Role Of Transnational Corruption In Pakistan Accounting Essay

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This Individual Research Paper forms an essential part of the Senior Management Course at National Management College. The subject of transnational corruption presents a tremendously wide spectrum of issues for debating the reasons for such corruption, and discussing the regulatory and accountability framework to detect and effectively handle the transnational corrupt practices. The corrupt practices in the transnational arena assume various styles like lobbying for a favorable bill in some other country, buying contracts of supply and construction through under-table deals, international bid rigging, kick-backs in mega deals, transfer pricing, etc.

Given the fact that the scope of the study, "Role of Transnational Corruption in Pakistan-Accountability vs. Regulatory Capture" is fairly catholic, the issue of transfer pricing by pharmaceutical sector of Pakistan has been picked as the area of research. Transfer pricing refers to unlawful siphoning out profits by a multinational company by overstating the cost paid for purchase of goods, services and intangible assets from the parent company or an associate. Multinational companies generally make purchases from their associates located in tax havens at abnormally high prices as there is no risk of taxation in tax havens. Besides tax evasion, transfer pricing entails compromise in the right of dividends of the domestic shareholders in the multinational corporations. Since a substantial part of international trade within global production network (almost 1/3rd), takes place between the firms and their foreign associates, transfer pricing poses one of the biggest challenges to world economies.

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Ideally speaking, the impact of transfer pricing should be measureable in any economy including Pakistan's. But the practical difficulties in getting hold of closely guarded business secretes of the multinational corporations working across the globe is an uphill task. Having analyzed variation in prices of similar products sold by multinational companies and their local counterparts, and on consulting tax records of some selected companies, this short study estimates that the impact of transfer pricing by pharmaceutical sector in Pakistan on tax revenues cannot be less than Rs. 840 Million per annum. Though a precise scientific study aiming at measuring the overall impact of transfer pricing by all sectors in Pakistan is not available, various people estimate or more precisely speaking "guestimate" an aggregate loss of around Rs 40 billion to Rs.70 billion per annum to the Pakistan economy.

This short research has come to explore that despite tremendous potential, neither FBR nor SECP has been capable of optimally capturing the issue. This sub-optimal handling of the issue has further been explored to be a combined effect of a host of factors like inherently deficient and outdated tax regulations, lower capacity of the FBR officials, intriguingly complex nature of the problem, tax appellate courts mindset of applying very rigid rule of establishing the fact of transfer pricing beyond reasonable doubt rather than following the principle of preponderance of evidence, SECP's misplaced belief that tackling transfer pricing is not their business, etc. Major issue with the taxation laws of Pakistan remains their overemphasis on post transaction tax audits or accountability style capture of malpractice rather than focusing on preventive or regulatory measures to block the very possibility of occurrence of transfer pricing

On studying the nature, extent and underpinnings of the problem, this short research focused on the global best practices in handling the issue. OECD guidelines on transfer pricing are the most relevant and current document on the issue. It has been observed that transfer pricing did pose a challenge to the rest of the world as well and an average transfer pricing litigation took at least 7/8 years to conclude, even in the most advanced nations like USA. Accordingly, a number of countries have started resorting to advance pricing agreements (APAs), with a view to have a negotiated settlement of the issue in advance. Besides that countries like India have made it obligatory on the taxpayers to attach very extensive information with the return of income which can facilitate the tax auditor to carry out a quick analysis for possible tax evasion via transfer pricing. Both these international practices have been found to be replicable in our scenario.

This short research ultimately concludes that urgent attention is required to suitably amend the Income Tax and Corporate Laws of the country to align them with the international best practices besides imparting capacity building training to the officers of these regulators. The study believes that a regulatory and preventive approach is more likely to succeed and deliver than the conventional accountability method of handling the problem. The recommendations, which are only another way of stating the conclusions, go on to propose that by urgently amending the Income Tax Laws, advance pricing agreements may be initiated with the help of a broad based team comprising of tax auditors, international economists and industry specialists. Besides that, following the Indian precedent, multinational companies working in Pakistan may be legally obligated to furnish in advance, all relevant data/ information regarding international transactions having direct or indirect bearing in transfer pricing. This paradigm shift in approach from reactive to proactive, from accountability capture to regulatory capture, coupled with appropriate capacity building of regulating agencies namely FBR/ SECP, has potential of retrieving around Rs. 1 billion per annum as tax revenues to the state from pharmaceutical sector alone, which at present is going down the drain.

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TABLE OF CONTENTS

Introduction

This Individual Research Paper aims at exploring some significant dimensions of transnational corruption with specific reference to Pakistan. The obvious hypotheses emanating from the very title of the IRP, "Role of Transnational Corruption in Pakistan-Accountability vs Regulatory Capture" are: (i) strong accountability mechanism or curative method of post-occurrence detection and punishment of transnational corruption is an effective solution to thwart and impede corrupt practices in the transnational arena; (ii) regulatory or preventive and proactive approach of looking for ways and means which can ensure transparency in transnational transactions before they actually take place is a relatively better methodology than merely focusing on the curative approach. These hypotheses have been tested in Pakistan's scenario with focus on transnational corrupt practices of transfer pricing by the multinational companies of pharmaceutical manufacturing sector.

Statement of Problem

Transnational corruption generally refers to a wide range of 'corrupt practices' resorted to by transnational or multinational corporations (MNCs) operating in various jurisdictions across the globe. These corrupt practices include international bid rigging, kickbacks in mega projects and defense deals, transfer pricing etc.

