By publicizing exaggerated tax gap estimates and demonizing tax avoidance schemes based on allegedly abusive transfer pricing schemes, governments and advocates of big-government are aggressively promoting their tax grabbing agenda. To be sure, the Organisation for Economic Cooperation and Development cannot be regarded as a champion of tax competition. However, just as there is no harm in acknowledging that the economists at the OECD occasionally generate sensible statistics and reports, it is worthwhile to be aware of policy issues on which the influence of the OECD is, at least on balance, positive. A case in point is to be seen in the realm of transfer pricing. While the European Commission, the European Parliament as well as high tax jurisdictions are keen on utilizing transfer pricing regulation for curbing tax competition, the OECD adopted a more moderate stance. The OECD has certainly facilitated stricter transfer pricing regulations in the context of the Base Erosion Profit Shifting (BEPS) project, but the actions and policies of the EU, specifically the state aid infringement procedures as well as the promotion of the Common Consolidated Corporate Tax Base (CCCTB), are likely to be much more detrimental to tax competition and are thus much more worrisome.
Specifically, the OECD’s effort to preserve the arm’s length principle as the leading paradigm of transfer pricing is positive. Why? Because the arm’s length principle allows entrepreneurs to sustain alignment between their transfer pricing system and their business processes as well as their strategic objectives, including minimization of the tax bill. Embracing an entrepreneurial approach to transfer pricing will go a long way towards minimizing tax risks as long as the arm’s length principle prevails. Emphasizing the entrepreneurial perspective on transfer pricing further seems suitable to counter the stigmatization of transfer pricing as a vehicle for tax avoidance – which in turn would contribute to dispelling the myth that formulary apportionment (CCCTB) is somehow a sensible idea.
The BEPS project – supporting the modernization of the arm’s length principle makes business sense
After reports on increasing tax gaps resulting from tax avoidance and tax evasion were propelled into the limelight, the OECD responded to mounting political pressures by embarking on a comprehensive revision of its international transfer pricing guidelines. While not legally binding, it is important to understand that the OECD transfer pricing guidelines are a widely accepted reference for tax authorities and taxpayers around the globe. The Leitmotiv of revising the guidelines was to “modernize” the paradigm of international transfer pricing, the so-called arm’s length principle.
Pursuant to the arm’s length principle, multinational enterprises are required to price their intercompany transactions by utilizing prices agreed between unrelated third parties (market prices) as a reference. Identifying sufficiently comparable third-party transactions is one of the main challenges for transfer pricing professionals. Transfer pricing is not an exact science and often transfer prices are set by multinationals within a broad range of comparable prices. From an entrepreneurial point of view this is absolutely sensible. A range of prices reflects differences in terms of market conditions, bargaining positions and other phenomena to be observed in a market economy. As such, utilizing a range of prices as a reference for transfer pricing rather than a single price, is hardly an artificial or sinister approach concocted by tax advisors. Entrepreneurs will often utilize a respective range in order further their strategic objectives, e.g. ensuring a sensible incentive structure for distribution entities.
Critics of the arm’s length principle lament that MNEs systematically abuse transfer pricing by setting transfer prices that favor subsidiaries located in low tax countries. The criticism is, however, misguided, as setting transfer prices within a range of reference prices seldom offers an enticing lever to shift profits. It should also be noted that tax authorities are notoriously suspicious of the benchmark studies, which are utilized by taxpayers to determine and defend arm’s length ranges, and do not hesitate to attack respective studies. In other words, it is plainly implausible to portray transfer pricing as a main pressure point of tax avoidance (let alone tax evasion). It is largely uncontested that aggressive tax avoidance schemes are based on legal elements and elaborate tax structuring, such as hybrid mismatches etc., rather than on systematic mispricing.
In the context of the BEPS project, the OECD has clarified that the measuring-rod of the effectiveness of the arm’s length principle is to be seen in the extent to which the transfer prices set by an MNE will result in a profit allocation that reflects the value contributions by the transacting parties. While there will be an inevitable time gap prior to the reforms impacting the tax gap calculations, there can hardly be any doubt that the reforms are indeed suitable to reach the target of the BEPS project, namely aligning the place of value creation with the place of taxation.
