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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Corporate F&A
- Sprache: Englisch
Learn OECD guidance on business taxation in multiple countries A business that is not aware of all of its exposure to the tax policy of each country in which it does business may find itself paying more in taxes that the share of profit it generates. The Organisation for Economic Co-operation and Development (OECD) seeks to reduce the risk of business taxation in multiple countries. Transfer Pricing Handbook explores how countries can apply the OECD Guidelines to tax businesses that conduct their endeavors in more than one country. It is the ultimate comprehensive guide for companies doing business globally. * Helps companies properly price their goods and services for global markets * Provides defenses for transfer pricing audits * Provides standards for creating comparables that multijurisdictional tax administrations will accept * Guides documentation requirements and timing issues If you're doing business in more than one country, Transfer Pricing Handbook is a must-have, essential guide for simplifying OECD regulations for your global company.
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Veröffentlichungsjahr: 2012
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Contents
Cover
Praise for Transfer Pricing Handbook: Guidance for the OECD Regulations
Title Page
Copyright
Dedication
Preface
Part I: Basic Transfer Pricing Standards
Chapter 1: Introduction
Control
Tax Havens
Complexities
Chapter 2: Arm's Length Principle
General Explanation of the Arm's Length Principle
Formal Statement as to the Arm's Length Principle
Comparability Considerations
Rationale behind the Arm's Length Principle
Compensation Issues
Applying the Arm's Length Principle to Contribution Analysis
Oligopolistic Conditions
Transactions That Independent Enterprises Would Not Undertake
Administrative Burdens of the Arm's Length Principle
Maintaining the Arm's Length Principle as the International Consensus
Rejection of Alternative Transfer Pricing Approaches
Chapter 3: Arm's Length Range
Single-Figure Approach to the Arm's Length Range
Reliability Requirement
Comparability Considerations
Consequences of Applying More Than One Transfer Pricing Method
Selecting the “Most Appropriate Point” in the Range
Extreme Results: Comparability Considerations
Chapter 4: Safe Harbor Simplification
Safe Harbor Burdens and Benefits
Defining “Safe Harbor”
Scope of the Safe Harbor Provisions
How Arbitrary Are the Safe Harbor Provisions?
Factors Supporting the Use of Safe Harbors
Problems That Safe Harbors Present
Multiple Jurisdictions
Possibility of Opening Avenues for Tax Planning
Statistical Data and a Safe Harbor Example
Undertaxation
Safe Harbor Principles
Equity and Uniformity Issues
Recommendations as to the Use of Safe Harbors
Safe Harbors as Surrender of the Tax Administration's Discretionary Power
Flexible Practices
Country-Specific Practices
Comprehensive Example
Chapter 5: Modifying Safe Harbor Simplification
The Study
Eleven Specific Transfer Pricing Measures
Chapter 6: Global Formulary Apportionment
Profit Split Methodologies
Global Dealing
Attack on Global Formulary Apportionment
Impact of the Arm's Length Principle
Comparing Global Formulary Apportionment with the Arm's Length Principle
Double Taxation
Lack of a Common Accounting System
Factor Selection
Transitional Issues
Economic Issues
Impact of Exchange Rate Movements
Compliance Costs and Data Requirements
Valuation Difficulties
Separate Entity Approach versus Global Formulary Apportionment
Bilateral Tax Treaties
Members of the Multinational Group Excluded from Global Formulary Apportionment
OECD's Rejection of Non–Arm's Length Methods
Safe Harbors
Part II: Transfer Pricing Methodologies
Chapter 7: Transactional Profit Split Measures
Transactional Profit Split Method Concepts
Strengths and Weaknesses of the Transactional Profit Split Method
Availability of Comparables in Applying the Transactional Profit Split Method
Importance of Functional Analysis in Applying Transactional Profit Split Methods
Transactional Profit Split Method Weaknesses
Applying Transactional Profit Split Methods
Guidelines Profit Splitting Approaches
Determining the Combined Profits to be Split
Actual Profits versus Projected Profits
Different Profit Measures When Applying the Transactional Profit Split
How to Split the Combined Profits
Reliance on Comparable Uncontrolled Transactions Data
Allocation Keys
Reliance on Internal Data
Conclusions as to Transactional Profit Split Methods
Chapter 8: Profit Split Illustrations
Three Basic Assumptions
Three Residual Profit Split Alternatives
Commentary
Chapter 9: Residual Profit Split Examples
Presumptions and Preconditions
Essential Factual Pattern Conflict
Functional Activities
Selecting Transfer Pricing Approaches
Applying the Residual Profit Split Approach
Drafters’ Disclaimer
Contribution Approach
Chapter 10: Transactional Net Margin Method
Initial TNMM Considerations
How the Transactional Net Margin Method Works
TNMM Reliability
Strengths of the TNMM
Weaknesses of the TNMM
Applying the Comparability Standard to the TNMM
Database Issues: The Audio Player Example
Impact on the Arm's Length Range
Selecting the TNMM
Selecting the Net Profit Indicator
Exclusion and Measurability
Cases in Which Net Profits Are Weighted to Sales
Cases in Which Net Profits Are Weighted to Costs
Cases in Which Net Profits Are Weighted to Assets
Berry Ratios
Other Guidance
TNMM Examples
How the OECD Views the TNMM
Chapter 11: Selecting Profit Indicators
Illustration 1
Illustration 2
Illustration 3
Chapter 12: Selecting Transfer Pricing Methods
When Can a Business Apply a Multisided Transfer Pricing Method?
When Should a Business Not Apply a Multisided Transfer Pricing Method?
