Transfer Pricing: Risk, Recharacterisation, and Special Measures

We have now published our submission in response to the consultation on BEPS Action Points 8, 9 & 10 Revisions to Chapter I of Transfer Pricing Guidelines (including Risk, Recharacterisation, and Special Measures)


We applaud this discussion draft (DD) as an attempt to reconsider the basic approach, which has too long dominated transfer pricing regulation, that taxation of a multinational corporate group must treat its various component parts as if they were independent entities and focus on the pricing of transactions between them. This independent entity assumption runs totally counter to the current reality existing within these centrally-managed groups, and produces a system which is terribly subjective, often very discretionary, and impossibly difficult to administer.

To examine the details of intra-firm transactions, this independent entity assumption requires tax administrations to use specialist staff, normally in short supply in developed countries and often non-existent in developing countries, with legal expertise in complex structures and transactions, economic analysis capabilities, and specific knowledge of the characteristics of each business sector.

Despite this willingness to reconsider the basic approach, the draft still clings to that mistaken independent entity assumption by continuing to require that inter-affiliate transactions should be the starting point. These transactions are then evaluated in terms of the functions performed, assets owned and risks assumed by the affiliated entities, and the draft attempts to analyse these three factors: Functions-Assets-Risks (F-A-R), especially Risks. The draft rightly recognizes that in an integrated multinational corporate group ‘the consequences of the allocation of assets, function, and risks to separate legal entities is overridden by control’. We cannot agree more with this, since the greater competitiveness and generally higher profits of a corporate group operating in an integrated way derives from the benefits of synergy, so that the whole is greater than the sum of its parts. It is generally difficult or impossible to decide what proportion of the total profits to attribute to particular F-A-Rs within the various group members, especially when central control allows a multinational to transfer at its sole discretion intangible assets, functions, and risks amongst group members solely for purposes of tax minimisation.

Hence, we agree with the analyses in the draft, for example that concerning ‘moral hazard’, which suggests that a contract between associated enterprises in which one party contractually assumes a risk without the ability to manage the behaviour of the party creating its risk exposure is clearly a sham. Following the approach of the DD, this means that non-recognition or other adjustments must be made to appropriately interpret the actual transaction as accurately delineated. Our preferred approach, however, is to begin from the assumption that contracts between associated enterprises cannot be likened to market transactions between independent parties, for that very reason, so that the starting point should be an assumption that contracts between related entities should be disregarded.

Our preference, as we have urged in our separate comments on another report, is that the profit split method should be regularized and systematized, by clarifying the methodology for defining the aggregate tax base to be split, and specifying definite concrete and easily determinable objective allocation keys for all commonly used business models, also including the principles for choosing such keys for new business models as they appear in the future.

Part II proposes some ‘special measures’ which could be applied in defined ‘exceptional circumstances’, which in effect attempt to deal with some of the gaping wounds of the current transfer pricing system. We generally support these as at least an improvement on current formulations: particularly Option 1 (Hard to Value Intangibles); Option 2, first variant (Independent Investor); and Option 4 (Minimum Functional Entity). While we support Option 3 (Thick Capitalisation), in our view it must not form part of the Transfer Pricing Guidelines but belongs in the rules on Controlled Foreign Corporations, which are being separately considered. We detail strong reasons for this view.

We consider that there is merit in the concept of Option 5 (Ensuring appropriate taxation of excess returns), but as presently described it would be counter-productive and only continue to encourage BEPS behaviour, particularly if x% (the defined ‘low-tax rate’) is below the general corporate tax rate in the home country and is both the trigger for application of the CFC rule and the rate of tax to be applied under the CFC rule in the home country of the MNE. We propose that the trigger for applying this Option 5 should be an average effective rate of tax defined as a percentage that is very close to the general corporate tax rate in the home country. In particular, we recommend that it be no less than 95% of that home country rate.

Overall, these amendments to the Transfer Pricing Guidelines, although extensive, would for that very reason make them even more complex, subjective, and, for the most part, impossible for most countries’ tax authorities to administer. These and other drawbacks mean that the overriding need at the present juncture is for rules which are easily administered and that provide results for taxpayers and countries that all regard as fair. In the immediate term, we therefore strongly urge a clear shift towards a systematised and regularised application of the Profit Split method. A next step is a fundamental reappraisal of the Guidelines, and a complete rewriting especially of chapter 1. It should begin by a reversal of the independent entity assumption and an acceptance of the principle that each multinational corporate group must be considered according to the business reality that it operates as an integrated firm under central direction.


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