to the current application of the Arm’s Length
Standard?
Thesis
University of Amsterdam
Submitted by
Ivonete Bezerra de Souza
Student number: 11365110
Supervised by
LIST OF ABBREVIATIONS... 6
CHAPTER I... 9
TRANSFER PRICING AND THE ARM’S LENGTH STANDARD...9
1. Introductory Remarks... 9
2. Historical Background... 9
3. The Arm’s Length as legal fiction and the methods as legal presumptions...13
4. Criticism to the Arm’s Length Standard...18
5. The alternative approaches for profit allocation...21
6. Is the Arm’s Length Principle being relegated to the back seat?...25
CHAPTER II... 29
REGIME OF FIXED MARGINS... 29
1. The Arm’s Length as a juridical a standard...29
2. Difficulties with the comparability analysis...34
3. The importance of Safe harbors for the feasibility of the transfer pricing rules...40
4. Regime of fixed margins: the experiences of Australia and Brazil...43
CHAPTER III... 49
PROPOSAL FOR REBUTTABLE FIXED MARGINS...49
1. Proposal for rebuttable fixed margins in a Post-BEPS scenario...49
2. Difficulties in the application of a regime of fixed margins...52
3. Strengths of the proposed rebuttable fixed margins...53
CONCLUSION... 56
Is the Regime of Fixed Margins an alternative to current application of the Arm’s Lenght Standard? In the globalized economy the number of intra-group transactions has grown exponentially and has gained representativeness in the volume of trade and investment worldwide.1 Therefore, the transfer pricing rules have become a hot topic in the international
agenda for aiming to impose a fair taxation of the MNE groups. Political disputes involving United States and European Union in cases such as Starbucks2 and Apple3 shows the
importance of these rules for tax collection in the states where the MNE carries on business activities.
Although setting prices for intra-group transactions can be considered as part of the MNE daily operations and not necessarily linked to tax avoidance or tax evasion4, the
transactions inside the MNE group are not driven by the opposite forces of competition, but by common interests of the group. Thus, as tax represents a cost that affects the overall group profitability, mis-pricing intra-firm transactions is a potentially strategy to reduce the global taxable income of the MNE group.5
The transfer princing legislation was originally designed with the intent to prevent such distortion and to achieve economic neutrality and equality among taxpayers, as an anti-avoidance measure.6 The debate about those rules, however, has evolved to how split the
MNE profits among countries where the group operates. In the battlefield, the shifting of taxing rights through formulas seems more proeminent than trying to solve the feasibility issues of the ALS7, which is the current international consensus towards the application of
transfer pricing rules, present in more than 3000+ DTAs.8
Nevertheless, it seems premature to abandon the ALS towards an arbitrary formulary apportionment without a consensus among countries with different economic realities and
1 OECD (2015), Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 - 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. Summary.
2 Commission Decision on SA. No 38374 2014/C (Starbucks) Oct.21. 2015. 3 Commission Decision on SA. No 38373 2014/C (Apple) Aug.30. 2016.
4 UN (2017) Practical Manual on Transfer Pricing for developing countries. B.1.1.7.
5 M. F. Wilde, Sharing the Pie: Taxing Multinationals in a Global Market (January 15, 2015).p. 335.
6L.E. Schoueri, Arm’s Length: Beyond the Guidelines of the OECD: “It is better to be roughly right than precisely wrong.”(John Maynard Keynes), 69 Bull. Intl. Tax. 12 (2015), Journals IBFD.
7 Ibid.
8 OECD (2015), Developing a Multilateral Instrument to Modify Bilateral Tax Treaties, Action 15 -2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. Introduction p. 15 par.8.
the taxpayer ability-to-pay and creating tools that bring more certainty and feasibility to the application of the ALS.
The current problem faced by the countries in the application of the transfer pricing methods is that the comparability analysis, the cornestone of OECD Guidelines, involves availability of information about comparables that may not be exist due to the highly integrated economy and the lack of stand alone companies in the sector.
Furthermore, it requires a level of expertise and data that are non-existent in many tax administrations of developing countries. The poor resources may constrain the possibility of the tax administrations to examine the circumnstances of each case and diminish the bargain power of these countries in negotiating MAPs. The subjectivity of comparability analysis leads in many circumnstances to double taxation and disputes for the lack of legal certainty that provides.
Moreover, the inefficiency in the application of the methods due the complexity of the system may encourage the MNEs to shift profits from less developed countries to low tax jurisdictions and may also create a barrier to attract Foreign Direct Investment.
In this context, the aim of this paper is to analyse if a regime of fixed margins could be an alternative to the current application of the ALS, as suggested by the OECD Guidelines, and the compatibility of such system with the DTAs. The proposal could eliminate the subjectivity of the comparability analysis in the application of transfer pricing rules and reduce compliance and litigation costs. The use of fixed margins is suggested not only for the cases where there are no comparables available or as safe harbor but also as a mechanism of simplification and empowerment for the tax administrations to tackle base erosion and profit shifting.
The idea is that prefixed profit margins could be set in the law with an acceptable margin of error that in practice would work as a profit range for each method. The margins would reflect the level of profitability that could be found in enterprises enganging in independent transactions in the same economic sector of the associated companies.
into consideration specificities of each sector the less risk of distortion.
The compatibility of such system with the the authoritative statement of the ALS found in paragraph 1 of Article 9 of the Bilateral Double Taxation Agreements (DTAs), that follows both OECD Model Tax Convention and UN Model Tax convention is also discussed.
The strenghts and difficulties of the methodology such as gains of administrability and possible loss of revenue are explained. Besides, some guidance is proposed of how the tax administration could prepare a study to subsidize the process of setting margins close to the arm’s lenght reality.
The changes in the OECD’s view towards the adoption of a more pragmatic approach in transfer pricing in a Post-BEPS scenario and the apetite of countries for more certainty in the taxable income to be reported10 to the tax authorities are pointed out as indicators of the
favourable momentum for the adoption of such system.
Lastly, the importance of international coordination through MAP and BAPA to avoid double taxation and double non-taxation in the regime of fixed margins is addressed.
10 S. S., Jonhston,United States Floats Transfer Pricing Safe harbors Rules, Tax Notes And Tax Notes International And Worldwide Tax Daily: News Stories 6 June 2017.
ALP/ALS Arm’s Length Principle/ Arm’s Length Standard
BEPS Base Erosion and Profit Shifting
CCCTB Consolidated Corporate Tax Base
CPM Cost Plus Method
COGS Cost of Goods Sold
CUP Comparable uncontrolled price
FA Formulary Apportionment
G20 Group of twenty
Gross profits The gross profits from a business transaction are the amount computed by deducting from the gross receipts of the transaction the allocable purchases or production costs of sales, with due adjustment for increases or decreases in inventory or stock-in-trade, but without taking account of other expenses.
