Integration, Fragmentation, and Global Value Chains – The Beginning of the End of the Arm's-Length Principle?

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By David Ernick, Esq.

PricewaterhouseCoopers LLP, Washington, DC

-- Primum non nocere ("First, do no harm").

In December 2014, the OECD released a package of six new discussion drafts as part of the BEPS Action Plan, three of which explore proposals under Actions 8-10 to modify the OECD Transfer Pricing Guidelines (Guidelines). The drafts on: (1) use of profit split methods (Profit Splits Draft); and (2) risk, recharacterization, and special measures (Risk Draft) provide fresh insights into the underlying principles animating the OECD's work to change the Guidelines and the arm's-length principle.1 With time growing short before the BEPS project is concluded, the drafts provide further evidence that the end result may be a significant retreat from the arm's-length principle by the OECD and a strong embrace of formulary apportionment.

The conceptual underpinnings of all the BEPS reports relating to transfer pricing issues can be traced to the original BEPS discussion draft on the tax challenges of the digital economy.  That report presaged a movement towards formulary apportionment and a unitary approach to the taxation of multinational enterprises (MNEs), as concisely summarized in this paragraph:When the arm's length principle was initially devised, it was common that each country in which an MNE group did business had its own fully integrated subsidiary to carry on the group's business in that country. This structure was dictated by a number of factors, including slow communications, currency exchange rules, customs duties, and relatively high transportation costs that made integrated global supply chains difficult to operate. With the advent of the development in ICT [information and communication technology], reductions in many currency and custom barriers, and the move to digital products and a service based economy, these barriers to integration broke down and MNE groups began to operate much more as single global firms. Corporate legal structures and individual legal entities became less important and MNE groups moved closer to the economist's conception of a single firm operating in a coordinated fashion to maximise opportunities in a global economy. Attention should therefore be devoted to the implications of this increased integration in MNEs and evaluate the need for greater reliance on value chain analyses and profit split methods. This work should also address situations where comparables are not available because of the structures designed by taxpayers and could also include simpler and clearer guidance on the use of profit splits along the lines that have been successfully applied in connection with global trading and other integrated financial services businesses.2

The transfer pricing reports released subsequent to the digital economy report craft arguments to reinforce that picture of MNEs as being a "single firm," where boxes on an organizational chart representing separate legal entities become blurred or even erased, at least for tax purposes. That type of approach, however, would require a fundamental reexamination not just of the existing transfer pricing principles, but also of the entire architecture upon which the international tax rules have been built for the last century.

For example, it may be true that an MNE consisting of many legally separate entities is, for economic purposes, a "single firm." Transfers of risks, assets, and functions among the group members are meaningless, as an economic matter, because ultimately the shareholders of the ultimate parent own the entire organization, including all legally separate entities. For tax purposes, however, transfers of risks, assets, and functions are, generally, quite meaningful.  Such transfers are generally respected, subject to having a minimum level of economic substance and to a host of exceptions and anti-abuse rules. The international tax rules have for the last century been built upon the premise that separate legal entities are generally respected for tax purposes. The outcome of the BEPS project, however, may be to overturn that architecture.

The Profit Splits Draft, for example, seems consistent with the concept from the digital economy report that MNEs should be treated as a single firm for tax purposes. That argument finds life in the assertions that MNEs now are more "integrated" than they had been in the past, that there may be "interdependence" and "integration" of functions and risks among the constituent entities of an MNE, and that "synergies" are the result of that integration. Those labels are then used as justification for asserting that a one-sided transfer pricing method cannot appropriately account for those developments, and, consequently, that use of profit split methods may be appropriate.

"Fragmentation" also is proposed as a new concept to question the reliability of proposed comparable transactions and one-sided transfer pricing methods. While "integration" creates difficulties in using one-sided transfer pricing methods, it also is asserted that the opposite of integration, "fragmentation," is occurring, making use of one-sided methods problematic. Both integration and fragmentation can happen at the same time, as it is asserted that functions can be "fragmented" within an "integrated" "value chain,"3 while functions and risks can be "integrated" within a "global value chain."4 (Also, "highly integrated functions" can be "fragmented" across several group companies.5) Both of these concepts may be used as a device for claiming that related parties are fundamentally different from unrelated parties, and that therefore proposed comparable uncontrolled transactions are never really comparable, and profit split methods must be used to overcome these deficiencies.

Finally, new terminology referring to the rise of "global value chains" is proposed and then used to make profit splits a near-default pricing method, or at least available in the tax administrator's discretion. That terminology is borrowed from a 2013 report by a group of OECD committees6 addressing the international "fragmentation" of production in global value chains and its consequences for the global economy. It is defined as the "full range of firms' activities, from the conception of a product to its end use and beyond … . It includes activities such as design, production, marketing, distribution and support to the final consumer."