Part III: Comparability Analysis
Chapter 13: How Comparability Analysis Works
Determining When Transactions Are Comparable
Factors and Comparability
Functional Analysis
Economic Circumstances
Business Strategies
Return on Investment
Recognizing the Actual Transactions Undertaken
Associated Enterprises and Independent Enterprises: In Contrast
Alternatively Structured Transactions
Losses
Multinational Enterprises
Implementing Business Strategies
Impact of Governmental Policies
Chapter 14: Comparability Techniques
General Comparability Guidance
Typical Comparability Processes
Broad-Based Analysis of the Taxpayer's Circumstances
Controlled Transaction and Choice of a Tested Party
Comparable Uncontrolled Transactions
Selecting or Rejecting Potential Comparables
Additive Approach
Comparability Adjustments
Arm's Length Range
Chapter 15: Timing and Comparability
Timing of Origin
Timing of Collection
Valuation That Is Highly Uncertain
Data from Years Following the Year of the Transaction
Multiple-Year Data
Compliance Tools
Part IV: Administrative Approaches
Chapter 16: Transfer Pricing Audits
Transactional Profit Split Method
Simultaneous Tax Examinations and Transfer Pricing
Tax Arrangements
Potential Levels of Cooperation between Tax Administrations
Examples
Chapter 17: Monitoring the Guidelines
Understanding the Monitoring Process
Method Selection
Specific Monitoring Processes
Working Party No. 6 Peer Reviews
Three Peer Review Levels
Peer Review Selection Criteria
Difficult Case Paradigms
Biennial Members of Tax Examiners
Business Community Involvement
Business Industry Advisory Committee
Business's Role in Contributing to the OECD
Peer Reviews and the Business Community
Business Community's Updates on Legislation and Practice
Role of the U.S. Council for International Business
Part V: Advanced OECD Analysis
Chapter 18: Documentation Requirements
Introductory Issues and Burden of Proof
Guidance on Documentation Rules and Procedures
Useful Information for Determining Transfer Pricing
Summary of Recommendations on Documentation
Chapter 19: Intangible Property
Basic OECD Intangible Property Provisions
Future Intangible Property Developments
Arm's Length Intangible Property Issues
OECD Intangible Property Developments
Soft Intangibles
Highly Uncertain Valuation Issues
Steps That an Independent Enterprise Might Undertake to Resolve Uncertainty
Tax Administrator's Response
Timing Considerations
OECD Highly Uncertain Valuation Examples
What the OECD Should Do Now
Chapter 20: Service Arrangements
Overview
Scope of Intragroup Arrangements
Shareholder Activities and Stewardship Activities
Adjusting to the Form of the Arm's Length Consideration
“On Call” Services
Evaluating “On Call” Services
Determining an Arm's Length Charge for the Intragroup Service
Including Service Costs in the Transfer of Goods
Double-Taxation Risks
Examining the Actual Use of the Services
Calculating the Arm's Length Consideration
Applying Transfer Pricing Methods
Functional Analysis
Business Strategies: Profits for the Service Provider
Applying the Cost-Plus Method for Intragroup Services
Cost-Benefit Issues and Safe Harbor
Intragroup Service Examples
Specialized Services
Multinational Service Enterprises
Specialized Service Industries
Applying the Transactional Profit Split Method to Services
Chapter 21: Cost Contribution Arrangements
Overview
Cost Contribution Arrangement Criteria
Mandatory CCA Arm's Length Requirements
Applying an Applicable Allocation Key
Tax Treatment of Contributions and Balancing Payments
Entry, Withdrawal, and Termination of a Cost Contribution Arrangement
Recommendations for Monitoring and Structuring Cost Contribution Arrangements
Documentation
Chapter 22: Business Restructuring
Special Risk Considerations
Compensation for Undertaking the Restructuring
Postrestructuring Remuneration
Recognition of the Actual Transactions Undertaken
Part VI: Putting the Guidelines to Work
Chapter 23: Malaysia-Singapore Allocation Keys
Importance of Allocation Keys
When the Transactional Profit Split Method Is the “Most Applicable” Transfer Pricing Method
Specialized Services
Applying the Transactional Profit Split Method
Four Allocation Key Categories
Key Functions
Selecting Potential Allocation Keys
Selecting among Allocation Keys
“Strong Correlation” Standard
Allocation Keys
Transfer Pricing Strategies
Chapter 24: China-Taiwan Trade
Taiwan and China: A History Lesson
Tax Considerations
Transactional Profit Split Method Criteria
APA Process
Chapter 25: Reverse Engineering the Transfer Pricing Process
Transactional Profit Split
Simultaneous Tax Examinations and Transfer Pricing
Tax Arrangements
How the Reverse Engineering Transfer Pricing Process Works
Functional Analysis Considerations
Transactional Profit Split Method
Success Parameters to the Reverse Engineering Process
Synergistic Activities
Undertaking Multijurisdictional Production Processes
Engaging in Extensive R&D Activities
Dealing in Unique Intangibles
Participating in a Cost Contribution Arrangement
Creating or Providing Specialized Services
Distributions of Generic Goods or Standardized Goods
Contract Manufacturers and Contract Service Activities
Planning
International LP Gas Companies Face Multinational Tax Claims
Multinational Service Enterprises
Part VII: Connecting Transfer Pricing and Permanent Establishment
Chapter 26: Permanent Establishment Parameters
OECD's Permanent Establishment Provisions
Overall Tax Considerations
OECD Approach to Determine Permanent Establishment
Hong Kong Applies the OECD Permanent Establishment Provisions
Common Law Permanent Establishment Criteria
Declining Businesses
“Preparatory to” and “Auxiliary from” Exemptions
Will the OECD Approach Prevail?
Chapter 27: Focus on Permanent Establishment
Background Considerations
Twenty-five Proposed Changes
About the Authors
Index
Praise for Transfer Pricing Handbook: Guidance for the OECD Regulations
“Margaret Kent and Robert Feinschreiber are nationally recognized international tax and transfer pricing specialists who have a wealth of experience in the area. For years, they have been providing useful insight on the transfer pricing practices around the globe. Their latest book reflects their passion for the area.”
Joseph CaliannoPartner, International Technical Tax Practice Leader,Grant Thornton LLP
“Feinschreiber and Kent have produced another book which is of great value to a transfer pricing practitioner. Whether you are in charge of transfer pricing for your company or arguing with the tax authority, this book is essential to substantiate your position. It is a must for any corporate tax department.”
