The valuation of related party transactions, i.e. of transfers of goods, services, intangibles or funding among members of the same multinational enterprise, is not necessarily an exciting topic for managers: in today’s world, multinational groups want to act globally, and transfering resources from one member to another member of the family is not where the focus of the attention should be ‘business-wise.’
But another reality of today’s world is that governments are not global and that direct and indirect taxes are assessed and levied domestically. Beyond differences in tax rates there are a number of reasons including cash repatriation strategies that may explain why it is not neutral for an MNE group to earn its profits in one country or another.
In addition, a number of industries such as the pharmaceutical industry or the financial industry have to deal with strict domestic regulatory requirements and are affected by the valuation of their intra-group transactions. Furthermore, corporate law, rules that protect creditors and labour law may all require, to a lesser or greater extent, that each member of an MNE group be treated as a separate legal entity and, as a consequence, that the terms and pricing of transactions with other parts of the same group be determined independently of the special relationship that exists within the group.
In fact, it is ironic that, with the development of global business models, cross-border transactions between related parties play an increasingly significant role in world trade and economy. While businesses develop operating models that tend to abolish the borders, governments see increasingly important revenue stakes in cross-border flows and tend to reinforce their control over transfer pricing compliance through transfer pricing regulations and audits, with a view to protecting their tax base while avoiding double taxation that would hamper international trade.
A phenomenon
One difficulty arises from the existence of various sets of rules and enforcement agencies looking at the valuation of related party transactions. One obvious example of this phenomenon is found in direct taxes (transfer pricing rules) and customs duties. For direct tax purposes, a higher transfer price may reduce the taxable income in the country of importation and increase the taxable income in the country of export. But for customs purposes, the lower the transfer price, the lower the customs value and the applicable customs duties. Hence, inevitably, there can be some conflicts of interest or contradictions between customs and revenue authorities within the same country, or between the direct tax department and the department in charge of customs duties within the multi-national group. (This, again, irrespective of the possible effects on other aspects such as the price of regulated drugs or the amount to be contributed to employee profit sharing by a particular entity of the group.)
Let’s have a look first at the applicable principles. Direct tax authorities tend to follow the arm’s-length principle and OECD transfer pricing guidelines for multinational enterprises and tax administrations which set the international standard for transfer pricing. Customs authorities apply the relevant provisions of the WTO Customs Valuation Agreement (the WTO Agreement). As a basic principle, both sets of rules require that an ‘arm’s-length’ or ‘fair’ value be set for cross-border transactions between related parties and associated enterprises. That is, the transfer price must not be influenced by the relationship between the parties or it must be set in the same way as if the parties were not related. However, there are significant differences in the application of this broad principle in relation to such major factors as policy objectives, operational functioning, timing of valuation, valuation methods, documentation requirements and dispute resolution mechanisms. Furthermore, it is often the case that two administrative bodies assess or review the valuation of cross-border transactions.
Unnecessarily complicated
The business community has explained on several occasions that the existence of two sets of rules, and, in many countries, of two different administrative bodies to deal with direct taxes and customs duties, can make cross-border trade overly complicated and costly, contrary to the objectives of the international organisations and national governments concerned. Does this situation make sense from theoretical and practical perspectives? Is there a need for greater convergence of the two sets of rules? If so, what should be the conceptual framework at national and international levels?
It is obvious that, while common purposes and similar concepts exist in international transfer pricing and customs valuation rules, there are also significant divergences. Tax and customs authorities are not obliged to accept a value that is calculated in accordance with each other’s legislative requirements. MNEs need to comply with obligations under both tax and customs legislation and regulations as well as other regulatory requirements where applicable.
In May 2006 and 2007, the WCO and the OECD held two joint international conferences on transfer pricing and customs valuation of related party transactions. The common objective of the two organisations was to provide a platform for public and private sector representatives to collectively explore, and attempt to advance, the issues identified and to encourage global coordinated efforts among business and governments, tax experts and customs specialists.
At those conferences, two schools of thought emerged on the desirability and feasibility of having converging standards for transfer pricing and customs valuation systems. The first was made up of those who viewed convergence of rules as highly desirable and largely feasible, pointing out that a credibility question does arise if two arms of the same Ministry can come up with different answers to virtually the same question (what is the arm’s-length / fair value for a transaction?), and that the current situation results in greater compliance costs for businesses which must follow and document two sets of rules and greater enforcement costs for governments which must develop and maintain two types of expertise (i.e. have customs specialists and transfer pricing experts examine the same transactions at different points in time and in light of two different standards). Those who are more cautious about convergence point out that the two systems are grounded in different theoretical principles (direct versus indirect tax systems) and fear that convergence could be more costly than the status quo. Concerns were also raised about the capacity of administrations in developing economies to deal with transfer pricing issues and with possible changes in customs valuation rules or enforcement. In effect, developing economies are often more dependent on customs than on direct tax revenues, and many of them are still experiencing difficulties in the application of the basic provisions of the WTO Agreement.
Looking to the next step
As a follow-up to the joint WCO-OECD conferences, four areas for possible further work were identified:
1) Examination of the interaction between the valuation methods used by customs and revenue authorities.
2) Provision of greater certainty for business, e.g. though the development of joint rulings and of more effective dispute resolution mechanisms covering both direct taxes and customs duties.
3) Achieving greater consistency in the transfer pricing and customs documentation compliance and better flows of information between tax authorities and customs authorities.
4) Improving the administrative capacity of tax and customs departments and reviewing the experience of countries that have merged or demerged their customs, VAT and direct tax departments.
Much remains to be done between direct and indirect taxes; other areas – corporate law and regulatory rules for example – also require that multi-national enterprises continue to pay attention to the valuation of related party transactions. Today’s world is not global in all respects.
The author would like to thank Mr Liu Ping from the World Customs Organisation for his contribution to this article.
This article expresses the views of its author and not necessarily the views of the OECD or of its members.