STATEMENT OF THE PROBLEM PROBLEMSThe transnational corporations, usually having their principal places of business in the developed industrialized world, find it easy to exploit the relatively weaker enforcement systems in the developing countries and, either in collusion with the officials of the developing countries or otherwise, tend to obtain undue business advantage. Under the apparently noble goal of promoting foreign direct and indirect investment in the developing economies, these MNCs are perceived to be working towards slowing down or inhibiting the pace of socio-economic growth in the developing economies. Weaker enforcement mechanism, absence of appropriate regulatory framework and inherent difficulty in extending domestic laws to the residents of foreign jurisdictions tend to aggravate this problem manifold. Given the overall extent and frequency of this highly sophisticated facet of corruption, the issue deserves to be given special attention by the citizens, politicians and bureaucracies of the developing countries.

Because of its gravity and intriguing nature, the problem presents a reasonably apt proposition for research to a student of public policy in Pakistan. However, covering the entire range of transnational corruption in Pakistan appears an uphill task for a relatively shorter research study like the one in hand. Per force, this paper focuses at the transfer pricing aspect of the transnational corruption. Transfer pricing refers to a mechanism whereby the multinational corporations, by overstating the price of various goods and services purchased from their own head offices, defraud the revenue administration and SECP. Accordingly, this Individual Research Paper(IRP) aims at assessing the frequency and intensity of transnational corruption with specific reference to transfer pricing and critically evaluating the effectiveness of prevailing legal dispensation for handling the problem, which is believed to be focused on accountability or curative methodology. Besides that exploring the possibility of pressing into service non-legal/informal or regulatory and preventive ways & means to tackle the problem more effectively, needs to be looked into.

Organization of the Paper

This Individual Research Paper has been organized into four sections which stand prefixed by an executive summary & introduction and suffixed by conclusion, recommendations and bibliography. Section-1 deals with the conceptual framework and dilates upon the concept of transnational corruption with specific reference to transfer pricing besides highlighting the enormity of the issue in international and Pakistani contexts. Section 2 aims at estimating the impact of transfer pricing in Pakistan by the pharmaceutical sector. Section 3 analyses the prevailing legal framework in direct taxation and corporate laws with a view to examine the successes and failures of prevailing legal/ administrative regime. Section 4 attempts to explore actionable space for policy intervention while having a close look at the international best practices in the field of transfer pricing. Conclusion and recommendations respectively summarize the inferences drawn by the research and way forward for policy intervention.

Methodology

This research employs a fair combination of descriptive, exploratory, analytical and data based research techniques while utilizing primary and secondary sources. While explaining the crucial concepts of transnational corruption/ transfer pricing, the descriptive and exploratory approach have been followed. For measuring the impact of transfer pricing in Pakistan, data from primary sources has been collected from tax records of various pharmaceutical companies being taxed in LTUs Lahore and Karachi as well as through perception surveys conducted through a reasonably representative sample of corporate lawyers, FBR officers and Chartered Accountants. Approach adopted for analyzing the degree of success of the prevailing legal regime is mainly analytical and uses the secondary sources of judgments of tax appeal courts and relevant rules and regulations. Similarly, research technique adopted for identifying actionable space is mainly exploratory. Primary sources include primary data from government records, information gathered through perception surveys and prices of various pharmaceutical products collected during the course of research and interview with experts in the field. Secondary sources include net surfing and review of literature.

Review of Literature

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As is evident from the bibliography, a number of books and statutes were studied during the course of research to trace the niceties of the problem in historical and current perspective with special focus on how the issue is being handled across the globe. Sources available on internet have also been extensively relied upon.

SECTION-1

Transnational Corruption

Corruption, in general and transnational corruption in particular, poses challenge of enormous scale to modern day economies. Societies are paying a very heavy cost of corruption in economic, social, psychological and developmental terms. The concept of corruption, transnational corruption and transfer pricing which refers to a specific aspect of transnational corruption is briefly discussed in the succeeding paragraphs.

1.1 Transnational Corruption

The word "Corruption" has its origin in a Latin verb "corruptus" meaning "to break". Literally, it means "a broken object". Its synonyms include dissolution, immorality, rot, putrefaction, putrescence, foulness, pollution, contamination. In simple words, corruption means "the misuse of entrusted power for private benefit." Conceptually, corruption is a form of behavior which departs from ethics, morality, tradition, law and civic virtue. [1] 

The term corruption has various definitions. The United Nations Manual on Anti-Corruption, the Transparency International, and the multilateral financial institutions like the World Bank and Asian Development Bank define corruption as, "abuse of public office for private gains" [2] Pakistan's National Anti-Corruption Strategy (NACS) has defined corruption as "a behavior on the part of office-holders in the public or private sector whereby they improperly and unlawfully enrich themselves and/or those close to them, or induce others to do so, by misusing the position in which they are placed." [3] Transnational has been defined as reaching beyond or transcending national boundaries.' [4] Accordingly, transnational corruption refers to abuse of public office by the officials of one state to seek private benefits from the nationals or corporations belonging to another state or the corporations of one state resorting to some unlawful practice during the course of its business operations, whereby prejudice is caused to the citizens or government of the other state.

Transnational corruption generally refers to a wide range of 'corrupt practices' resorted to by transnational or multinational corporations (MNCs) operating in various jurisdictions across the globe. These corrupt practices include international bid rigging, kickbacks in mega projects and defense deals, transfer pricing, etc.

STATEMENT OF THE PROBLEM PROBLEMSThe transnational corporations, usually having their principal places of business in the developed industrialized world, find it easy to exploit the relatively weaker enforcement systems in the developing countries and, either in collusion with the officials of the developing countries or otherwise, tend to obtain undue business advantage. [5] Under the apparently noble goal of promoting foreign direct and indirect investment in the developing economies, these MNCs are perceived to be working towards slowing down or even inhibiting the pace of socio-economic growth in the developing economies. Weaker enforcement mechanism, absence of appropriate regulatory framework and inherent difficulty in extending domestic laws to the residents of foreign jurisdictions tend to aggravate this problem manifold. Given the overall extent and frequency of this highly sophisticated facet of corruption, the issue deserves to be given special attention by the citizens, politicians and bureaucracies of the developing countries.

