Reprinted from British Tax
Review
Issue 5, 2013
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The BEPS Action Plan and Transfer Pricing: The
Arm’s Length Standard Under Pressure?
Georg Kofler
*
Abstract
The OECD Action Plan on Base Erosion and Profit Shifting puts strong emphasis on substantive transfer
pricing issues, devoting 3 of its 15 Actions to them. Aiming at assuring that transfer pricing outcomes are
in line with value creation, the main concerns raised in the Action Plan relate to income shifting and the
creation of “stateless income” through transfers of intangibles, the allocation of risks and capital, and
transactions which would not, or would only very rarely, occur between third parties. This contribution
will present the Actions identified in the Action Plan, put them into context, and identify potential routes
for change.
Introduction
Entities of multinational enterprises (MNEs) are generally taxed separately in each country.
1
Hence, the allocation of taxing rights with respect to the separate entities of MNEs can have a
major impact on the tax revenue of individual states, as a large portion of world business is
between associated enterprises.
2
It is, therefore, generally recognised in international tax law
that affiliated companies conducting cross-border business must do so on market principles, that
is, they must act as if such business was being conducted between independent parties.
3
The
price charged for goods and services—the transfer price—must be in accordance with the “arm’s
length principle”, which requires taxpayers to put a constructed or fictional market price on their
non-market transactions to measure the profits to be allocated to each entity of the MNE.
4
The
arm’s length principle, though heavily criticised and perhaps a mere by-product of history,
5
is a
globally-accepted standard in the area of international taxation. It is not only enshrined in Article
9 of the OECD Model Convention with Respect to Taxes on Income and on Capital (OECD
MC) and maintained and developed in the OECD Transfer Pricing Guidelines (OECD TPG),
6
but is also employed in Article 9 of the United Nations’ “Model Double Taxation Convention
*
Univ. Prof. DDr. Johannes Kepler University of Linz.
1
OECD Transfer Pricing Guidelines (OECD TPG), Preface, para.5.
2
See, e.g. OECD TPG, above fn.1, para.1.3.
3
H. Hamaekers, “The Arm’s Length Principle and the Role of Comparables” (1992) 46 BIFD 602, 603.
4
Y. Brauner, “Value in the Eye of the Beholder: The Valuation of Intangibles for Transfer Pricing Purposes” (2008)
28 Va. Tax Rev. 79, 97; see, however, also J.S. Wilkie, “Reflecting on the ‘Arm’s Length Principle’: What is the
‘Principle’? Where Next?” in W. Schön, and K.A. Konrad (eds), Fundamentals of International Transfer Pricing in
Law and Economics (2012), 137, 144 and following and 152 and following, for a discussion of the difference between
the concepts of profits and prices in light of OECD Model Convention with Respect to Taxes on Income and on
Capital (OECD MC) Art.9, available at: http://www.oecd.org/tax/treaties/1914467.pdf [Accessed November 6, 2013].
5
See S.I. Langbein, “The Unitary Method and the Myth of Arm’s Length” (1986) 30(7) Tax Notes 625.
6
OECD TPG, above fn.1, para.1.6, noting that “the authoritative statement of the arm’s length principle is found in
paragraph 1 of Art. 9 of the OECD Model Tax Convention.”
[2013] BTR, No.5 © 2013 Thomson Reuters (Professional) UK Limited and Contributors646
between Developed and Developing Countries” (UN MC),
7
Article 9 of the “US Model Income
Tax Convention” (US MC),
8
and Article 4(1) of the Arbitration Convention between the EU
Member States.
9
Moreover, a 2011 OECD survey showed that all responding OECD and
non-OECD countries “indicate that their legislation establishes a general obligation to comply
with the arm’s length principle”.
10
Some even consider the arm’s length principle as having the
status of customary international law.
11
Arm’s length pricing, however, depends on markets. Hence problems naturally arise where
no sufficiently-established market for unrelated-party transactions exists or where reliable
information is not available.
12
Moreover, the transactional relationships between associated
enterprises may differ from potentially comparable transactions between unrelated parties in
important and fundamental ways.
13
In particular, practical difficulties relate to both identifying
appropriate comparables and determining how any “integration benefits” (for example, the
synergistic cost savings, finance savings) should be apportioned amongst the participating
entities
14
; this gives rise to the so-called “continuum price problem”, that is, a situation in which
the sum of the returns for separate transactions by independent parties is less than the actual
return of the combined MNE.
15
7
United Nations, Model Double Taxation Convention between Developed and Developing Countries (updated 2011),
available at: http://www.un.org/esa/ffd/documents/UN_Model_2011_Update.pdf [Accessed November 6, 2013]. For
the UN’s work on a transfer pricing manual, see the Note by the UN Secretariat, “Transfer Pricing Practical Manual
for Developing Countries” (2009) 18 Tax Mgmt Trans. Pricing Rep. 714. The UN’s Practical Manual on Transfer
Pricing for Developing Countries has recently been published and is available at: http://www.un.org/esa/ffd/documents
/UN_Manual_TransferPricing.pdf [Accessed November 20, 2013].
8
US Model Income Tax Convention of November 15, 2006, available at: http://www.irs.gov/pub/irs-trty/model006
.pdf [Accessed November 6, 2013]. US Model Technical Explanation Accompanying the US Model Income Tax
Convention on November 15, 2006 on Art.9 (treating the arm’s length principle as a treaty obligation).
9
Convention 90/436/EEC on the elimination of double taxation in connection with the adjustment of profits of
associated enterprises [1990] OJ L225/10. The importance of the arm’s length principle has also been frequently
highlighted by EU institutions. See, e.g. Company Taxation in the Internal Market (SEC(2001)1681), 256; Commission
of the European Communities (ed.), Report of the Committee of Independent Experts on Company Taxation—Ruding
Report (1992), 205.
10
See OECD, Multi-Country Analysis of Existing Transfer Pricing Simplification Measures (2011), 9.
11
C. Thomas, “Customary International Law and State Taxation of Corporate Income: The Case for the Separate
Accounting Method” (1996) 14(1) Berkeley Journal of International Law 99; contra. J. Wittendorff, Transfer Pricing
and the Arm’s Length Principle in International Tax Law (2010), 288–290.
12
See also OECD TPG, above fn.1, para.1.13.
13
See, e.g. H.N. Higinbotham and M.M. Levey, “When Arm’s Length Isn’t Really Arm’s Length: Issues in Application
of the Arm’s Length Standard” (1998) 26 Intertax 235 and following (discussing economies of integration, allocation
of functions and risks, ownership of intangibles, non-equivalent bargaining situations, and related party agreements
for tax purposes); J. Wittendorff, “The Arm’s-Length Principle and Fair Value: Identical Twins or Just Close Relatives?”
(2011) 62 TNI 223, 239–248 (discussing economies of integration, centralised purchasing functions, intangibles,
financial transactions, and implicit support).
14
See, e.g. Higinbotham and Levey, above fn.13; D.L.P. Francescucci, “The Arm’s Length Principle and Group
Dynamics” (2004) 11 ITPJ 55, and following. For a recent attempt to address this issue see OECD, Revised Discussion
Draft on Transfer Pricing Aspects of Intangibles (Revised Discussion Draft) (issued on July 30, 2013), paras 18–23.
15
It will specifically arise in the presence of economies of integration if a one-sided transfer pricing method (i.e. a
method where only one party is tested) is used: if, first, two different one-sided methods are applied to each of the
associated enterprises, there will be an unallocated residual profit attributable to the economies of integration. If,
secondly, only one one-sided method is applied, the residual profit will be allocated to the non-tested party, so that
profit allocation indeed depends on the choice of method. See for a discussion of these issues, e.g. Langbein, above
fn.5, 626; Francescucci, above fn.14, 72; Wittendorff, above fn.13, 239–241.
The BEPS Action Plan and Transfer Pricing 647
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Indeed, the arm’s length standard, originally developed in a low tech, bricks-and-mortar
economy and while perhaps theoretically sound,
16
is largely viewed as disfunctional in a globalised,
high-tech economic environment, especially with regard to intangibles.
17
On a fundamental level,
the basic criticism of the arm’s length standard is that a transactional approach does not reflect
economic reality. This is because MNEs are usually integrated entities to which each subsidiary
contributes and in which typical inefficiencies and duplication are avoided while economies of
scale and integration (“synergy rents”) are achieved.
18
Hence, the profit of an integrated firm
cannot be soundly divided with market prices.
19
Moreover, transfer pricing using the arm’s length
standard is considered “absurdly complex”
20
and as creating enormous compliance and
enforcement costs,
21
while nevertheless leading to widespread opportunities for income shifting.
