Can the WTO Save the Arm's-Length Principle?

By David Ernick, Esq.

PricewaterhouseCoopers LLP, Washington, DC

O, that way madness lies; let me shun that;

No more of that.

- William Shakespeare, King Lear, Scene IV

Just four short years ago, the OECD resoundingly reaffirmed its
commitment to the arm's-length principle1 and
all seemed well in the world of transfer pricing. Fast forward to
2014, where BEPS2 dominates the
international tax landscape, and suddenly the arm's-length
principle is "under assault" and the transfer pricing world stands
on the verge of "international tax chaos."3 The BEPS Action
Plan notes certain "flaws" in the arm's-length principle, and
contemplates "special measures, either within or beyond the arm's
length principle," in order to address issues with respect to
"intangible assets, risk and over-capitalisation." Nothing is
taboo, and OECD officials now openly discuss the possibility that
the organization may approve new transfer pricing rules
inconsistent with the arm's-length principle.4

Consistent with those comments, the Revised Discussion Draft on
the Transfer Pricing Aspects of Intangibles seems to depart from
the traditional functions, assets, and risks analysis of the
arm's-length principle and moves towards a formulary approach to
transfer pricing that places less emphasis on ownership of
intangibles and contractual assumptions of risk, and more emphasis
on the location of people performing "important functions."
Similarly, the new country-by-country reporting (CBCR) template
provides a transfer pricing risk assessment tool, but one where the
determination of risk is made by evaluating whether a
multinational's profit allocation corresponds to the allocation
which would have occurred under three-factor (employees, sales, and
tangible assets) formulary apportionment, disregarding the role of
ownership of intangibles and assumptions of risks in creating value
and allocating profits among jurisdictions. That is all consistent
with the BEPS Action Plan, which mandates: (1) that the transfer
pricing rules be modified to "[a]ssure that transfer pricing
outcomes are in line with value creation"; (2) that international
tax rules in general should "better align rights to tax with
economic activity"; and (3) that there should be "[a] realignment
of taxation and relevant substance."

However, based upon the substantive proposals to date to address
those concerns, it appears that OECD member countries equate the
location of "value creation," "economic activity," and "substance"
with the location of people performing certain "important
functions." As the location of workers becomes increasingly
important to support allocation of profits to a particular
jurisdiction, the OECD correspondingly mandates that the transfer
pricing rules be modified "to ensure that inappropriate returns
will not accrue to an entity solely because it has contractually
assumed risks or has provided capital." In the context of transfer
pricing, the goal of aligning profit allocation among jurisdictions
more closely with the location of people seems to foreshadow a new
regime based more upon formulary apportionment based on headcount
than the arm's-length principle. The future seems quite bleak for
proponents of the arm's-length principle. But will it be darkest
before the dawn? Its work is not yet complete and so the fate of
the arm's-length principle is still undecided, but if the OECD were
inclined to adopt formulary apportionment, are there any external
constraints on its power to do so which have not been

There may well be. The World Trade Organization (WTO) is another
influential multilateral organization, currently composed of 159
member countries, whose role in setting tax policy has been largely
overlooked so far. The WTO is primarily concerned with trade rules,
but the natural imbrication of tax law and trade rules raises
interesting questions about its role in this debate.  And
whereas the OECD is merely a standard-setting organization without
the power to police its recommendations, the WTO has both dispute
settlement mechanisms and enforcement power; its rules are not
merely aspirational. As this commentary will discuss in more
detail, although most countries jealously guard their sovereign
authority when it comes to tax matters, it may be that OECD
countries belonging to the WTO have ceded more authority to the WTO
than they realize, particularly with respect to their transfer
pricing rules.

The WTO is an organization for opening trade and a forum for
settling trade disputes. It was born out of the 1986-1994
negotiations called the "Uruguay Round," and earlier negotiations
under the General Agreement on Tariffs and Trade (GATT). The WTO
Agreement is the "umbrella" agreement, underneath which are
agreements for: (1) each of the three broad areas of trade that the
WTO covers (goods, services, and intellectual property); (2)
dispute settlement; and (3) reviews of governments' trade

None of the WTO agreements deals predominantly with tax
measures, yet lurking within the agreements are several limitations
on how member countries may design their tax systems. Some of those
limitations may not be obvious or the full import of the extent of
the limitations may not yet be clear. Buried in an agreement
providing rules on trade subsidies is a single footnote, of which
many transfer pricing experts are unaware, which may have already
bound WTO member countries to the arm's-length principle.