The risk of employing new terminology without providing objective definitions is that words like "integration," "interdependence," and "synergies" can be used to mean whatever the speaker wants them to mean.7 Also, if the test will be that a tax authority merely has to show that "integration," "interdependence," and/or "synergies" are present in any particular MNE taxpayer to justify the use of a profit split method, that may well become the default method and one-sided transfer pricing methods effectively written out of the Guidelines. MNEs generally are organized to take advantage of the benefits that come from acting in an integrated, interdependent, and synergistic manner. By definition, the ultimate parent company in a controlled group of related companies always has control over every other subsidiary and group member and can require them to work together in an integrated manner for the common good of the group. It is not clear how it could ever be shown that those things do not exist within a particular MNE.

The "global value chain" terminology could be used as a device for viewing an MNE as a single unitary business and disregarding legally separate entities. It is not clear why examining a firm's "global value chain," including the "full range of firms' activities, from the conception of a product to its end use and beyond" will be helpful to the transfer pricing analysis of most related-party transactions. It cannot be relevant to the majority of transactions involving transfers of functions, assets, and/or risks, except those that concern the "full range of firms' activities, from the conception of a product to its end use and beyond," which will likely be a very small fraction.  Transfer pricing is necessarily a facts and circumstances exercise, and the economic analysis should only concern itself with functions, assets, and risks relevant to the particular transactions taking place in a particular jurisdiction.

That type of analysis, viewing an MNE as a single unitary business, is consistent, however, with the new master file documentation requirement. Some commentators have criticized the master file reporting requirements because they provide tax authorities with the "combined reporting" type of information that would enable transfer pricing assessments consistent with global formulary apportionment. It is difficult to understand why tax authorities would need information that is by definition not relevant to the local subsidiaries and activities occurring within their jurisdiction. Concerns have been raised that reporting that type of information would result in a search for "system profits" anywhere within an MNE and in attempts by tax authorities, now seeing profits outside their jurisdiction, to claim that a local intangible exists and justifies using a profit split method in order to claim a piece of those profits for their local jurisdiction. Concerns also were expressed that transfer pricing assessments may be based on factors having to do with the global profitability of an MNE instead of being based on the functions, assets, and risks within a particular jurisdiction.

Similarly, the new country-by-country (CBC) reporting requirements have been criticized because of their focus on data points (number of employees, tangible assets, and sales) seemingly more relevant to an allocation of profits based on a formulary apportionment type system than one based on the arm's-length principle. Viewed together, the master file and the CBC template have similarities with the combined reporting and formulary apportionment used by the States.  The new recommendation to conduct a "global value chain" analysis seems to be another step toward achieving combined reporting and treating an MNE for tax purposes as a "single firm." The danger exists that "global value chains" would be a tool tax authorities might use to claim that separate legal entities should not be respected and to allocate to themselves a larger share of MNE "system profits," despite only a tenuous relation to those profits. But that may be the intent of some countries participating in the BEPS project, as that sort of results-oriented analysis was explicitly recommended in an earlier report addressing comparability issues.8 That report noted that if a one-sided transfer pricing method could not be used with a domestic entity as the tested party, "[t]esting the foreign counterparty may also mitigate the risk that the domestic party will only be allocated a routine return without considering whether it should share in any residual return that may arise in the transaction."

In the same manner, the new Risk Draft uses the same terminology found in the Profit Splits Draft, making the assertions that associated enterprises may "fragment"9 certain activities, but also that the separate entities within a multinational enterprise may work together toward a common goal, in a coordinated fashion, and when they do there may be certain "interdependencies," "synergies," and "integration" that are presumed not to exist between unrelated parties.10 That terminology is repeated throughout the Risk Draft and used as a justification for concluding that otherwise comparable uncontrolled transactions are not really comparable, and therefore some sort of exceptional treatment from the usual rules may be appropriate.

Those concepts then are combined with the new term "moral hazard" to raise a question as to whether the allocation of risks and other conditions between associated enterprises should be re-ordered, differently from what they had been in contractual arrangements. Questions also are raised as to whether transactions between associated enterprises should be recognized where the sole effect is to shift risk, and as to whether basic economic principles should apply to transactions between related parties. While it notes that, according to the "risk-return trade-off," a seller of a risky income-producing asset may accept a lower but more certain amount of income and forego the possibility of a potentially higher but riskier return, the draft questions whether that concept should apply to related parties, because it may be used "opportunistically."