22
It hence comes as no surprise that income shifting based on transfer pricing has entered the
limelight of the current discussion on base erosion and profit shifting, on a national level (for
example, in the UK
23
and the US
24
) as well as on an international level: supported and pushed by
16
OECD TPG, above fn.1, para.1.14; for an opposing position see Langbein, above fn.5, 627.
17
E. Chorvat, “Forcing Multinationals to Play Fair: Proposals for a Rigorous Transfer Pricing Theory” (2003) 54 Ala.
L. Rev. 1251, 1259–1262; Brauner, above fn.4; R.S. Avi-Yonah, “Between Formulary Apportionment and the OECD
Guidelines: A Proposal for Reconciliation” (2010) 2 WTJ 3, 8; M.C. Durst, “It’s Not Just Academic: The OECD
Should Reevaluate Transfer Pricing Laws” (2010) 57 TNI 247, and following.
18
R.S. Avi-Yonah, “The Rise and Fall of Arm’s Length: A Study in the Evolution of US International Taxation”
(1995) 15 Va. Tax Rev. 89, 148–150; E.E. Lester, “International Transfer Pricing Rules: Unconventional Wisdom”
(1995) 2 ILSA J. Int’l & Comp. L. 283, 295–297; Higinbotham and Levey, above fn.13; H. Hamaekers, “Arm’s
Length—How Long?” in P. Kirchhof, et al. (eds), Staaten und Steuern, Festschrift für Klaus Vogel (2000), 1043,
1052; J. Li, “Global Profit Split: An Evolutionary Approach to International Income Allocation” (2002) 50 CTJ 823,
832; Chorvat, above fn.17, 1259–1262; Francescucci, above fn.14, 55 and following; Brauner, above fn.4; R.S.
Avi-Yonah, K.A. Clausing and M.C. Durst, “Allocating Business Profits for Tax Purposes: A Proposal to Adopt a
Formulary Profit Split” (2009) 9 Fla. Tax Rev. 497, 501; R.J. Vann, “Taxing International Business Income:
Hard-Boiled Wonderland and the End of the World” (2010) 2 WTJ 291, and following; J.J.A. Burke, “Re-Thinking
First Principles of Transfer Pricing Rules” (2011) 30 Va. Tax Rev. 613, 626–627; J. Li, “Soft Law, Hard Realities
and Pragmatic Suggestions: Critiquing the OECD Transfer Pricing Guidelines” in W. Schön and K.A. Konrad (eds),
Fundamentals of International Transfer Pricing in Law and Economics (2012), 71, 82 and following.
19
H. Luckhaupt, M. Overesch and U. Schreiber, “The OECD Approach to Transfer Pricing: A Critical Assessment
and Proposal” in W. Schön and K.A. Konrad (eds), Fundamentals of International Transfer Pricing in Law and
Economics (2012), 91, 116.
20
Avi-Yonah, above fn.17, 3, 7; see also Lester, above fn.18, 283, 298; W. Hellerstein, “The Case for Formulary
Apportionment” (2005) 12 ITPJ 103, 108; Avi-Yonah, Clausing and Durst, above fn.18, 497, 502.
21
Avi-Yonah, above fn.18, 150–151; Hamaekers, above fn.18, 1043, 1056–1057; Hellerstein, above fn.20, 103, 109;
Brauner, above fn.4; Durst, above fn.17, 247, 252.
22
Avi-Yonah, above fn.18, 151–152; Lester, above fn.18, 283, 297; Chorvat, above fn.17, 1251, 1253; Hellerstein,
above fn.20, 103, 109; Avi-Yonah, Clausing and Durst, above fn.18, 497, 506–507; Durst, above fn.17, 247, 251–252;
Avi-Yonah, above fn.17, 3, 6–7; S.C. Morse, “Revisiting Global Formulary Apportionment” (2010) 29 Va. Tax Rev.
593, 597–598. For a review of the empirical literature see Luckhaupt, Overesch and Schreiber, above fn.19, 91 and
following.
23
See, e.g. UK House of Lords Select Committee on Economic Affairs, Tackling corporate tax avoidance in a global
economy: is a new approach needed? (The Stationery Office, July 31, 2013) HL Paper 48 (1st Report of Session
2013–14).
24
See, e.g. US Joint Committee on Taxation, Present Law and Background Related to Possible Income Shifting and
Transfer Pricing (JCX-27-10, 2010).
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[2013] BTR, No.5 © 2013 Thomson Reuters (Professional) UK Limited and Contributors
the G20,
25
the G8
26
and the EU,
27
the OECD issued a lengthy report on Addressing Base Erosion
and Profit Shifting on February 12, 2013 (BEPS Report)
28
and a concrete Action Plan on Base
Erosion and Profit Shifting on July 19, 2013 (Action Plan).
29
Transfer pricing is at the heart of
this Action Plan. However, the OECD does not intend to give up on the arm’s length principle
altogether (and, for example, move to a formulary system),
30
but rather to “fix” the flaws of the
current system, noting that
“[i]n the area of transfer pricing, the rules should be improved in order to put more emphasis
on value creation in highly integrated groups, tackling the use of intangibles, risks, capital
and other high-risk transactions to shift profits”.
31
As the BEPS Report highlights:
“One of the underlying assumptions of the arm’s length principle is that the more extensive
the functions/assets/risks of one party to the transaction, the greater its expected remuneration
will be and vice versa. This therefore creates an incentive to shift functions/assets/risks to
where their returns are taxed more favorably. While it may be difficult to shift underlying
functions, the risks and ownership of tangible and intangible assets may, by their very
nature, be easier to shift. Many corporate tax structures focus on allocating significant risks
and hard-to-value intangibles to low-tax jurisdictions, where their returns may benefit from
a favorable tax regime. Such arrangements may result in or contribute to BEPS.”
32
25
At its Los Cabos meeting on June 18–19, 2012, the G20 Leaders referred to “the need to prevent base erosion and
profit shifting” and stated that they would “follow with attention the ongoing work of the OECD in this area”.
Thereafter, the G20 finance ministers welcomed the OECD report at their Moscow meeting on February 15–16, 2013
and declared to be “determined to develop measures to address base erosion and profit shifting, take necessary
collective actions and look forward to the comprehensive action plan the OECD will present to [them] in July”. And
at the Moscow meeting on July 19–20, 2013 the G20 finance ministers “fully endorse[d] the ambitious and
comprehensive Action Plan submitted at the request of the G-20 by the OECD aimed at addressing base erosion and
profit shifting (BEPS) with a mechanism to enrich the Plan as appropriate. We welcome the establishment of the
OECD/G20 BEPS project and encourage all interested countries to partici-pate”. Finally, the G20 Leaders’ Declaration
from the Russia G20 Summit in September 2013 fully endorses “the ambitious and comprehensive Action
Plan—originated in the OECD—aimed at addressing base erosion and profit shifting with mechanism to enrich the
Plan as appropriate. We welcome the establishment of the G20/OECD BEPS project and we encourage all interested
countries to participate. Profits should be taxed where economic activities deriving the profits are performed and
where value is created”.
26
The 2013 Lough Erne G8 Leaders’ Communiqué states that, “[o]n tax avoidance, we support the OECD’s work to
tackle base erosion and profit shifting”.
27
See the EU Commission’s Press Release, Commissioner Šemeta welcomes G20 Finance Ministers’ commitments
on new measures to fight tax evasion and avoidance (MEMO/13/711, July 20, 2013), warmly welcoming “the G20
Finance Ministers’ commitments today on concrete measures to better tackle tax evasion and corporate tax avoidance
worldwide”.
28
OECD, Addressing Base Erosion and Profit Shifting (OECD Publishing, 2013), 42, available at: http://www.oecd
.org/ctp/beps.htm [Accessed November 7, 2013].
29
OECD, Action Plan on Base Erosion and Profit Shifting (OECD Publishing, 2013), available at: http://dx.doi.org
/10.1787/9789264202719-en [Accessed November 7, 2013].
30
In defence of the arm’s length standard J. Owens, “Myths and Misconceptions About Transfer Pricing And the
Taxation of Multinational Enterprises” (2013) 21 Tax Mgmt Trans. Pricing Rep. 1051, and following.
31
Action Plan, above fn.29, 14.
32
BEPS Report, above fn.28, 42.
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Consequently, the OECD’s Action Plan identifies a number of “pressure areas”, divided into
15 concrete Actions where international co-operation is needed. As for transfer pricing, substantive
issues are addressed by Actions 8 (intangibles), 9 (risk and capital) and 10 (other high-risk
transactions),
33
all of which are intended to assure that transfer pricing outcomes are in line with
value creation or—phrased differently—to “align taxation and substance”
34
; these Actions should
lead to changes in the OECD TPG and possibly in the OECD MC within two years.
