United nations of tax incentives

Transfer pricing
Transfer pricing has been described as “the Achilles heel of tax 
holidays”,
 25 
although it can be a problem with other forms of 
investment incentives. There is a tendency to think of transfer pricing 
as a phenomenon that occurs internationally in transactions between 
25 
Charles E. McLure, Jr., “Tax holidays and investment incentives: a compara-
tive analysis”, 
Bulletin for International Fiscal Documentation
, vol. 53 (1999).

---

30
Design and Assessment of Tax Incentives
related enterprises in different countries. Transfer pricing can also 
take place in a single country in which an investor has two or more 
operations or derives income from more than one activity. If one of 
those operations, or one type of income, enjoys a tax preference, the 
investor will tend to allocate profits to the preferred activity.
Transfer pricing is likely to take place in the following 
scenarios: (a) an investor undertakes two or more activities, one of 
which qualifies for an incentive, such as manufacturing or exporting, 
and another does not; (b) an investor has operations in two or more 
locations, one of which is in a tax-privileged region and another is 
not; or (c) an investor owns two or more subsidiaries, one of which 
enjoys a tax holiday and another does not. In each case, the investor 
will wish to allocate as much profit as possible to the tax-exempt or 
tax-privileged entity or activity. In cases (a) and (b) there may be only 
a single entity, in which case there is no transfer pricing as such, but 
an equivalent result is achieved through the allocation of revenue and 
expenditure.
Substantial challenges exist for monitoring transfer pricing, 
especially for small or less developed countries. One approach may be 
to use tax incentives that are less prone to transfer pricing abuses. For 
example, in contrast to tax holidays, investment allowances or credits 
provide an exemption from tax of a given amount, rather than for a 
given period, therefore artificial transfers of profits to a firm that has 
been granted an investment allowance or credit may result in its tax 
liability being postponed but not eliminated.
Overvaluation
Overvaluation, and sometimes undervaluation, is a constant problem 
in any tax system, and tax incentives may provide additional temptation 
to inflate the value of assets. For example, when granting a tax holiday 
is conditional upon a firm investing a certain minimum amount, the 
value of assets contributed to the new firm can be manipulated to 
achieve the target figure. This may be done legitimately, for example, by 
purchasing machinery rather than leasing it from independent lessors. 
In other cases, however, an inflated value is attributed to the property 
contributed, especially in cases of intellectual property. When investors 
also receive an exemption from customs duties for newly contributed 

---

31