Gregorio TorresManager of Taxation,Roche (Mexico)
“A most intriguing view on the OECD Transfer Pricing Guidelines from a practitioner's perspective. Feinschreiber and Kent provide a multitude of case studies and offer insights into transfer pricing trends in the OECD. Helpful for anyone involved in transfer pricing.”
Alexander VöegeleChairman of the Advisory Board,NERA Economic Consulting
“Bob Feinschreiber and Margaret Kent have once again produced a well-written treatise that presents a complex and challenging subject in a concise and practical manner. This book should be a staple in any transfer pricing practitioner's library.”
William T. BradfieldPartner, Rödl & Partner
“I found this book to be extremely insightful and interesting. It should be required reading for anyone involved in transfer pricing.”
Lawrence J. ChastangManaging Partner of International Services,CliftonLarsonAllen, LLP
“The authors have sought to provide the reader with an example-focused, practical guide as to how to identify transfer pricing and corollary issues, determine a transfer pricing method and document the considerations and determinations. This Handbook is a useful primer to navigate the contentious issue of transfer pricing.”
Alan Winston GranwellDLA Piper LLP (U.S.)
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The Wiley Corporate F&A series provides information, tools, and insights to corporate professionals responsible for issues affecting the profitability of their company, from accounting and finance to internal controls and performance management.
Copyright © 2012 by Robert Feinschreiber and Margaret Kent. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.
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Library of Congress Cataloging-in-Publication Data:
Feinschreiber, Robert.
Transfer pricing handbook : guidance on the OECD regulations / Robert Feinschreiber, Margaret Kent.
p.cm. – (Wiley corporate F&A series)
Includes bibliographical references and index.
ISBN 978-1-118-34761-4 (cloth); ISBN 978-1-118-37655-3 (ebk.); ISBN 978-1-118-37656-0 (ebk.); ISBN 978-1-118-37657-7 (ebk.)
1. Transfer pricing-Taxation. 2. Transfer pricing-Taxation-Law and legislation. I. Kent, Margaret, 1942– II. Title.
HJ2305.F45 2012
338.8′8–dc23
2012012435
To Steven Feinschreiber and Kathryn Feinschreiber Hagedorn,and to our grandchildren, Alexander, Elizabeth, and Henry,in the hope that they will follow in our footsteps.
Preface
Welcome to the Transfer Pricing Handbook: Guidance on the OECD Regulations. This book is the fifth volume of Transfer Pricing Handbook series, which we began 20 years ago with Wiley. The first two transfer pricing volumes have a U.S. perspective; the third volume focuses on the rest of the world; and the fourth volume addresses transfer pricing methods. The fifth volume, which you now have before you, examines the 2010 Organisation of Economic Co-Operation and Development (OECD) Regulations, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which we call the Guidelines. Watch out for our sixth volume, Transfer Pricing Handbook: Asia-Pacific.
The OECD was comparatively late to the transfer pricing arena. The OECD's first promulgation on transfer pricing was the OECD report Transfer Pricing and Multinational Enterprises, in 1979. The OECD transfer pricing provisions are dynamic, not static, and the OECD expects to issue more guidance in the years to come. We are thankful to those at the OECD who assisted us in this venture. The Guidelines are now 371 pages, with more to come in the future.
We have examined many facets of the 2010 Guidelines, doing so to make this analysis comprehensive for both multinational enterprises and tax administrations. We address the difficulties in applying the arm's length standard, transfer pricing methodologies, and the determination of comparables. We examine administrative approaches to resolve transfer pricing disputes and transfer pricing documentation. Then we examine intangibles, intragroup services, and cost contribution arrangements. Finally, we examine the business aspects of business restructuring, practical transfer pricing applications, and permanent establishment considerations. We divide the handbook into seven parts:
One again, we are pleased to be selected by John Wiley & Sons to be the authors of this comprehensive book on transfer pricing. We are grateful to Sheck Cho at John Wiley & Sons for developing and nurturing the transfer pricing project and to both Tim Burgard and Stacey Rivera at John Wiley & Sons. In addition, we have a debt of gratitude to Natu Patel, then the principal tax official at John Wiley & Sons, for continuing to encourage us to undertake this project despite our extensive international schedule.
Readers are welcome to contact us to suggest additional topics or suggestions or to inform us about transfer pricing planning or audit and litigation techniques. Our e-mail address is [email protected]. Our web site is TransferPricingConsortium.com.
Robert Feinschreiber Margaret Kent Key Biscayne, Florida May 2012
Part I
Basic Transfer Pricing Standards
Chapter 1
Introduction
The Organisation of EconomicCo-Operation and Development (OECD) Transfer Pricing Guidelines are becoming the international pricing standard. This pricing standard applies to multinational enterprises that have business relationships with their related enterprises or have business activities that have associated enterprises in differing tax jurisdictions. This pricing standard applies to the tax administrations that monitor these multinational enterprises. The OECD developed these Transfer Pricing Guidelines in July 2010 to impact multinational enterprises and tax administrations in equal fashion.
The OECD promulgated its Transfer Pricing and Multinational Enterprises in 1979. The OECD's Committee on Fiscal Affairs then issued the initial Transfer Pricing Guidelines on June 27, 1995, and the OECD Council approved publication of the Guidelines on July 13, 1995. The initial Guidelines included five chapters: the arm's length principle, transfer pricing methods, comparability analysis, administrative approaches to avoiding and resolving transfer pricing disputes, and documentation.
The Committee on Fiscal Affairs adopted the transfer pricing report as to property and services on January 23, 1996 (DAFFE/CFA[96]2). The OECD Council on April 11, 1996, incorporated Chapter VI, pertaining to intangibles, and Chapter VII, pertaining to services (C[96]46).
The Committee on Fiscal Affairs adopted the transfer pricing report as to cost contribution arrangements on June 25, 1997 (DAFFE/CFA[97] 27). The OECD Council on July 24, 1997, incorporated Chapter VIII (C[97]144).