35
Moreover,
Action 13 deals with transparency and calls for a re-examination of transfer-pricing
documentation,
36
which might lead to requirements of value-chain analyses in transfer-pricing
documentation to identify—country-by-country—value-creating activities in different industries
and under different business models. Indeed, the dissociation of functions, risks, and intangibles
over various countries in highly integrated industries has been one major concern for tax
administrations and has led to calls for a stronger focus on contribution analyses within the
transactional profit methods.
37
Aligning transfer pricing outcomes with value creation
Fixing the flaws in the current system
The Action Plan identifies three concrete critical issues within the transfer pricing area, that is,
intangibles, allocation of risk and capital, and other “high-risk” transactions. Indeed, it is mainly
in these areas that MNEs have been able to use contractual arrangements to move taxable income
to low- and zero-tax jurisdictions, that is to create so-called “stateless income”.
38
Google’s
“Double Irish Dutch Sandwich” structure being probably the most prominent example,
39
this
form of tax planning can lead to a situation in which income from business activities is subject
to tax only in a low- or zero-tax jurisdiction that is neither the source of the factors of production
through which the income was derived, nor the domicile of the group’s parent company. This
outcome is at the heart of the income shifting concerns raised in the Action Plan and its aim to
align transfer pricing outcomes with value creation:
“Transfer pricing rules serve to allocate income earned by a multinational enterprise among
those countries in which the company does business. In many instances, the existing transfer
pricing rules, based on the arm’s length principle, effectively and efficiently allocate the
income of multinationals among taxing jurisdictions. In other instances, however,
33
However, also Action 4 (base erosion through interest deductions and other financial payments) touches on transfer
pricing.
34
See OECD, BEPS Frequently Asked Questions (2013), 3.
35
As for Action 8 (intangibles), the Action Plan, above fn.29, sets the timeframe with September 2014 and September
2015, as for Actions 9 (risk and capital) and 10 (other high-risk transactions) the timeframe is September 2015.
36
See also OECD, White Paper on Transfer Pricing Documentation (July 30, 2013), available at: http://www.oecd
.org/ctp/transfer-pricing/white-paper-transfer-pricing-documentation.pdf [Accessed November 7, 2013].
37
See G. Steiner, “Aktionsplan der OECD zum BEPS-Report—Konzernbesteuerung, quo vadis?” (2013) 23 SWI
385, 390, referring, inter alia, to paras 2.109, 2.112, 2.119 and 2.120 of the OECD TPG, above fn.1.
38
E.D. Kleinbard, “Stateless Income” (2011) 11 Fla. Tax Rev. 699, and following.
39
For a description of this structure see, e.g. the example at BEPS Report, above fn.28, 74–76; C. Fuest, et al., Profit
Shifting and “Aggressive” Tax Planning by Multinational Firms: Issues and Options for Reform (ZEW Discussion
Paper No.13-044, July 2013), 3–6.
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[2013] BTR, No.5 © 2013 Thomson Reuters (Professional) UK Limited and Contributors
multinationals have been able to use and/or misapply those rules to separate income from
the economic activities that produce that income and to shift it into low-tax environments.
This most often results from transfers of intangibles and other mobile assets for less than
full value, the over-capitalisation of lowly taxed group companies and from contractual
allocations of risk to low-tax environments in transactions that would be unlikely to occur
between unrelated parties.”
40
Although neither the BEPS Report nor the Action Plan reveals preconceptions as to the precise
nature of the changes that may be required to address these issues or a concrete approach towards
“value creation”, the Action Plan notes that the focus is not on a conceptual change but rather
“to directly address the flaws in the current system, in particular with respect to returns
related to intangible assets, risk and over-capitalisation”.
It also notes, however, that the measures may be “either within or beyond the arm’s length
principle”.
41
This clearly indicates that the OECD does not exclude changes of Article 9 of the
OECD MC that would lead to a deviation from the arm’s length principle, which in turn would
acknowledge that this leading principle does not have universal application and would undermine
its importance.
Moving even one step further, the current shortcomings have led commentators to propose
alternative approaches to transfer pricing,
42
hybrid forms or simplifications involving both the
arm’s length standard and formulary apportionment,
43
or a move to global formulary
apportionment.
44
As to the latter, conceptually, the difference between the arm’s length standard
40
Action Plan, above fn.29, 20.
41
Action Plan, above fn.29, 20.
42
See, e.g. Chorvat, above fn.17.
43
See, e.g. Francescucci, above fn.14, 235 and following (composite approach using a multilateral residual profit split
method); M.C. Durst, “A Statutory Proposal for US Transfer Pricing Reform” (2007) 46 TNI 1041, 1044–1045
(allocation of market-return based on the cost-plus method and formulary apportionment of the remainder); N. Herzig,
M. Teschke and C. Joisten, “Between Extremes: Merging the Advantages of Separate Accounting and Unitary
Taxation” (2010) 38 Intertax 334 (combination of separate accounting with aspects of unitary taxation); Avi-Yonah,
Clausing and Durst, above fn.18, 497 and following, and Avi-Yonah, above fn.17, 3, 16–17 (formula-based residual
profit split); Luckhaupt, Overesch and Schreiber, above fn.19, 91 and following (pooling transactions and allocating
profits along the value added chain according to easily observable apportionment factors).
44
See, with further references, the discussion by, e.g. Langbein, above fn.5, 625 and following; L.M. Kauder,
“Intercompany Pricing and Section 482: A Proposal to Shift from Uncontrolled Comparables to Formulary
Apportionment Now” (1993) 58 TN 485, and following; J.R. Hellerstein, “Federal Income Taxation of Multinationals:
Replacement of Separate Accounting with Formulary Apportionment” (1993) 60 TN 1131; Avi-Yonah, above fn.18,
153 and following; Lester, above fn.18, 283, 303–304; Hamaekers, above fn.18, 1043, 1061–1062; K. Sadiq, “Unitary
Taxation—The Case for Global Formulary Apportionment” (2001) 55 BIFD 275, and following; C.E. McLure, Jr.,
“Replacing Separate Entity Accounting and the Arms Length Principle with Formulary Apportionment” (2002) 56
BIFD 586, and following; Li, above fn.18, 823, and following (global profit split); Hellerstein, above fn.20, 103 and
following; F. Vincent, “Transfer Pricing and Attribution of Income to Permanent Establishments: The Case for
Systematic Global Profit Splits (Just Don’t Say Formulary Apportionment)” (2005) 53 CTJ 409, and following; M.
Kobetsky, “The Case for Unitary Taxation of International Enterprises” (2008) 62 BIT 201, and following (discussing
a multilateral tax treaty); Brauner, above fn.4, 79, 159–164; Durst, above fn.17, 247 and following; for critical analyses
of formulary apportionment see, e.g. R. Ackerman and E. Chorvat, “Modern Financial Theory and Transfer Pricing”
(2002) 10 Geo. Mason L. Rev. 637, and following; J. Roin, “Can the Income Tax Be Saved—The Promise and Pitfalls
of Adopting Worldwide Formulary Apportionment” (2008) 61 TLR 169, and following; Morse, above fn.22, 593 and
following (discussing destination sales-based formulary apportionment); H.K. Kroppen, R. Dawid, and R. Schmidke,
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and global formulary apportionment is that the arm’s length standard starts with treating each
entity in an affiliated group as separate taxpayers, hypothetically dealing with each other at arm’s
length, whereas the formulary approach starts with the entire affiliated group as one unitary
enterprise.
45
Indeed, the EU Commission is currently pursuing such a formula-based regime in
its proposal for a “Common Consolidated Corporate Tax Base” (CCCTB) as a solution to transfer
pricing problems within the EU, with little progress, however, at the level of the Council so far.
46
Until recently the OECD has taken a rather clear position “that moving to a system of formulary
apportionment of profits is not a viable way forward”,
47
as it is supposedly not acceptable in
theory, implementation or practice,
48
and calls for maintaining the arm’s length principle as the
international consensus.
49
The openness, however, of the Action Plan to go “beyond the arm’s
length principle” implies that
“[t]ax administrations should be prepared to ‘stretch’ the profit-based methods so that
tailored profit-based formulae can be used to allocate profits in certain circumstances”.
50
Along those lines, it has already been argued that the traditional arm’s length standard in the
form of the comparable uncontrolled price method and global formulary methods are not polar
extremes, but rather parts of a continuum,
51
and that therefore
“[g]overnment decisions on where they want to be on this spectrum should be guided by
what approach is likely to deliver the minimum amount of friction and compliance costs
and a sharing of the tax base that accurately reflects the economic activities carried out in
each jurisdiction.”
52
Intangibles (Action 8)
Transfer pricing for intangible property is an increasingly important area in cross-border taxation
and presents a number of specific problems.