Because of its gravity and intriguing nature, the problem presents a reasonably apt proposition for research to a student of public policy in Pakistan. However, covering the entire range of transnational corruption in Pakistan appears an uphill task for a relatively shorter research study like the one in hand. Per force, this paper focuses at the transfer pricing aspect of the transnational corruption.

1.2 Transfer Pricing

Transfer Price is the price charged for sale of physical goods and intangible property and/or provision of services. Intra-Group transfer prices also include payments for intra-group services and transfers of technology. [6] 

Transfer pricing, on the contrary, is the process of establishing arm's length prices charged or paid upon the transfer of physical goods and intangible property or supply of services in transactions undertaken between associated enterprises located in the same or different tax jurisdictions. Intra-company transfer pricing refers to the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately. [7] 

Transfer pricing concept has attained more importance with the accent of global trade. Multinational corporations (MNCs) are devoting more and more attention to intra-firm trade involving different national centers. Historically, MNCs conducted their operations through self-sufficient subsidiaries. With increasing inter-linkages in global manufacturing, outsourcing and marketing, the MNCs look at possibilities of optimizing their global profits.

According to the Economic and Political Weekly, India, "The borderline between criminal fraudulent over and under-invoicing and lawful transfer pricing can be thin at times. Transactions through tax-havens showing lower profits in both the exporting and importing countries as well as evading tariffs in the importing countries further complicate things for the tax administrators.' [8] 

Transfer pricing ends in managing lowered profits to the entity, with two immediate outcomes; reduction in tax liability and reduction in profits available for distribution by way of dividend. Given the very scheme of things, major stakeholders in the transfer pricing are multinational corporations, minority shareholders, tax administration, Securities & Exchange Commissions, chartered accountant firms, company auditors, tax advisors, corporate lawyers, local competitors of multinational corporations and public at large.

1.3 Growing Concern for Transfer Pricing

The World Bank Development Report points out that one-third of the world trade takes place within global production networks. American imports and exports between their firms and the foreign affiliates, or parents, account for 40 per cent of the total US trade. Similarly, 40 per cent of the US-Europe trade is between parent firms and their affiliates, and in respect of Japan and Europe, it is 55 per cent; with regard to US-Japan trade, it is 80 %. [9] 

Transfer pricing poses big issue in international economic transactions. The importance of the phenomenon can be easily gauged from the fact that a cursory research on the words 'transfer pricing' in Google leads to mining 10.2million websites discussing this concept in one way or the other in just 0.14 seconds. [10] Official websites of all known chartered accountant firms like PWC, KPMG, Arthur Anderson, Earnest & Young, Baker Tilly, etc. carry advertisements for transfer pricing planning issues. [11] The websites of Chartered Accountant Firms go on to stress that tax administrations across the globe are becoming more aware of the transfer pricing issues and are gradually far better equipped in detecting tax evasion/ avoidance through transfer pricing. All countries particularly the developed one appear to be more concerned with effectively blocking the menace. OECD has laid down very elaborate guidelines and enlisted international best practices for effectively handling the issues. Official website of OECD provides linkages with the transfer pricing rules of more than sixty countries of the world. [12] The issue finds an important place on the UN agenda. UN is emphasizing the developing countries to adopt anti- transfer pricing legislations. [13] The international accounting body has also shown keen interest in the subject International Financial Reporting Standard 24 emphasizes on full disclosure of related party transactions. [14] Regulators of Joint Stock Companies across the world are also concerned with the issue as transfer pricing prejudicially affects the profitability of the company and resultantly right to dividend of the shareholders gets compromised. [15] 

1.4 Transfer Pricing in Pakistan-Major Sectors

Transfer pricing may be a feasible business option for all multinational companies like telecom service providers, courier companies, oil marketing companies, automobile manufacturers, pharmaceutical manufacturers and chemical manufacturing. [16] A transfer pricing perception survey was carried out on a largely representative sample of chartered accountants, IRS officers and corporate lawyers. The perception survey forms reveal that Lahore based corporate lawyers have hardly faced any litigation between the shareholders and the companies regarding transfer pricing. An absolute majority of them was quite oblivious of this phenomenon. By and large all chartered accountants have a reasonably good understanding of the transfer pricing issues and majority of them believe that all the aforementioned sectors are involved in shifting of profits through transfer pricing. The chartered accountants however believe that tax officers of Pakistan lack understanding as well as training in the field. The officers of FBR particularly those posted in Lahore, hardly come across transfer pricing practices. The most aware lot of FBR officers is posted in the Large Taxpayers' Unit Karachi, where a vast majority of multinationals is being assessed to tax. Pharmaceutical sector, in the rating of chartered accountants as well as Tax Officers of LTU Karachi, is the sector which deserves to be ranked as prime suspect of transfer pricing. [17] Outcome of the transfer pricing perception survey has been discussed and analyzed in Section 2 of this Paper, which has been titled as Impact of Transfer Pricing.

1.5 Measuring the Impact of Transfer Pricing

Ideally speaking, the impact of transfer pricing should be measureable in any economy including Pakistan's. But the practical difficulties in getting hold of closely guarded business secretes of the multinational corporations working across the globe is an uphill task. Why should a multinational corporation share the actual cost incurred by it on acquisition of various raw materials, inputs, services, intangible assets, etc.? These cost transactions determine whether or not issue of transfer pricing is involved on the part of the multinational corporations. Sometimes, it becomes difficult to determine the exact price as quality of the inputs or services purchased may not be exactly comparable with the products and services available in the open market. Things become even more complicated when the parent countries of the multinational corporations are more interested in protecting the interest of their own enterprises rather than third world economies. The most suitable apparatus to measure the impact of transfer pricing would be a fully trained and equipped tax administration having international exposure and legal instruments to extract pertinent information from various corners of the globe [18] . In these circumstances, a precise or a fairly accurate measure of transfer pricing in Pakistan is not possible. However, a fairly dependable estimate can be made by analyzing some transactions from representative samples of multinational companies from various sectors of economy and extrapolating that information to the entire sector by using the available statistical tools.