MAP Mutual agreement procedure
MNE Multinational enterprise
OECD Organization for Economic Co-operation and Development
OECD MC OECD Model Tax Convention on Income and Capital
RPM Resale Price Method
SME Small and Medium Enterprise
TNMM Transactional net margin method
1. Introductory Remarks
This chapter gives a brief out line of way countries have adopted transfer pricing rules and addresses the historical development of the ALS. In addition, it discusses the main challenges of applying such standard, especially the difficulties of finding independent comparables. It also discusses the role of the OECD guidelines and the updates from BEPS project and if there is a trend to departure from the Arm’s Length Standard towards formulary apportionment.
2. Historical Background
In the globalized economy the number of intra-group transactions has grown exponentially and has gained representativeness in the volume of trade and investment transactions worldwide. Therefore, the taxation of Multinational groups enterprises (MNEs) has become an important concern for the states seeking to collect part of revenue created by the groups that is connected with their jurisdiction. 11
The transfer pricing rules were initially designed as an anti-avoidance measure to prevent base erosion and profit shifting from high tax jurisdictions to low tax jurisdictions. 12
A transfer price is a price charged for services, rights, rental fees, goods, assets, intangibles in cross-border transactions carried out between related entities (parents, subsidiaries, head offices, permanent establishments).13 The existence of price charged
between related entities requires that they should be considered as different entities even if they have not been formally incorporated and therefore has no legal personality (separate entity approach).14 Besides, managers of the MNEs can view the transfer pricing as a tool to
measure the efficiency of each subsidiary within the group.15
Anti-avoidance measures are linked with the ability-to-pay and equal treatment or neutrality principles of taxation. The share that each taxpayer should contribute to a given 11 OECD (2015), BEPS Actions 8-10, 2015 Final Reports, Summary.
12 Schoueri, supra n. 6.
13 J. Owens, ‘Should the arm's length principle retire?’, ‘International transfer pricing journal’ Amsterdam. -Vol. 12 (2005), no. 3.
14 S. Mayer, Formulary Apportionment for the Internal Market, IBFD Doctoral Series n.17,p. 9. 15 Owens, supra n. 13.
determine the ability-to-pay of each taxpayer including corporations, therefore to define the proportion of income that should be allocated to the community as tax revenue.17
On the other hand, the neutrality principle implies that the taxpayer could structure its business or make economic decisions without regarding the tax consequences. The state should design such a neutral framework for taxation that there would be no efficiency advantages or disadvantages for choosing any specific structure or business transaction.18
Although it is recognized that setting price for the intra-group transactions is part of the MNE daily operations and not necessarily linked to tax avoidance and tax evasion,19 the
transactions inside the MNE group are not driven by the common forces of the free market such as offer and demand, but by common interest of the group.
Therefore, the process of pricing the transaction between the associated enterprises may lead to some level of distortion and manipulation (mis-pricing or unjustified pricing) that will impact the tax returns of these companies forcing the tax administration to adjust the prices and launch the tax due.
Wilde (2015) defends that the tax arbitrage and the tax avoidance through transfer pricing is an intrinsic result of the separate entity approach. As the corporate tax is considered a cost from an economic perspective, the MNE has an incentive to build up a global strategy to minimize the tax burden by shifting the taxable income among jurisdictions through intra-group transactions of goods and services.20
The potential use of transfer pricing as a tool to reduce the global taxable income of the MNE group, made the rules evolve from a purely anti-avoidance mechanism to prevent the company from manipulating the costs of the transactions in order to allocate less profit in the jurisdictions to a complex and intricate system to split the fair share of the profit entitled to each jurisdiction where the group carries on business activities.
16 H. Ávila, Teoria da Igualdade Tributária 2nd ed., p. 42 (Malheiros 2009). 17 Schoueri, supra n. 6.
18 G. Cottani, Transfer Pricing, Topical Analyses IBFD (accessed 8 May 2017). 19 UN (2017), supra n.4.
The ALS is the current international consensus toward the application of transfer pricing rules. It implies that the transactions between related parties should be valued and therefore taxed as if they were carried out between unrelated parties.
The theory is that uncontrolled transactions are subject to the full play of market forces and so these are, by definition, arm’s length. They provide a benchmark against which the controlled transaction can be evaluated.21
Historically, the consensus on the application of the ALS was reached as part of the work development of the League of Nations activities. The rise of taxes by the states to finance the war made double taxation increase and became an important topic in the agenda. However, no formal international standard of profit allocation was defined until 1933, when Mitchel B. Carrol report was published.22
The author identified three possible methods of allocation of income: separate accounting; “empirical methods” that would require an estimative of the distribution income of the taxpayer by comparing with similar companies; and “fractional” (formulary apportionment). The choice of the separate method approach is due exclusively to the prevalence of the separate entity approach in most national provision not in any economic evidence that this method would the most rational or the most practical fashion to allocate profit in the MNE group. The report criticizes the formulary apportionment on the basis that differences in national accounting rules and difficulties in agreeing on a common basis would make it less desirable. 23
These considerations led to the adoption of the separate entity approach and therefore the arm’s length principle in the draft of The League of Nations Model Convention and subsequently in OECD Model Convention.24
Nowadays, the ALS is found in paragraph 1 of Article 9 of the Bilateral Double Taxation Agreements (DTAs), that follows both OECD Model Tax Convention and UN Model Tax convention. These models form the basis of bilateral tax treaty framework involving OECD member countries and developing countries. The paragraph 1 of Article 9 has the same wording in both Model Conventions:
21 Owens, supra n. 133.
22 M. Koomen, Transfer Pricing in a BEPS Era: Rethinking the Arm’s Length Principle – Part I, 22 Intl. Transfer Pricing J. 3 (2015), Journals IBFD.
23 Mayer, supra n.14. 24 Ibid.
“Where conditions are made or imposed between the two [associated] 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.”25
The ALS is the core of the international transfer pricing regime as is embodied in more than 3,000 tax treaties.26 The main reason why the ALS is adopted is because it leads to
equality and neutrality. The companies involved in the same kind of activities with the same level of assets and risks should be equally remunerated, regardless if the transaction takes place between associated companies.
Therefore, the state should not receive less tax revenue because of the integration decisions made by the market players. Intrinsically, the ALS requires that the taxpayers and tax administrations have sufficient information available to compare the transactions of the associated enterprises with independent parties and to challenge the prices and make the correspondent adjustments.
The equality principle in taxation is a way of distributing the burden among taxpayers to achieve social fairness. It requires that the taxpayers under the same circumstances should give the same amount of contribution to the community.