The OECD has 34 members. All of these members apply many facets of the 2010 Guidelines. In addition to the 34 members, the OECD has 9 near members that follow the OECD precepts. Then, in addition to these 34 members and 9 near members, at least 7 countries voluntarily follow the OECD precepts. It is fair to state that these 50 or so countries that follow the 2010 OECD Transfer Pricing Guidelines are participants in a voluntary but pervasive international tax system that includes virtually all nations that participate in international trade.
Despite the importance of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, these Guidelines are an invention, taking 30 or so years to reach maturity. Some key dates to bear in mind are
The OECD has spent considerable effort in developing transfer pricing methodologies beyond the traditional comparable uncontrolled price method, the resale method, or the cost-plus method. These newer methods are the transactional net margin method and, most recently, the transactional profit split method.
Despite these great strides that the OECD has already undertaken to develop the transfer pricing system, it our view that the Guidelines themselves have three major defects:
Control
The 2010 Guidelines are 371 pages in length. Absent from these Guidelines are control mechanisms—the manner in which one party is assumed to control another party. The Guidelines are quick to ascertain the consequences that are to take place if a controlled relationship exists, but the Guidelines are short on establishing the control parameters themselves and are very short on addressing one crucial facet: the presence or absence of “control.”
Regrettably, the OECD has chosen not to pursue this path of defining control, thus allowing countries to have differing definitions of control. Not having a universal definition of control, the taxpayer is at the mercy of each country regarding control issues.
Tax Havens
It is our view that the OECD has failed to pursue an examination of tax haven structures in the transfer pricing context. Outsourcing and reinvoicing are part and parcel of schemes that culprits undertake to shift income to tax havens, while hiding affiliated ownership in non–tax haven countries. As we shall see, the tax administrations are, even now, unprepared to challenge these tax-evading devices.
Complexities
The OECD has undertaken some steps to eliminate transfer pricing complexities. Nevertheless, taxpayers need more guidance in complex areas. As of now, the OECD has been opposed to permitting taxpayers to apply safe harbors. Clearly, there is much to be done.
Chapter 2
Arm's Length Principle
The Organisation of Economic Co-Operation and Development (OECD), in its revision of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Guidelines) in 2010, has been taking the position that the arm's length principle is the “international pricing standard.”1 This current OECD position reiterates the OECD's previously established position.2 It is our view that although the OECD treats the arm's length principle as close to being sacrosanct, the arm's length principle on some occasions becomes illusory and impractical. We provide four suggestions for modifying the arm's length principle:
Chapter I of the Guidelines examines four facets of the arm's length principle:
This chapter addresses the OECD's general explanation and formal statement concerning the arm's length principle. We address impractical implications of the arm's length principle that arise.
General Explanation of the Arm's Length Principle
The OECD, in terming the arm's length principle the international pricing standard, specifies that OECD member countries have agreed that multinational businesses and tax administrations are to use the arm's length principle for tax purposes.3 The reader should realize that the arm's length principle has broader recognition than the presence of the OECD members as a whole would reflect. In fact, the arm's length principle applies to other subject matters other than taxation; the arm's length principle often goes far beyond taxation itself.
Independent Enterprises versus Associated Enterprises
The OECD views enterprises as being of two categories, independent enterprises or associated enterprises, treating these two terms as reflecting “all or nothing” propositions. Thus, the Guidelines fail to reflect any “gray area” (i.e., enterprises that might or might not be associated or related, depending on the specific circumstances). As a result, the Guidelines reflect the independent enterprise versus associated enterprise delineation:
The drafters provide that associated enterprises often seek to replicate the dynamics of market forces in their transactions with one another. The Guidelines fail to provide definitions of “commercial relations,” “financial relations,” or “market forces.”
The drafters caution that tax administrations should not automatically assume that associated enterprises have sought to manipulate their profits. The drafters, in issuing this caution, acknowledge that an associated enterprise might have “genuine difficulty” in accurately determining a market price in the absence of market forces or when adopting a particular commercial strategy.
The Guidelines refer to “the need to make adjustments” to approximate arm's length transactions, plausibly suggesting that the tax administration, rather than the taxpayer, would make such adjustment. This pricing adjustment arises irrespective of any contractual obligation the parties undertake to pay a particular price or of any intention of the parties to minimize tax. The drafters take the position that a tax adjustment that the tax administration determines under the arm's length principle would not affect the taxpayer's underlying contractual obligations for nontax purposes between affiliated enterprises.
The Guidelines comment that it might be appropriate for the tax administration to make its ensuing transfer pricing adjustment even where the taxpayer expresses no intent to minimize tax or to avoid tax. The Guidelines delineate transfer pricing adjustments from tax fraud or from tax avoidance. Nevertheless, the drafters note that the taxpayer might apply transfer pricing policies that could cause tax fraud or tax evasion.
Nonmarket Forces That Distort Income
The OECD accepts the concept that transfer pricing, as constituted, might not reflect market forces and, as such, these market forces might not reflect the arm's length principle. Such transfer pricing determinations could distort the tax liabilities of the associated enterprises and could distort the tax revenues of the host countries.5 In light of the preceding factors, the OECD member countries through their tax administrations have agreed that they can adjust the profits of the associated enterprises for tax purposes, as necessary, to correct any such distortions and to satisfy the arm's length principle. The Guidelines inform us that the OECD members consider that they have achieved an appropriate transfer pricing adjustment by establishing the conditions of the commercial relations and establishing the conditions of the financial relationship. The OECD members would then expect to find commercial and financial relations “between independent enterprises in comparable transactions under comparable circumstances”—the essence of comparability itself.
