The Arm's-Length Principle, Developing Countries, and Expansion of OECD Membership

By David Ernick, Esq.

PricewaterhouseCoopers LLP, Washington, DC 

On March 11, 2014, the Organisation for Economic Co-Operation and Development (the OECD) released a paper entitled "Transfer Pricing Comparability Data and Developing Countries" (the Paper), which may have been easy to miss in the flurry of important discussion drafts issued that same month related to the Base Erosion and Profit Shifting (BEPS) Action Plan. However, while the Paper is not technically part of the BEPS project, it is obviously influenced by it, and should not be overlooked or viewed as only applicable to developing countries (especially since the developing countries include China, India, and Brazil). It raises important questions not only about transfer pricing and the arm's-length principle, but also as to the role of the OECD as a standard-setting organization and its relationship with developing countries and the United Nations (UN).

The Paper is part of the OECD's work with non-OECD economies, and was discussed at the March 26-28, 2014 meeting of the Global Forum on Transfer Pricing (Global Forum). The Global Forum represents part of the OECD's efforts to expand its influence in transfer pricing beyond its limited membership of 34 countries, including through a policy dialogue and capacity-building activities. The Paper begins by noting that comparability is at the heart of transfer pricing, and application of the arm's-length principle often requires a comparison of the prices charged in transactions between related parties with the prices charged in similar transactions between unrelated parties. Concerns have arisen regarding the application of the arm's-length principle in practice. Specifically, questions have been raised regarding the availability and quality of information concerning similar transactions between unrelated parties.

Finding good comparables is particularly important for developing countries, as highlighted in the Paper and in the UN Transfer Pricing Manual for Developing Countries (2012), which details the particular challenges developing countries face in finding reliable comparables. These include the lower number of "organized players" in any given sector as compared to developed countries, the lack of commercial databases featuring data from developing country markets and the difficulty and expense of accessing commercial databases with developed country data, as well as a lack of comparables due to the existence of more "first movers" who have just come into existence in developing countries.

Recognizing these concerns, in its Lough Erne Communique´ of June 13, 2013, the G8 asked the OECD "to find ways to address the concerns expressed by developing countries on the quality and availability of the information on comparable transactions that is needed to administer transfer pricing effectively." The Paper, prepared by the OECD Secretariat in conjunction with the Task Force on Tax and Development, is the OECD's response to that request.

The Paper takes a four-pronged approach to addressing tax authorities' concerns over the lack of information on local comparable transactions, recommending:

  •   Expanding access to data sources for comparables;
  •   Using data sources for comparables more effectively;
  •   Reducing reliance on direct comparables; and
  •   Utilizing Advance Pricing Agreements and mutual agreement procedures. 

The Paper proposes some useful measures to ameliorate concerns regarding lack of reliable comparables, but is also infused with an anti-abuse tone, and reflects BEPS themes about improving the arm's-length principle by allowing for exceptions to it when justified by special circumstances.

Several possibilities for expanding access to data sources for comparables are discussed, including increasing coverage within commercial databases of financial data on companies and relevant transactions in developing countries, assisting developing country tax administrations in financing access to commercial databases, and expanding the obligation for companies to file statutory accounts in the jurisdictions in which they operate. Notably, it is also suggested that even if public availability of statutory accounts is not possible, tax administrations will nonetheless have access to company financial statements and can use that data to "populate" an internal comparables database. Concerns regarding use of secret comparables are acknowledged, but overcome by noting that although the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Transfer Pricing Guidelines) hold that it is unfair to use secret comparables for making substantive transfer pricing adjustments, it may be acceptable to use them for risk evaluation purposes. The distinction is not persuasive, however, as in both cases the taxpayer is denied an opportunity to adequately defend its own position when it is not privy to the tax administration's analysis. The use of secret comparables is a significant issue in practice and a recommendation for more widespread use for any purpose seems fraught with risk.

With respect to using data sources for comparables more effectively, the OECD suggests ensuring that tax authorities have the appropriate skill and experience to properly utilize commercial databases. It also offers options for dealing with scarce information (including identifying appropriate foreign comparables) and making comparability adjustments. However, the Paper also states that where local or regional comparables are not available, it may be appropriate to use the foreign counterparty to a transaction as the tested party in order to reduce the risk that the domestic entity will only receive a "routine" return and not share in any residual profits. However, it has long been understood that when the cost plus, resale price, or transactional net margin method is the most reliable method, by definition the tested party will "only" earn a routine return, because that is consistent with the deal the parties have struck as to risk allocation. Thus, the Paper effectively recommends a results-oriented approach that disregards the contractual risk allocation agreed to by the parties in order to allow developing countries to capture a portion of the residual profits. No mention is made if this approach should also apply in years when overall losses exist.