However, equality does not mean that the taxpayers are in identical positions, but in comparable ones. Thus, an element to compare factual circumstances is required. The criteria should be transparent enough to offer a justification in case of different tax treatment. The ability-to-pay is considered the parameter of the equality principle because it defines how much each taxpayer should contribute according to their particular economic capacity.27
Although intra-group transactions are not subject to market competition, which gives the MNE a high power to influence the prices, the ALS intends to establish comparison between the ability-to-pay of associated enterprises and independent enterprises in similar transactions. Therefore, the ALS main objective is to promote equality among the taxpayers giving them a level playing field in terms of taxation. The associated enterprises that purely
25 OECD (2014), Model Tax Convention on Income and on Capital: Condensed Version 2014, OECD Publishing. Article 9. par. 1.
26 E. Baistrocchi, The Transfer Pricing Problem: A Global Proposal for Simplification, 59 The Tax Law. 4, p. 943 (2006).
carry out their business through cross-border trade within members of the same group will not go untaxed or over-taxed when compared with independent enterprises.
3. The Arm’s Length as legal fiction and the methods as legal presumptions
The ALS brings a legal fiction in order to submit different situations to the same level of taxation.28 Instead of just calculating the profit based on the prices registered by the
associated enterprises in their accounting books and hence the tax base and the amount of corporate income tax due, the prices should be recalculated, according to a most appropriate method, and adjusted for tax purposes as if they would have been charged by companies under free market conditions.
The methodology of calculation, so called Transfer Pricing Methods (CUP, RPM, CPM, TNMM and PSM), creates a legal presumption that if enterprises were operating under market competition that would be the most accurate way to define the prices of the transactions.29
Nevertheless, the legal presumption created by the methods of calculation of the ALS is rebuttable (juris tantum). According to Paulo de Barros Carvalho: “The presumption of
legitimacy is present in all acts practiced by the Tax Administration, including the tax launch. Given to the taxable person, it will be considered as authentic and valid, until proven otherwise, by operating for his benefit the presumption juris tantum.”30 (Translated by the
author). The taxpayer has the burden of proof to contradict the assessment made by the tax administration by presenting an interpretation of facts and circumstances with sufficient evidence to justify the suitability of the original prices.
Therefore, it is important to highlight that the conduct of the independent enterprises remains unknown for both taxpayers and tax administration and the ALS methodology attempts to give the best version of the reality and not the reality itself. This lack of precision makes transfer pricing to be referred31 as “an art not a science”.
The methods to calculate the Arm’s Length price are found in the OECD Transfer Pricing Guidelines (OECD Guidelines) that represent a cornerstone for the application of the Transfer Pricing rules. It represents a consensus reached by the member states, mostly well-developed countries, about how to calculate the arm’s length price and it is benchmark for
28 Schoueri, supra n.6. 29 Ibid.
30 P.D.B. Carvalho, Curso de Direito Tributário 18th ed., p 425 (Saraiva 2007). 31 Cottani, supra n.18.
many domestic legislations. It offers guidance on the application of each method, the comparability analysis, administrative approaches, documentation and cost contribution arrangements.
International consistency in the application of the ALS may be beneficial for the taxpayers as they would be subjected to same kind of analysis in order to find the market price for the transactions and therefore the same type of adjustments which would in theory prevent double taxation in case that a correspondent adjustment was granted, according to paragraph 2 article 9 of both OECD and UN Model Conventions.
“2.Where a Contracting State includes in the profits of an enterprise of that State -and taxes accordingly - profits on which an enterprise of the other Contracting State has been charged to tax in that other State and the profits so included are profits which would have accrued to the enterprise of the first-mentioned State if the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other State shall make an appropriate adjustment to the amount of the tax charged therein on those profits. In determining such adjustment, due regard shall be had to the other provisions of this Convention and the competent authorities of the Contracting States shall if necessary consult each other.”32
However, transfer pricing rules are a matter of domestic legislation, each country has sovereignty to adopt their own legislation, according to its own economic reality and feasibility for the tax administration. These rules are domestically limited by the constitutional order of each country and internationally by its own double tax treaty network.
The comparability analysis is the core of the application of the ALS. The comparable profit, price or margin of similar transactions to be used as a parameter to test the arm’s length price of an intra-group transaction may be found internally, when the company also carries on transactions with companies outside the MNE group, or externally when the transactions taken into consideration are not the transactions carried on by the own company, but for other companies in the same market or industry.33
The Comparable Uncontrolled Price Method (CUP) is considered as the most reliable method to apply the arm’s length and should be the preferable one whenever possible. The OECD Guidelines suggest: “Where it is possible to locate comparable uncontrolled
32 OECD (2014), Art. 9, par 2.
transactions, the CUP method is the most direct and reliable way to apply the arm's length principle. Consequently, in such cases the CUP method is preferable over all other methods.”34
It consists in comparing directly the price charged for a property or a service in an intra-group transaction with the price charged in an independent transaction.
The furnishing of services between related parties for transfer pricing, however, only occurs when the service would be traded in theory between independent enterprises. The incidental gains related to being member of a MNE group such as synergy and gains of scale due to integration cannot justify a payment under the ALS and thus are not subjected to transfer pricing rules.35
However, making sufficient adjustments to make the transactions comparable may lead to some degree of complexity. In addition, the main focus of comparability analysis is the business functions performed rather than the product.36 Thus, it may be difficult to make
reasonable adjustments that can eliminate the effect on the prices.37
The Resale Price Method (RPM) compares the gross profit margin between the transactions. It begins by comparing the price the reseller charges an independent buyer to find out the price that the product was initially sold from an associated enterprise.
The resale price is deducted by a gross profit margin (sales less cost of sales) that represents the amount that the associated enterprise would seek by selling the product to cover his/her operating expenses and make a reasonable profit.38 After reducing the gross profit
margin, adjustments for other costs related to the purchase such as customs duties39 can be
made to reach the arm’s length price or the price that would be charged by associated enterprises if they were under free market conditions.
The gross profit margin is determined according to the functions performed, assets and risks assumed. Comparing to the CUP method less adjustments are necessary when the independent transaction deals with a different product as these minor differences have less impact in the gross profit margin as they have in the price.40
34 OECD (2010) Transfer Pricing Guidelines for Multinationals Enterprises and Tax Administrations, par. 2.14. 35 Cottani, supra n.18. 36 Ibid. p.64 37 Ibid. 38 Ibid. p.65 39 Ibid. 40 Ibid. p.66.
The RPM may be more difficult to apply when the reseller adds significant value to the product.41 When it is no longer the same product that is being traded with the independent
enterprise more adjustments are required. In comparing the functions performed by independent and associated enterprises is important to take into consideration which party supports the inventory risk of the transaction and if there is any intangible property associated with the product or if the reseller acts as an exclusive agent.