Nontax Factors That Distort Commercial Relations and Financial Relations
The Guidelines recognize that although tax factors might distort the commercial relations and financial relations between associated enterprises, factors other than tax considerations might distort these commercial relations and financial relations.6 Such nontax factors might include conflicting governmental factors, cash flow requirements, and shareholder reporting. All of the following factors might affect transfer prices and the amount of profits that accrue to associated enterprises within the multinational group:
Intercompany Autonomy and Company Bargaining Positions
The OECD warns multinational enterprises and tax administrations that the conditions that associated enterprises establish as to their commercial relations and financial relations might or might not deviate from what the open market would demand. As a practical matter, multinational enterprises differ as to the extent the control group exercises its power over its affiliated enterprises. In fact, associated enterprises within a multinational group sometimes have a considerable amount of autonomy, and these enterprises can often bargain with one another as though they were independent enterprises.7
The arm's length principle, as the OECD presently constitutes that term, fails to take into account the evaluating and rewarding of associated enterprises. The arm's length principle, as the OECD presently constitutes that term, fails to ascertain the limits of control among associated enterprises. Thus, the OECD, in implementing the arm's length principle, fails to take into account the differing impact of cost centers and profit centers. Furthermore, the OECD, within the confines of the arm's length principle, fails to address the differing impact of autonomous transactions as compared with mandated transactions.
The drafters inform us that enterprises respond to economic situations that arise from marketing conditions.8 The enterprises respond to these conditions in their relations with both third parties and associated enterprises. The drafters provide an example: The local manager might be interested in establishing good profit records. As such, the manager would not want to establish prices that would reduce the profits of his company. Furthermore, a point that the OECD fails to address, the manager would not want to establish prices that reduce or eliminate the company's share of its profit sharing or the manager's other personal compensation.
The OECD advises that tax administrations should keep those considerations as to autonomous powers in mind when the tax administration seeks to facilitate the efficient allocation of its resources. The OECD expects the tax administrations, as part of their resources, to select targets for tax examinations and to conduct transfer pricing examinations. The relationship of the associated enterprises might influence the outcome of the bargaining between them. The drafters provide that the evidence of hard bargaining alone is not sufficient to establish that the transactions are at arm's length.
Formal Statement as to the Arm's Length Principle
The OECD Guidelines specify that the arm's length principle contains two facets:
Paragraph 1 of Article 9 of the OECD Model Tax Convention provides the authoritative statement of the arm's length principle.9 Article 9 forms the basis of bilateral tax treaties involving OECD member countries. An increasing number of non–OECD member countries apply these Article 9 provisions and apply the arm's length principle.
Article 9 defines the circumstances in which the tax administration can include profits and delineate the profits that one of the enterprises would otherwise include in income. The tax administration can make this adjustment when conditions are such between two associated enterprises in their commercial relations or their financial relations where these conditions differ from those that would be made between independent enterprises.
Article 9 seeks to adjust profits by reference to conditions the taxpayer would have obtained “between independent enterprises in comparable transactions and comparable circumstances.” The Guidelines make clear that the arm's length principle follows the approach of treating members of a multinational group as “separate entities,” rather than as “inseparable parts of a single unified business.” The OECD focuses on the nature of these transactions between these members and on whether the conditions thereof differ from the conditions obtained in comparable uncontrolled transactions. The Guidelines portray this comparability analysis as being “at the heart” of the application of the arm's length principle.
Comparability Considerations
The Guidelines seek to treat the issue of comparability in perspective within the transfer pricing context. The drafters ostensibly seek to balance the reliability of the comparability analysis with the burden that comparability creates for taxpayers and tax administrations.10 Nevertheless, the OECD seeks to bar global formulary apportionment and safe harbors in all circumstances, regardless of the taxpayer's factual pattern.11
The Guidelines indicate that Paragraph 1 of Article 9 of the OECD Model Tax Convention is the foundation of comparability analysis. This paragraph introduces the need for a comparison between conditions that associated enterprises impose and those that independent enterprise would impose. These conditions include prices but are not limited to prices. An enterprise would make this comparison between associated enterprises and independent enterprises to determine whether Article 9 of the OECD Model Tax Convention would authorize the rewriting of accounts for purposes of calculating the tax liabilities of associated enterprises. In this regard, see paragraph 2 of the Commentary on Article 9.
In addition, Paragraph 1 of Article 9 of the OECD Model Tax Convention is the foundation of comparability analysis because it introduces the need for determining the profits that the enterprise would have accrued at arm's length. The enterprise would undertake this comparability analysis to determine the quantum of rewriting of the accounts.
Rationale behind the Arm's Length Principle
The Guidelines indicate that there are several reasons why OECD member countries and other nonmember countries have adopted the arm's length principle.12 The drafters assert that one such principal reason for applying the arm's length principle is that this arm's length method provides “broad parity” of tax treatment for members of multinational groups and independent enterprises. The Guidelines, however, fail to address the scope of the “broad parity” concept.
The drafters take as a given the OECD's concept that the arm's length principle puts associated enterprises and independent enterprises on a “more equal” footing for tax purposes. These drafters conclude that the arm's length principle would avoid the creation of tax advantages or tax disadvantages that would otherwise distort the relative competitive positions of either type of entity. The arm's length principle, then, promotes the growth of international trade and investment by removing these tax considerations from economic decisions.
The Guidelines believe that tax administrations and multinational enterprises view the arm's length principle as working effectively “in the vast majority of cases.”13 Even if we were to acknowledge that statement as valid, we would need to assert that the Guidelines have fully addressed the exceptions to this principle. The drafters then proceed to identify two situations in which the enterprise is likely to find arm's length prices as being reflected in comparable transactions undertaken through comparing “independent entrepreneurs under comparable circumstances”:
Compensation Issues
In addition, the Guidelines comment that there are many cases in which the taxpayer or the tax administration can make a relevant comparison necessary for applying the arm's length principle. The taxpayer or the tax administration can make this determination at the financial indicator level. Such financial indicators include
The OECD acknowledges that there are some significant cases in which the taxpayer or the tax administration will find that it is “difficult and complicated” to apply the arm's length principle. Such “difficult and complicated” situations would apply to
Having acknowledged that that there are some significant cases in which the taxpayer or the tax administration will find that it is “difficult and complicated” to apply the arm's length principle, the OECD then concludes that “solutions exist” to deal with such difficult cases. Such a solution, according to the OECD, is a transactional profit split method that Chapter II of the Guidelines portrays. Part III of Chapter II specifies those situations in which the transactional profit split is most appropriate in the circumstances of the case. The Guidelines specify the contribution analysis and residual analysis as alternatives but state that these approaches are not necessarily exhaustive or mutually exclusive.14
Applying the Arm's Length Principle to Contribution Analysis
The Guidelines fail to provide examples that illustrate contribution analysis. Instead, the OECD warns that it can be difficult for the taxpayer to determine the relative value of the contribution that each of the associated enterprise makes to the controlled transactions. The Guidelines specify that the contribution approach will often depend on the facts and circumstances of the case.15 The answer may rely on the selection of an allocation key under the transactional profit split method.16
The Guidelines specify that in the absence of comparable data, the associated enterprises participating in the controlled transactions will normally take into account the assets they use and the risks they assume.17 We suggest that risk analysis is often too uncertain for the associated enterprises to apply. Instead, we suggest that associated enterprises take into account the assets they use and the labor costs that they incur. We need to consider this contribution analysis for the transfer of work-in-process inventories and the integrated production of highly specialized goods.