In analyzing approaches to reducing reliance on direct comparables, the Paper begins by reconfirming support for the arm's-length principle and the dangers of moving towards formulary apportionment. And yet the very next paragraph launches a discussion of a variety of measures likely to undercut, rather than support, the arm's-length principle. For example, a "global value chain analysis" is outlined, without defining what that new term means, or how it differs from the traditional functional analysis recommended in the Transfer Pricing Guidelines. In addition, use of the profit split method is suggested, which, along with the work to "clarify" when the profit split method is the best method under the BEPS Action Plan, seems likely to increase the trend among several countries to make the profit split method the default method in order to ensure the capture of some part of the residual profits. These are familiar themes from the BEPS work, and, if adopted, may indicate a shift from a narrow examination of the pricing of the relevant related-party transaction to a broader "global value chain analysis," which could lead to a search for the existence of significant "system profit" somewhere within the group that inappropriately influences the transfer pricing analysis.

The OECD also introduces the so-called "sixth method," stated to be popular in Latin America and Africa, which provides for mandatory use of publicly quoted commodity prices for related-party transactions in commodities. The sixth method starts and ends with publicly quoted commodity prices, allowing no comparability adjustments to account for differences in things like volume, geography, economic circumstances, time of delivery, and other relevant contractual terms. It is thus inconsistent with the arm's-length principle, yet the OECD contends that it may nonetheless serve as a useful anti-avoidance measure.

The Paper also offers another anti-avoidance measure which is not limited to transfer pricing, suggesting the denial or limitation of deductions for transactions involving companies in low- or zero-tax jurisdictions under circumstances indicative of tax avoidance. The direction of the work has thus turned from finding better comparables and methods for determining arm's-length prices, to focusing on anti-avoidance measures and the wholesale denial of deductions that are not considered legitimate. The danger exists, however, that if related parties are not allowed deductions for the same expenses and in the same amounts as unrelated parties are in similar transactions under similar circumstances, then the transfer pricing rules may become unmoored from any underlying principle, and profits simply allocated among the members of a multinational enterprise by fiat.

The final section of the Paper discusses the use of Advance Pricing Agreements (APAs) and proceedings under Mutual Agreement Procedure articles (MAPs) as effective tools for dealing with tax controversies in a less adversarial manner. Given the potential increase in controversies over the next few years if consensus around the arm's-length principle begins to fray, increased access to MAPs, including those allowing taxpayers to choose mandatory binding arbitration, will be essential.

In analyzing the message being telegraphed, it may be that the willingness to consider deviations from the arm's-length principle and the accommodation of differing positions on tax policy signal a desire for a new foundation for the transfer pricing rules. Consequently, the Paper should not be viewed as merely addressing esoteric comparability issues, and only applicable to developing countries. Rather, it should be viewed as part of a larger debate within the OECD regarding the role of consensus and standard-setting. For several years, the OECD has been considering expansion of its membership in order to maintain, or at least reduce the decline in, its members' share of world GDP, particularly as the economies of the larger developing countries expand more rapidly than the economies of OECD countries. Part of the debate that surrounds that expansion concerns the issues of consensus and standard-setting. Working Party No. 6, which is responsible for transfer pricing, has traditionally maintained the most robust consensus requirements of any of the working parties of the Committee on Fiscal Affairs. But as OECD membership expands, unanimous consensus becomes more difficult to achieve, especially if new members have views on tax policy matters inconsistent with traditional OECD member norms. As the difficulty increases, some have suggested that the unanimity model give way to practical concerns, and that members be free to express disagreement (in OECD terminology, "reservations" and "observations") within the Transfer Pricing Guidelines.

The outcome of the expansion debate will thus have important consequences for transfer pricing. The OECD has long been the premier standard-setting body for international tax rules. But critics of the narrowness of OECD membership and its homogeneity (it has sometimes been referred to as a "rich-country club") question its status as a standard-setter, and the resulting cleavage of the world into groups of "rule-makers and rule-takers." That sentiment likely accounts for the recent emergence of the UN, and its Committee of Experts on International Cooperation in Tax Matters, as a potential contender to be a second standard-setter for international tax rules.

The OECD's expansion drive, and its efforts to integrate non-OECD economies into its work in creating the rules in order to gain greater acceptance of them in practice, may ultimately increase its sphere of influence. But it likely will be difficult to achieve without a substantial loosening of the existing consensus requirements. The question then becomes whether an international standard that does not require consensus is an oxymoron.

Those appear to be the issues underlying the approach taken in the Paper - can the OECD maintain its status as the premier standard-setting organization in the international tax arena while also maintaining a relatively narrow, homogenous membership list, operating under a consensus model? Or should it throw open the gates to the Chaˆteau1 on rue Andre´ Pascal, expand membership, and try to be all things to all people? The future of the Transfer Pricing Guidelines hangs in the balance - they may remain a consensus document providing a single set of rules for designing member country transfer pricing regimes and resolving disputes, or they may devolve into a catalogue of disparate member views. The ability to achieve consensus and expansion of the OECD's membership list may not be mutually exclusive, but there is clearly an inverse relationship between the two.

This commentary also will appear in the June 2014 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Culbertson, Durst, and Bailey, 894 T.M., Transfer Pricing: OECD Transfer Pricing Rules and Guidelines, and in Tax Practice Series, see ¶3600, Section 482 -- Allocations of Income and Deductions Between Related Taxpayers, and ¶7160, U.S. Income Tax Treaties.

Tax Management International Journal.

1  Since 1949, the OECD has been headquartered at the Chaˆteau de la Muette, on the edge of the Bois de Boulogne in Paris, France.