53
When it comes to the kind of income shifting
“Profit Split, the Future of Transfer Pricing?” in W. Schön, and K.A. Konrad (eds), Fundamentals of International
Transfer Pricing in Law and Economics (2012), 267 and following; Owens, above fn.30, 1051, 1053–1054.
45
Avi-Yonah, above fn.18, 92–93.
46
The current status of the CCCTB Proposal is that the subsidiarity analysis by the National Parliaments (Art.5(3)
EUT) has been closed (no reconsideration necessary), the opinion of the European Economic and Social Committee
has been given ([2012] OJ C24/63) and the Legislative Resolution of the European Parliament has been issued
(P7_TA(2012)0135 of April 19, 2012). Currently, Council is conducting technical issues, with a compromise proposal
being published in Doc. 8387/12 FISC 49 and Doc. 8790/12 FISC 52 (April 16, 2012) (reprinted in (2012) 10 Highlights
& Insights on European Taxation 5, and following, with comments by Nou-wen and Van de Streek) and in Doc.
9180/13 FISC 80 (May 2, 2012). It should, however, be noted that the German Government’s analysis has taken an
outspoken position against consolidation and optionality; see BT-Drs 17/5748 of May 5, 2011.
47
Action Plan, above fn.29, 14.
48
See the discussion in OECD TPG, above fn.1, paras 1.16–1.31.
49
OECD TPG, above fn.1, paras 1.14–1.15.
50
Owens, above fn.30, 1051, 1054.
51
Avi-Yonah, above fn.18, 91–94; Li (2012), above fn.18, 71, 81.
52
Owens, above fn.30, 1051, 1054.
53
For detailed discussions of the transfer pricing issues with respect to intangibles, see the contributions in IFA (ed.),
Transfer pricing and intangibles, CDFI Vol.92a (2007), and, e.g. M. Markham, The Transfer Pricing of Intangibles
(2005); Brauner, above fn.4; T. Rosembuj, “Intangible Assets and Transfer Pricing” in L. Hinnekens and P. Hinnekens
(eds), A Vision of Taxes within and outside European Borders, Festschrift Frans Vanis-tendael (2008), 756 and
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addressed in the Action Plan, the basic concerns arise from intragroup contracts with regard to
licences and other transfers of rights to intangible property in which a “cash-box” subsidiary,
perhaps located in a low-tax jurisdiction, agrees to bear the risk of further development and
receives the right to income from future exploitation of the intangibles,
54
but conducts little or
no additional business activity and is typically limited to the making of financial contributions
(for example, using funds contributed by the parent company).
55
A typical structure is a cost
contribution arrangement (CCA),
56
that is, in US-terminology a “cost sharing agreement”,
57
where
one party contributes the right to use existing intangible property for further research and
development (that is, a platform contribution), whereas the other party makes a buy-in payment
to acquire these rights and also makes further contributions to fund research and development
conducted by the parent company; the rights to the asset being developed and the costs pertaining
are then shared based on the expected profit potential of the rights. This raises not only issues
with regard to the arm’s length amount of buy-in payments, but also with regard to the question
of whether the mere funding of research and development without the assumption of further
risks and functions would entitle the funder to more than a risk-adjusted rate of anticipated return
on the capital investment. Likewise in “ordinary” licensing situations, the fundamental transfer
pricing question is whether sufficient profits have been allocated to each party to compensate
adequately for the contribution of resources to the supply chain and the assumption of risks in
it. Against this background, the Action Plan puts emphasis on intangibles and states as Action
8:
“Develop rules to prevent BEPS by moving intangibles among group members. This will
involve: (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring
that profits associated with the transfer and use of intangibles are appropriately allocated
in accordance with (rather than divorced from) value creation; (iii) developing transfer
pricing rules or special measures for transfers of hard-to-value intangibles; and (iv) updating
the guidance on cost contribution arrangements.”
58
Progress has already been made during the past few years on the OECD’s work on updating
Chapter VI of the OECD TPG, which contains “special considerations for intangibles”.
59
Indeed,
following; J. Wittendorff, “Valuation of Intangibles under Income-Based Methods” (2010) 17 ITPJ 323, and following,
and 383 and following.
54
There is also the deeper issue that under the current set of OECD guidance the transfer of the business opportunity
(“profit potential”) itself, e.g. that a subsidiary may build a business by developing a market, does not constitute the
transfer of intangible property and therefore does not require compensation under arm’s length rules. See OECD TPG,
above fn.1, para.9.65 and the criticism voiced by M.C. Durst, “A Two-Option Compromise for Intangibles Guidelines”
(2012) 68 TNI 1123, 1124.
55
See Durst, above fn.54, 1123, 1123–1124.
56
OECD TPG, above fn.1, Ch.VIII.
57
US Treas. Reg. § 1.482–7 (IRB 2012-12 of March, 19 2012).
58
Action Plan, above fn.29, 20.
59
See Revised Discussion Draft, above fn.14, and preceding this the OECD’s Discussion Draft, Revision of the Special
Considerations for Intangibles in Chapter VI of the OECD Transfer Pricing Provisions and Related Provisions (2012),
which itself was based on the Scoping Document, Transfer Pricing and Intangibles (January 25, 2011). For analysis
see, e.g. Durst,above fn.54, 1123 and following; J. Wittendorff, “Shadowlands: The OECD on Intangibles” (2012)
67 TNI 935, and following. Indeed, the Revised Discussion Draft notes that the “work on intangibles is listed as one
of the BEPS actions in that Action Plan” and that this work “is closely related to other BEPS actions contained in the
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the Revised Discussion Draft on Transfer Pricing Aspects of Intangibles (Revised Discussion
Draft), which was issued on July 30, 2013, takes major steps in aligning transfer pricing outcomes
with—what the states represented in the OECD view as—“value creation”. First, in line with
the Action Plan’s call for “adopting a broad and clearly delineated definition of intangibles”,
60
the Revised Discussion Draft sets out to define intangibles separately from property law or
accounting rules as
“something which is not a physical asset or a financial asset, which is capable of being
owned or controlled for use in commercial activities, and whose use or transfer would be
compensated had it occurred in a transaction between independent parties in comparable
circumstances”.
61
This includes inter alia patents, know-how and trade secrets, trademarks, trade names and
brands, rights under contracts and government licences, licences and similar rights in intangibles,
goodwill and ongoing concern value, but excludes group synergies and market specific
characteristics (for example, location savings, assembled workforce, market premium).
62
While
the OECD takes the position that market specific characteristics should be taken into account
through the comparability analysis, this issue will likely raise further debate, as, for example,
China is of the view that profits arising from location specific advantages should be allocated
according to one of the transfer pricing methods, including a profit split.
63
Secondly, the Revised Discussion Draft deals with the allocation of an “intangible related
return” and hence addresses the Actions Plan’s call for
“ensuring that profits associated with the transfer and use of intangibles are appropriately
allocated in accordance with (rather than divorced from) value creation.”
The Revised Discussion Draft tries to align pricing with value creation by considering legal
ownership of an intangible as being a mere starting point in the analysis and focusing on the
relevant contributions by each entity of an MNE to the anticipated value of the intangibles through
its functions performed, assets used, and risks assumed.
64
Hence, the legal owner of an intangible
is entitled to all returns attributable to the intangible only if, in substance, it performs and controls
all of the important functions
65
related to the development, enhancement, maintenance and
protection of the intangibles; controls other functions outsourced to independent enterprises or
associated enterprises and compensates those functions on an arm’s length basis; provides all
Action Plan”; moreover, “[s]ome of the text and examples contained in this Revised Discussion Draft raise BEPS
issues that the OECD intends to address through the various actions contained in the Action Plan”.
60
Action Plan, above fn.29, 20.
61
Revised Discussion Draft, above fn.14, para.40. For a recent and comprehensive analysis see J.S. Wilkie, “The
Definition and Ownership of Intangibles: Inside the Box? Outside the Box? What is the Box?” (2012) 4 WTJ 222,
and following.
62
Revised Discussion Draft, above fn.14, paras 52–64.
63
See Chs 10.3.3 and 10.3.5 of “China Country Practice” in the UN’s Practical Manual on Transfer Pricing for
Developing Countries, above fn.7, 374 and following.
64
Revised Discussion Draft, above fn.14, para.73.
65
Specifically design and control of research and marketing programmes, management and control of budgets, control
over strategic decisions regarding intangible development programmes, important decisions regarding defence and
protection of intangibles, and ongoing quality control over functions performed by independent or associated enterprises
that may have a material effect on the value of the intangible; see Revised Discussion Draft, above fn.14, para.79.
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assets necessary to the development, enhancement, maintenance, and protection of the intangibles;
and bears and controls all of the risks and costs related to the development, enhancement,
maintenance and protection of the intangible.
