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Treaty Application for Companies in a Group (FM nr. 178) 2022/5.3.2.2
5.3.2.2 The arm’s length principle
L.C. van Hulten, datum 06-07-2022
- Datum
06-07-2022
- Auteur
L.C. van Hulten
- JCDI
JCDI:ADS659465:1
- Vakgebied(en)
Omzetbelasting / Plaats van levering en dienst
Voetnoten
Voetnoten
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.3.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.6.
The CUPM can generally be seen as a reliable method for establishing the arm’s length price for the transfer of commodities between associated enterprises. If there are differences in pricing between a controlled and uncontrolled transaction this may mean that the conditions are not arm’s length and the controlled price may need to be amended. To determine whether an uncontrolled transaction is comparable to a controlled transaction for purposes of the CUPM one of the following two conditions should be met: (1) there is no material impact on the price in the open market as a result of differences between the transactions being compared or between the enterprises undertaking those transactions, or (2) it is possible to determine reasonably accurate adjustments to eliminate the material effect of such differences (examples of elements that could influence the transfer price are differences in terms of transportation and insurance or differences in volume). If there are comparable uncontrolled transactions, the CUPM is according to the OECD the most direct and reliable, and thus the preferable, method (OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 2.14, 2.15, 2.18, 2.25 and 2.26).
The RPM starts with the resale price used in a transaction with an independent enterprise of a product that has been purchased from an associated enterprise. The price is subsequently reduced by an appropriate gross margin, taking into account selling and other operating expenses. The gross margin should lead to an appropriate profit considering the functions performed (taking into account assets used and risk assumed). The method is according to the OECD most useful if it is applied to marketing operations. Determining an appropriate price under the RPM is easiest where the reseller does not add substantially to the value of the product. The margin of the reseller in a controlled transaction can be calculated by taking the resale price margin that the same reseller earns on items bought and sold in comparable uncontrolled transactions as a starting point (internal comparable). Additionally, the resale price margin of an independent enterprise in a comparable uncontrolled transaction may be used (external comparable). To determine whether situations are comparable, the principles as described for the CUPM are equally applicable. However, normally less adjustments are needed for the RPM, as minor product differences are less likely to materially influence profit margins rather than prices (OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 2.27, 2.28, 2.29 and 2.35).
The CPM takes the costs incurred by the supplier of property or services as the starting point. Subsequently, an appropriate mark-up is added to these costs. The mark-up should lead to an appropriate profit considering the functions performed and the market conditions. The CPM seems most useful for the sale of semi-finished goods between associated enterprises, for joint facility agreements or long-term buy-and-supply arrangements between associated parties, or where the controlled transaction is the provision of services. Ideally the cost plus mark-up should be determined via a comparable uncontrolled transaction (internal comparable). The cost plus mark-up that would have been earned by an independent enterprise in a comparable transaction may serve as a guide (external comparable). Whether situations are comparable, should be determined based on the principles described for the RPM. The mark up for an uncontrolled transaction might need adjustments. For application of the CPM it is important to apply a comparable mark up to a comparable cost basis. Differences in level and types of expenses (operating expenses and non-operating expenses) should be considered in light of the functions performed and risks assumed (OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 2.45, 2.46, 2.47, 2.50 and 2.51).
The TNMM examines the net profits relative to an appropriate base (e.g., costs, sales or assets) realized in a controlled transaction or aggregated controlled transactions. The method shows similarities to the CPM and the RPM. The net profit indicator should be established by reference to the net profit indicators the same taxpayer earns in comparable uncontrolled transactions (internal comparable). If this is not an option, the net margin that would have been earned by an independent enterprise in a comparable transaction might be used (external comparable). If each party involved in a transaction makes unique and valuable contributions the TNMM is not the most appropriate method. However, the method may be applied if only one party is responsible for such unique contributions. A strength of the method is the fact that net profit indicators (e.g., return on assets and operating income to sales) are less influenced by transactional differences than prices as such (OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 2.64, 2.65 and 2.68).