That question seems driven by concerns that, under the traditional arm's-length principle, returns in high-tax jurisdictions will be lower when the risks and functions occurring there are low. But disregarding the risk-return trade-off, which exists among unrelated parties, would further divorce the Guidelines from the arm's-length principle and require contractual allocations of risk to be ignored. The draft also attacks use of the cost-plus method to limit returns in high-tax jurisdictions, questioning whether it is really appropriate when the entity providing the remuneration on such a basis does not have the capacity to manage the risk that is shifted through a cost-plus method.

The Risk Draft recognizes that related parties may legitimately engage in transactions in which unrelated parties may not and that those transactions should be recognized for tax purposes and can be priced. However, the draft then makes the contrary assertion that non-recognition may be appropriate when related-party transactions do not have "arm's length attributes," "commercial rationality," or "fundamental economic attributes." An example is provided of a sale of a valuable trademark to a related party in a low-tax jurisdiction for a lump-sum payment, with a license back to the seller for annual royalty payments. The conclusion of the example is that, rather than recognizing this common type of transaction and ensuring arm's-length pricing for both the sale and the license, the whole transaction should be disregarded because the seller has "lost commercial value" by parting with such a valuable trademark and is now dependent on another party (who has no capability to itself exploit the trademark) to license the trademark for use in its business.

Although the draft purports to accept that related parties may engage in transactions in which unrelated parties may not, the example is consistent with the view espoused by several tax authorities that some transactions, such as transfers of "crown jewel" intangibles, simply would never take place among unrelated parties, can never be priced, and therefore should be disregarded when they occur between related parties. The danger of such a view is that it could lead to endless disputes, as tax administrators second-guess legitimate business transactions whenever good comparables among independent parties are not available.

Finally, the report requests comments on several options for "special measures" with regard to intangibles, risks, and over-capitalization. The options include a deemed contingent-payment pricing mechanism, special rules for independent investors in "capital-rich, asset-owning companies," an option for dealing with "thick capitalization," and a proposal for reallocating the profits reported by certain "minimal functional entities." All of the options seem to raise serious concerns regarding consistency with the arm's-length principle and the separate-entity concept on which the international tax rules historically have been based.

To recap, when read together, the BEPS reports touching on transfer pricing issues reflect a coordinated movement toward a unitary view of MNEs and greater emphasis on formulary apportionment of profits. The digital economy report established the conceptual paradigm: that an MNE is really just one "single firm." The master file and the "global value chain" concept provide the tools to move towards combined reporting of the entire operations of an MNE, instead of just reporting relevant local information to each country. The intangibles discussion draft places more emphasis on the location of the performance of certain important functions by employees in determining profit allocations and less emphasis on ownership of intangibles and contractual allocations of risk. CBC reporting requires a transfer pricing risk assessment based predominantly on three factors very similar to those used by the states to allocate income based on formulary apportionment. The Risk Draft targets "fragmentation" of functions in separate legal entities, and counters that those functions may be managed in a coordinated manner, similar to one big "integrated" firm. That approach would make it easier for tax authorities to disregard contractual allocations of risk, to recharacterize transactions, and to utilize "special measures" inconsistent with the arm's-length principle. The Profit Splits Draft reflects a similar emphasis on "integration," and proposes more frequent application of profit splits as the best transfer pricing method. Finally, the report on permanent establishments (PEs) proposes a significant lowering of the PE threshold, which could lead to more assertions of PEs and then greater attribution of profits to those PEs through use of a profit split method.

The danger of such an approach, if that is what is intended by the OECD, is that it would represent a sudden departure from a longstanding commitment to the arm's-length principle.11 Concerns have been expressed by Congressional tax writers that such an approach simply may reflect a desire to increase foreign taxes on U.S. MNEs.12 In response, the Treasury Department has promised that it will resist modifying the arm's-length principle in such a manner.13

But time is growing short, as the OECD now has passed the half-way point toward completion of the BEPS project.  If the arm's-length principle and separate entity accounting are to emerge from the BEPS project unharmed and maintained in the Guidelines in a manner consistent with the current understanding of those concepts, there will have to be significant work done to convert the transfer pricing discussion drafts into consensus final reports. If the result of the BEPS project is to turn the Guidelines into a chimera, composed of some parts supporting the arm's-length principle and other parts supporting a unitary approach and formulary apportionment, it would likely contribute, along with proposals under other BEPS workstreams, to a proliferation of tax disputes and the "global tax chaos marked by the massive re-emergence of double taxation" of which the BEPS Action Plan warned. The prior work of the OECD to gain widespread acceptance of a uniform standard for transfer pricing rules based on the arm's-length principle coupled with the consequent minimization of double taxation from that effort should not be lightly disregarded.  The potential for the BEPS work on transfer pricing issues to result in increased double taxation, thus impairing cross-border trade and investment, would be counterproductive to both taxpayers and tax authorities, and needs to be carefully evaluated.