SECTION-2

Measuring the Impact of Transfer Pricing in Pakistan

Transfer pricing, a highly private and secretive affair of a business organization, remains a subject of anybody's wild imagination or guess unless one lays hand on the relevant accounting information of the organization and price of comparable products &services sold in the same period in an arm's length transactions by independent business actors. Besides the commercial information, one must also have reasonably good ability to carry out analysis of the accounting data. Privilege to direct production of relevant record and go for an analysis of the financial data of the organization is restricted to the state regulators which primarily include the tax administration of the country and Securities & Exchange Commission. The former has to determine the corporate tax liability of the organization and the later has to ensure that the accounting information presented in the financial statements does depict a fair and accurate picture of the organization's affairs. Tax records of the organization being legally confidential and subject to penal action in case of unauthorized disclosure [19] and SECP not having statutory authority to conduct detailed audit in normal circumstances [20] , further limit a researcher's ability to measure the impact of transfer pricing. Operating in the limitations, an endeavor has been made to firstly, gather information through a 'structured perception survey' administered to various important stakeholders in handling the issue of transfer pricing like corporate lawyers, chartered accountants and FBR Officers; secondly, strike a comparison of market prices of various identical or nearly identical products of the pharmaceutical companies in Pakistan and lastly, gather information as to transfer pricing litigation in a few cases which have already gone public for one reason or the other.

2.1 Transfer Pricing Perception Survey (The survey Questionnaire is attached as 'Annexure-A')

What transpired during the transfer pricing perception survey conducted on a representative sample of chartered accountants, corporate lawyers and FBR Officers is reduced in the following table:

Question No. 1: Opportunity to come across transfer pricing planning, litigation or tax audit [21] :

CAs

Corporate Lawyers

FBR Officers

Size of the sample

23

17

53

Never came across

20%

100%

79%

Handled few cases

70%

0%

2%

Frequently came across

10%

0%

19%

Information gathered through survey suggests that Chartered Accountants are much more aware of the transfer pricing issues than corporate lawyers and FBR officers. Since multinational corporations are generally grouped under the jurisdiction of Karachi Large Taxpayers Unit [22] , the FBR officers posted elsewhere have relatively less chances of being confronted with the issue.

Question No. 2: Whether transfer pricing a challenge to:

Good corporate governance

CAs

Corporate Lawyers

FBR Officers

Size of the sample

23

17

53

Yes

21%

No comments

32%

No

79%

No comments

68%

Proper taxation of income

CAs

Corporate Lawyers

FBR Officers

Size of the sample

23

17

53

Yes

80%

No comments

98%

No

20%

No comments

2%

As is evident from above, transfer pricing is perceived by the stakeholders to be a much bigger a challenge for corporate taxation than an issue impacting the good corporate governance.

Question No. 3: Percentage of multinational companies involved in transfer pricing:

CAs

Corporate Lawyers

FBR Officers

Size of the sample

23

17

53

0% - 4%

20%

No comments

4%

5% - 25%

30%

No comments

37%

26% - 50%

45%

No comments

43%

51 % - 75%

5%

No comments

5%

Greater than 75%

NIL

No comments

NIL

Survey results show that around 43% to 50% multinational companies tend to engage in transfer pricing as per popular belief.

Question No. 4: Sectors involved in transfer pricing-perception regarding prime suspect:

(Scale- 5 highest and 1 lowest)

CAs

Corporate Lawyers

FBR Officers

Size of the sample

23

17

53

Scale

Pharmaceutical

No comments

Pharmaceutical

Other Chemicals

No comments

Automobile manufacturers

Telecommunications

No comments

Courier services

Automobile manufacturers

No comments

Other Chemicals

Courier services

No comments

Telecommunications

There appears consensus that pharmaceutical and chemical sector is the chief suspect of transfer pricing followed by automobile manufacturers and courier service providers.

Question No. 5: Transfer pricing-awareness level:

Response by CAs (Scale- Negligible to High)

Concerned Quarter

Degree of Awareness

Negligible

Low

Medium

SECP

19%

43%

38%

FBR

47%

33%

11%

Corporate Courts

87%

11%

2%

Tax Courts

5%

17%

53%

Corporate Lawyers

88%

12%

Tax lawyers

3%

20%

56%

Chartered Accountants

17%

10%

22%

Investment Advisors/stock-exchange brokers

92%

8%

Shareholders

98%

2%

Response by FBR Officers (Scale- Negligible to High)

Concerned Quarter

Degree of Awareness

Negligible

Low

Medium

SECP

60%

37%

3%

FBR

79%

3%

3%

Corporate Courts

Uncertain

Tax Courts

6%

15%

60%

Corporate Lawyers

Uncertain

Tax lawyers

63%

17%

12%

Chartered Accountants

21%

12%

42%

Investment Advisors/stock-exchange brokers

Uncertain

Shareholders

Uncertain

Chartered accountants are believed to be the most aware lot on the issue followed by the FBR officers whose composition in the medium and high degree of awareness range is just 30%. Corporate lawyers and courts are least aware of the issue.

Question No. 6: Efficacy of prevailing legal dispensation:

(Scale- insufficient, reasonably sufficient and more than sufficient)

CAs

Corporate Lawyers

FBR Officers

Size of the sample

23

17

53

Scale

Insufficient

77%

-

43%

Reasonably sufficient

12%

-

7%

More than sufficient

0%

-

0%

Uncertain

21%

100%

50%

As is evident from above, it is largely believed that the prevailing legal dispensation and the regulating agencies are tremendously weak in enforcing the transfer pricing regulations.

