What is transfer pricing?
It embodies the fundamental pricing calculation when services, tangible property and intangible property are bought and sold across international borders between related parties. The arm’s-length principle is formally defined in Article 9 of the OECD’s model tax convention as following:
“Where conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”
As the IRS’s section 482 puts it more plainly, transfer pricing regulations are necessary to prevent related taxpayers in differing taxing jurisdictions from easily and artificially shifting items of income and expense between these different tax jurisdictions (with differing rates of tax). The intent of the law is to ensure that an arm’s-length price is charged in all related-party multi-jurisdictional transactions.
Under the umbrella of “best method”, the most important factors to be taken into account for each inter-company transaction is “the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparable, and the quality of the data and assumptions used in the analysis”.
For tax authorities, the pricing calculation is vital because it fixes the profits of the business that are subject to tax in particular jurisdictions. Increasingly these authorities are prepared to re-calculate inter-company pricing if they consider the agreed price would be different from that agreed between two unrelated – or arm’s-length – parties. In short, they are on the look-out for transactions they regard as manipulated in order to obtain a tax advantage. When that happens tax charges can be expected to increase, especially when extra interest and even penalties are applied.
There are important inconsistencies and disagreements between different tax authorities over the interpretation of the arms-length standard. But the OECD’s methodologies have become the gold standard in transfer pricing calculations. Thus the use of arm’s-length provides a measure of certainty and, if properly observed, is likely to keep any adjustments to a minimum. Essentially, it is based on a transfer price being reached that would have been arrived at by unrelated parties for the same transaction.
Regulations Versus Principle
The dominance of the internationally accepted arm’s-length standard in all issues of transfer pricing has tended to blunt the effect of the multiplicity of regulatory changes introduced over the last twenty years. This is because the principle of arm’s-length requires that the prices employed in related-party transactions must make commercial sense. Thus, unlike most other areas of tax law, the measure is not based on explicit rules but a principle grounded firmly in issues of economic substance. As a result it hardly matters what new set of regulations is issued by a taxing authority or even by the OECD because the analytical process required to justify the prices reached in a particular related-party transaction remains the same. Namely, the arm’s-length standard. Therefore arm’s-length, essentially an economic issue, remains pre-eminent as the cornerstone of transfer pricing methodologies.
For example, many countries specify a hierarchy of transfer pricing methodologies to be used (e.g., direct price comparisons are first in the hierarchy and gross margin comparisons are second and third). Before the mid-1990s, the US too specified such a hierarchy in its 1969 regulations. Then the US abolished the hierarchy. Did the change in the US alter real practice? No. “Under the old 1969 rules I never saw a situation in which both parties agreed that method B was better than method A, but nonetheless method A was used because it was higher up in the regulatory hierarchy” Greg Ballentine, of The Ballentine Barbera Group, a CRA International company, explains. “If one party preferred method A and the other method B, they had to debate the issue on the basis of the accuracy of the method employed.”
The introduction in the US in the early 1990s of the best method-rule, replacing the hierarchy, has hardly changed things at all. “We are still seeing the same debate we had until the changes were made,” Mr Ballentine adds. “But it now occurs in the context of the best-method rule.”
It would be overstating the case to claim that all the modifications of the past 20 years have had no effect. Some have manifestly served to clarify issues around the edges. However there is a strong argument that in summary those changes have tended to confuse the issue. In particular they give the impression that, as long as one reads the local taxing authority’s regulations and follow them step by step, the prices reached must therefore be acceptable regardless of the degree to which those prices may clash with commercial reality. In fact this is deceiving because the nub of the arm’s-length standard is that it essentially requires commercial commonsense, whatever the local rules may say.