The Cost Plus Method (CPM) tests the mark-up (gross profit margin) of the transaction added to the cost when a product or a service is supplied to an associated purchaser. It begins with the cost incurred in the acquisition of property or service from an independent party and adds a comparable mark-up to find out the arm’s length price that it should be charged from the associated enterprise.
This method is reliable for calculating the appropriate price for low-value adding services, semi-finished goods or long-term buy-and-supply arrangements. The mark-up should be compared with the profit made by the supplier in sales for unrelated parties or tested with the mark-up that the independents enterprises normally earn in the same transaction.42
The functional analysis is also the center for the application of the method because the mark-up comparison relies on the functions performed by each party rather than the product itself.
The level and types of expenses are an important factor to be compared along with the functions performed, assets and risks. They may be linked to extra functions performed that need to be remunerated or to efficiencies and inefficiencies in administrative costs, which may not require adjustments in the gross profit margin.43
Accounting consistency is extremely important in applying RPM and CPM because if the definition of COGS is different from an accounting perspective it will also lead in difference in the gross profit margin making the comparison not reliable.44 In order to obtain
reliability in the comparison some adjustment may be necessary to ensure that the same types of costs are taken into consideration. The OECD guidelines admit that in some extent
41 Ibid. p.68. 42 Ibid. p.72. 43 Ibid. p.73. 44 Ibid p.73.
operating costs may also need to be taken into consideration, however it may cause the reverse effect making the uncontrolled transaction less reliable.
The methods described above (CUP, RPM and CPM) are considered Traditional Transactional Methods and they are the most direct way of establishing comparison between controlled and uncontrolled transactions. The arm’s length price or margin can be reached by transaction comparison and function comparison. Sometimes the difference in products may require rejection of the application of the CUP, nonetheless if the products are still similar and with the accounting measures (COGS), it can be useful for RPM and CPM by comparing the gross profit margin of sales that the company should earn.45
The Transactional Profit Methods differ from the traditional ones to the extent that there is no need to compare with one specific uncontrolled transaction under the same circumstances of an identical or similar product. The comparability analysis will be based on the net profit margin of aggregated operations of independent enterprises in the same particular line of business or will be compared with the return expected from an arrangement between non-associated enterprises for the contribution with valuable intangibles or highly integrated operations.46
The profit split method is designed to allocate the profits as it would be expected in an arm’s length situation among the MNE group according to its unique contributions for highly integrated activities and those associated with development, enhancement, maintenance, protection and exploitation (DEMPE functions) of intangible assets.47 The method is
considered a two-sided method as both parties of the transactions are tested through functional analysis. However, most of the time there are no comparables for this method.
The Transaction Net Margin Method examines the Net Profit Margin relative to an appropriate base that could be assets, costs (berry ratio) and sales. The difference between gross profit margin and the Net profit margin is that the operating expenses are taken into consideration to find the arm’s length profit.
The OECD Guidelines initially introduced the Transactional Profit Methods as a last resource for the application of the ALS, mostly because the operating expenses that are taken into consideration may lead to some distortion in the level of comparability. For instance poor
45 UN (2017), supra n. 4.par. B.1.5.4 – B.1.5.6. 46 Ibid. par B.1.5.7- B.1.5.9.
management and cost control may reduce the net profit without having any relation with price or gross profit margin of the transaction.48
However, in the revised 2010 version of the OECD Guidelines the use of TNMM and profit split was broadened mostly due to difficulties in the practical application of the traditional methods. Normally, information about gross profit margins is not publicly available whilst financial statements provide useful information about the operating costs and therefore the functions performed by the enterprise.49
The use of Transactional Profit Methods leads to the inevitable question of how much presumption can ALS tolerate to still be sufficiently close to the reality to bring fairness and equality among taxpayers.
4. Criticism to the Arm’s Length Standard
Many of the criticism to the ALS rely on the fact that is very distant from the economic reality. If independent comparables could be easily found in the same line of business, it would mean that the MNE group was not operating efficiently, otherwise it would have made sufficient return from its structure to take out its competitors from the market.50
The Theory of the firm by Coase51 and the organizational framework by Williamson52
suggest that the MNEs are created to gain competitiveness due to its organizational structure. The aggregate return imputable to the MNE is higher then the sum of each separate component mostly because of the gain of efficiency in the allocation of resources. The MNE group is able to generate economy of scale by saving fixed costs, having bigger power of bargain, fully exploiting its assets.53
According to Avi-Yonah, even if functional analysis is carried out separately for each activity of the MNE and then the profit tested at arm’s length basis still some residual profit would remain either not taxed or arbitrarily allocated among jurisdictions.54
48 Cottani, supra n.18. 49 Cottani, supra n.18.
50 R.S. Avi-Yonah, The Rise and Fall of Arm’s Length: A Study in the Evolution of U.S. International Taxation, Pub. & Leg. Theory Working Paper Series, Working Paper No. 92, p. 3 (Sept. 2007). The article is based on an article by the same name in 15 Va. Tax Rev. 1, p. 89 (1995). The references in this article refer to the most recent publication.
51 M. Koomen, Transfer Pricing in a BEPS era: Rethinking the Arm’s Length Principle – Part II. 22. Intl. Transfer Pricing J. 4 (2015) Journals IBFD, which refers to R.H. Coase, The Nature of the Firm, 4 Econometrica (1937), at 386-405.
52 Ibid, which also refers to O.E. Williamson, The Theory of the Firm as Governance Structure: From Choice to Contract, 16 J. Economic Perspectives (2002).
53 Ibid. 54 Ibid.
The lack of recognition of the gains of scale due to the integration and other synergy rents55 and consequently the non-attribution of profits to parts of the MNE group is the
inherent flaw of the ALS.
Vann (2010) argues that the returns of the MNE arises not exclusively from the transactions it carries on but also from intrinsic competitive advantages that is not present in independent market transactions. The new trends in business management such as outsourcing and focus on the core activities of the enterprise and intangibles are important feature for the MNE organizational value.56
M.A. Kane (2014) explains that inherent flaw seems mostly present when it comes to the category of common control value. The fact that the control value exists in an integrated MNE group is the reason why these companies are under the same control in the first place. If the synergy value is uniquely tied up to the fact of common control across affiliated entities then one may infer that there is no comparables available in the market as a conceptual matter.57
The OECD guidelines suggest that “an associated enterprise should not be considered
to receive an intra-group service when it obtains incidental benefits attributable solely to its being part of a larger concern, and not to any specific activity being performed.”58
The BEPS final report (Base Erosion and Profit Shifting) on transfer pricing actions 8, 9, 10 clarifies that the wording “incidental benefits” does not mean that these benefits are relatively insignificant. 59
However, those benefits, unless deliberately concreted services or transactions normally found in the market and able to be valued at arm’s length, do not give rise to any sort of compensation. The membership benefit that is created only by the synergy of the MNE group, such as management and telecommunication integration and economy of scale, cannot be reallocated therefore taxed in any jurisdiction.
