The 2013 Organisation for Economic Co-operation and Development (OECD) Action Plan on Base Erosion and Profit Shifting (BEPS) recognised that existing internationally agreed rules for transfer pricing could be misapplied, resulting in outcomes where the allocation of profits is not aligned with the economic activity that produced those profits.
Of the fifteen Action Points in the BEPS Project, Actions 8 – 10 directly addressed transfer pricing and the arm’s length principle.
The 2015 Final Report on Actions 8 – 10 reaffirmed the importance of the arm’s length principle as the cornerstone of transfer pricing rules and confirmed the concern that existing guidance on its application has proven vulnerable to manipulation.
The arm’s length principle is enshrined in Article 9(1) of the OECD and UN Model Tax Conventions. It has not been changed by the BEPS project and reads as follows:
an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or
the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,
and in either case 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.”
The 2015 BEPS Report sets out to clarify and strengthen the guidance on the application of the arm’s length principle and does this by taking the form of amendments to Chapter 1 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, hereafter referred to as the “Guidelines”.
As this is a clarification and strengthening, there should be no material difference between the outcome of correctly applying of the arm’s length principle under the 2010 Guidelines and its application under the 2015 Report.
This note focuses on the amendments to Chapter 1 of the Guidelines.
A “comparability analysis” is at the heart of the application of the arm’s length principle and requires a comparison of the conditions in a controlled transaction with the conditions that would have been made had the parties been independent and undertaking a comparable transaction under comparable circumstances.
There are two parts to a comparability analysis:
Identification of the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attaching to those relations in order that the controlled transaction is accurately delineated.
Comparison of the accurately delineated transaction with the conditions and economically relevant circumstances of comparable transactions between independent enterprises.
Chapter 1 of the Guidelines provides guidance on identifying the commercial or financial relations between associated enterprises and on accurately delineating the controlled transaction.
The key elements of the 2015 Report amendments to Chapter 1 are as follows:
Accurate delineation of the actual transaction
The mere fact that the transaction may not be seen between independent parties does not mean that it does not have the characteristics of an arm’s length transaction, but this has to be considered in the context of the full ‘economically relevant characteristics’, not on the basis of a superficial comparability analysis.
The economically relevant characteristics of the transaction (or comparability factors) are:
The contractual terms of the transaction,
The functions performed by each of the parties to the transaction, taking into account assets used and risks assumed, including how those functions relate to the wider generation of value to the group, the circumstances surrounding the transaction and industry practices,
The characteristics of the property transferred or services provided,
The economic circumstances of the parties and the market in which they operate, and
The business strategies pursued by the parties.
No significant changes have been made to the guidance regarding the final three on the above list.
Assumption of risk
The ‘accurate delineation of the transaction’ involves a full functional analysis covering functions, assets and risks, but the new guidance focuses in particular on the assumption and allocation of risk.
The executive summary in the Final Report notes that “risks contractually assumed by a party that cannot in fact exercise meaningful control over the risks, or does not have the financial capacity to assume the risks, will be allocated to the party that does exercise such control and does have the financial capacity to assume the risks”.
The control of risk is the capability to make decisions to take on or decline a risk-bearing opportunity and the capability to make decisions as to whether and how to respond to the risk, together with the actual performance of these capabilities.
This can be distinguished from the management of risk, which is the capability and performance of risk mitigation functions.
An important element of ‘control’ is the capability and exercising of these decision-making functions. It does not include high-level policy setting but rather the day to day control of risk.
It is accepted that some risks cannot be directly influenced by the parties to a transaction, e.g. commodity price cycles. Control over such risks is the capability, authority and exercising of the decision to take on the risk and how to respond to the risk, e.g. the timing of investments, marketing strategies, production schedules etc.
Assumption of risk means taking on the upside and downside consequences of the risk with the result that the party assuming a risk will also bear the financial and other consequences if the risk materialises.
There are three levels of ‘assumption’:
Assumption as aligned with actual conduct, which may be different from the contractual arrangements, and
Assumption based on control and financial capacity, which may be different from both of the above
With this in mind, the revised Guidelines set out a 6-step process for pricing the actual transaction:
Identify the economically significant risks with specificity
Determine the contractual assumption of the economically significant risks
Carry out a functional analysis to determine, in particular, which enterprises control or mitigate risk, bear upside or downside consequences and have the financial capacity to assume the risk.
On the basis of the above, determine whether the contractual assumption of risk is consistent with the parties’ conduct and whether the party identified as assuming the risk, controls and has the financial capacity to assume the risk.
Allocate the risk to the appropriate party
Price the actual transaction.
The above approach requires both sides of a transaction to be considered, which may result in tax authorities making greater use of ‘exchange of information’ powers should MNEs be unwilling or unable to provide the required level of detail.
Non-recognition of the actual transaction
The ‘economic substance’ circumstance in the 2010 Guidelines has been omitted from the revised guidelines and the ‘commercial irrationality’ circumstance has been clarified, emphasising the need to consider the perspectives of the parties to the transaction and the options realistically available to them.
Where it is decided that an alternative transaction should replace the actual transaction it should comport as closely as possible with the actual transaction whilst achieving a commercially rational result.
‘Synergies’ are the result of the parties acting in concert to produce the synergies. Therefore they will get the bulk of the benefit and reward. The reward doesn’t go to the party appointed to coordinate the synergies because that party would not have the ability to make the other parties work together.
Increased use of Profit Split?
The 2010 Guidelines stress the need to apply the most appropriate methodology given the particular facts and circumstances. This principle has not been changed.
However, the revised Guidelines seek to clarify the situations in which profit split is likely to be the most appropriate methodology. The increasingly integrated nature of Multi-National Enterprises is likely to result in more situations where profit split will be the most appropriate method.
Further work is to be carried out in the use of profit split across global value chains.
Deliberate concerted action
The concept of ‘deliberate concerted action’ has been introduced to demonstrate contrast with ‘incidental benefits’ from the 2010 Guidelines. There is no provision of a service or requirement for a payment in respect of incidental benefits received by a party attributable solely to its membership of an MNE group.
The 2015 BEPS Final Report on Actions 8 – 10 reaffirmed the importance of the arm’s length principle as the cornerstone of transfer pricing rules.
It has clarified and strengthened the 2010 OECD Guidance on the application of the arm’s length principle by amending Chapter 1.
As this is a clarification and strengthening, there should be no material difference between correctly applying the arm’s length principle under the 2010 Guidelines and its application under the 2015 Report.
But the correct application should now be clearer.