Praise for Transfer Pricing Handbook: Guidance for the OECD Regulations

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3 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 Calianno Partner, 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 Torres Manager 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 V oegele Chairman 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. Bradfield Partner, R odl & Partner I found this book to be extremely insightful and interesting. It should be required reading for anyone involved in transfer pricing. Lawrence J. Chastang Managing 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 Granwell DLA Piper LLP (U.S.)

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5 Transfer Pricing Handbook

6 Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Asia, and Australia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers professional and personal knowledge and understanding. 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.

7 Transfer Pricing Handbook Guidance on the OECD Regulations ROBERT FEINSCHREIBER MARGARET KENT John Wiley & Sons, Inc.

8 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) , fax (978) , or on the Web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hobok en, NJ 07030, (201) , fax (201) , or online at m/go/ permissio ns. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) , outside the United States at (317) or fax (317) Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at 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 (cloth); ISBN (ebk.); ISBN (ebk.); ISBN (ebk.) 1. Transfer pricing-taxation. 2. Transfer pricing-taxation-law and legislation. I. Kent, Margaret, 1942 II. Title. HJ2305.F dc Printed in the United States of America

9 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.

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11 Contents Preface xvii PART I: BASIC TRANSFER PRICING STANDARDS 1 Chapter 1: Introduction 3 Control 4 Tax Havens 5 Complexities 5 Chapter 2: Arm s Length Principle 7 General Explanation of the Arm s Length Principle 8 Formal Statement as to the Arm s Length Principle 10 Comparability Considerations 11 Rationale behind the Arm s Length Principle 11 Compensation Issues 12 Applying the Arm s Length Principle to Contribution Analysis 13 Oligopolistic Conditions 14 Transactions That Independent Enterprises Would Not Undertake 15 Administrative Burdens of the Arm s Length Principle 15 Maintaining the Arm s Length Principle as the International Consensus 16 Rejection of Alternative Transfer Pricing Approaches 17 Notes 18 Chapter 3: Arm s Length Range 19 Single-Figure Approach to the Arm s Length Range 19 Reliability Requirement 20 Comparability Considerations 20 Consequences of Applying More Than One Transfer Pricing Method 21 Selecting the Most Appropriate Point in the Range 22 Extreme Results: Comparability Considerations 23 Notes 24 Chapter 4: Safe Harbor Simplification 27 Safe Harbor Burdens and Benefits 28 Defining Safe Harbor 29 ix

12 x & Contents Scope of the Safe Harbor Provisions 30 How Arbitrary Are the Safe Harbor Provisions? 31 Factors Supporting the Use of Safe Harbors 31 Problems That Safe Harbors Present 33 Multiple Jurisdictions 39 Possibility of Opening Avenues for Tax Planning 40 Statistical Data and a Safe Harbor Example 40 Undertaxation 41 Safe Harbor Principles 41 Equity and Uniformity Issues 41 Recommendations as to the Use of Safe Harbors 42 Safe Harbors as Surrender of the Tax Administration s Discretionary Power 43 Flexible Practices 43 Country-Specific Practices 44 Comprehensive Example 44 Notes 45 Chapter 5: Modifying Safe Harbor Simplification 47 The Study 47 Eleven Specific Transfer Pricing Measures 48 Notes 55 Chapter 6: Global Formulary Apportionment 57 Profit Split Methodologies 58 Global Dealing 58 Attack on Global Formulary Apportionment 58 Impact of the Arm s Length Principle 59 Comparing Global Formulary Apportionment with the Arm s Length Principle 60 Double Taxation 60 Lack of a Common Accounting System 61 Factor Selection 62 Transitional Issues 62 Economic Issues 62 Impact of Exchange Rate Movements 63 Compliance Costs and Data Requirements 63 Valuation Difficulties 64 Separate Entity Approach versus Global Formulary Apportionment 64 Bilateral Tax Treaties 65 Members of the Multinational Group Excluded from Global Formulary Apportionment 65 OECD s Rejection of Non Arm s Length Methods 66 Safe Harbors 66 Notes 67