66
Conversely, to the extent that one or more members
of the MNE group other than the legal owner perform functions, use or contribute assets, or
assume risks or costs related to the development, enhancement, maintenance, and protection of
the intangible, returns attributable to the intangible must accrue to such other members through
arm’s length compensation reflecting their anticipated contribution to intangible value.
67
This
means, for example, that the mere funding of research and development without the assumption
of further risks and functions would entitle the funder to no more than a risk-adjusted rate of
anticipated return on the capital investment.
68
Thirdly, “transfers of hard-to-value intangibles” have been the subject of an ongoing debate,
and the Action Plan calls for “developing transfer pricing rules or special measures”
69
for these
transactions. Based on a rejection of hindsight and respecting ex ante valuation, the current
OECD TPG
70
on issues of highly uncertain valuation favour a case-by-case analysis and do not
authorise adjustments to, for example, royalty rates or purchase prices solely because the actual
profits generated by the transferred intangibles differ—even substantially differ—from those
projected ex ante.
71
However, the main question is to determine whether the valuation was indeed
so uncertain at the outset so that the parties at arm’s length would have required a price adjustment
mechanism, while
“the mere existence of uncertainty at the time of the transaction should not require an ex-post
adjustment without a consideration of what third parties would have done or agreed between
them”.
72
The Action Plan now explicitly addresses “transfers of hard-to-value intangibles”,
73
that is,
dispositions at a point in time when the intangible does not yet have an established value (for
example, pre-exploitation), and calls for the development of pertaining “transfer pricing rules
or special measures”. The main concern seems to be situations where there is a significant gap
between the level of expected future profits that was taken into account in the valuation made
at the time of the sale transaction and the actual profits derived by the transferee from the
exploitation of the intangibles thus acquired. This problem, however, is not new and has been
66
Revised Discussion Draft, above fn.14, para.89.
67
Revised Discussion Draft, above fn.14, para.90.
68
Revised Discussion Draft, above fn.14, para.84.
69
Action Plan, above fn.29, 20.
70
OECD TPG, above fn.1, paras 6.28–6.35 and 9.87–9.88. The Revised Discussion Draft, above fn.14, paras 199–206,
has retained the language of the 2010 Guidelines on hard to value intangibles, noting, however, that “[t]he BEPS
Action Plan suggests that one area for future BEPS related work involves the transfer pricing treatment of hard to
value intangibles” and that this “will include a detailed review of the language and approach currently outlined in the
Transfer Pricing Guidelines on this topic”, so that “it is anticipated that sub-stantial work will be focused on this topic
in coming months”.
71
See A. Bullen, Arm’s Length Transaction Structures (IBFD, 2011), 672.
72
OECD TPG, above fn.1, para.9.88; for a critical analysis of the OECD’s approach see J. Wittendorff, “The
Transactional Ghost of Article 9(1) of the OECD Model” (2009) 63 BIT 107, 120-122; Wittendorff, above fn.11,
689–694; Wittendorff, above fn.53, 83, 399.
73
Action Plan, above fn.29, 20.
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addressed by the US beginning in the late 1980s: based on the 1988 US Treasury White Paper,
74
the 1994 US transfer pricing regulations
75
address transfer pricing methods as well as the
“commensurate with income standard” for intangibles, which was introduced in IRC § 482 by
the 1986 Act.
76
The “commensurate with income standard” requires that the consideration for
intangible property transferred in a controlled transaction be commensurate with the income
attributable to the intangible. This means that the subsequent annual performance of those
intangibles is used to determine whether the consideration received for the initial transfer was
at arm’s length, and periodic adjustments are made to reflect such performance unless certain
exceptions are met (the so-called “super royalty” concept).
77
While two OECD Task Force
Reports, issued in 1992
78
and 1993,
79
were critical of the “commensurate with income standard”,
80
it now seems to be a possible route to address these issues comprehensively at the OECD level.
81
Also, since the Action Plan explicitly mentions “special measures” that can go “beyond the arm’s
length principle”,
82
the possible hurdle that the “commensurate with income standard” might be
incompatible with the arm’s length principle could be overcome by an amendment to Article 9
of the OECD MC.
83
74
Department of the Treasury and IRS, A Study of Intercompany Pricing under Section 482 of the Code (Notice
88-123, 1988-2 C.B. 458, 1988).
75
59 Fed. Reg. 34971 (1994), T.D. 8552, 1994-2 C.B. 93.
76
US Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, 2561, and following. A similar rule is found in German
tax law since 2008; see, e.g. W. Kessler and R. Eicke, “Out of Germany: The New Function Shifting Regime” (2007)
48 TNI 53, and following; see also Wittendorff, above fn.11, 684–689. Moreover, in Canada, paras 150–151 of the
Canadian Circular 87-2R of September 27, 1999 note with reference to § 247(2)(b) of the Canadian Income Tax Act
1985 and the OECD TPG, above fn.1, that long-term agreements between non-arm’s length parties for the right to
use intangibles will be reviewed and may be recharacterised under certain conditions.
77
See US Treas. Reg. § 1.482-4(f)(2)(i) and (ii); see also the US Chief Counsel Memorandum of March 27, 2007,
AM-2007-007 (concerning “Taxpayer Use of Section 482 and the Commensurate With Income Standard”); for
analyses of the CWI standard see, e.g. R.G. Clark, “Transfer Pricing, Section 482, and International Tax Conflict:
Getting Harmonized Income Allocation Measures from Multinational Cacophony” (1993) 42 Am. U. L. Rev. 1155,
1177 and following; Wittendorff, above fn.11, 677–684.
78
OECD, Tax Aspects of Transfer Pricing within Multinational Enterprises: The United States Proposed Regulations
(1993).
79
OECD, Intercompany Transfer Pricing Regulations under US Section 482 Temporary and Proposed Regulations
(1993).
80
See also Wittendorff, above fn.11, 45–46 and 104–105.
81
See also Fuest, et al., above fn.39, 14 (an adequate valuation of intangible assets and relating royalty payments “can
be done by implementing an adjustment clause in the national tax code which provides tax authorities with the
opportunity to levy additional exit tax if the earnings potential turns out to be substantially higher than initially
expected”).
82
Action Plan, above fn.29, 20.
83
See for a critical discussion of compatibility with Art.9 OECD MC, above fn.4, e.g. G. Maisto, “General Report”
in IFA (ed.), Transfer pricing in the absence of comparable market prices, CDFI Vol.77a (1992), 19, 55; Clark, above
fn.77, 1155, 1177; Kessler and Eicke, above fn.76, 53, 56; Brauner, above fn.4, 79, 100–101; Wittendorff, above
fn.72, 107, 121; Wittendorff, above fn.11, 167 and 689–694; J. Wittendorff, “The Arm’s-Length Principle and Fair
Value: Identical Twins or Just Close Relatives?” (2011) 62 TNI 223, 227. See, however, for the US position on the
compatibility with the arm’s length standard US Tech. Expl. on Art.9(1) of the 2006 US MC (concerning the
“commensurate with income” standard); see also the US Chief Counsel Memorandum of March 27, 2007,
AM-2007-007; see also Treas. Reg. § 1.482-4(f)(2)(i) (adjustments under commensurate with income rule “shall be
consistent with the arm’s length standard”).
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Fourthly, and finally, the Action Plan calls for “updating the guidance on cost contribution
arrangements”.
84
Currently, Chapter VIII of the OECD TPG provides supplementary guidance
for situations in which the resources and skills of two or more associated enterprises (along,
perhaps, with independent enterprises) are pooled and the consideration received is, in whole or
in part, the reasonable expectation of mutual benefits.
85
A frequently-encountered type of such
“cost contribution arrangement” (CCA) is an arrangement for the joint development of
intangibles,
86
although the guidance in the OECD TPG—unlike the US approach to “cost sharing
agreements”
87
—is not limited to intangibles and covers “any joint funding or sharing of costs
and risks, for developing or acquiring property or for obtaining services”.
88
Within the guidance
on cost contribution arrangements, two issues have been notorious for controversy; these are,
the valuation of “buy-in payments” and the extent of the shared cost pool,
89
with the former being
of particular concern with respect to income shifting. Again, the OECD might draw inspiration
from developments in the US, which has recently established its position on this issue: using the
“income method” for determining the initial “buy-in payments” in—what the US IRS considers
to be—“typical” cost sharing scenarios in which the US participant owns all the existing intangible
property and employs all the technical workforce and decision makers, and the foreign participant
is a simple cash box. Under this method, the appropriate “buy-in payments” are determined by
comparing a controlled participant’s expected results under the cost sharing agreements to its
expected results under its best realistic alternative,
90
the latter being likely to be a situation where
one participant incurs all the intangible property development costs and licenses the intangible
property to the other participant or participants. This approach—technically implemented through
a comparison of discounted expected operating income
91
—sets the “buy-in payment” so that the
“cash box” subsidiary is left indifferent between participating in the cost sharing agreement and
simply licensing the intangible property. Moreover, economically, the US approach assumes
that an integrated enterprise’s financial results will not be affected by its decision as to how to
split intangible property ownership within the MNE.