In any case, the solution proposed by the critics of the arm’s length principle, namely adopting a system based on formulary apportionment (such as the CCCTB), would constitute a drastically misguided paradigm shift. Under a system based on formulary apportionment, the allocation of profits would be based on a notion of a “fair” distribution of profits according to an arbitrary formula. Applying a global formula would not only constitute a milestone towards greater tax harmonization, i.e. coupling the introduction of CCCTB with compulsory ‘minimal tax rates.’ It would also constitute a delinking of transfer pricing from business processes. A political formula, irrespective of its calibration, can never be aligned with the business processes of an individual MNE. Furthermore, a formula, from which intangibles are absent, is obviously conceptually ill-suited to result in a profit allocation that reflects the value contributions by the transacting parties. Instead of a market-based profit allocation, a tax system based on formulary apportionment would reflect a planned economy.
Responding to BEPS – keep calm and fight against bad regulations
While there is no magic bullet available to taxpayers, a viable strategy for minimizing transfer pricing related tax risks in a post-BEPS world, is to pay closer attention to documenting the economic substance of cross-border transaction. Instead of compiling mind numbingly extensive documents, however, taxpayers should focus on explaining the value contributions made by the individual transacting parties by conducting a value chain analysis. In the process, the tax department, which in most cases will be assigned the responsibility for compiling transfer pricing documentation, should talk to the senior management as well as to the controlling and accounting departments. It needs to be ensured that the analysis is consistent with the business processes. Having a respective documentation in place, will alleviate the imbued suspicion of tax auditors and facilitate smoother tax audit proceedings. Often it will pay dividends to compile documents, such as cost center reports, invoices etc., to be utilized as a “back-up” during tax audits. Additional information about internal planning data and market information will often prove invaluable for substantiating that the pricing adopted for transactions with related parties is identical to the pricing adopted with unrelated third-parties.
Admittedly, the outlined approach is “transfer pricing 101.” Efficient transfer pricing does not require fancy structuring and glossy reports. Adopting an entrepreneurial approach, i.e. not confining transfer pricing to the tax department, will align the business perspective with an effective implementation of the arm’s length principle. A healthy and legitimate dose of tax optimization will and should naturally remain feasible. All tax authorities must remain obliged to judge the transfer prices of each MNE based on the arm’s length principle and limit their taxation to the arm’s length profits earned by entities within their jurisdiction. In other words, tax authorities will have to keep competing for their tax base instead of colluding about apportioning global income amongst each other according to some convenient (tax maximizing) formula.
Allocating profits to entities that lack economic substance will, however, become increasingly difficult. While diluting the principle that residual profits are to be allocated to the legal owners of the underlying intangible is far from unproblematic, the revised transfer pricing guidelines by and large offer an acceptable mechanism. By focusing on a more holistic evaluation of the value contributions by the transacting parties, the guidance is compatible with an entrepreneurial approach to transfer pricing (i.e. even applying bargaining theory seem feasible ).
Despite the positive sentiments exuded thus far, MNEs will have to remain vigilant and fight bad regulations. One of the toughest battles against tax-grabbing tax authorities will have to be fought with respect to the taxation of intangibles. It must be ensured that the discretionary powers of tax authorities in implementing the “modernized” arm’s length principle remain limited. Most importantly, tax authorities must continue to bear the burden of proof. The latest discussion draft of the OECD in respect to the transfer pricing issues of hard to value intangibles gives rise to grave concerns. Its main feature is that tax authorities are issued a carte blanche for utilizing hindsight. Where, for example, the actual income of a transaction turns out to be significantly higher than the anticipated income on which the pricing was based, then this will be regarded as “presumptive evidence” that the projected income used in the original valuation should have been higher.
In case the taxpayer adopts a policy based on an entrepreneurial approach to transfer pricing, he would be able to document that the assumptions made at the time of anticipating future earnings were in fact commensurate with best practices for decision-making under uncertainty. The discretionary powers of the tax authorities must be limited, by obliging them to conclusively demonstrate that the underlying assumption of the analysis conducted by the taxpayer deviated from arm’s length conditions. Unfortunately, the discussion draft does not reflect an appropriate restrain on discretionary powers.
Hopefully, the business community will actively participate in the discussion, making it clear that a sensible regulation cannot be based on scapegoating MNEs. In turn, MNEs should engage in a critical dialogue and not snub the OECD’s efforts in the realm of transfer pricing. As long as the threat of a CCCTB is on the table, it certainly would not hurt to adopt a more proactive stance on defending the arm’s length principle.