3.3.3.5 Art. 9 OECD MTC: Associated enterprises

Introduction

Art. 9 OECD MTC essentially requires companies to transact with each other as if they were third parties. This is the pre-eminent provision that takes into account that entities may be affiliated with other entities. The systematics of this provision differ enormously from the other provisions in the OECD MTC. The other provisions revolve around the allocation of taxing rights of elements of income that a taxpayer acquires in a cross-border situation. Art. 9 OECD MTC deals with the income of two persons who may be resident in two different states.1 In short, the provision limits national legislation in so far as it provides for adjustments to profits between associated enterprises which go beyond those permitted under the arm’s length principle.2

Two steps must be followed to determine whether a certain transaction must be corrected under art. 9 OECD MTC. Firstly, there must be an associated enterprise. The relationship can take the form of a parent-subsidiary relationship (vertical relationship) or of two sister companies (horizontal relationship). For both forms of kinship, the association can exist on the basis of share ownership as well as through participation in the management or control of an entity. The OECD MTC does not further define the concept of associated enterprise, e.g., by requiring a certain percentage of shares.3 This makes it a substantive approach. Furthermore, art. 9 OECD MTC covers both situations of direct and indirect participation. For example, there can also be affiliation if various companies are interposed.

The second question to assess whether a certain transaction should be corrected under art. 9 OECD MTC is whether the transaction between the two related entities was entered into under conditions that deviate from the conditions that independent parties would have agreed to under the same circumstances. Thus, it must be determined whether the terms of a transaction satisfy the arm’s length criterion. The various methods that can be used to determine whether an arm’s length price applies are detailed in a separate OECD report called Transfer Pricing Guidelines for Multinational Enterprises and Tax authorities (TP Guidelines).4 The arm’s length principle is the standard for determining transfer prices for transactions within multinational groups. The report includes the internationally agreed standards.5

Economic double taxation

Through the application of art. 9, par. 2, OECD MTC, the OECD aims to prevent the economic double taxation6 that may result from a transfer pricing adjustment.7 The provision stipulates that in the event of a transfer pricing adjustment in one country, the other country must provide an appropriate adjustment. Such an adjustment should only be made if the arm’s length principle is complied with. The other state should consider the adjustment justified, both in principle and as regards the amount.8 There is, hence, no obligation to revise the price. If the economic double taxation is in principle not resolved due to discussions about the appropriate adjustment, the MAP of art. 25 OECD MTC can offer a solution.9

The substantive approach underlying art. 9 OECD MTC may cause various problems. Differences in the interpretation and application of the concept of associated enterprise can lead to economic double taxation under the application of the article. This can be the case if, for instance, one country gives a fairly broad interpretation to the concept of associated enterprise, while another country applies a more limited definition. Economic double taxation arises when the country applying the broad interpretation makes a transfer pricing adjustment, while the other country refuses to make a corresponding adjustment.10

In addition, some countries apply a very broad definition of the term associated enterprise, so that even situations involving de facto control fall within the scope of the provision. As a result, a transfer pricing adjustment may be made in one country, while according to the other country, art. 9 OECD MTC does not apply at all. An example is the situation where one entity is responsible for virtually all of the turnover of the other entity. Even though legal affiliation between the two entities does not need to exist in such a situation, a country can claim there is de facto control.11

The two examples outlined above may lead to economic double taxation (in the broad sense).12 The OECD MTC in principle only aims to eliminate juridical double taxation. Still, for the application of art. 9 OECD MTC the importance of the elimination of economic double taxation is recognised.13 Thus, the fact that art. 9, par. 2, OECD MTC aims to prevent economic double taxation seems to contribute to the objective of the article. In this context, however, it should be kept in mind that the provision does not include an obligation to follow a price adjustment.14 An adjustment of the transfer price by one country will usually not be accepted by the other country without further explanation.15

Group companies

Art. 9 OECD MTC acknowledges the existence of group companies. The provision as such does not include a group approach.16 The TP Guidelines indicate that a group relationship may influence transactions between group companies. The arm’s length principle aims to eliminate such influences.17 As the principle aims to remove tax considerations from economic decisions, it aims to contribute to the neutrality of the system.18 Group situations can lead to synergies. Such synergies may, inter alia, arise from economies of scale, integrated computer and communication systems, integrated management and increased borrowing capacity. Being part of a group can also have downsides. A large multinational corporation is, for instance, more likely to have a bureaucratic and time-consuming process for making strategic changes than a stand-alone entity.19

Under the arm’s length principle, associated entities must act as if they were independent parties.20 However, some intra-group transactions cannot be effected between independent parties. Furthermore, the question is how to deal with the ‘additional profit’ that a group realizes versus an independent entity operating in the market.21 At the same time, the proper information for applying the arm’s length principle is not available in all cases.22 This may lead to discussions and may provide opportunities for tax avoidance. Criticism of the application of the arm’s length principle is increasing, and the question arises whether this system is still appropriate in today’s society.23 The OECD also recognises that the separate entity approach underlying the arm’s length criterion is under pressure, because it does not always take into account economies of scale and the interrelationships between different activities due to the increasing integration of businesses.24

The difficulties outlined above relating to the application of the arm’s length principle raise the question whether the application of this principle as a profit allocation method still meets the objectives of the OECD MTC.25 Additionally, a general problem with the application of art. 9 OECD MTC is essentially that profits are determined on a country-by-country basis, without any mutual coordination. The difficulties involved in application of the arm’s length principle may produce situations of double taxation or tax avoidance. The operation of art. 9 OECD MTC hence does not appear to be in line with the objectives of the OECD MTC.26