An international issue
The most important issues in transfer pricing over the last twenty years relate to the heightened scrutiny by taxing authorities around the world. Transfer pricing long seemed like a purely US issue but it is now very much a multinational one. The authorities in many countries are rapidly training up auditors to cast a cold eye on transfer prices, even in those jurisdictions with relatively low tax rates and/or tax holidays where they would not be expected to take much interest. It increasingly seems there is no escape as taxing authorities catch up with the international dynamics of the commercial world.
The implications for taxpayers are obvious – they must take every care to fulfil compliance obligations under the relevant jurisdiction’s tax laws. According to UK-based accountancy firms, documentation should cover sales prices, purchase prices, management fees, interest paid on any loans, and even the price paid for general use of facilities such as office space and computer systems. After amending its own regulations in 2004 [see below], Her Majesty’s Revenue and Customs allowed a documentation holiday of two years but the requirements are now fully in force. In the absence of complete records, jurisdictions may feel free to construct the facts as they see fit, which is not generally in taxpayers’ interests.
However in the existing system the taxpayer risks falling between two stools. On the one hand there is a need for local documentation or some well-supported form of defence under the particular jurisdiction’s specific rules. On the other there is the need for a worldwide consistency. The latter becomes especially important as local taxing authorities increasingly seek pricing information in jurisdictions other than their own. For instance, BBG/CRAI regularly finds that, despite a client’s documentation declaring sufficiently high local, taxable profits to satisfy the relevant authority, the IRS also wants to sight the documentation under its own set of transfer pricing rules.
State of flux
The entire transfer pricing issue is highly dynamic, with constant modifications occurring in many arenas. For example, in late 2007 US Treasury urgently recommended measures to combat what it termed transfer pricing abuses. Arguing that the original regulations had remained in force essentially unchanged for almost 40 years, it added: “These regulations have proven to be inadequate to handle the increased volume and complexity of multinational operations and transactions that have occurred since that time.”
US Treasury singled out in particular the absence of updated regulations for the transfer of services which “has led to discontinuities between transfer pricing for services and transfer pricing for tangible and intangible property”. Just one area ripe for attention, US Treasury said, was global dealing rooms.
And in 2004 the UK government amended its rules so they encompassed for the first time transactions between connected UK companies. This was because Her Majesty’s Revenue and Customs feared it could be successfully challenged in the European Court of Justice on the grounds it discriminated against companies from other EU countries because the rules did not apply to transactions between UK companies. Other countries have also been busily updating their regulations in their determination to maximise tax revenue.
Even the OECD, which has made the international pace on transfer pricing, is in the middle of a review of its approach. As of this moment it is weighing up responses to its proposals to modify its application of transactional profit methods, specifically on the issues of profit split and net margin. It is considered highly likely that modifications will result. Indeed the OECD sees the harmonisation of transfer pricing rules as a significant element in fostering world trade.
Economists in demand
As further proof of the economic nature of the arm’s-length principle, BBG has seen a marked swing recently towards the use of economic expertise as clients and governments alike struggle to settle transfer pricing issues. Until relatively recently, BBG/CRA’s economic expertise was in demand by US-based clients because that is what US Treasury-devised laws require whereas, outside the US, clients believed they needed accountants. “I am convinced that a major reason for this is that the IRS relied on economists while foreign tax authorities did not”, adds Mr Ballentine.
However like much else in transfer pricing, this is changing. The Canadian Revenue Authority, which has for years employed economists on transfer pricing audits, has called them in as expert witnesses in transfer pricing trials there. The Australian Tax Authority, another entity that employs economists, has enquired whether BBG’s economists would serve as expert witnesses on several cases heading towards trial. And in New Zealand, clients have tapped BBG/CRA’s expertise and that of other US economists in cases taken by the New Zealand authorities. Similarly in Britain where HMRC has sounded out BBG/CRA’s US-based economists about supplying expert testimony in possible trials there.
Taken together, these examples support the case that arm’s-length is less a tax regulation-based issue than one grounded on economic substance.
For further information tel 202.662-7831; email gballentine@crai.com; www.crai.com