Integrated Production of Highly Specialized Goods
The OECD acknowledges that the arm's length principle is “difficult and complicated” for the taxpayer and the tax administration to apply in certain situations.18 One such difficult and complex situation that occurs is the transfer of the integrated production of highly specialized goods, creating work-in-process inventories. In essence, one associated enterprise transfers its work-in-process inventory to another associated enterprise as part of its integrated production activities. We suggest a solution to this transfer pricing dilemma, but we suggest that the underlying issue is broader than what the OECD perceives and affects the transfer of work-in-process inventories, not only the integration production of highly specialized goods.
At the outset, the Guidelines fail to delineate situations in which an enterprise transfers integrated production from one entity to another regarding highly specialized goods. These asset transfers occur more commonly than we might expect, and the process affects the transfer of work-in-process inventories and more broadly based work-in-process transfers. Consider the following three situations in which an enterprise might be engaged in such a transfer from one associated enterprise to another:
The OECD raises an issue that the OECD does not resolve as to the integrated production of highly specialized goods in applying the arm's length principle. We suggest that each associated enterprise be entitled to apportion costs under the following apportionment formula and then allocate revenues in a manner that is consistent with apportionment of its costs. Our approach here would be to apply this apportionment formula only to the transfer of work-in-process inventories. As a result, this method is considerably narrower than is global functional analysis.
Oligopolistic Conditions
The OECD acknowledges that practitioners view the arm's length principle as inherently flawed because the separate entity approach might not always account for
The OECD has acknowledged that the arm's length principle might be inherently flawed as to economies of scale and to the integrated business relationships. The OECD would excuse taxpayers’ and tax administrations’ use of the arm's length principle on the basis that there are no widely accepted objective criteria for allocating the economies of scale or the benefits of integrating associated enterprises.19 We suggest that the OECD seek to apply the arm's length principle to businesses that do not create monopolistic or oligopolistic conditions, and that the presence of monopolistic or oligopolistic conditions would destroy arm's length parameters. Thus, in future years, we suggest that the OECD should seek to integrate tax and antitrust concerns.
Transactions That Independent Enterprises Would Not Undertake
The OECD acknowledges that some transactions are inherently unique, and, for that reason, the transactions are not subject to a comparable analysis. For example, an associated enterprise might undertake a transaction that independent enterprises would not undertake.20 An associated enterprise might undertake these unique transactions for purposes other than tax avoidance. Instead, the associated enterprise might undertake these transactions because members of a multinational group face different commercial circumstances than do independent enterprises.
Thus, independent enterprises might seldom undertake transactions of a particular type that an associated enterprise undertakes. It is difficult to apply the arm's length principle in that associated enterprise situation because there is little or no direct evidence of the conditions being applicable to independent enterprises. The Guidelines caution, though, that the mere fact that a transaction might not be found between independent parties does not necessarily mean that the associated enterprise transaction is not at arm's length.
The Guidelines fail to provide examples of situations in which an associated enterprise might undertake a transaction that independent enterprises would not undertake. Nevertheless, it appears that an associated enterprise might undertake transactions with another affiliated enterprise in a by-product situation or in a joint-product situation.
Administrative Burdens of the Arm's Length Principle
The Guidelines acknowledge that applying the arm's length principle might cause an administrative burden for the multinational enterprise and for the tax administration.21 These administrative burdens become more prevalent in evaluating the significant numbers and types of cross-border transactions. The drafters presuppose that associated enterprises would normally establish the conditions for the transaction, doing so at the time the associated enterprises undertake the transaction. Nevertheless, despite the presence of these conditions, at some point the enterprises may be required to demonstrate that these conditions are consistent with the arm's length principle.
The OECD warns the taxpayer that the tax administration might have to engage in a verification process regarding the transactions that the taxpayer incurred. The tax administration might be engaging in this verification process some years after the associated enterprise undertook the transactions. Under this verification process, the tax administration would review any supporting documentation the taxpayer prepares.
The taxpayer would prepare its documentation to demonstrate that its transactions are consistent with the arm's length principle. The tax administration might need to gather information about comparable uncontrolled transactions and the market conditions taking place at the time of the transaction, and so forth, for numerous and varied transactions. The OECD cautions that the verification process usually becomes more difficult with the passage of time.
The Guidelines caution that tax administrations and taxpayers often have difficulty in obtaining adequate information to apply the arm's length principle for the following reasons:
Database Issues
The OECD warns the taxpayer that the information the taxpayer would need to implement the arm's length principle might be incomplete. In addition, the information might be difficult for the taxpayer to interpret. Other information that the taxpayer seeks for purposes of the arm's length principle might not exist. If the information does exist, it might be difficult for the taxpayer to obtain this information because of the geographic location of the enterprise or because another party owns the information.
Independent enterprises might develop their own internal data. Nevertheless, such enterprises would not make this information available to other enterprises to protect their own confidentiality concerns. In other situations, information about an enterprise that might be relevant, but such information might not exist. In yet other situations, there might be no comparable independent enterprises. In addition, comparables might not exist if such an industry is vertically integrated.