13 Contents & xi PART II: TRANSFER PRICING METHODOLOGIES 69 Chapter 7: Transactional Profit Split Measures 71 Transactional Profit Split Method Concepts 72 Strengths and Weaknesses of the Transactional Profit Split Method 73 Availability of Comparables in Applying the Transactional Profit Split Method 74 Importance of Functional Analysis in Applying Transactional Profit Split Methods 74 Transactional Profit Split Method Weaknesses 75 Applying Transactional Profit Split Methods 76 Guidelines Profit Splitting Approaches 77 Determining the Combined Profits to Be Split 79 Actual Profits versus Projected Profits 80 Different Profit Measures When Applying the Transactional Profit Split 81 How to Split the Combined Profits 82 Reliance on Comparable Uncontrolled Transactions Data 83 Allocation Keys 83 Reliance on Internal Data 86 Conclusions as to Transactional Profit Split Methods 88 Notes 89 Chapter 8: Profit Split Illustrations 91 Three Basic Assumptions 91 Three Residual Profit Split Alternatives 92 Commentary 96 Notes 97 Chapter 9: Residual Profit Split Examples 99 Presumptions and Preconditions 99 Essential Factual Pattern Conflict 100 Functional Activities 100 Selecting Transfer Pricing Approaches 101 Applying the Residual Profit Split Approach 101 Drafters Disclaimer 104 Contribution Approach 104 Notes 105 Chapter 10: Transactional Net Margin Method 107 Initial TNMM Considerations 107 How the Transactional Net Margin Method Works 108 TNMM Reliability 109 Strengths of the TNMM 110 Weaknesses of the TNMM 111 Applying the Comparability Standard to the TNMM 112 Database Issues: The Audio Player Example 114 Impact on the Arm s Length Range 114

14 xii & Contents Selecting the TNMM 115 Selecting the Net Profit Indicator 115 Exclusion and Measurability 120 Cases in Which Net Profits Are Weighted to Sales 120 Cases in Which Net Profits Are Weighted to Costs 121 Cases in Which Net Profits Are Weighted to Assets 123 Berry Ratios 124 Other Guidance 126 TNMM Examples 126 How the OECD Views the TNMM 128 Notes 128 Chapter 11: Selecting Profit Indicators 133 Illustration Illustration Illustration Notes 139 Chapter 12: Selecting Transfer Pricing Methods 141 When Can a Business Apply a Multisided Transfer Pricing Method? 142 When Should a Business Not Apply a Multisided Transfer Pricing Method? 144 PART III: COMPARABILITY ANALYSIS 147 Chapter 13: How Comparability Analysis Works 149 Determining When Transactions Are Comparable 149 Factors and Comparability 152 Functional Analysis 155 Economic Circumstances 161 Business Strategies 162 Return on Investment 164 Recognizing the Actual Transactions Undertaken 165 Associated Enterprises and Independent Enterprises: In Contrast 167 Alternatively Structured Transactions 167 Losses 168 Multinational Enterprises 168 Implementing Business Strategies 169 Impact of Governmental Policies 170 Notes 173 Chapter 14: Comparability Techniques 177 General Comparability Guidance 177 Typical Comparability Processes 179 Broad-Based Analysis of the Taxpayer s Circumstances 181 Controlled Transaction and Choice of a Tested Party 181 Comparable Uncontrolled Transactions 188

15 Contents & xiii Selecting or Rejecting Potential Comparables 193 Additive Approach 193 Comparability Adjustments 196 Arm s Length Range 199 Notes 202 Chapter 15: Timing and Comparability 205 Timing of Origin 206 Timing of Collection 206 Valuation That Is Highly Uncertain 207 Data from Years Following the Year of the Transaction 208 Multiple-Year Data 208 Compliance Tools 210 Notes 210 PART IV: ADMINISTRATIVE APPROACHES 213 Chapter 16: Transfer Pricing Audits 215 Transactional Profit Split Method 216 Simultaneous Tax Examinations and Transfer Pricing 216 Tax Arrangements 217 Potential Levels of Cooperation between Tax Administrations 218 Examples 220 Notes 224 Chapter 17: Monitoring the Guidelines 227 Understanding the Monitoring Process 228 Method Selection 228 Specific Monitoring Processes 229 Working Party No. 6 Peer Reviews 229 Three Peer Review Levels 230 Peer Review Selection Criteria 231 Difficult Case Paradigms 231 Biennial Members of Tax Examiners 232 Business Community Involvement 233 Business Industry Advisory Committee 233 Business s Role in Contributing to the OECD 235 Peer Reviews and the Business Community 235 Business Community s Updates on Legislation and Practice 236 Role of the U.S. Council for International Business 236 Notes 237 PART V: ADVANCED OECD ANALYSIS 239 Chapter 18: Documentation Requirements 241 Introductory Issues and Burden of Proof 241