The TPSM takes the total profits from a controlled transaction as the starting point and divides them amongst the associated enterprises on an arm’s length basis. The method may be the most appropriate method for situations in which both parties involved make unique and valuable contributions. Additionally, this method may be appropriate if the parties in a transaction form a highly integrated business, for which a one-sided method would not be appropriate. The combined profits can be split via the contribution analysis, the residual analysis or via another approach. The contribution analysis divides the combined profits between the associated enterprises via a reasonable approximation of the division of profits independent enterprises would have expected to realize from a comparable transaction. The residual analysis requires a two-step approach. First the participants in the transaction are allocated an arm’s length remuneration (via one of the traditional methods or the TNNM) for its non-unique contribution to the controlled transaction. Subsequently, the residual profit or loss is allocated among the parties taking into account the facts and circumstances of the situation (OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 2.119, 2.120, 2.149, 2.150 and 2.152).
In this context, incidental does not refer to the size of the benefit, nor does it suggest that the benefit should be small (OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.178 and par. 7.13).
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.178.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.179.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.181.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.182.
I.J.J. Burgers & J. van der Meer-Kooistra, ‘Chapter 13: Control frameworks for cross-border internal transactions: the tax perspective versus the management control perspective’, in R. Russo (ed.), Tax assurance, Deventer: Wolters Kluwer 2015, par. 4.
International Fiscal Association, Cahiers de Droit Fiscal International – Group approach and separate entity approach in domestic and international tax law (vol. 106a), Rotterdam: International Fiscal Association (IFA) 2022, p. 28.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.8.
R.J. Vann, ‘Chapter 5: Reflections on Business Profits and the Arm’s-Length Principle’, p. 140, in B.J. Arnold, J. Sasseville & E.M. Zolt (eds.), The Taxation of Business Profits Under Tax Treaties, Toronto: Canadian Tax Foundation 2003.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.9.
E.g., W. Hellerstein, ‘The Case for Formulary Apportionment’, International Transfer Pricing Journal 2005, vol. 12, no. 3 and K. Sadiq, ‘Unitary taxation – The Case for Global Formulary Apportionment’, Bulletin for International Taxation 2001, vol. 55, no. 7. The OECD also recognizes 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 companies (OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.10).
M.F. de Wilde, ‘Some Thoughts on a Fair Allocation of Corporate Tax in a Globalizing Economy’, Intertax 2010, vol. 38, no. 5, par. 2.
E. Reimer et al., Klaus Vogel on Double Taxation Conventions, Alphen aan den Rijn: Kluwer Law International 2022, p. 705.
K. Sadiq, ‘Unitary taxation – The Case for Global Formulary Apportionment’, Bulletin for International Taxation 2001, vol. 55, no. 7, par. 2.
R.J. Vann, ‘Chapter 5: Reflections on Business Profits and the Arm’s-Length Principle’, p. 141, in B.J. Arnold, J. Sasseville & E.M. Zolt (eds.), The Taxation of Business Profits Under Tax Treaties, Toronto: Canadian Tax Foundation 2003.
J. Wittendorff, Transfer Pricing and the Arm's Length Principle in International Tax Law, Deventer: Wolters Kluwer 2010, par. 21.2.2.2.1. Additionally, a company may, e.g., choose to establish a foreign subsidiary to exploit an intangible asset abroad, even though it may be more efficient to license it to an unrelated party.
J. Wittendorff, Transfer Pricing and the Arm's Length Principle in International Tax Law, Deventer: Wolters Kluwer 2010, par. 1.2. A common interpretation would prevent this.
J. Wittendorff, Transfer Pricing and the Arm's Length Principle in International Tax Law, Deventer: Wolters Kluwer 2010, par. 3.3.3.3.
T.S. Newlon, ‘Chapter 9: Transfer pricing and income shifting in integrating economies’, par. 1.2, in S. Cnossen (ed.), Taxing Capital Income in the European Union: Issues and Options for Reform, Oxford: Oxford University Press 2000.
E.g., via intra-group loans.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.13.
J. Owens, ‘Should the Arm’s Length Principle Retire?’, International Transfer Pricing Journal 2005, vol. 12, no. 3, par. 6.