The OECD reminds taxpayers and tax administrators that the transfer pricing objective is to find a “reasonable estimate” of an arm's length outcome, based on reliable information. The OECD, however, fails to delineate the parameters of the “reasonable estimate” determination. In a similar manner, the OECD reminds taxpayers and tax administrators that transfer pricing is not an exact science, but that transfer pricing does require an “exercise of judgment” on the part of the taxpayer and on the part of the tax administration. The OECD would leave the multinational enterprise or the tax administration to ascertain what the “reasonable estimate” and the “exercise of judgment” might be.
Maintaining the Arm's Length Principle as the International Consensus
The OECD continues to acknowledge these limiting considerations in applying the arm's length principle. Nevertheless, the OECD continues to hold that the arm's length principle should govern the evaluation of transfer prices among associated enterprises. The Guidelines assert that the arm's length principle is “sound in theory” because the arm's length method provides the “closest approximation” to the working of the open market.23 Here, the Guidelines are referring only to situations in which an associated enterprise is transferring property such as goods, other types of tangible assets, types of intangible assets, or services between associated enterprises. The OECD fails to adequately address the treatment of transactions that go beyond that range.
The Guidelines acknowledge that it might not be straightforward to apply the arm's length principle in practice to other situations. Nevertheless, the Guidelines assert that the arm's length principle generally produces “appropriate levels of income” between members of the multinational group that are acceptable to tax administrations. The arm's length principle, then, reflects the economic realities of the controlled taxpayer's facts and circumstances and is said to adopt as a benchmark “the normal operation of the market.”
Rejection of Alternative Transfer Pricing Approaches
The OECD rejects transfer pricing alternatives that are different from the arm's length principle. A move away from the arm's length principle, according to the OECD, would be deleterious because this modification would
The Guidelines contend that experience under the arm's length principle has become sufficiently broad and sophisticated to establish a substantial body of common understanding among the business community and among tax administrations.
The Guidelines assert that what they perceive to be “the shared understanding” that what the arm's length principle brings to the table is of great practical value in achieving the objectives of securing the “appropriate tax base” in each jurisdiction. We suggest that the Guidelines, in seeking an appropriate tax base in each jurisdiction, have set their sights too low, and the Guidelines should be striving for the determination of a common tax base.
The Guidelines suggest that administrations should draw on their experiences for the following purposes:
In sum, the Guidelines specifically indicate that the OECD member countries continue to support strongly the arm's length principle. The OECD makes clear that no legitimate or realistic alternative to the arm's length principle has emerged. The Guidelines make clear that global formulary apportionment, then, occasionally mentioned by some as a possible transfer pricing alternative, would not be acceptable to the OECD in theory, in implementation, or in practice.
Notes
1. R. Feinschreiber and M. Kent, “Challenging the OECD's Arm's Length Principle,” Journal of International Taxation (June 2011): 38.
2.OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2010, (Guidelines) 1.1.
3.Guidelines 1.1.
4.Guidelines 1.2.
5.Guidelines 1.3.
6.Guidelines 1.4.
7. R. Feinschreiber, “Business Facets of Transfer Pricing/Autonomous Transactions,” Transfer Pricing Handbook, vol. 1, 3rd ed. (New York: John Wiley & Sons, 2001), chap. 1.3.
8.Guidelines 1.5.
9.Guidelines 1.6.
10.Guidelines 1.7.
11.Guidelines 1.15; Guidelines 4.122.
12.Guidelines 1.8.
13.Guidelines 1.9.
14.Guidelines 2.118.
15.Guidelines 2.120.
16.Guidelines 2.134.
17.Guidelines 2.119.
18.Guidelines 1.9.
19.Guidelines 1.10.
20.Guidelines 1.11.
21.Guidelines 1.12.
22.Guidelines 1.13.
23.Guidelines 1.14.
24.Guidelines 1.15.
Chapter 3
Arm's Length Range
The Organisation for Economic Co-Operation and Development (OECD), in re-promulgating the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Guidelines) on July 22, 2010, addressed basic issues impacting the determination of the arm's length range, which is a central transfer pricing ingredient.1 The OECD guidance, however, failed to address certain current arm's length range issues. We caution the reader that the arm's length discussion implicitly pertains to the transactional net margin transfer pricing method and to other one-sided transfer pricing methods, including the comparable uncontrolled sales method, the resale method, and the cost-plus method. Perhaps by design, the OECD arm's length range provisions fail to address the applicability of the arm's length range in the context of the transactional profit split method as a two-sided transfer pricing method.
Single-Figure Approach to the Arm's Length Range
In certain instances, it might be possible for the enterprise or the tax administration to apply the arm's length range principle to ascertain a single transfer pricing figure (e.g., a price or a margin).2 That price or margin is supposed to be the “most reliable” amount (i.e., the amount that the enterprise or the tax administration ascertain is the “most reliable” amount). This amount would establish whether the conditions of the transaction are at arm's length. The Guidelines, however, fail to indicate the parameters that would bring the transactions within the “single-figure” transfer pricing regime.
The Guidelines begin their discussion of the arm's length range by indicating that reliance on a “range” of results might be premature. The concept of an arm's length range is comparatively new to the transfer pricing regime. Many years ago, before the transfer pricing white paper, the transfer pricing regime in the United States did require the taxpayer to determine one transfer price (e.g., a single figure).
Reliability Requirement
The Guidelines recognize that transfer pricing is not an exact science. As such, there will be many occasions in which the application of the “most appropriate” transfer pricing method or methods produce a range of figures. The Guidelines then contemplate that this range of figures would be “relatively equally reliable.” The reliability of the figures would thus be a point of issue. Regrettably, the drafters fail to consider the parameters for ascertaining the reliability of these figures.
In general, the application of the arm's length principle produces only an approximation of the conditions that independent enterprises establish. Differences in these figures that comprise the range occur because the results are a range of figures that are relatively equally reliable. The drafters recognize that it is possible that the different points in the range do occur because independent enterprises engaged in comparable transactions might not establish exactly the same price for the transaction.
