. However, we have known for decades that the rules of intra-firm trade do not in fact create markets inside companies. In this sense, regulation has failed,” Ylönen says.
According to Ylönen and Teivainen, talking about markets inside companies is also ideological and helps maintain the current defective system.
“Adam Smith’s idea of the invisible hand of the market has evoked criticism for centuries. The idea of affiliates trading at an arm’s length is similarly controversial, but this has not been sufficiently understood.”
Multinationals to be taxed as entities
The Amartya Sen Prize Competition sought concrete models for solving the problems of international tax evasion and tax avoidance.
“Understanding the ideological side of contemporary rules would help us make better decisions," Ylönen posits.
“One key issue, which has also been discussed in the EU, is to tax multinational companies as single entities. The tax revenue could then be distributed to governments according to a formula they would agree to among themselves. This would bypass the artificial pricing arrangements.”
Matti Ylönen is currently working in an Academy of Finland research project run by Aalto University’s Department of Economics, and has previously published books on tax havens, the debt crisis and political consultants. Teivo Teivainen is currently on leave from his duties as professor for the academic years 2014–2016, working as a researcher at the Helsinki Collegium for Advanced Studies.