E.g., finding comparable prices for intangible property will be almost impossible (M. Kobetsky, ‘The Case for Unitary Taxation of International Enterprises’, Bulletin for International Taxation 2008, vol. 62, no. 5, par. 2).
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.11.
E. Reimer et al., Klaus Vogel on Double Taxation Conventions, Alphen aan den Rijn: Kluwer Law International 2022, p. 705.
W. Hellerstein, ‘The Case for Formulary Apportionment’, International Transfer Pricing Journal 2005, vol. 12, no. 3, par. 6.2.1.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2022, par. 1.12.
E. Reimer et al., Klaus Vogel on Double Taxation Conventions, Alphen aan den Rijn: Kluwer Law International 2022, p. 706.
K. Sadiq, ‘Unitary taxation – The Case for Global Formulary Apportionment’, Bulletin for International Taxation 2001, vol. 55, no. 7, par. 3.
E. Reimer et al., Klaus Vogel on Double Taxation Conventions, Alphen aan den Rijn: Kluwer Law International 2022, p. 705.
E.g., E. Reimer et al., Klaus Vogel on Double Taxation Conventions, Alphen aan den Rijn: Kluwer Law International 2022, p. 705 and W. Hellerstein, ‘The Case for Formulary Apportionment’, International Transfer Pricing Journal 2005, vol. 12, no. 3, par. 8.
Highlights arm’s length principle
The arm’s length principle is the international standard that OECD member countries agreed upon for tax purposes. If transfer pricing is not in line with market forces and the arm’s length principle, this can distort the tax liability of the associated enterprises and the tax revenues for the countries involved. Therefore, profits of associated enterprises may be corrected for tax purposes to eliminate those distortions and to make sure the arm’s length principle is satisfied.1 The aim of the arm’s length principle is to adjust profits by refence to the conditions that would have been obtained by independent enterprises in comparable transactions and comparable circumstances, the comparable uncontrolled transactions.2 By so doing, the members of a multinational group are treated as separate entities, rather than as group members.
Various transfer pricing methods are available for determining the conditions that would have been agreed between independent enterprises. The methods are subdivided into the traditional transaction methods and the transactional profit methods. There are three traditional transaction methods. First, the Comparable Uncontrolled Price Method (CUPM)3 determines a transfer price by comparing a related-party transaction with a comparable transaction between unrelated parties. Under this method prices for property or services are compared directly. The Resale Price Method (RPM)4 and the Cost Plus Method (CPM)5 are indirect methods: the arm’s length price is determined by taking into account a resale price margin or a cost-plus markup. If there is no comparable for the product market available, the traditional methods cannot be applied properly. In that situation, the transactional profit methods might be feasible. In contrast to the traditional transaction methods, these methods are based on net profit margins. The Transactional Net Margin Method (TNMM)6 takes into account net profit margins in relation to a certain base. The Transactional Profit Split Method (TPSM)7 takes the total profits from a controlled transaction as a starting point and splits them among the associated enterprises on an arm’s length basis.
If certain incidental8 benefits arise from simply being part of a group, without there being any deliberate coordinated action or transaction, no intra-group service is deemed to be provided to obtain those benefits. In such a case, no remuneration should be taken into account.9 There may also be a deliberate concerted action or transaction that gives rise to material, clearly identifiable structural advantages or disadvantages compared with entities that are not part of the group but are engaged in comparable business activities.10 In such a case, consideration must be given to the extent of the advantage or disadvantage and how a division can be made between the entities concerned.11 Generally, synergy benefits should be shared among group entities in proportion to the contribution of the respective entity to the benefit.12 However, those synergy effects are determined from the perspective of the individual parts of the group instead of from the perspective of the group as a whole.13 All in all, transfer pricing still leans mainly towards the separate entity approach.14
The OECD member countries and other countries have adopted the arm’s length principle amongst others because it provides broad parity of tax treatment for members of multinational groups versus independent enterprises. According to the OECD associated and independent enterprises are treated in a similar manner for tax purposes, which avoids the creation of tax advantages or disadvantages that could have an impact on the competitive position of the enterprises.15 Basically, in the view of the OECD, affiliated and non-affiliated firms are treated equally. Using market prices for transactions between separate but related companies leads to the same tax outcomes as for transactions between unrelated companies.16 As tax considerations should not alter economic decisions, the arm’s length principle allegedly promotes international trade and investment. Additionally, the arm’s length principle is successful in practice.17 The principle has international support and is used in most countries worldwide.
