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Transfer Pricing and the Arm's Length Principle After BEPS by Collier, Richard; Andrus, Joseph L (17th August 2017)


Richard S Collier, Joseph L Andrus

From: Transfer Pricing and the Arm's Length Principle After BEPS

Richard Collier, Joseph L Andrus

Formation of contract — Interpretation of contract — Payment of price — Modes of payment — Time for payment

(p. 1) Introduction

I.01  For many years, transfer pricing has been the exclusive domain of tax specialists: lawyers, economists, and accountants. Recently, transfer pricing has emerged onto a broader stage as evidenced by many articles in the popular press, challenges raised by NGOs and others concerned with economic development, and the status of transfer pricing as one of the primary areas of focus in the G20/OECD project to address corporate tax base erosion and profit shifting (hereafter BEPS).

I.02  Critics have asserted that traditional transfer pricing approaches permit multinational corporations to easily shift their income away from the taxing jurisdictions where that income is earned and into tax-advantaged locations. The OECD has hurriedly written hundreds of pages of new guidance in its BEPS Project in an attempt to shore up the traditional approach and constrain transfer pricing abuses. The European Union has challenged favourable transfer pricing rulings granted to some companies under its trade regulations related to state aid. At the urging of the G20 and OECD, many countries are in the process of dramatically expanding tax reporting rules to require companies to report comprehensively the geographic allocation of their income on a country-by-country basis in the hope that greater transparency will aid more effective tax enforcement.

I.03  One question necessarily underlies all of the recent furore over transfer pricing. That question is whether the so-called arm’s length principle (hereafter, the ALP), which forms the core of traditional transfer pricing policy and thought, is fit for purpose. Critics have asserted that it is not. Governments and taxpayers thus far have asserted that there are serious difficulties in abandoning the ALP in favour of some other approach. Some have questioned, however, whether the governments’ continuing adherence to transfer pricing rules based on the ALP, reiterated most recently in the OECD work on BEPS and the work of the United Nations on its Practical Manual, is grounded on a sufficiently careful and thorough analysis.

I.04  This book seeks to address this question of whether the ALP is fit for purpose by evaluating the strengths, weaknesses, and continuing viability of the ALP after BEPS.

A.  The ALP

I.05  Transfer pricing rules regulate for tax purposes the prices and other terms on which members of a global corporate group of companies (hereafter, a multinational enterprise, or (p. 2) MNE group) sell products, services, and group assets to one another. Those prices determine the allocation of the income of an MNE group among the countries in which it does business. Under the existing laws and tax treaties of most countries, the prevailing transfer pricing rules are based on the ALP. Simply stated, the ALP requires the terms and conditions of transactions and other commercial relations between related entities to be consistent with those that would be agreed among similarly situated unrelated or independent entities.

I.06  The definitive statement of the ALP is found in Article 9(1) of the OECD Model Tax Convention on Income and on Capital, and in the virtually identical Article 9 of the United Nations Model Double Taxation Convention Between Developed and Developing Countries. The relevant treaty language states:

Where (a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or (b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

I.07  Under the ALP, then, a corporation that is a member of an MNE group is required to report the same profits from the conduct of its financial and commercial relations with other group members that it would report from conducting similar financial and commercial relations with an unrelated entity. The ALP is also applied to attribute income between a branch (or ‘permanent establishment’) of a corporation in one country and the head office of the corporation in another country. However, in a branch situation the generally accepted approach to applying the ALP varies in important ways from the approach used in considering the commercial relations between two related corporations. The primary focus in this book is on the operation of the ALP as it relates to transactions or arrangements between separate corporations in the same MNE group.

I.08  The ALP was enshrined as the international transfer pricing standard in the first half of the twentieth century and has remained the foundational transfer pricing principle for nearly 100 years. That is not to say, however, that transfer pricing rules have been static over that period of time. Commercial developments and expanding practical experience in applying transfer pricing principles have resulted in a rather pronounced evolution in our understanding of the implications of the ALP and the ways it can and should be applied.

B.  Evaluating the ALP

I.09  The task we have set for ourselves in this book is to evaluate carefully the viability of the ALP. Essentially, the book poses the question: can the ALP work in today’s commercial environment? In addressing that question, we will necessarily consider whether the BEPS (p. 3) changes to the OECD Transfer Pricing Guidelines adequately address the problems that existed with the ALP as it was applied in the period immediately preceding BEPS.

I.10  In asking whether the ALP can work, we need to be clear what ‘working’ means. In our view, there is no single test for assessing the ALP. The following five considerations seem especially important, however:

  • –  Ease of administration—is the ALP easy to understand and apply in practice? That is, can transfer pricing rules based on the ALP be readily administered in a transparent and even-handed manner by all relevant taxpayers and tax administrations?

  • –  Economic efficiency, including especially distortions to the scale or location of investment—does the ALP influence the scale or form of investment or the location where investment is made or where capital is located? Is the ALP efficient in minimizing double taxation and preventing less than single taxation?

  • –  Robustness to abuse—can transfer pricing rules based on the ALP effectively prevent potential abuses, including geographic manipulation of the tax base?