Question No. 7: Effective control of transfer pricing and foreign direct investment

(Scale- not sure to highly positive)

CAs

Corporate Lawyers

FBR Officers

Size of the sample

23

17

53

Scale

Not sure

23%

100%

20%

Mild Negative

4%

-

7%

Negative

1%

-

27%

Highly Negative

0%

-

46%

Mild Positive

21%

-

-

Positive

51%

-

-

Highly Positive

-

-

-

Interestingly, Chartered Accounts believe that certainty in transfer pricing regulations will tend to improve foreign direct investment, and FBR Officers believe to the contrary.

2.2 Product Price Pattern in Pharmaceutical Sector in Pakistan

Data regarding prices and the packing of various products of the pharmaceutical companies in Pakistan is readily available in a business information brochure called Pharma-guide Pakistan and is also accessible at internet on the website www.epharmaguide.com. Analysis of pricing pattern of various pharmaceutical products indicates that identical products, having same chemical composition, sold by multinational companies are much costlier than the same being sold by their local counterparts. Raw materials in respect of these products are generally purchased by the multinational companies from their parent companies or other close associates. Such a sharp difference in pricing pattern, powerfully points towards transfer pricing practices, as profit margins of both set of companies remaining the same, market prices of the products of multinationals are on a much higher side.

In the following tables, average tagged market price of various pharmaceutical products of local companies has been compared with the price of identical product of the multinational pharmaceutical companies.

Product Name: MECOBLAMIN 500MG [23] 

Alternate Brands

Manufacturer/Manufacturer's Representative

Packing

R. Price (Rs.)

Local Pharmaceuticals

INCOBAL

INDUS PHARMA (PVT) LTD.

30s

110

MECOL

EPLA LABORATORIES (PVT) LTD.

30s

165

COBSAL

DRUG PHARMACEUTICALS CHEM. (PVT).

30s

108

VERIL

STANLEY PHARMACEUTICALS (PVT) LTD.

30s

150

COBOLMIN

MACTER INTERNATIONAL (PVT) LTD.

30s

123.75

FLENCH

TABROS PHARMA

30s

120

Average

127.39

Multinational Pharmaceuticals

NEUTANX

MARTIN DOW PHARMACEUTICALS (PAK) LTD.

30's

172.5

MYLAXON

BARRETT HODGSON PAKISTAN (PVT) LTD.

30s

225

LIZOBAL

BOSCH PHARMACEUTICALS (PVT) LTD.

30s

120

Average

172.5

Difference in Average Price (B-A)

45.11

Percentage difference in average price (C/A x 100=D)

35.4%

Product Name: Terbizine (Terbinafine125mg) [24] 

Alternate Brands

Manufacturer/Manufacturer's Representative

Packing

R. Price (Rs.)

Local Pharmaceuticals

ANTIFIN

ENGLISH PHARMACEUTICALS INDUSTRIES

10s

313.00

CUTIS

TABROS PHARMA

10s

200.00

DOCINAF

PARAMOUNT PHARMACEUTICALS

10s

313.00

EXINOFIN

BROOKES PHARMACEUTICAL LABORATORIES (PAK.) LTD.

10s

250.00

FUNGE

WILSHIRE LABORATORIES (PVT) LTD.

10s

250.00

Average

265

Multinational Pharmaceuticals

LAMISIL

NOVARTIS PHARMA (PAK) LTD

10s

408.88

Average

408.88

Difference in Average Price (B-A)

143.88

Percentage difference in average price (C/A x 100=D)

54.3%

Product Name: MOXIFLOXACIN 400MG [25] 

Alternate Brands

Manufacturer/Manufacturer's Representative

Packing

R. Price (Rs.)

Local Pharmaceuticals

AVEROX

LINEAR PHARMA

5's

250

BIOFLOXACIN

MEDISURE LABORATORIES PAKISTAN (PVT.) LTD.

5s

250

ENGMOX

ENGLISH PHARMACEUTICALS INDUSTRIES

5s

250

FLOXAMOX

LOWITT PHARMACEUTICALS (PVT) LTD

5s

250

FOSTY

TAGMA PHARMA (PVT) LTD.

5s

250

MACTIC

WELMARK PHARMACEUTICALS

5's

250

MOBIK

MASS PHARMA (PRIVATE) LIMITED

5s

250

Average

250

Multinational Pharmaceuticals

ABOMOX

ABBOTT LABORATORIES (PAKISTAN) LIMITED.

5's

475

ACFLOX

W.WOODWARD PAKISTAN (PVT) LTD.

5's

475

Average

475

Difference in Average Price (B-A)

225

Percentage difference in average price (C/A x 100=D)

90%

Product Name: EFXONE (CEFTRIAXONE 1.0G) [26] 

Alternate Brands

Manufacturer/Manufacturer's Representative

Packing

R. Price (Rs.)

Local Pharmaceuticals

CEFCIN

CIRIN PHARMACEUTICALS (PVT) LTD.

1s

185.00

ROCIMED

MEDICRAFT PHARMACEUTICALS (PVT) LTD.

1s

185.00

RYXON

BROOKES PHARMACEUTICAL LABORATORIES (PAK.) LTD.

1s

200.00

TOKOM

NEUTRO PHARMA (PVT) LTD.

1s

160.00

Average

182.5

Multinational Pharmaceuticals

CEFIN

MACTER INTERNATIONAL (PVT) LTD.

1s

450.00

ROCEPHIN

ROCHE PAKISTAN LTD.

1s

477.68

Average

408.88

Difference in Average Price (B-A)

281.34

Percentage difference in average price (C/A x 100=D)

155%

Product Name: Pepdis (Famotidine 40mg) [27] 

Alternate Brands

Manufacturer/Manufacturer's Representative

Packing

R. Price (Rs.)

Local Pharmaceuticals

ACICON

BARRETT HODGSON PAKISTAN (PVT) LTD.