Problems with the arm’s length principle
The arm’s length principle is heavily criticized in tax literature.18 The arm’s length principle is a fiction. It assumes that intra-group transfer prices are set as if transactions had been concluded between unrelated parties, while the activities are carried on in-house.19 As described in chapter 2, the activities are conducted in-house because of economic considerations, which is not taken into account under the arm’s length principle. The basic fundamental criticism on the arm’s length standard is that is does not reflect economic reality.20 As a result of economies of integration, the arm’s length price is inappropriate.21 As the transactions at market prices do not include all the value added by a firm, the ‘additional value’ can be allocated to a chosen company, or it can be spread over the firm.22 Therefore, the arm’s length principle does not safeguard tax neutrality with respect to the choice of organizational form (i.e., legal form neutrality).23
Disputes about the application of the arm’s length principle can lead to economic double taxation.24 This is for example the case if a transfer pricing adjustment is made, in which the profits of one enterprise are included in the profits of the other enterprise. The OECD MTC aims to solve this issue by providing protection for taxpayers against primary adjustments and by providing taxpayers with corresponding adjustments that accord with the arm’s length principle. However, economic double taxation may still arise if Contracting States apply different rules from a domestic perspective or disagree on the applicable fact pattern25 or valuation. Due to the risk of double taxation, the arm’s length standard influences decisions as to where to produce and sell.26 A risk of double taxation can influence corporate decisions: it would be preferable to invest domestically rather than internationally.
Additionally, the separate entity approach that is underlying the arm’s length principle leads to opportunities for base erosion and profit shifting in an intra-group context.27 Under the separate entity approach, taxable presence is created via the concept of residency and permanent establishments, which provides multinational entities with the opportunity to structure their legal arrangements in an artificial manner to avoid tax. The BEPS project solely led to fixing some flaws of the current system, but not to a fully new approach.
Additionally, it will often be difficult to apply the arm’s length principle. The information to apply the arm's length principle is not always available.28 It can be difficult to find comparable transactions between independent parties.29 There are for example intra-group transactions that do not exist between independent parties.30 The reason for this is not necessarily tax avoidance, but the fact that the group faces different commercial circumstances.31 For some industries there can even be no independent parties performing similar transactions at all. As the arm’s length principle depends on markets, problems arise when there is no market for unrelated transactions.32 To be able to apply the arm’s length principle requires a lot of official and secondary sources to properly interpret the arm’s length principle, which makes the method very complex.33 This can provoke discussion and provide opportunities for tax avoidance. Apart from that, the arm’s length principle entails an administrative burden for both the taxpayer and tax administrations.34
The lack of clear rules can result in uncertainty, which is only partially solved by the possibility for a taxpayer to request for an Advance Pricing Agreement (APA) from the local tax authorities or for a bilateral or even multilateral APA under the MAP of a tax treaty.35 The aim of such an APA is basically to establish a transfer pricing methodology to be used for future transactions.36
All in all, the arm’s length principle has positive but certainly also negative aspects. The separate entity approach that is at the heart of the arm’s length principle seems to be increasingly problematic due to the globalized world. The concepts that were developed in a low-tech, bricks-and-mortar economy might be theoretically sound, but are generally perceived as not functional in the globalized economy.37 The basic criticism of the arm’s length principle from a fundamental perspective is the fact that entities within a group of companies are perceived as separate legal entities which does not reflect economic reality.38 Moreover, it can lead to double taxation as well as provide opportunities for tax avoidance. Hence, the application of the arm’s length principle does not contribute to the neutrality of the tax system. In tax literature formulary apportionment is often proposed as a potential alternative method. In the following section formulary apportionment will be discussed on a high-level basis.