Those synergy benefits will only play a role for the comparability analysis60 and hence 55 Schoueri, supra n.6.
56 R. J. Vann, Reflections on Business Profits and the Arm’s Length Principle, p. 149-150. (November 17, 2010). The Taxation of Business Profits Under Tax Treaties, p. 133-169, B.J. Arnold, J. Sasseville, E.M. Zolt, eds., Canadian Tax Foundation, 2003; Sydney Law School Research Paper No. 10/127.
57 M.A. Kane, Transfer Pricing, Integration and Synergy Intangibles: A Consensus Approach to the Arm’s Length Standard, 6 World Tax J. (2014), Journals IBFD.
58 OECD (2010) Transfer Pricing Guidelines, supra n.25, par. 7.13. 59 OECD (2015), BEPS Actions 8-10, 2015 Final Reports, par. 1.158. 60 Cottani, supra n.18.
in the adjustments that will have to be made in order to apply the most appropriate method. This lack of allocation rights among jurisdictions of the residual profits of the MNE group conflicts directly with the ability-to-pay principle and in broader sense the principle of equality. The MNE group is being discriminated as a taxpayer because its full tax liability is not taken into consideration by the states where it operates.
The inherent flaw of the ALS is addressed by the OECD Guidelines on a very simplistic approach: while there is no consensus among countries on how to split the residual profit made by the MNE due to the benefits of scale created by its own structure the ALS remains the best option to allocate taxing rights.
Besides, the OECD Guidelines create a self-referencing contradiction when it comes to the application of the ALS. On one hand, the OECD Guidelines state that the ALS is based on the comparability of transactions between related and unrelated parties. On the other hand, it recognizes that associated enterprises may engage in deals that cannot be found in the free market due to commercial circumstances61 of the independent parties, but those transactions
can still be ALS.
The link between the ALS and economic reality becomes blurred, as the price will be set based on the hypothetical conditions that generally would have been agreed on between unrelated parties.62
The economic and commercial conditions of the transactions would need to be hypothesized at ALS.63 Therefore, if certain transactions would not actually take place
between independent parties, then how much fiction the ALS can tolerate?
5. The alternative approaches for profit allocation
Since the adoption of ALS as the international standard as discussed in the section 1.1, the alternative approaches to ALS have always been a hot topic in the international taxation agenda. Especially when the states need more revenue to face their budgetary expenses, the limitation of the ALS to tax the residual profit generated by the MNE group raise questions about equality among taxpayers and the necessity of the states to adopt unilateral measures in their domestic legislation to circumvent such limitation and tax 100% of the profit.
61 OECD (2010) Transfer Pricing Guidelines, supra n.25, par. 7.13. 62 Koomen, supra n.51.
However, these unilateral provisions, which aim to tax the residual profit without coordination among the states, would increase double taxation without having framework in the treaty to grant tax relief. The bilateral treaties that follows OECD and UN Models only foresee correspondent adjustments by the tax authority of the other contracting state, paragraph 2 of Article 9, if the primary adjustment made by the tax authority of the contracting state is in accordance with the ALS.
Therefore, international consensus and uniform application in the criteria of allocating profit among the jurisdictions where the MNE group operates is key for the international tax system to be able to achieve neutrality for free trade and investment.
The most common alternative advocated is formulary apportionment method. This formula would take the global profit of the group and split amongst affiliates companies in different countries based on a preset factors such as payroll, assets, and sales. This methodology would require no comparison with independent transactions, but strong cohesion among countries in deciding which factors are relevant.
Avi-Yonah (2007) suggests that if the application of the ALS does not necessarily require comparability it may also encompasses the allocation of profits based on the formulary apportionment if the formula can translate similar market results.64
Schoueri (2015) disagrees that the formulary apportionment would lead to arm’s length results because of the arbitrary manner that the allocation formula is derived. The fact that the formulae may produce similar results to the commercial and economic rationality of transactions between unrelated parties taking into account the global profit is incidental.65
Avi-Yonah (2007) explains that the adoption of the profit split method represents the
fall of the traditional comparable-based ALP and its replacement by an expanded definition of "arm's length," which includes any method reaching arm's length results.66
According to the author, after the acceptance of the application of arm’s length with no requirement of comparability analysis, the ALS would also encompass a formulary method. The new approach would be an extended version of the ALS taking into consideration simplicity and practicality issues.
64 Avi-Yonah, supra n.50. 65 Schoueri, supra n.6. 66 Avi-Yonah, supra n.50.
Avi-Yonah addresses the main issues to the adoption of formulary apportionment and defends that the US should take a unilateral measure to its adoption to be then followed by OECD countries that in practice face the same problems in applying the ALS.
One of the major criticisms to the use of the formula is the extra compliance burden to the multinationals to provide consistency in accounting records to reach the global gross income. However, the author highlights that nowadays the MNE groups already have sophisticated accounting system that can provide the worldwide income in a uniform basis.
Besides, after the adoption of action 13 on Transfer Pricing documentation of the BEPS project as a minimum standard, the MNE group is already required to report to tax administration the global consolidate profit (master file) and the operations and functions performed on country-by-country basis.67
The assumption that consensus on the formula cannot be reached is also demystified by Avi-Yonah, because of the similarities among OECD economies. Furthermore, the idea that a consensus on a new standard could not be reached among countries seems too conservative.
The BEPS Project and other initiatives such as Global Forum on Transparency and Exchange of information for Tax Purposes has shown that the International tax arena has changed deeply and the G-20 participation in the process of tackling tax avoidance and profit shifting leads the environment towards more cooperation.
Nevertheless, the process of defining a new international standard cannot depart from developed economies without taking into consideration the different economic reality of non-OECD countries and developing economies. The new international tax order should reach fairness in the allocation of taxing rights; otherwise it will only increase the arbitrariness and inequality and number of double taxation disputes going in the same direction of the criticism of the ALS.
Lebovitz (2008) proposes a formula based on the worldwide income of the MNE group, but with no uniform definition of taxable income. The definition of the taxable income, deductions and rates (including zero rate) would be a matter of fiscal sovereignty of each state on the income allocated to its jurisdiction.68 The author agrees that calculating the share 67 OECD (2015), Transfer Pricing Documentation and Country-by-Country Reporting, Action 13 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
percentage for each state may be controversial, thus he suggests to be based on the social costs the MNE Group imposes to each state through its subsidiaries.
The idea is that goods and services impose costs to the states based on its consumption and in the infrastructure necessary to make them accessible to the costumers, therefore the sales in that country would be a reasonable criterion to define the share of the gross income of the MNE group. 69
In his view, the advantages of such method such as simplification of the international tax system, reduction of costs and the end of transfer pricing would outweigh the difficulties of agreeing on such formula.