10s

135.00

APSIN

DON VALLEY PHARMACEUTICALS (PVT) LTD.

1x10s

72.80

BAN-ULCER

PAKHEIM INTERNANATIONAL PHARMA

10s

112.50

FAMOSCOT

SCOTMANN PHARMACEUTICALS

1x10s

90.00

Average

102.5

Multinational Pharmaceuticals

PEPCIDINE

MERCK SHARP & DHOME OF PAKISTAN LTD.

10s

263.70

Average

263.7

Difference in Average Price (B-A)

161.2

Percentage difference in average price (C/A x 100=D)

157%

Product Name: ISOTRETINOIN (ISODERM 20MG) [28] 

Alternate Brands

Manufacturer/Manufacturer's Representative

Packing

R. Price (Rs.)

Local Pharmaceuticals

ACNETRAC

WARAFANA PHARMACEUTICALS

5's

304

ACNOREN

GENOME PHARMACEUTICALS (PVT) LTD

5's

304

BEFAST

WEBROS PHARMACEUTICALS

5's

304

ISOWAN-T

SWAN PHARMACEUTICALS(PVT) LTD

5's

304

ISOZAM

VALOR PHARMACEUTICALS

5's

304

RECUTE

SHAWAN PHARMACEUTICALS

5's

304

ROACADVAN

ADVANCED PHARMACEUTICALS

5's

304

Average

304

Multinational Pharmaceuticals

ROACCUTANE

ROCHE PAKISTAN LTD.

5's

858

Average

858

Difference in Average Price (B-A)

554

Percentage difference in average price (C/A x 100=D)

182%

Product Name: Omeprazole 20mg [29] 

Alternate Brands

Manufacturer/Manufacturer's Representative

Packing

R. Price (Rs.)

Local Pharmaceuticals

HELEZOL

BIOGENICS PAKISTAN (PVT) LTD.

14s

110.00

HUPRA

LINEAR PHARMA

14's

144.00

INGIS

KOBEC PHARMACALS

14s

175.00

IRZAZOLE

IRZA PHARMA (PVT) LTD.

14s

144.00

Average

143.25

Multinational Pharmaceuticals

ETIPRO

ICI PAKISTAN LTD.

14s

488.34

LOSEC

BARRETT HODGSON PAKISTAN (PVT) LTD.

14s

688.10

Average

588.16

Difference in Average Price (B-A)

444.91

Percentage difference in average price (C/A x 100=D)

310%

Product Name: Montelukast sodium [30] 

Alternate Brands

Manufacturer/Manufacturer's Representative

Packing

R. Price (Rs.)

Local Pharmaceuticals

AEROMAX

SHROOQ PHARMACEUTICALS

10s

160.00

AEROTEL

HIGHNOON LABORATORIES LTD.

14s

210.00

ASFREE

MEDISURE LABORATORIES PAKISTAN (PVT.) LTD.

14s

210.00

MNTK

MACTER INTERNATIONAL (PVT) LTD.

14s

196.00

Average

194

Multinational Pharmaceuticals

SINGULAIR

MERCK SHARP & DHOME OF PAKISTAN LTD.

14s

1301.79

Average

1301.79

Difference in Average Price (B-A)

1107.79

Percentage difference in average price (C/A x 100=D)

571%

The above data bears a clear testimony that the price difference of selected products of multinational companies in comparison with the same of the national companies, in percentage terms, varies from 35% to alarmingly high 571%. The data is enough to give an indication that foreign owned pharmaceutical sector has a very strong likelihood of indulging in transfer pricing practices in respect of some products.

2.3 Taxation of Transfer Pricing Transactions

We may now examine the taxation trends in some multinational pharmaceutical companies regarding transactions involving transfer pricing and the fate of tax assessments in such cases before the appellate fora. Whatever information, this short study could gather from the tax offices is summarized in the following table:

Summary of Transfer Pricing Additions in Multinational Companies-Pharmaceutical Sector [31] 

Name of Company

Tax year

Important Products/services purchased from foreign associates

Price Charged

Comparable Price

Quantum of Addition

Tax Impact

(Rs.)

Fate in 1st Appeal

Fate in 2nd Appeal

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

Glaxosmithkline,

Karachi

2008

CeftazedimePentahydrate

Cefuroxime Sodium

107,043.20/kg

55,166.78

24,091.00

16,429.00

57,604,300

37,914,374

Total 93,564,487

Related to local sales @ 97.35033%

91,085,337

31,897,867

Assessment confirmed

Set aside for reassessment

Novartis Pharma Pakistan Limited,

Karachi

2008

calcium lactate gluconate

Tizanidine Hydrochloride

97 per KG

1,637,032 per KG

246

24,276

130,087,944

19,352,952

149,440,896

Related to local sales @ 99.50%

148,693,692

52,042,792

-do-

-do-

Bayer Pakistan Limited,

Karachi

2009

Ciprofloxacin HCL

ClotrimazoleMicrofine

14,738.24

9,078.08

1,546

2,557

47,279,540

9,424,397

56,703,937

19,846,378

-do-

-do-

Medipharm (Pvt.) Ltd, Lahore

2008

Azelaic Acid

Lormetazepam Micro20

38,413

1028.29

50.57

421.200

26, 449,420/-

9,257,297/-

Confirmed

Sub-judice

The data shows that there is an ample scope of taxation of transactions involving transfer pricing in the pharmaceutical sector. Average tax impact in the above mentioned four companies comes to Rs. 28 (M) per year approximately. Applying the same average to the thirty major multinational companies of the pharmaceutical sector, total quantum of profits unlawfully shifted through the process of transfer pricing may not be less than Rs. 2,400 (M) per annum, which at the given tax rate of 35% involves tax implications of around Rs. 840(M) per annum. That figure will grow manifold if the transfer pricing impact of all major sectors like automobile manufacturing, oil marketing companies, telecommunication, courier service providers, etc. is taken into account. A study conducted by Mr. Ashfaq Bokhari states that, the conclusion of this study is that transfer pricing poses a big challenge to the Pakistan economy as it results into an approximate loss of Rs. 70 (B) to the state exchequer and loss of right in dividend to the tune of Rs. 130 (B) approximately every year. [32] As any authentic or scientific study to corroborate what Mr. Ashfaq Bokhari has said is not available, the impact worked out by him can at the best be rated as a good indication emanating from guestimate. [33] 