  • –  Overall systemic stability—does the operation of the ALP promote actions by taxpayers and/or countries which destabilize the system of transfer pricing or the wider international tax system?

  • –  Fairness—though questions of fairness are inevitably more subjective, it is appropriate to ask whether the ALP fairly allocates taxing rights to those countries in which the MNE group’s valuable assets are held and those countries in which economic activities and value creation occur?

I.11  Supplementing our consideration of these questions must be an examination of whether areas of critical transfer pricing concern in fact arise because of flaws in the underlying international tax architecture. In the BEPS work, for example, transfer pricing issues have been evaluated primarily through a lens focused on high income, low function entities, located in low-tax or tax haven jurisdictions. Is the prevalence of corporate tax structures that shift income to such entities principally a transfer pricing issue, or do such concerns have their roots in the fundamental source/residence compromises of the 1920s? If so, can a transfer pricing system based on the ALP, or indeed any transfer pricing regime, solve the underlying problems?

I.12  We do not intend to address these questions by way of a detailed comparison of arm’s-length-based transfer pricing rules with possible alternative approaches, including formulary apportionment. A great deal of squabbling has taken place in recent years about whether arm’s-length transfer pricing should be replaced with an alternative approach. For us, that question should only be considered after a careful evaluation of whether the current system works or can be made to work. The transaction costs of changing systems would be significant. Those costs should only be incurred if one can first conclude both that an ALP-based system cannot be made to work and that there is an alternative system that would be an improvement. In this book, we address only the first question, whether an ALP-based system can be made to work, recognizing that a consideration of whether alternative systems can be made to work as well or better than one based on the ALP is an undertaking at least as complex as the one we have set for ourselves.

(p. 4) C.  The Structure of the Book

I.13  To assess the system of ALP-based transfer pricing rules, we need to clarify the nature of the ALP, examine its derivation and evolution, and consider how it operates in practice. That consideration should include an analysis of both conceptual and practical problems that arise in applying the ALP. In particular, the problems that the OECD identified and is seeking to address through its BEPS Project merit detailed consideration. The transfer pricing work undertaken in the BEPS project itself must be examined to evaluate whether the OECD work will solve the perceived problems and whether that work will create new difficulties.

I.14  The first two chapters of the book examine the adoption and evolution of the ALP. The adoption of the ALP in the 1920s and 1930s was inextricably bound up with the development of the foundational principles of the modern international tax system. That relationship, as conceived by those contributing to the architecture of the tax system, provides a necessary foundation for understanding the ALP. However, this examination also shows that the ALP is far from a static construct. Rather, as outlined in Chapter 2, the transfer pricing rules have evolved continuously, and often dramatically, since their adoption. Change has come about in response to accumulating practical experience, a changing global economy, and the pressures of transfer pricing controversy between taxpayers and governments.

I.15  The historical evolution in the ALP is brought into sharp focus by the emerging divergence in the approach to income allocation for branches and subsidiaries. Whereas the ALP was deemed the appropriate approach for both branch and separate entity situations by those initially constructing the international tax system, more recent thinking has led Article 7 and Article 9 down very different paths. Central to that divergence has been the treatment of investment capital under the two sets of rules, a topic which is discussed in detail in Chapter 5.

I.16  With the historical foundation established in the first two chapters, Chapter 3 provides a snapshot of the application of the ALP on the eve of the BEPS Project. The chapter examines the critical principles underlying modern transfer pricing analysis, using the 2010 OECD Guidelines and the UN Practical Manual as a guide. This summary provides a baseline against which to describe and evaluate the transfer pricing work undertaken in connection with the BEPS Project. Chapters 4 and 5 examine conceptual and practical problems encountered in applying the ALP. Although many of the problems summarized in these chapters were critical in setting the direction of the BEPS work, some of the issues were bypassed in the BEPS Action Plan. Serious problems relating to the availability of comparables received very little attention. The problems surrounding the transfer, use, and rewards to capital were only partially identified in the BEPS work and were addressed in a very limited way. Chapter 5 is devoted to the capital problem, reflecting the view of the authors that issues surrounding the transfer pricing treatment of capital are particularly challenging and lie at the heart of much of the criticism levelled at the ALP-based transfer pricing regime.

I.17  Chapters 6 and 7 are devoted to an examination of the BEPS transfer pricing work.1 Chapter 6 describes the principal changes in the application of the ALP adopted in (p. 5) connection with BEPS, and Chapter 7 evaluates those changes, considering whether they provide a solid foundation for future transfer pricing determinations. The chapter also considers some of the collateral consequences that may flow from the BEPS work.

I.18  Finally, in Chapter 8 we consider whether ALP-based transfer pricing rules, as modified in connection with the BEPS work, satisfy the considerations discussed above for a workable transfer pricing system. We conclude that further evolution will certainly be required if the ALP is to continue to play a central role in the tax system, although we recognize that such evolution is problematic for several reasons. We also conclude that the approach to the capital problem reflected in BEPS is inadequate and incomplete. Whether the ALP provides a workable response to the problems related to capital movements and capital allocations that exist in the current system is, in our view, highly doubtful.


1  References in this book are to the original BEPS reports and not to their accumulation in the 2017 Transfer Pricing Guidelines which were released as this book was being published.