There are many ideas of how to achieve the most precise formula to allocate profits and which factors would reflect a reliable proxy to determine the ability-to-pay of the MNE in each state, the VAT base as allocator factor has also being considered.70
The European Union has been discussing the proposal of the implementation of the CCCTB. The commission has identified the burdensome application of transfer pricing legislation, double taxation and limits on cross-border tax relief as impediments to the internal market. 71
The CCCTB aims to promote harmonization of the tax base, consolidation of group income and formulary apportionment.72 The main idea is to bring simplification in the
calculation of profits of the MNE group because it will be treated as a single unity as opposed to the separate entity approach.
The CCCTB formula includes the classical factors (labor, assets and sales) equally weighted. Each state would be entitled to tax its share of the MNE group’s consolidated income including permanent establishments according to its own rate. On the other hand, the taxable amount would be calculated under the same rules, EU would define the deductions and exemptions for all the member states. The common base could serve the purpose of minimizing the effects of harmful tax competition among member states.
Wilde (2105) proposes a new system (Corporate Tax 2.0) for global allocation of
69 Ibid.
70 Owens, supra n 13.
71 Communication from the Commission, Towards an Internal Market without tax obstacles - A strategy for providing companies with a consolidated corporate tax base for their EU-wide activities, COM(2001) 582 final, 23 October 2001, p. 10 et seq.
72 E. Röder, Proposal for an Enhanced CCTB as Alternative to a CCCTB with Formulary Apportionment, 4 World Tax J. (2012), Journals IBFD.
taxing rights of MNE group’s profit in which the separate entity approach is also replaced by a unitary entity approach. The fundamental idea is that the tax base should belong to the country where the group sells its products rather than the current system of taxing where the investments are made. Besides, the tax base should be calculated only on the excess of returns above the investment and double tax relief system should be based on the credit method, but not limited to the amount of tax paid abroad instead limited to the amount due in the country providing the credit.73 The system would disregard the ALS due to its inherent flaw and reach
a formulary apportionment. In the author’s opinion, the separate entity approach and ALS were already suppressed in practice by the adoption of a quasi-formulary method of the profit split.74
6. Is the Arm’s Length Principle being relegated to the back seat?
The BEPS project is based on agreement between G-20/ OECD economies to tackle tax avoidance and counter base erosion and profit shifting through a coordinated tax policy.
The BEPS report on Actions 8-10 represents a commitment for the countries involved, but is not minimum standard that countries have to follow and will not lead to a Peer Review monitoring process. Brazil which is a non-OECD country, therefore, not binded in its domestic legislation by the OECD, has expressly required a footnote where it states that it will continue to apply its fixed margins and to curb double Taxation through Mutual Agreement Procedure.75
The report proposes a revision of the OECD guidelines to align value creation with transactions and profits reported.76 The actions try to stretch further the ALS by empowering
the tax administrations to look beyond transactions undertaken by associated enterprises and to adopt special measures that may go beyond the ALS.
The recommendations found in the report tries to evaluate the economic substance of transactions over purely contractual form. In order to do so, it allows a higher level of fictions to be introduced to enhance the ALS. Options such as profit split methods, formulary arrangements, reallocation and recharacterization are taken into account in the final report and further guidance is given on the application of such measures.77 It goes a step beyond the ALS 73 M. F. Wilde, Sharing the Pie: Taxing Multinationals in a Global Market (2015) 43 Intertax, Issue 6/7, p. 438–446.
74 Wilde, supra n.5, p. 354.
75 OECD (2015), BEPS Actions 8-10, 2015 Final Reports. n. 1. 76 Ibid. Summary.
by disregarding contractual arrangements of legal ownership of assets to attribute risks if the contract fails to match economic rationality.
Business were invited to comment on the discussion draft of the BEPS proposal on the Transfer Pricing Actions 8-10 and many organizations and associations raised concerns that the wording in the draft reflected a significant abandonment of the ALS.78 Many
commentators highlighted that the discussion of risk in the draft overlook the way that unrelated parties contract with each other.79 The idea of recharacterization of contract
arrangements between members of the MNE group and disregard of transactions undertaken by the tax authority based on subjective criteria such as the enhancement of commercial position would lead to legal uncertainty in the application of the ALS and increase litigation.
80
One of special measure proposed in the draft was to ensure appropriate taxation of excess returns. It was strongly criticized by the business because clearly represents a divorce from the ALS towards formulary apportionment. The option was applicable in circumstances where the MNE had shifted profits through intra-group activities for a low tax jurisdiction. The excess profit not attributable to the functions performed and thus not taxed or taxed at a low rate in the jurisdiction would then be allocated to the parent jurisdiction and taxed accordingly.81
The main argument of the private sector is that inefficient taxation may depress free trade and investment, especially if there is no neutrality for the businesses structures and organization.82 The deployment of assets and labor force worldwide for the MNE group has
always been one of the main reasons for vertical integration. Therefore, taking out the ability of the MNE group to freely organize its business in a way that seems economically profitable may lead to endless disputes and prevent the development of some activities that in the end of the day could become a source of revenue for the same states that are trying to limit the risk of having their tax bases eroded by aggressive tax planning.
The modification of chapter VII of the OECD guidelines relating to Low Value
78 OECD public comments: BEPS Actions 8, 9 and 10: Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines (Including Risk, Recharacterisation, and Special Measures), (1 Dec. 2014–6 Feb. 2015), 19 Dec. 2014; online: http://www.oecd.org/ctp/transfer-pricing/discussion-draft-actions-8-9-10-chapter-1-tp-guidelines- risk-recharacterisation-special-measures.htm.
79 Ibid.
80 Ibid. See in particular NTFS comment. 81 Ibid.
Adding Intra-Group Services and the creation of a fixed ration rule based on the EBIT to limit interest deduction on Action 4 which aims to Limit base erosion via interest payments and other financial payments shows that the OECD perspective about the need of comparables for the application of the ALS has changed even further.
Robillard (2015) explains that the change in chapter VII report, where it suggests that the use of internal comparables is more reliable than external comparables, for low-adding value services represents the fall of ALS and the seed for the adoption of a formulaic approach when comparables are allegedly not available or the comparability is deemed to be poor.83
The idea is that the ALS determination can be reached through a simplified approach of a cost-plus method plus a 5% Mark-up for common intra-group services. The goal is to equalize the costs of the associated enterprises in the same circumstances by allocating the same key value for all the recipients of the service. This approach would bring more transparency and make clear to the payer country if interposed companies were used to inflate the costs of the intra-group services.84 The report also suggests a threshold for the application
of the simplified approach and a limit of 5% Mark-up for the application of withholding taxes. The BEPS Action 4 proposes that countries allow an interest deduction with a fixed ratio from 10 to 30% of the EBITDA of the payee entity.85 The manipulation of the tax base
through interest deduction arising from loans between associated entities has been addressed traditionally by Thin Capitalization Rules. However, the thin cap rules create a limitation based on the interest paid and the total of equity of the enterprise that is easy for a group to manipulate by increasing the amount of equity in the particular enterprise and such rules do not define interest rate limitation, what could lead to base erosion for the payee country.