SECTION-3

Enforcement of Transfer Pricing Regulations-Analyses

Law enforcement broadly refers to any system, by which some members of society, usually referred to as law enforcement agencies, act in an organized manner to promote adherence to the law by discovering and punishing persons who violate the rules and norms governing that society. Although the term may encompass entities such as law enforcing administrative agencies, courts and prisons, it is most frequently applied to those who directly engage in patrols or surveillance to dissuade and discover criminal or deviant activity, and those who investigate crimes, apprehend offenders and impose civil penalties. Furthermore, although law enforcement may be most concerned with the prevention and punishment of crimes or undesirable activities, organizations exist to discourage a wide variety of non-criminal violations of rules and norms, affected through the imposition of less severe penalties. [34] 

Effectiveness of any law enforcement system is squarely dependent upon the precision, comprehensiveness & certainty of the rules and regulations, preparedness & capacity of the law enforcing agency to apply rules in proper perspective and probability of judicial sustainability of action taken by the law enforcing agency. Given this background, it appears highly relevant to carry out a brief analysis of the transfer pricing regulations both under the Income Tax and Company Laws of Pakistan besides looking into the way, the courts of the country treat the siphoning out of profits through transfer pricing mechanism. The analysis will fundamentally target on inherent capacity or weaknesses of the law enforcement system in controlling the transfer pricing in Pakistan.

3.1 Tax Law on Transfer Pricing

Transfer pricing provisions in the income tax legal frame work of Indo-Pakistan subcontinent date back to the very inception of the first formal and regular law of income taxation, i.e. the Indian Income Tax Act, 1922. [35] Section 42 of the Indian Income Tax Act, 1922 adopted by Pakistan after independence and its corresponding section 79 of its successor law, the Income Tax Ordinance, 1979 [36] empowered the tax authorities to critically examine the element of transfer pricing in dealings between a resident taxpayer and his non-resident associate. However, no detailed rules on methodology of working of transferred price were provided in those statutes. In a significant departure from the past, Income Tax Ordinance, 2001 and the rules made there- under i.e. Income Tax Rules, 2002, currently prevailing legal dispensation, provide specific provisions to capture tax evasion by transfer pricing transactions. Section 108 of the income Tax Ordinance, 2001 lays down broad parameters of re-characterization of transactions between associates in case the same do not fulfill the criterion of arm's length principle. The said provision of law reads as under:

"108. Transactions between associates. (1) The Commissioner may, in respect of any transaction between persons who are associates, distribute, apportion or allocate income, deductions or tax credits between the persons as is necessary to reflect the income that the persons would have realized in an arm's length transaction.

(2) In making any adjustment under sub-section (1), the Commissioner may determine the source of income and the nature of any payment or loss as revenue, capital or otherwise." [37] 

Detailed methodology for computing the exact extent of transfer pricing has been elaborated in the Income Tax Rules, 2002. Rules 20 to 27 of the said Rules provide various methods which can be used by the tax collectors for determining transfer pricing and its tax impact. These methods include; (a) The comparable uncontrolled price method;(b) The resale price method ;(c) the cost plus method; and (d) the profit split method. [38] 

The comparable uncontrolled price method provides standards, when unrelated party prices, transactions, profitability or other items are considered sufficiently comparable in testing related party items. Such standards typically require that data used in comparisons be reliable and that the means used to compare, produce a reliable result. The U.S. and OECD rules require that reliable adjustments must be made for all differences (if any) between related party items and purported comparables that could materially affect the conditions being examined. [39] Application of this method presupposes availability of a lot of pertinent information from the international market regarding the comparable prices of the goods or services purchased by the resident taxpayer. Method sounds very good in theory but it is tremendously difficult to apply to real life situation in a fool proof and judicially sustainable manner.

Resale price method (RPM) works on the premise that goods are regularly offered by a seller or purchased by a retailer to/from unrelated parties at a standard "list" price less a fixed discount. Testing is done by comparison of the discount percentages of the unrelated and related parties. The method focuses on what may be considered as a reasonable discount percentage in a given scenario and like the first method, also hinges upon reliable data regarding trends of margins on sales.

In the cost plus (C+) method, goods or services provided to unrelated parties are consistently priced at actual cost plus a fixed markup. Testing is done by comparison of the markup percentages. This operates on a logic converse to the resale price method.

The profit split method is applied where transactions are so interrelated that the arm's length result cannot be determined on a separate basis. The profit split method determines the arrangement on which independent persons would have agreed on the basis that they are dealing with each other at arm's length.

Perusal of legal provisions shows that apparently adequate legal framework to capture transactions suspected of transfer pricing is available in the tax laws of Pakistan. For guidance of tax authorities and improving certainty & objectivity level of law enforcement, rules for determining transferred price have also been made. However, a number of inherent deficiencies continue to mar the possibility of application of these regulations in a fashion that can sustain the test of appeal before the tax courts. These inherent factors impeding the application of law include;

The prevailing legal regime sticks to post transaction analysis during tax audit and altogether ignores any preventive measures which may be or should be taken to check the menace of transfer pricing beforehand. It does not recognize the internationally recognized practice of Advance Pricing Agreement (discussed in detail in Section 4) as one of the possible options to address the issue in advance. The present approach is considered outdated.