Risks and capital (Action 9)
Naturally, the assumption of risks or the funding of investments by a group member is trailed
by the right to an increased allocation of income from the group’s business activities, that is, the
84
Action Plan, above fn 29, 20.
85
OECD TPG, above fn.1, para.8.5; for analyses see, e.g. Wittendorff, above fn.11, 537–592.
86
OECD TPG, above fn.1, para.8.6; see also the OECD Document, Transfer Pricing and Intangibles: Scope of the
OECD Project, paras 27–28 (approved by the Committee on Fiscal Affairs on January 25, 2011).
87
US Treas. Reg. § 1.482-7 (IRB 2012-12 of March 19, 2012).
88
OECD TPG, above fn.1, para.8.7.
89
For a discussion of the US approach and relevant case law—especially the decisions in Xilinx Inc. v Commissioner
(US Tax Court of August 30, 2005, 125 TC 4, and eventually US Court of Appeals Ninth Circuit of March 22, 2010,
598 F.3d 1191) and Veritas Software Corp v Commissioner (US Tax Court of December 9, 2009, 133 TC 14)—e.g.
H.A. Keates, R. Muylle and D.R. Wright, “Temporary Cost Sharing Regulations: A Comment” (2009) 16 ITPJ 166;
Y. Brauner, “Cost Sharing and the Acrobatics of Arm’s Length Taxation” (2010) 38 Intertax 554, and following;
Wittendorff, above fn.11, 537–592; for a survey of the US developments on cost sharing see, e.g. I. Benshalom,
“Sourcing the Unsourceable: The Cost Sharing Regulations and the Sourcing of Affiliated Intangible-Related
Transactions” (2007) 26 Va. Tax Rev. 631, and following.
90
US Treas. Reg. § 1.482-7(g)(4)(i)(A).
91
US Treas. Reg. § 1.482-7(g)(4)(i)(A).
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right to future income. Within a MNE, risks are assigned by contracts, and the contractual terms
of a transaction generally define explicitly or implicitly how the responsibilities, risks and benefits
are to be divided between the parties.
92
Indeed, within MNEs risks may be assigned among the
parties by contractual arrangements, which should be respected by tax administrations subject
to what is said in the OECD TPG on the importance of the economic substance of the transaction
93
and the exceptional circumstances under which a transaction need not be recognised by a tax
administration
94
.
95
This also means that for transfer pricing purposes risks need not necessarily
be aligned with capital allocation or people functions.
96
The OECD, however, calls this adherence
to the contractual allocation into question, noting in the BEPS Report that
“the Guidelines are perceived by some as putting too much emphasis on legal structures
(as reflected, for example, in contractual risk allocations) rather than on the underlying
reality of the economically integrated group”.
97
Dealing with this issue, the BEPS Report moreover states:
“At a fundamental level they raise the question of how risk is actually distributed among
the members of a MNE group and whether transfer pricing rules should easily accept
contractual allocations of risk. They also raise issues related to the level of economic
substance required to respect contractual allocations of risk, including questions regarding
the managerial capacity to control risks and the financial capacity to bear risks. Finally, the
question arises as to whether any indemnification payment should be made when risk is
shifted between group members.”
98
The Action Plan seems to go even further, stating with regard to the allocation of risks and capital
in Action 9:
“Develop rules to prevent BEPS by transferring risks among, or allocating excessive capital
to, group members. This will involve adopting transfer pricing rules or special measures to
ensure that inappropriate returns will not accrue to an entity solely because it has
contractually assumed risks or has provided capital. The rules to be developed will also
require alignment of returns with value creation. This work will be co-ordinated with the
work on interest expense deductions and other financial payments.”
99
It should be noted that the issue of risk allocation has been addressed quite recently by the
OECD in the context of business restructurings.
100
Such business restructurings often involve a
92
OECD TPG, above fn.1, para.1.52.
93
OECD TPG, above fn.1, paras 1.47–1.54.
94
OECD TPG, above fn.1, paras 1.65–1.66.
95
See also OECD, 2010 Report on the Attribution of Profits to Permanent Establishments (2010 Report) (July 22,
2010), para.68.
96
See, e.g. OECD TPG, above fn.1 para.9.21.
97
BEPS Report, above fn.28, 42.
98
BEPS Report, above fn.28, 42–43.
99
Action Plan, above fn.29, 20.
100
The topic of business restructurings was also discussed by the US Joint Committee on Taxation in 2010, though
with a different focus; see US Joint Committee on Taxation, Present Law and Background related to Possible Income
Shifting and Transfer Pricing (JCX-37-10 , July 20, 2010), and for a comparative and critical discussion of the OECD
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cross-border centralisation not only of intangible assets but also of risks with a profit potential
attached to them, for example, the conversion of fully-fledged distributors into limited-distributors
or commissionaires or the conversion of fully-fledged manufacturers into contract- or
toll-manufacturers.
101
These situations raise a number of transfer pricing issues,
102
and the discussion
about these has been especially driven by the introduction of statutory rules on the transfer of
functions in Germany with effect from 2008.
103
At the OECD level, the topic was originally dealt
with in the 2008 Discussion Draft on the Transfer Pricing Aspects of Business Restructurings
104
which led to the addition of a new Chapter IX in the OECD TPG in 2010. That new chapter
addresses four sets of transfer pricing issues arising from business restructuring, among them
the circumstances in which tax authorities may challenge the purported contractual allocation
of risks between related parties in the context of Article 9 of the OECD MC
105
and the issue of
compensation payments for the restructuring transaction itself.
106
As for the contractual allocation
of risk, in the absence of comparables the OECD TPG’s focus is on whether the party assuming
the risk has greater control over, and has the financial capacity to bear, that risk.
107
This is not a
particularly high threshold: “control” over risk in this context refers to the capacity to make
decisions to take on the risk and decisions on whether and how to manage the risk, internally or
using an external provider
108
; the financial capacity to bear risk means to have the capacity to
bear the consequences of the risk should it materialise or that a mechanism to cover it is put in
place (for example, insurance).
109
It remains to be seen whether and to what extent this approach will be maintained and refined
in the future or whether the transfer pricing guidance will move in the direction of the “Authorised
OECD Approach” (AOA) for profit allocation involving permanent establishments (PEs) under
Article 7 of the OECD MC, which is viewed by some as an approach that would better align
returns with value creation and hence a possible inspiration for transfer pricing reform. The AOA
puts the emphasis on the “identification of significant people functions relevant to the assumption
and JCT statements see R.T. Ainsworth and A.B. Shact, Transfer Pricing & Business Restructurings—Intangibles,
Synergies and Shelters (Boston University School of Law Working Paper No.11-24, June 3, 2011).
101
OECD TPG, above fn.1, para.9.2.
102
For analyses of the transfer pricing treatment of business restructurings, see the contributions in IFA (ed.),
Cross-border business restructuring, CDFI Vol.96A (2011), and in A. Bakker, Transfer Pricing and Business
Restructurings (2009).
103
For analyses of these rules also in light of Art.9 OECD MC, above fn.4, see, e.g. G. Frotscher and A. Oestreicher,
“The German Approach to Taxing Business Restructurings: An Arm’s Length Ahead?” (2009) 37 Intertax 375, and
following. The German Ministry of Finance has provided extensive guidance; see German Administrative
Principles—Business Restructurings of October 13, 2010, BMF IV B 5 – S 1341/08/10003, BStBl I. 774 (2010)
(English translation published in (2011) 18 ITPJ 65).
104
OECD Discussion Draft 2008: Transfer Pricing Aspects of Business Restructurings, available at: www.oecd.org
/dataoecd/59/40/41346644.pdf [Accessed November 20, 2013].
105
OECD TPG, above fn.1, paras 9.10–9.47.
106
OECD TPG, above fn.1, paras 9.48–9.122.
107
OECD TPG, above fn.1, paras 9.22–9.38; see also, e.g. Wittendorff, above fn.11, 413–414. See, e.g. H.-K. Kroppen
and J.C. Silva, “General Report” in IFA (ed.), Cross-border business restructuring, CDFI Vol.96A (2011), 17, 49–50;
for a detailed discussion on the transactional adjustment aspects see Wittendorff, above fn.11, 168–176; Bullen, above
fn.71, 511 and following.
108
OECD TPG, above fn.1, paras 9.23–9.28.
109
OECD TPG, above fn.1, paras 9.29–9.32.