In this context, one may argue that the Transfer Pricing discussion has evolved from a measure to counter tax-avoidance to application of an International Tax Regime.86 In the
83 R. Robillard. BEPS: Is the OECD Now at the Gates of Global Formulary Apportionment? Intertax. - Alphen aan den Rijn. - Vol. 43 (2015), no. 6&7; p. 447-453.
84 OECD (2015), BEPS Actions 8-10, 2015 Final Reports. p. 141.
85 OECD (2017), Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 - 2016 Update: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
86 “remarkable degree of convergence even in the purely domestic tax law of developed countries” (e.g. the concept of residence, corporation and permanent establishment)” see AVI-YONAH R.S., Commentary (Response
to H.D. Rosenbloom), p. 168, in Tax Law Review, vol. 53 (2000), no. 2, p. 167-175 (see also Id., Tax Competition cit., p. 131).
battlefield, the shifting of taxing rights seems more prominent than trying to solve the feasibility issues of the ALS.
Schoueri (2015) argues that ALS and FA comparison is not methodologically accurate, the former is a tool to indicate the ability-to-pay of the taxpayer and the latter uses a different criterion to determine the fair amount that a MNE group should contribute to each community where it carries on activities. Therefore, the comparison of criterions of taxation should be between the ability-to-pay and the FA.87
The goal is to increase the capacity of states to collect revenue from the residual profit that is not taxable for the states in the current regime due to the inherent flaw of the ALS. Nonetheless, the departure from ALS to a hybrid solution with adoption of Formulary apportionment seems premature.88 Mainly because the FA fails to meet the equality principle
among taxpayers and its arbitrariness in the allocation factors may lead to a dispute of bargain powers among developed and developing nations.89
Therefore, the BEPS project aims to empower the tax administrations with guidance to enhance the ALS not to abandon it. However, the disregard of the need of comparability analysis in some circumstances is an attempt to achieve more certainty in the application of the methods.
As a conclusion, it is soon to abandon a standard that counts with long years of experience and that is present in more than 3000+ DTAs.90 Therefore, the debate should
remain in building more effective ways to determine the taxpayer ability-to-pay and creating tools that bring more certainty and more feasibility in the application of the ALS.
87 Schoueri, supra n.6. 88 Ibid.
89 Ibid.
1. The Arm’s Length as a juridical a standard
Although the wording of the introductory paragraph of the OECD Guidelines refers to the Arm’s Length as a principle, it doesn’t address the theory behind juridical principles in order to be able to determine its nature.91
Article 9 of both OECD MC and UN MC brings a rule for allocation of taxing rights between jurisdictions. The command is designed to allow adjustments in the tax base of a contracting state only if the profit from intra-group activities was calculated using conditions that deviate from the financial and commercial conditions normally applied to independent enterprises.92
Vann (2010) explains that paragraph 1 of article 9 literally provides an interpretation in which the right to make adjustments arises only if the conditions arm’s length are observed, but no obligation to make such adjustment, not even obligation that any adjustment must follow the arm’s length conditions. In his opinion, the OECD goes beyond that literal interpretation to suggest that the adjustment must be made in the conditions explained in the Guidelines and even creates an expectation that the primary and correspondent adjustments should be made.
Therefore, the author argues two possible views of paragraph 1 of article 9. On one hand, it could be in fact empty of content as a permissive provision in the treaty would require domestic regulation to become effective and serves only as prelude for the correspondent adjustment of paragraph 2. On the other hand, if one admits there are no useless words in the law, the meaning of paragraph 1 would go further than being just a preface to the provision of paragraph 2 to actually bind the contracting partners to do adjustments exclusively on arm’s length basis.93
91 L. E. Schoueri: O Arm’s Length como Standard Jurídico. Estudos de Direito Tributário em Homenagem ao Professor Gerd Willi Rothmann. São Paulo. Quartier Latin 2016.p 228.
92 Ibid.
adjustments through other methods under their domestic law. 94
In the US, the legislation makes express reference to the arm’s length as a standard and in its development the congress had to discuss a white paper95 to define if the
commensurate with income clause was a valid solution to attribute profit to the parts of the
MNE group from the benefits generated by intangibles. The congress then decided that the need of comparables could not be determinant if the methods could reach the price that independent parties would agreed on under comparable circumstances. 96
“(1) In general. In determining the true taxable income of
a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer. A controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if un controlled taxpayers had engaged in the same transaction under the same circumstances (arm's length result).”97
In this context, a juridical standard is defined by Rothmann (1966) “as a criterion to
assess the juridical concrete relationships that reflects the average social conduct and derives from the statute or from case laws.”98 (Translated by the author). Schoueri (2016)
concludes that is exactly the nature of the arm’s length, a standard that derives from the treaty and requires a level of common ground interpretation in its application, but also allows a certain freedom and a level of arbitrariness from judges.99
The concept behind article 9, as a juridical standard, reflects a flexible parameter in the sense that requires for the application of the transfer price adjustment a search for the average conduct of the independent enterprises, but multiple interpretations and different tools are allowed to obtain such price in the concrete case.
94 Ibid.
95 Avi-Yonah, supra n.50, which refers to I.R.S. Notice 88-123, 1988-2 C.B. 458, 475. 96 Ibid.
97 IRC § 1.482-1 b (1).
98 G. W. Rothmann, O Standard Jurídico. Revista dos Tribunais.Vol. 371, 1966, p 9-20. 99 Schoueri, supra n.91.
Another argument in favor of this view is that the arm’s length could not be simply relegated or disregarded if it was a principle, as the wording “may be adjusted” in the same article suggests, but only weighted with other principles.100
How each country transposes the standard (how independent parties would act) from the treaties to its domestic law may differ and is limited by constitutional principles such as strict legality, equality and legal certainty.101 As the standard has no direct application to
calculate the price, the methods are used as legal presumptions, as discussed in section 3 of chapter 1.
Australia for instance has adopted the arm’s length as a juridical guiding principle in its tax code that enables the tax administration go further to achieve the most practical arm’s length estimate, as a rule of optimization.
