#3 - JRL 8247 - JRL Home
Moscow Times
June 10, 2004
Transfer Pricing and Calculating Russian GDP
By Nat Moser
Nat Moser is an independent oil industry consultant (Natmoser@aol.com). He contributed this comment to The Moscow Times.

In an opinion piece published earlier this year in The Moscow Times, Christof Ruehl of the World Bank and Mark Schaffer of Heriot-Watt University identified transfer pricing by Russian oil and gas companies as the reason behind the oil and gas sector's share of Russia's GDP being dramatically understated, and the trade sector's share similarly overstated, in the official figures. This argument has been repeated in several publications since, including in The Economist's recent Russia Survey.

In fact, there is a more important, though rather mundane, reason for the distortion in the GDP figures: the lack of consolidation of accounts in Russia. Furthermore, transfer pricing is nothing like the "problem" Ruehl and Schaffer suggest, and, in certain circumstances, can actually be beneficial.

Transfer pricing occurs when one part of a company sells goods or services to another part of the same company. If the price does not reflect market prices, value is transferred within the company. Effectively, one part of the company can become a profit center and another part a cost center.

The managements of Russian oil and gas companies almost universally employ transfer pricing between their production subsidiaries and their trading subsidiaries. The trading subsidiaries purchase oil from the production subsidiaries at less than market prices, which they then sell on at a considerable profit. The obvious result is that the trading subsidiaries are much more profitable than the production subsidiaries.

Within each oil company, the various production and trading subsidiaries file separate accounts with the state authorities under Russian Accounting Standards (RAS). These are used by Goskomstat, now known as the Federal Statistics Service, in its GDP calculations. The distortion in the GDP figures -- the overstatement of the trade sector and understatement of the oil and gas sector -- takes place simply because the separate accounts of the subsidiaries are not consolidated. Thus, a trading subsidiary of an oil company is counted by Goskomstat as being in the trade sector and not as being in the oil sector.

Western oil and gas companies also engage in transfer pricing. For example, when a number of companies are jointly operating an oil field, it is common practice for them to use a production-sharing approach. This involves oil being purchased at cost from the point of production, and profit being generated in the trading arms of the companies. However, because Western oil company accounts are consolidated -- which means that a company's trading arm is counted as being in the oil sector -- these practices do not have an impact on GDP numbers.

Ironically, most major Russian oil and gas companies do actually publish consolidated accounts that bring together their various different subsidiaries into one set of financial figures. These are published under International Accounting Standards (IAS) and U.S. Generally Accepted Accounting Principles (GAAP) mainly for foreign investors and creditors. They are not, however, used by Goskomstat in its GDP calculations.

From both a fiscal and a corporate governance point of view, transfer pricing in the Russian oil industry is actually much less of an issue now than it was in the 1990s. A major overhaul of taxation in the oil sector in 2001 shifted the main basis of upstream tax calculation from revenue to production. This meant that reducing revenues at the production subsidiary level through transfer pricing no longer lowered taxes (other than profit tax). By the end of this year, the profit tax loopholes, which have enabled companies to reduce their tax bills by establishing trading companies in regions with lower profit tax rates, will have gone as well. The other major tax in the oil sector, the export tax, is calculated on the basis of quantity of exports and the international price of oil -- two variables which are unaffected by transfer pricing.

From the corporate governance perspective, various oil company share-consolidation schemes of the late 1990s largely shifted outside minority ownership in Russian oil companies from the level of the production subsidiary to the holding company level. Owning shares in production subsidiaries is generally not a good idea because, as discussed above, due to transfer pricing the production subsidiaries are cost centers. In contrast, at the holding company level, minority shareholders' interests are much more likely to be aligned with those of management in terms of maximizing revenue, profit and thus the share price.

Finally, given the controversy that it seems to inspire, the question arises as to why managers of Russian oil companies still seem so keen on transfer pricing.

In the last 10 years, many such companies have made significant strides in transforming themselves from Soviet enterprises that produced oil to fulfill a state plan into Western-style corporations that aim to maximize profits. This process has been greatest at a top management level. But further down the chain, changes have been less significant, and the production level modus operandi still closely resembles that of the Soviet period. Even in the most progressive companies, production subsidiaries are often run by the same Soviet-era general directors. These may be good oil men, who know how to extract oil and who will apply the latest technology to that end, but they are not necessarily too concerned about keeping costs under control. Budgets are spent instantaneously, or in advance.

Even when you can control the spending of the drilling teams, there is always the black hole of new filtering and processing plants, pumping stations and feeder pipelines, built through all sorts of opaque contracts.

In such a situation, the last thing you want is billions of dollars of export revenues flowing straight into the hands of the production subsidiaries. One answer to this question, then, is that transfer pricing is actually a rather useful device for top management to enforce a hard budget constraint at the production level.