This commentary also will appear in the March 2015 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Axelsen, Plotkin, Stone, Langbein, Clowery, and Morgan, 889 T.M., Transfer Pricing: Perspectives of Economists and Accountants, Culbertson, Durst, and Bailey, 894 T.M., Transfer Pricing: OECD Transfer Pricing Rules and Guidelines, and in Tax Practice Series, see ¶3600, Section 482 — Allocation of Income and Deductions Between Related Taxpayers.

Copyright©2015 by The Bureau of National Affairs, Inc.


  1 A third discussion draft released in December 2014 on transfer pricing issues is more narrow in scope, not setting forth changes to principles and only examining pricing of commodity transactions, primarily under the comparable uncontrolled price method.

  2 "BEPS Action 1: Address the Tax Challenges of the Digital Economy,"  at ¶ 166, Mar. 24, 2014, emphasis added

  3 Profit Splits Draft, ¶ 26.

  4 Profit Splits Draft, ¶ 8.

  5 See the discussion draft relating to risks, recharacterisation, and special measures, ¶ 21.

  6 Interconnected Economies: Benefiting from Global Value Chains, OECD Publishing.

  7 See IRS Official Says Special Measures in OECD Draft Like "Religion," Not Law, 09 Bloomberg BNA Daily Tax Rep. G-8 (Jan. 14, 2015), summarizing comments of Ken Wood, Senior Advisor, Office of Transfer Pricing Operations, noting that because the drafting in the risk and recharacterization draft is ambiguous and lacks any objective guideposts, it is not even clear under the Risk Draft what the new transfer pricing rules are and when they will apply because "[i]t's making up the rules as we go along."

  8 Transfer Pricing Comparability Data and Developing Countries, ¶ 22.

  9 "Fragmenting" by MNEs appears to be a particularly strong concern, as the work under Action 7 to prevent artificial avoidance of permanent establishment (PE) status proposes changes to prevent both fragmentation of activities between related parties to qualify for the preparatory or auxiliary exception to PE status and the splitting-up of contracts in order to avoid the existence of a PE.

  10 Paragraph 21 of the Risk Draft shares the same conceptual underpinnings as ¶ 166 of the digital economy report, which made the assertion that MNE groups are really just a "single firm." It makes the assertion that although an MNE group may "fragment" functions across several group members, those functions are actually "coordinated," "integrated," "interdependent," and at the end of the day under "common control," with the implication that it is really just one big "single firm."

  11 The arm's-length principle is a near-worldwide standard, implemented by all 34 OECD member countries, many developing countries, and every major economy save Brazil. In the 2010 update to the Guidelines, the OECD strongly reaffirmed its commitment to the arm's-length principle, and noted that advocates of global formulary apportionment argue:… that an MNE group must be considered on a group-wide or consolidated basis to reflect the business realities of the relationships among the associated enterprises in the group. They assert that the separate accounting method is inappropriate for highly integrated groups because it is difficult to determine what contribution each associated enterprise makes to the overall profit of the MNE group.

The "global value chain" analysis set forth in the Profit Splits Draft seems entirely consistent with the contention noted in ¶ 1.19, from advocates of formulary apportionment, that an MNE group must be examined on a group-wide or consolidated basis. The argument that MNE groups are now operating on a more "integrated" basis (consistent with the economist's conception of a single firm operating in a coordinated fashion) seems entirely consistent with the argument, rejected in 2010, that separate accounting is inappropriate, and that a unitary approach which erases the boxes on a legal entity organizational chart is appropriate.  It is difficult to reconcile arguments set forth in the Profit Splits Draft with the reasons given in 2010 for rejecting global formulary apportionment, and it is of concern that such fundamental principles are being questioned so soon after being endorsed.

  12 See "Camp, Hatch Statement on 2014 OECD Tax Conference:"[W]e are concerned that the BEPS project is now being used as a way for other countries to simply increase taxes on American taxpayers. When foreign governments – either unilaterally or under the guise of a multilateral framework – abandon long-standing principles that determine taxing jurisdiction in a quest for more revenue, Americans are threatened with an un-level playing field.

  13 See Testimony of Robert B. Stack, Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury, Before the Senate Finance Committee (July 22, 2014) ("We must steadfastly avoid turning longstanding transfer pricing principles into a series of vague concepts easily manipulated by countries to serve their revenue needs at the expense of the U.S. tax base and our multinationals.").