16 xiv & Contents Guidance on Documentation Rules and Procedures 242 Useful Information for Determining Transfer Pricing 244 Summary of Recommendations on Documentation 245 Notes 245 Chapter 19: Intangible Property 247 Basic OECD Intangible Property Provisions 247 Future Intangible Property Developments 248 Arm s Length Intangible Property Issues 249 OECD Intangible Property Developments 249 Soft Intangibles 250 Highly Uncertain Valuation Issues 250 Steps That an Independent Enterprise Might Undertake to Resolve Uncertainty 251 Tax Administrator s Response 253 Timing Considerations 254 OECD Highly Uncertain Valuation Examples 254 What the OECD Should Do Now 259 Notes 260 Chapter 20: Service Arrangements 263 Overview 263 Scope of Intragroup Arrangements 264 Shareholder Activities and Stewardship Activities 267 Adjusting to the Form of the Arm s Length Consideration 270 On Call Services 270 Evaluating On Call Services 271 Determining an Arm s Length Charge for the Intragroup Service 272 Including Service Costs in the Transfer of Goods 275 Double-Taxation Risks 276 Examining the Actual Use of the Services 276 Calculating the Arm s Length Consideration 276 Applying Transfer Pricing Methods 277 Functional Analysis 278 Business Strategies: Profits for the Service Provider 278 Applying the Cost-Plus Method for Intragroup Services 279 Cost-Benefit Issues and Safe Harbor 280 Intragroup Service Examples 281 Specialized Services 283 Multinational Service Enterprises 283 Specialized Service Industries 284 Applying the Transactional Profit Split Method to Services 284 Notes 285 Chapter 21: Cost Contribution Arrangements 289 Overview 289 Cost Contribution Arrangement Criteria 291

17 Contents & xv Mandatory CCA Arm s Length Requirements 296 Applying an Applicable Allocation Key 300 Tax Treatment of Contributions and Balancing Payments 302 Entry, Withdrawal, and Termination of a Cost Contribution Arrangement 306 Recommendations for Monitoring and Structuring Cost Contribution Arrangements 309 Documentation 310 Notes 312 Chapter 22: Business Restructuring 315 Special Risk Considerations 316 Compensation for Undertaking the Restructuring 318 Postrestructuring Remuneration 321 Recognition of the Actual Transactions Undertaken 323 Notes 325 PART VI: PUTTING THE GUIDELINES TO WORK 327 Chapter 23: Malaysia-Singapore Allocation Keys 329 Importance of Allocation Keys 329 When the Transactional Profit Split Method Is the Most Applicable Transfer Pricing Method 330 Specialized Services 331 Applying the Transactional Profit Split Method 332 Four Allocation Key Categories 333 Key Functions 333 Selecting Potential Allocation Keys 334 Selecting among Allocation Keys 336 Strong Correlation Standard 337 Allocation Keys 337 Transfer Pricing Strategies 342 Notes 343 Chapter 24: China-Taiwan Trade 345 Taiwan and China: A History Lesson 345 Tax Considerations 348 Transactional Profit Split Method Criteria 352 APA Process 355 Notes 356 Chapter 25: Reverse Engineering the Transfer Pricing Process 357 Transactional Profit Split 358 Simultaneous Tax Examinations and Transfer Pricing 358 Tax Arrangements 359 How the Reverse Engineering Transfer Pricing Process Works 367

18 xvi & Contents Functional Analysis Considerations 369 Transactional Profit Split Method 370 Success Parameters to the Reverse Engineering Process 370 Synergistic Activities 371 Undertaking Multijurisdictional Production Processes 372 Engaging in Extensive R&D Activities 373 Dealing in Unique Intangibles 374 Participating in a Cost Contribution Arrangement 374 Creating or Providing Specialized Services 375 Distributions of Generic Goods or Standardized Goods 376 Contract Manufacturers and Contract Service Activities 377 Planning 377 International LP Gas Companies Face Multinational Tax Claims 377 Multinational Service Enterprises 379 Notes 380 PART VII: CONNECTING TRANSFER PRICING AND PERMANENT ESTABLISHMENT 383 Chapter 26: Permanent Establishment Parameters 385 OECD s Permanent Establishment Provisions 386 Overall Tax Considerations 388 OECD Approach to Determine Permanent Establishment 389 Hong Kong Applies the OECD Permanent Establishment Provisions 389 Common Law Permanent Establishment Criteria 391 Declining Businesses 394 Preparatory to and Auxiliary from Exemptions 395 Will the OECD Approach Prevail? 395 Notes 396 Chapter 27: Focus on Permanent Establishment 397 Background Considerations 398 Twenty-five Proposed Changes 398 Notes 413 About the Authors 415 Index 417