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of risks, and the attribution of risks to the permanent establishment”,
110
that is, the permanent
establishment is considered as assuming any risks of the overall enterprise
“for which the significant people functions relevant to the assumption of risk are performed
by the personnel of the PE at the PE’s location”.
111
Likewise, under the AOA, the PE is treated as having an appropriate amount of capital in order
to support the functions it performs, the assets it uses and the risks it assumes.
112
Consequently,
the amount and nature of the risks assumed by the PE also affects the amount of capital that
needs to be (and can be) attributed to the PE.
113
In short, under the AOA risk follows functions
and capital follows risk. Needless to say, however, that an approach that would require an arm’s
length determination of capital based on risks and functions and hence a possible re-allocation
of “excess capital” between separate legal entities would embark on a slippery slope with all
kinds of theoretical and practical problems and with the potential pitfall that, quite contrary to
the OECD’s intention, people and functions could eventually follow risks and capital to low-tax
jurisdictions.
Other high-risk transactions (Action 10)
The OECD TPG currently acknowledge that associated enterprises may engage in transactions
that independent enterprises would not undertake,
114
and stress that
“it should not be assumed that the conditions established in the commercial and financial
relations between associated enterprises will invariably deviate from what the open market
would demand”.
115
Moreover, the OECD TPG observe that the fact that independent entities do not enter into
certain transactions does not mean that these transactions are not on arm’s length terms.
116
However, such transactions have raised some concerns from the perspective of tax administrations
and are addressed in Action 10 of the Action Plan as “other high-risk transactions” that warrant
attention:
“Develop rules to prevent BEPS by engaging in transactions which would not, or would
only very rarely, occur between third parties. This will involve adopting transfer pricing
rules or special measures to: (i) clarify the circumstances in which transactions can be
recharacterised; (ii) clarify the application of transfer pricing methods, in particular profit
splits, in the context of global value chains; and (iii) provide protection against common
types of base eroding payments, such as management fees and head office expenses.”
117
110
See Art.7 No.21 of the OECD MC, above fn.4, Comm. 2010.
111
2010 Report, above fn.95, para.68.
112
2010 Report, above fn.95, paras 107 and following.
113
2010 Report, above fn.95, para.71.
114
OECD TPG, above fn.1, para.1.11.
115
OECD TPG, above fn.1, para.1.5.
116
OECD TPG, above fn.1, para.1.11.
117
Action Plan, above fn.29, 20–21.
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The Action Plan calls for “adopting transfer pricing rules or special measures”
118
for a range
of issues involving transactions which would not, or would only very rarely, occur between third
parties. Such transactions clearly raise problems with regard to the administrative burdens for
the taxpayer and tax administrations,
119
as third-party data on such transactions will by definition
hardly be available. Hence, despite the OECD TPG’s preference for an empirical approach, a
hypothetical approach, using the OECD TPG’s analytical tools, principles, and methods, may
be best suited “to determine whether the conditions in the controlled transaction are conditions
that would have been adopted between independent parties under similar circumstances” and
that “it may be appropriate, in relevant circumstances, to use a [profit-split method] with no
comparables data”.
120
Moreover, on the level of the comparability analysis, the OECD stresses
that independent parties who are dealing at arm’s length would each compare the options
realistically available (including “no action” at all) to them, and will only enter into the transaction
“if they see no alternative that is clearly more attractive.”
121
It should be highlighted that Action 10 also calls for a clarification of “the circumstances in
which transactions can be recharacterised”
122
and raises the sensitive issue of non-recognition of
a taxpayer’s chosen structure by tax administrations. A footnote in the Revised Discussion Draft
may moreover imply that some countries seek more leeway to disregard transactions that “would
not normally occur between independent enterprises”, especially with regard to transfers of
intangibles.
123
The direction of this new guidance remains to be seen. It must, however, be noted
that the current OECD TPG already contain a quite reasonable set of tools to balance the interests
between tax administrations and taxpayers. Indeed, the OECD TPG currently suggest that, as a
general rule, a transfer pricing evaluation “should be based on the transaction actually undertaken
by the associated enterprises as it has been structured by them” (the “as structured principle”),
124
which also finds support in the wording of Article 9 of the OECD MC.
125
This limits the ability
118
Action Plan, above fn.29, 20.
119
OECD TPG, above fn.1, para.1.12.
120
Response of the Committee on Fiscal Affairs to the Comments received on the September 2009 Draft Revised
Chapters I-III of the Transfer Pricing Guidelines (2010), para.21.
121
OECD TPG, above fn.1, para.1.34; Revised Discussion Draft, above fn.14, paras 128–132; see also, e.g. Australian
Taxation Ruling 94/14 of May 31, 1994 para.66, and Australian Taxation Ruling 97/20 of November 5, 1997 para.2.4.
122
Action Plan, above fn.29, 20–21.
123
See Revised Discussion Draft, above fn.14, footnote 5 at 63.
124
OECD TPG, above fn.1, para.1.64; see also OECD, Transfer Pricing and Multinational Enterprises (1979), para.23;
cf. e.g. the Canadian Circular 87-2R of September 27, 1999 para.43; Australian Taxation Ruling 97/20 of November
5, 1997 paras 2.71–2.72; for extensive analyses see F.M. Horner, “International Cooperation and Understanding:
What’s New About The OECD’s Transfer Pricing Guidelines” (1996) 50 U. of Miami L. Rev. 577, 581–582;
Wittendorff, above fn.11, 332–334; G. Liaugminaite, “Recognition of the Actual Transactions Undertaken” (2010)
17 ITPJ 107, and following; Bullen, above fn.71. The “as structured principle” is supplemented by the ex-ante approach,
i.e. a rejection of the use of hindsight; see Bullen, above fn.71, 305–322.
125
Although the notion of “conditions” in Art.9(1) is not per se limited to prices and other valuation elements (e.g.
margins), the different references in Art.9(1) to the associated enterprises’ (i.e. “their”) commercial and financial
relations and “those conditions” suggests that only the “made or imposed” price or other types of valuation
conditions—but not the underlying transactions themselves (i.e. the commercial and financial relations)—should be
the object of an adjustment. See F.C. De Hosson, “Codification of the Arm’s Length Principle in the Netherlands
Corporate Income Tax Act” (2002) 30 Intertax 189, 195; Wittendorff, above fn.72, 107, 116; Wittendorff, above
fn.11, 152; for a critical analysis of this textual argument see Bullen, above fn.71, 113–115.
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of domestic tax administrations to disregard a controlled transaction as actually undertaken and
to substitute another (hypothetical) transaction for it.
126
Its rationale is that
“[r]estructuring of legitimate business transactions would be a wholly arbitrary exercise,
the inequity of which could be compounded by double taxation where the other tax
administration does not share the same views as to how the transaction should be
structured”.
127
Leaving aside permissible recharacterisations based on domestic anti-abuse rules,
128
the
OECD—despite rejection from domestic courts
129
and criticism in scholarship
130
—explicitly
addresses transactional or structural adjustments that recognise the existence but not the form
of a transaction: first, the OECD MC Commentary accepts that the recharacterisation of a loan
into equity by means of a thin capitalisation rule falls squarely within the scope of Article 9 of
the OECD MC.
131
Secondly, paragraphs 1.65 and 1.66 of the 2010 OECD TPG deal with structural
adjustments relating to the totality of the terms of a structure or transaction,
132
although such
structural adjustments are restricted to “exceptional circumstances” (that is, “restricted structural
adjustments”).
133
The application of these restricted structural adjustments in the area of business
restructurings is furthermore explored in some detail in Chapter IX of the OECD TPG.
134
The OECD TPG
135
currently provide detailed guidance on the relevance of the actual
transactions undertaken by associated enterprises and the exceptional—that is, “rare” or
“unusual”
136
—circumstances in which it may be legitimate and appropriate for a tax administration
not to recognise, for transfer pricing purposes, a transaction that is presented by a taxpayer, such
126
Bullen, above fn.71, 137.
127
OECD TPG, above fn.1, para.1.64; for a discussion of these rationales see Bullen, above fn.71, 232–273.
128
OECD TPG, above fn.1, para.9.162 refers to the general discussion of the relationship between domestic anti-abuse
rules and treaties in Nos 9.5, 22 and 22.1 OECD MC, above fn.4, Comm. on Art.1; see also 2008 OECD Discussion
Draft on Business Restructuring para.195; cf. Wittendorff, above fn.72, 107, 118; Wittendorff, above fn.11, 152 and
154; Liaugminaite, above fn.123, 107, 110, and following; Bullen, above fn.71, 171–179. However, Art.9 arguably
bars the re-characterisation of transactions based on domestic anti-abuse rules that apply standard conditions without
regard to whether a transaction lacks substance; see Wittendorff, above fn.72, 107, 118–119; Wittendorff, above
fn.11, 161.
129
Bullen, above fn.71, 732 with note 3089.