Pakistan tax law on the subject does neither specifically requires the taxpayer to separately disclose the transactions with non-resident associates nor it makes obligatory to attach comprehensive information regarding the costing methodology of goods, services and intangibles from the foreign associates with the tax return, like the Indian practice (discussed in Section 4).

Pakistan tax law and practice is too heavily dependent on selecting a case for tax audit on the first instance and then, seeking information from the taxpayer to determine the incidence of transfer pricing. The concept of universal self-assessment scheme (USAS) sets the taxpayer at liberty to declare any quantum of income he likes with a further privilege to attach minimum documentation with the declaration.

Catching transfer pricing transaction, in the prevailing legal scenario, is exclusively dependent upon tax authorities' capacity of data hunting/mining regarding commercial information from a complex setting of national and international sources.

Given the legal bottlenecks and capacity constraints, the only course open to the tax officials is to go for "the comparable uncontrolled price method" which is subject to a very grave challenge of proving that two business situation were exactly alike. This proposition puts the whole exercise to jeopardy as proving the two business situations to be identical in the way courts demand becomes a Herculean task.

3.2 Tax Courts and Transfer Pricing

Having conducted a brief analysis of some inherent deficiencies of the prevailing legal framework, this research paper now turns to examine various court judgments to ascertain the ratio of judicially sustainable tax assessments on the point of transfer pricing. Following table gives a summary of ultimate fate of transfer pricing litigation in a number of cases.

Case No. / Name

Adjudicating authority

Findings

ITA No.1551/HQ of 1998-99 dt: 09.01.1999

ITAT

Collusive arrangement between Pakistani company and Cayman Island based foreign associate established beyond reasonable doubt. Taxation confirmed by the court.

M/S Bayer Pakistan Limited

High Court of Sindh, Karachi

Tax authorities failed in establishing that controlled transactions were comparable with uncontrolled transactions. Tax assessment vacated.

ITA No 573/KB/ 1998-99

ITAT

The learned tribunal, while agreeing with the CBR's Clarification in principle, did not confirm the departmental action with observation that the assessing officer has failed to establish that transfer pricing did actually take place.

ITA No. 746/IB/ 1999-2000 (Pharmacia and Upjohn (Pvt.) Limited

ITAT

Assessment was made rather in haste without properly considering the arguments and contentions of the taxpayer. Hence the same was set aside.

71 TAX27 (Trib.)

ITAT

There cannot be much difference in the efficacy of raw material from different sources that are registered with the ministry of health and have identical composition. Departmental action confirmed.

67TAX55 (Trib.)

ITAT

The party (Income Tax Department) who is interested in any assertion/ finding has to discharge the onus of proving that assertion. There is a difference between basic requirement and excellence. The material compared by the department may have the same chemical composition / requirement but not necessarily the same efficacy/ excellence. Assessment vacated.

77TAX 140(Trib.)

ITAT

The entire comparison by the department is erroneous in the sense that what have been compared are two different materials in terms of effectiveness.

M/s Welcome Pakistan Ltd

ITAT

Transfer pricing additions deleted in respect of assessment years 1985-86 through 1987-88 and 1990-91 through 1992-93. Comparison of purchase of similar raw material from M/s Siemens Class of West Germany not considered relevant by the Court.

M/s Ciba Geigy Pakistan Limited

ITAT

Transfer pricing addition deleted for assessment year 1989-90 on the basis that department has failed to discharge its onus.

M/s Beecham Pakistan Limited. (1998)-PTD-Trib-447

ITAT

The departmental actions failed for not proving that raw of material of similar chemical composition imported by other manufacturers in Pakistan are of the same efficacy.

M/s Pfizer Laboratories Ltd.(1989)-PTD-612

Sindh High Court

-do-

M/s Glaxo Laboratories Ltd (1991) PTD 393

Sindh High Court

-do-

It is evident from the above analysis that sustainability of tax department's actions in capturing transfer pricing by multinational corporations has remained tremendously poor. The court upheld action in the case of company where machinery was purchased from the European counterpart and transactions were routed through Cayman Island, a tax haven. In such situation the entire transactions were shrouded in mystery and suspicion beyond any reasonable doubt. In the rest of the cases, courts did not buy the departmental argument of similarity of chemical composition of raw material being enough to justify similarity in efficacy as well. There were some initial successes by the department when the courts held that similarity of chemical composition as certified by the Ministry of Health does furnish a valid ground to compare prices of products for invoking transfer pricing actions. However, shortly afterwards, the trend was reversed by the courts on the premise that chemical composition alone does not render the products comparable unless it is proved by the department that the products were also identical in efficacy as well. That made the departmental job extremely difficult, thereby resulting into failure of the accountability or tax audit methodology of capturing the mal-practice. Given the different degrees of efficacy, a highly subjective concept or at least a thing, Income Tax department was never capable of establishing beyond doubt, that the raw material purchased by the company under investigation and the comparable product were essentially identical.

3.3 Corporate Law and Transfer Pricing

One of the principle objectives of the company law is to protect the right of the shareholders and guard them against the excesses committed by the management. Company law, accordingly, lays much emphasis on maintenance of proper books of accounts by the companies, following International Financial Reporting Standards (IFRS) previously called International Accounting Standards (IAS) and giving disclosure of all transactions with the sister concerns, associates and subsidiaries. Sections 230 to 247 of the Companies Ordinance, 1984 deal with maintenance of accounting records and incidental matters [40] . Section 234 of the Companies Ordinance, 1984, obligates the public companies to prepare their financial statements in accordance with IFRS. IFRS 24 lays down that all transactions with th