“1.15. Where the information available is inadequate to determine the income to be attributed to an enterprise on an arm's length basis, Australia's transfer pricing rules allow the Commissioner to invoke subsection 136AD(4). Having regard to the clear policy expressed in Division 13 that the arm's length principle be used as guiding principle (including the fact that subsection 136 AD(4) enables the deeming of the amount of the arm's length consideration, which is then used in the application of subsection 136 AD(1), (2) or (3) as appropriate), subsection 136 AD(4) must be applied in a way that achieves the closest practicable estimate of an arm's length result (see also TR 94/14, paragraphs 82, 83 and 338 to 340).”102
In Brazil, Marozzi (2011) understands that the arm’s length was introduced in the domestic legislation as a consequence of the principle equality and ability-to-pay and should be considered also a juridical principle whose application could be limited by other principles such as practicability. 103 Thus, in the search for the arm’s length consideration the burden of
the comparability analysis should be reasonable to grant the effectiveness to the legislation. That is the reason why the application of CPM and RPM do not follow the analysis set in the OECD Guidelines, but instead prefixed margins set by the law.104
100 Ibid. 101 Ibid.
102 OECD (2010) Transfer Pricing Guidelines, supra n.25, par.1.15.
103 R. M. Gregorio: preços de transferência – Arm’s Length e Praticabilidade. São Paulo. Quartier Latin 2011. p 263.
According to Schoueri (2016), the practicability principle in Brazil cannot be invoked to admit generalizations or presumptions that differ so much of the reality that could jeopardize the principles of equality or ability-to-pay105. However, in order to guarantee the
practicability in the use of fixed margins a level of standardization is required, therefore, it may be necessary to not take into account whole display of wealth of the taxpayer.106
Ávila (2011) supports standardization in the application of the ability-to-pay principle if the following requirements are met: a) need for simplification; b) broad application; c) compatibility; d) neutrality; e) proportionality; and f) rebuttability.107
Transposing Ávila’s requirements (2011) to the application of the Brazilian transfer pricing rules, the need for simplification is clear considering the complexities of performing a full comparability analysis proposed by the OECD guidelines, especially for the lack of public information on the gross profit margin and mark-up in the transactions carried out between unrelated enterprises for calculating the arm’s length price when applying RPM and CPM. Besides, the transfer pricing documentation that the taxpayer is required to keep for compliance can be quite burdensome and the comparability analysis on case-by-case has always a subjective aspect that lead only to an estimation of the arm’s length price.108
The requirement of broad application is fulfilled if the margins are sufficiently close to the real profit margins in independent transactions for a large number of taxpayers. Thus, the fixed profit margins must be calculated accurately to encompass a big proportion of the industry.
The compatibility requirement means that the fixed margins should be periodically reviewed in order to remain compatible with the reality during the time of its application.
The neutrality in this context would mean that one type of industry should not be penalized by a high fixed profit margin that could have an impact in the industry competitiveness, especially when compared to the profit margins of other industries that produce similar goods or services.
105 Ibid.
106 P. V.V. Rocha, Contribuição ao estudo dos direitos fundamentais em materia tributária: restrições a direitos do contribuinte e proporcionalidade. Tese de Doutorado. Faculdade de Direito de São Paulo 2014. p.139. 107 H. Ávila. Teoria da igualdade Tributária p. 89.
The proportionality as a standardization requirement means that the fixed margin should not lead to a confiscatory tax effect after being used to calculate the transfer pricing adjustments and consequently the taxable base.
Lastly, the requirement that would make the regime of fixed margins in the RPM and CPM work as legal presumptions (Juris Tantum) is the rebuttability. The taxpayer may argue that the circumstances of its case are so particular that the general rule may not apply without harming the principles of equality and ability-to-pay and the tax administration should be able to evaluate the concrete case and adjust the margin accordingly.
For instance if the law foresees a fixed margin of 30% for the RPM which tests the price of products sold to an associated enterprise and later resold to an independent buyer, the arm’s length consideration for the first transaction should be the price of the resale minus a fixed margin of 30%. This fixed profit would represent the amount that the reseller would be willing to make after deducting his selling and operating expenses. Therefore, if the taxpayer operations reveal from internal or external comparables that this margin is too high and does not correspond to the reality of the industry, a special ruling should be issued to reduce margin in the concrete case.
Another example would be if the law would had set a fixed margin of 20% for CPM which tests the price of purchase made by an associated enterprise in supply agreements of semi-finished goods, thus the Arm’s length price would be the price that goods or services were originally purchased plus a fixed mark-up of 20%. However, if the taxpayer demonstrates the goods or services have a lower cost-plus mark-up due to particular economic reasons, even if its mark-up represents the average of the same industry, a specific margin alteration should be granted.
As a conclusion the arm’s length derived from article 9 of the treaties is compatible with the nature of a juridical standard and the transfer pricing methods are the presumptions used in the domestic legislation for transposing this standard into concrete cases.109 The use of
fixed margins, therefore, does not conflict with the treaties as they simplify and assures more practicability for the application of the standard. Furthermore, as long as the fixed profit margins are rebuttable (Juris Tantum) and a profit margin alteration could be effectively granted to the taxpayers, the regime is also compatible with the ability-to-pay and equality principles.
2. Difficulties with the comparability analysis
Notwithstanding the criticism discussed in Chapter 1 about broadening the use of PSM and reducing the importance of comparables for the application of the ALS, the comparability analysis is still the cornerstone of the application of Transfer Pricing methods in the OECD guidelines.
The key aspect of the analysis is to accurately delineate the controlled transaction taking into account the financial and commercial relationship between the associated companies, making the necessary adjustments (such as asset intensity, working capital, risk-based, accounting consistency, economic circumstances)110 in order to compare under the
same conditions the transactions between unrelated parties. The determination of which comparability factors should be used is another fundamental step of the methodology.
The five comparability factors proposed by the OECD Guidelines are the characteristics of product and services, functional analysis, contractual terms, economic circumstances, business strategies.111 Differences in the quality good and services and are
often translated into prices and are taking into account for the comparison with unrelated parties, especially in the CUP method.
The functional analysis involves determining what are the functions performed by the associated enterprises, the risks assumed by each of them and the assets deployed. The analysis is relevant because the transactions would be comparable only if similar operations and the same level of responsibilities are undertaken.112
The contractual terms are relevant to identify the relationship between the associated companies and which factors may influence the profit margin expected in that transaction. However, the final reports on Actions 8-10 of the BEPS add a substance over form approach in which the contractual terms are only the first step to be evaluated in order to allocate risks and assets.113 The requirement is that only companies who actually bear the risks could have
the ownership of an intangible property for instance. The reports address the situation of the
cash-box companies that are created with a big inflow of equity in low tax jurisdictions to
110 E. Muyaa, Transfer Pricing Comparability Adjustments: The Pursuit of “Exact” Comparables, 21 Intl. Transfer Pricing J. 5 (2014), Journals IBFD.
111 OECD (2010) Transfer Pricing Guidelines, supra n.25, par.1.36. 112 Ibid. par. 1.42-1.51