19 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 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: & & Part I looks at the basic OECD transfer pricing standards, beginning with the arm s length principle and the limits to this arm s length range concept. We examine the OECD s safe harbors simplification approaches and its safe harbor modifications. Then we analyze the global formulary apportionment alternative. Part II looks at the OECD s transfer pricing methodologies, recognizing the importance of the transactional profit split alternative, the application of the residual profit split, and limitations on the transactional net margin method. Then we examine profit indicators and other transfer pricing ramifications. xvii

20 xviii & Preface & & & & & Part III provides a comprehensive look at comparability analysis, examining how the specifics of the comparability process and comparability analysis techniques, as well as the timing issues that arise in assessing comparability. Part IV examines the OECD s administrative approaches. We look at audits and advance pricing agreement techniques, and we examine the monitoring process itself. Part V provides advanced OECD analysis. We examine the documentation requirements, intangible properties, and services arrangements. Then we analyze cost contribution arrangements and business restructuring. Part VI puts the Guidelines to work. We examine factual patterns we developed in Malaysia as to Singapore operations and in Taiwan as to Chinese operations. Then we analyze techniques to reverse engineer the transfer pricing process. Part VII connects transfer pricing with permanent establishment under the OECD provisions. 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-ma il address is mult ijur@aol.c om. Our web site is Transf erpricingc onsort ium.c om. Robert Feinschreiber Margaret Kent Key Biscayne, Florida May 2012

21 I PART ONE Basic Transfer Pricing Standards

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23 1 CHAPTER ONE Introduction THE ORGANISATION OF ECONOMIC Co-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 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, 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 3

24 4 & Introduction 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 discussion on transfer pricing began in 1979 with the OECD report Transfer Pricing and Multinational Enterprises. & The OECD published the original Guidelines in 1995 but the Guidelines excluded intangible property, services, cost contribution arrangements, monitoring procedures, advance pricing agreements, and business restructurings. & The OECD included guidance for intangible property and services in & The OECD included guidance for cost contribution arrangements in & The OECD included guidance for monitoring procedures in & The OECD included guidance for advance pricing agreement procedures in & The OECD included guidance for business restructuring in 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: 1. Control 2. Tax havens 3. Complexities 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. & & Countries might seek to ascertain the presence of control empirically, based on a data analysis, contractual provisions, or both. Alternatively, a government might issue its own transfer pricing control standards, based on common ownership, ownership over the second company, family ownership, or other criteria.

25 Complexities & 5 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.

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27 2 CHAPTER TWO 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: 1. Applying contribution analysis principles to modify the arm s length principle. 2. Interrelating between intercompany autonomy and company bargaining positions. 3. Recognizing the transfer of intermediate goods and work-in-process inventories and the integrated production of highly specialized goods. 4. Taking into account economies of scale in oligopolistic conditions. Chapter I of the Guidelines examines four facets of the arm s length principle: 1. A general explanation of the arm s length principle. 2. A formal statement concerning the arm s length principle. 3. Disparagement of the global formulary apportionment concept. 4. Guidance for specific 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. 7

28 8 & Arm s Length Principle 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: & & Independent Enterprises: When independent enterprises transact with one another, market forces determine the conditions of their commercial and financial relations. These market forces are the price of the goods transferred, the services provided, and the conditions of the transfer or provision. Associated Enterprises: When associated enterprises transact with one another, external market forces might not directly affect their commercial and financial relations in the same manner. 4 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

29 General Explanation of the Arm s Length Principle & 9 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: & & & The enterprises might be subject to conflicting governmental pressures in the domestic context, as well as in the foreign country. Such governmental pressures might include customs valuations, antidumping duties, exchange controls, or price controls. The enterprise might be subject to transfer price distortions caused by cash flow requirements within a multinational group. The publicly held multinational group might feel pressure from its shareholders to show profitability at the parent company level. The group might feel this pressure particularly if shareholder reporting is not reflected on a consolidated basis. 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

30 10 & Arm s Length Principle 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: 1. Reliance on Article 9 of the OECD Model Tax Convention. 2. Maintaining the arm s length principle as the international consensus. 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