130
The proposition that Art.9(1) applies to adjustments other than pricing transactions is widely rejected in scholarship;
see, e.g. Wittendorff, above fn.72, 107, 115–119; J. Wittendorff, above fn.11, 152–154 and also, e.g. 332, 396–397.
131
OECD MC, above fn.4, Comm Art.9 No.3(b) and (c).
132
See also OECD TPG, above fn.1, paras 9.161 and following and 2008 OECD Discussion Draft on Business
Restructuring paras 201–205; see also Wittendorff, above fn.72, 107, 122–129; M. Erasmus-Koen, “Art. 9 of the
OECD Model Convention” in A. Bakker (ed.), Transfer Pricing and Business Restructurings (2009), 99, 106–117;
Wittendorff, above fn.11, 172; Liaugminaite, above fn.124, 107, 121–122.
133
OECD TPG, above fn.1, para.1.65.
134
OECD TPG, above fn.1, paras 9.168–9.187.
135
OECD TPG, above fn.1, paras 1.64–1.69 (non-recognition adjustments in exceptional circumstances); see also
paras. 9.34–9.38 (explanation of the difference between making a comparability and a non-recognition adjustment
and discussion of the relationship between the guidance at para.1.49 and paras 1.64–1.69) and paras 9.161 and following
(concerning recognition of the actual transactions undertaken in the context of business reorganisations).
136
OECD TPG, above fn.1, para.9.168.
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as risk assignments
137
or the terms of a CCA.
138
Such non-recognition of the parties’ characterisation
or structuring of a transaction or arrangement may be appropriate in two particular
circumstances
139
: first, if the economic substance of the transaction or arrangement differs from
its form (for example, recharacterisation of debt investments as a subscription of capital in
accordance with its economic substance).
140
Secondly, while the form and substance of the
transaction are the same, if the arrangements made in relation to the transaction, viewed in their
totality, differ from those which would have been adopted by independent enterprises behaving
in a commercially rational manner (the “commercial rationality test”)
141
and the actual structure
impedes, from a practical perspective, the tax administration’s ability to determine an appropriate
transfer price (the “practical impediment test”)
142
; the OECD TPG mention, as an extreme example,
the recharacterisation of a long-term, lump-sum sale contract granting to the buyer unlimited
entitlement to intellectual property rights arising from future research conducted by the seller
as a continuing research agreement between the buyer and seller.
143
In each of these situations, the parties’ characterisation or structuring of the transaction or
arrangement (that is, the totality of its terms) is regarded as the result of a condition that would
not have existed between independent enterprises
144
; Article 9 of the OECD MC would thus
“allow an adjustment of conditions to reflect those which the parties would have attained
had the transaction been structured in accordance with the economic and commercial reality
of parties transacting at arm’s length”.
145
In restructuring, tax administrations have to determine the underlying reality behind a
contractual arrangement
146
and may additionally refer to an uncontrolled alternative characterisation
or structure that comports as closely as possible with the actual facts of the case (for example,
the closing down of a factory, an actual transfer of property)
147
to determine an appropriate
137
OECD TPG, above fn.1, para.1.69; see also OECD TPG, above fn.1, paras 1.49, 9.34–9.38 and 9.165–9.166 (also
discussing the difference between making a comparability adjustment and not recognising the risk allocation in the
controlled transaction); cf. OECD, The Taxation of Global Trading of Financial Instruments (1998), para.123, assuming
that restructuring of risk allocation is indeed only feasible under the “exceptional circumstances” of (then) the 1995
OECD TPG paras 1.36–1.37 (now OECD TPG, above fn.1, paras 1.64–1.65); for an extensive discussion see Bullen,
above fn.71, 198, 199–202, 482–507.
138
OECD TPG, above fn.1, paras 8.29–8.30; Bullen, above fn.71, 183, 199.
139
OECD TPG, above fn.1, para.1.65; for an extensive analysis see Bullen, above fn.71.
140
OECD TPG, above fn.1, paras 1.65 and 9.170; see also Australian Taxation Ruling 97/20 of November 5, 1997
para.2.72; the Canadian Circular 87-2R of September 27, 1999 paras 43–45; US Treas. Reg. § 1.482–1(f)(2)(ii) (stating
that the tax administration “will evaluate the results of a transaction as actually structured by the taxpayer unless its
structure lacks economic substance”); see also Bullen, above fn.71, 433–459.
141
For a discussion of this test see OECD TPG, above fn.1, paras 9.171–9.179; see also 2008 OECD Discussion Draft
on Business Restructuring (2008), paras 207–213; cf. Bullen, above fn.71, 511–574.
142
Bullen, above fn.71, 564–574.
143
OECD TPG, above fn.1, paras 1.65 and 9.170; see also, e.g. the Canadian Circular 87-2R of September 27, 1999
paras 150–151; the Netherlands Decree IFZ2001/295M of March 20, 2001 para.5 (English translation published in
(2001) 8 ITPJ 184, and (2004) 13 Tax Mgmt Trans. Pricing Rep. 494), referring to Dutch Supreme Court of August
17, 1998, no. 32.997, BNB 1998/385.
144
OECD TPG, above fn.1, para.1.66.
145
OECD TPG, above fn.1, para.1.66; for the consequences of a structural adjustment see Bullen, above fn.71, 423–430.
146
OECD TPG, above fn.1, paras 1.67 and 9.185.
147
OECD TPG, above fn.1, para.9.187.
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substitute for the non-recognised transaction.
148
However, non-recognition may only take place
in exceptional cases
149
and is excluded if the controlled structure can indeed be identified between
unrelated enterprises.
150
In that regard, the “commercial rationality test” must be applied with
“great caution” to prevent unnecessary interference with the business decisions of a taxpayer.
151
Particularly, the fact that a related-party arrangement is unlike those found between independent
parties (that is, it is a unique transaction or transaction structure) does not mean, in and of itself,
that the chosen arrangement was not made at arm’s length.
152
Moreover, a structural adjustment
is certainly not warranted merely because an alternative structure triggering a higher tax burden
could have been adopted or because the choice of transaction is tax motivated.
153
Summary
Supported by political leaders, the OECD’s Action Plan identifies a number of “pressure areas”
of BEPS, including actions in the area of transfer pricing with regard to intangibles, the allocation
of risk and capital and other high-risk transactions. All of these actions are intended to assure
that transfer pricing outcomes are in line with value creation or—phrased differently—to “align
taxation and substance”. In doing so, the OECD addresses the key areas of income shifting and
creation of “stateless income”, but also touches upon the ongoing discussion about the amount
of value creation in source countries. However, neither the BEPS Report nor the Action Plan
reveals preconceptions as to the precise nature of the changes that may be required to address
these issues. The course of action is not to facilitate conceptual changes and to renounce the
arm’s length principle, but rather
“to directly address the flaws in the current system, in particular with respect to returns
related to intangible assets, risk and over-capitalisation”.
154
As such measures may be “either within or beyond the arm’s length principle”,
155
changes to
Article 9 of the OECD MC may be a possible route of action, with such changes probably being
accompanied by a multilateral instrument mentioned in Action 15 to facilitate a swift revision
of the more than 3,000 existing bilateral double taxation conventions.
In any event, the OECD’s suggested actions in the transfer pricing area will certainly spur the
ongoing debate on whether some form of formulary apportionment could nevertheless be the
ultimate solution to BEPS through transfer pricing. Moreover, alternative routes to policy solutions
may receive additional attention. For example, it has been suggested that an extension or
strengthening of CFC rules, which is addressed as Action 3 in the OECD’s Action Plan, might
take pressure off transfer pricing as it would make the residence countries of group parents
148
OECD TPG, above fn.1, paras 1.68 and 9.186–9.187.
149
OECD TPG, above fn.1, para.9.168.
150
OECD TPG, above fn.1, para.9.172; see also Bullen, above fn.71, 392 and 493–494.
151
OECD TPG, above fn.1, paras 9.171 and following.
152
2008 OECD Discussion Draft on Business Restructuring para.27; see also Bullen, above fn.71, 403–422, also with
a discussion of a hypothetical arm’s length test to be applied.
153
OECD TPG, above fn.1, para.9.181; Bullen, above fn.71, 391.
154
Action Plan, above fn.29, 20.
155
Action Plan, above fn.29, 20.
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largely indifferent about income shifting in the group; conversely, such rules would also reduce
the incentives of MNEs to shift income out of source countries
156
.
156
See for this debate K.A. Bell and B.W. Reynolds, “New CFC Rules May Provide Better Solution to BEPS Than
Transfer Pricing Overhaul, U.S. Official Suggests” (2013) 21 Tax Mgmt Trans. Pricing Rep. 1127, and following.
Arm’s length transactions; OECD; Transfer pricing; Risk
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