Here Comes The Great Global Tax War

On the campaign trail in 1992, Bill Clinton vowed to make multinationals pay $45 billion more in taxes. Following the President's cue, the Internal Revenue Service has hit such Japanese companies as Hitachi, Yamaha, and Nissan with hefty claims.

Now, Japan is striking back. The Japanese National Tax Administration Agency (NTAA) has socked Coca-Cola Co. with a $145 million tax deficiency for 1990-92. They also hit AIU Insurance Co., the Japanese subsidiary of giant American International Group Inc., with an $87 million bill that was later reduced to $37 million in a settlement. "There is clearly a war going on," says a Tokyo lawyer who advises foreign companies on Japanese tax laws.

All of these cases involve disagreements over what is called transfer pricing, the accounting system by which companies report cross-border transactions among subsidiaries. Governments believe that multinationals manipulate these figures so as to underreport profits and lower their taxes. For example, the IRS said Nissan's U.S. subsidiary inflated the prices it paid to its parent for finished cars it was importing.

LITTLE BITE. In the U.S., the IRS has been moving aggressively to pierce the transfer-pricing veil. It's putting in penalties of up to 40% for underreporting, and it's tightening up rules. Companies are particularly upset by new requirements for enormous amounts of expensive documentation. The burden is on them to prove that the transfer prices they report are "arms length," or the same as those that would have been reached by unrelated parties. "It doesn't say you have to hire an outside economist or lawyer, but the fact is any sizable company will have to do that," says William C. Gifford, a tax partner at the New York law firm of Davis Polk & Wardwell in New York.

American multinationals are also feeling the IRS's bite. PepsiCo Inc. is now battling the IRS over an $880 million bill for 1985-89 that was levied after an extensive audit of such subsidiaries as Taco Bell, Pizza Hut, and Kentucky Fried Chicken. PepsiCo is asking for a $213 million refund.

But the Japanese think they are being made special targets. They are also annoyed at what many lawyers say is a shoot-from-the-hip approach by the IRS. Indeed, many of these cases end up being settled for much less than the IRS initially sought. For example, in reaching a $160 million settlement with Nissan, the IRS backed down more than $600 million from its initial calculation of the U.S. subsidiary's profits, reports BNA International Business & Finance Daily.

Still, the stepped-up enforcement has certainly caught the attention of the Japanese authorities. Once considered unsophisticated on transfer pricing, they have come up the learning curve rapidly. The AIG case, for instance, involves financial services, a far tougher business to audit than manufacturing. The NTAA said that American International Group was inflating reinsurance fees paid to subsidiaries in Bermuda and elsewhere. The Japanese "are trying to get on the dance floor, too," says David Rosenbloom, a transfer pricing specialist at Caplin & Drysdale in Washington.

PEACE EFFORT. Rosenbloom adds that other countries are also trying to tap into what they see as a potentially lucrative revenue stream. The German tax agency is "heightening audit activity beyond what they ordinarily do," he says.

Fear is widespread that an all-out tax war is about to erupt. To head that off, the Organization for Economic Cooperation & Development has been trying to update its 1979 guidelines for transfer pricing that most countries use.

The big issue is whether there will be a move away from "arms length", which some lawyers say is an unworkable standard for companies in other than commodities businesses. Experts and some members of Congress are pushing for a possibly simpler system that allocates profits by a formula such as the state of California's that factors in percentages of world sales, assets, and other indicators.

The OECD, lobbied hard by the IRS, is likely to stump for keeping the arms-length concept. But it may recommend use of a formula system in some cases such as global financial trading, where even the IRS seems to be agreeable. Whatever the outcome, the confusion is unlikely to end anytime soon.