Comparability Considerations
The drafters speak of a “relatively equal degree of comparability,” but the Guidelines fail to ascertain how the multinational enterprise or the tax administrations are to determine the parameters for assessing comparability. Furthermore, the Guidelines fail to ascertain the manner in which the multinational enterprise or the tax administrations are to determine the degree of comparability. The Guidelines do acknowledge, however, that not all comparable transactions examined will have a relative degree of comparability.3
The Guidelines would impose a stark remedy when some uncontrolled transactions have a lesser degree of comparability than do others. The stark remedy that the Guidelines suggest is to eliminate entirely these offending uncontrolled transactions. Regrettably, the Guidelines fail to inform the multinational enterprise or the tax administrations as to the parameters under which they ascertain that some uncontrolled transactions have a lesser degree of comparability. As practitioners, we suggest that the multinational enterprise or the tax administrations would be better served to diminish these offending uncontrolled transactions, rather than excluding these transactions under a cliff-type approach.
Nevertheless, the Guidelines do recognize that the multinational enterprise or the tax administrations might make use of transactions that have comparability defects.4 The multinational enterprise or the tax administrations might not be able to identify or quantify these comparability defects, and, as such, these defects remain, and the multinational enterprise or the tax administrations cannot adjust these amounts.
The transfer pricing range might include a sizable number of observations, such as in the transactional net margin method comparing unrelated distributors of a specific type. The Guidelines acknowledge that in these situations involving a sizable number of observations, the multinational enterprise or the tax administrations might make use of statistical tools that take into account the central tendency that narrows the range. Such statistical tools that narrow the range could encompass the interquartile range or these statistical tools could be other percentiles that might help the reliability of the analysis.
Consequences of Applying More Than One Transfer Pricing Method
The multinational enterprise or the tax administrations might seek to apply more than one transfer pricing method. The multinational enterprise or the tax administrations might thus produce a range of results when applying more than one transfer pricing method to evaluate a controlled transaction.5 Consider the following example:
The drafters acknowledge that no general rule can be stated regarding the use of ranges that the multinational enterprise or the tax administrations derive from the application of multiple transfer pricing methods. The conclusions the multinational enterprise or the tax administrations derive from their use will depend on the relative reliability of the transfer pricing methods the multinational enterprise or the tax administrations employ to determine the ranges and the information that the multinational enterprise or the tax administrations use in applying the different transfer pricing methods.
The Guidelines address issues that can arise when the range of figures results in a substantial deviation among points in that range.6 Regrettably, however, the Guidelines fail to address the parameters for such a “substantial deviation.” The presence of such a standard deviation points out that the data the multinational enterprise or the tax administrations use in establishing some of the points in the range might not be as reliable as the data the multinational enterprise or the tax administrations use to establish other points in the range.
In particular, the arm's length principle does not require the multinational enterprise or the tax administrations to use more than one transfer pricing method for a given transaction or set of transactions.7 In fact, such a reliance on other transfer pricing methods could create a significant burden on the taxpayers. Thus, these Guidelines do not require the tax examiner or the taxpayer to perform the transfer pricing analysis under more than one transfer pricing method.
The Guidelines, in addressing the multinational enterprise's or the tax administrations’ application of multiple transfer pricing methods, provide for two types of adjustments:
The multinational enterprise or the tax administrations might have to undertake a further analysis of these points to evaluate their suitability for inclusion in any arm's length range.8
Selecting the “Most Appropriate Point” in the Range
Regrettably, the Guidelines fail to provide a mechanism under which the multinational enterprise or the tax administrations are to determine the most appropriate point in the range for transfer pricing purposes. What the Guidelines do, however, is to address mechanisms that the multinational enterprise or the tax administrations can use to resolve disputes in ascertaining the most appropriate point in the range. The Guidelines state that the multinational enterprise or the tax administrations should make no adjustments to the range if the relevant condition of the controlled transaction (e.g., the price or the margin) is within the arm's length range.9 The Glossary defines the “arm's length range” as a range of figures that is “acceptable” for establishing that the conditions of a controlled transaction are at arm's length and that the multinational enterprise or the tax administrations derive these figures either from applying the same transfer pricing method to multiple comparable data or by applying different transfer pricing methods. The Guidelines fail to define “acceptable” in the arm's length range context.
The Guidelines implicitly postulate that the multinational taxpayer would establish the arm's length range for its transactions, and that the tax administration would review and then potentially challenge the range of results established by the multinational taxpayer. The Guidelines recognize that the “relevant condition” of the controlled transaction (e.g., the price or the margin) might fall outside the arm's length range, as asserted by the tax administration. The Guidelines provide that the taxpayer should have the opportunity to present arguments to the tax administration that the conditions of the controlled transactions satisfy the arm's length principle, that the results fall within the arm's length range, and that the arm's length range is different from the range asserted by the tax administration.10
The drafters recognize that the taxpayer might not be able to demonstrate the preceding facts regarding controlled transactions being outside the range. If taxpayers fail in this endeavor, the baton is passed to the tax administration. It is then the responsibility of the tax administration to determine the point within the arm's length range to which the tax administration will adjust the conditions of the controlled transfer.
The Guidelines recognize that in determining the preceding point, it could be argued that any point in the range satisfies the arm's length principle. The Guidelines implicitly accept the equal point concept only when the taxpayer establishes that the range comprises results of “relatively equal and high reliability.”11 In light of the preceding dilemma and in recognition of comparability defects, the Guidelines suggest that the multinational enterprise or the tax administrations use measures of central tendency in order to minimize the risk of error due to unknown or unquantifiable remaining comparability defects.12 These central tendency measures include the median, the mean, or weighted averages, and so forth, perhaps including the mode as central tendency measures.
Extreme Results: Comparability Considerations
The Guidelines seek to explain the parameters of results that the multinational enterprise or the tax administrations consider to be extreme.13 Extreme results, according to the drafters, might consist of losses or unusually high profits. Note that some commentators, taking the Guidelines