It all begins with trade in goods. From 1947 to 1994 the GATT
provided rules for trade policies affecting goods moving in
international commerce. Certain nondiscrimination policies are
provided ("national treatment" and "most favored nation"
treatment), as well as limitations prohibiting certain subsidies
for trade in goods. Since 1995, however, the GATT has become the
WTO's "umbrella" agreement for trade in goods, and its disciplines
with respect to subsidies have largely been superseded by the
Agreement on Subsidies and Countervailing Measures (SCM).

The SCM provides disciplines on the use of subsidies and also
regulates the actions countries may take to counter the effect of
subsidies. The SCM defines the term "subsidy" as "government
revenue that is otherwise due [that] is foregone or not collected
(e.g., fiscal incentives such as tax credits)." Consequently, it is
clear that tax measures may be within its ambit and subject to its

Along with the definition of a "subsidy," the SCM introduces the
concept of "specific" subsidies - those which are available only to
an enterprise, industry, group of enterprises, or group of
industries in the country that gives the subsidy. The SCM only
applies to specific subsidies, which can be either domestic or
export subsidies. Subsidies that are not specific are thus
non-actionable. Prohibited subsidies, however, are automatically
deemed to be specific, because they are particularly harmful to
international trade.5

The SCM further defines two separate categories of subsidies:
"prohibited" and "actionable." Prohibited subsidies are those that
require the recipients to meet certain export targets, or to use
domestic goods in place of imported goods. These types of subsidies
are prohibited precisely because of their high potential to distort
trade and the consequent allocation of resources within an economy.
Prohibited subsidies can be challenged through the WTO dispute
settlement procedure. If the dispute settlement procedure
determines that a subsidy is prohibited, it has to be withdrawn
immediately; if not, the country bringing the complaint is allowed
to take certain "countermeasures." Also, when domestic producers
are hurt by the import of subsidized products, countervailing
duties may be imposed. Actionable subsidies, in contrast, are those
for which the complaining country must show that the subsidy
adversely affects its interests; otherwise the subsidy is

With respect to prohibited subsidies, the SCM provides that
prohibited export subsidies specifically include those listed in
Annex I of the agreement (Illustrative List of Export
Subsidies).  This is where the connection to tax measures
becomes most obvious.  The fifth item of the list refers to
"[t]he full or partial exemption remission, or deferral
specifically related to exports, of direct taxes or social welfare
charges paid or payable by industrial or commercial enterprises."6 A footnote to that
item provides additional guidance on the definition of direct tax
subsidies, including an important limitation on the transfer
pricing policies which may be adopted by WTO member countries:The
Members recognize that deferral need not amount to an export
subsidy where, for example, appropriate interest charges are
collected. The Members reaffirm the principle that prices for
goods in transactions between exporting enterprises and foreign
buyers under their or under the same control should for tax
purposes be the prices which would be charged between independent
enterprises acting at arm's length.
Any Member may draw the
attention of another Member to administrative or other practices
which may contravene this principle and which result in a
significant saving of direct taxes in export transactions. In such
circumstances the Members shall normally attempt to resolve their
differences using the facilities of existing bilateral tax treaties
or other specific international mechanisms, without prejudice to
the rights and obligations of Members under GATT 1994, including
the right of consultation created in the preceding sentence.

Paragraph (e) is not intended to limit a Member from taking
measures to avoid the double taxation of foreign source income
earned by its enterprises or the enterprises of another Member.

SCM Agreement, Annex I, Item (e), fn 59 (emphasis added).

The key question then becomes, what is the scope of this mandate
to use arm's-length pricing for trade in goods? In a dispute
settlement proceeding brought by the European Communities (EC) in
1998, the EC raised the claim that the pricing rules in the U.S.
Foreign Sales Corporation (FSC) rules violated the arm's-length
principle in footnote 59, although the Panel deciding the case
ultimately declined to rule on that issue, deciding the case on
other grounds.  It appears that no cases have addressed the
scope of the arm's-length pricing requirement in footnote 59.

Thus, important questions remain unanswered.  For example,
what does "arm's length" mean and who gets to decide that?7 Transfer pricing
is known for being an "art" and not a "science,"8 involving a large
number of subjective determinations.  Can a tax administration
simply deem its rules to be consistent with the arm's-length
principle, or could it be subject to detailed fact-finding in a WTO
dispute settlement procedure? What if the rules themselves are
arm's-length on their face, but a tax administration, for example,
consistently uses the information to be provided by the new CBCR
template to make transfer pricing adjustments on audit that are
consistent with formulary apportionment? Could a single instance of
doing so be enough to invoke dispute settlement proceedings at the
WTO or would it have to be a consistent practice?

WTO trade rules can intrude in unexpected ways upon a country's
sovereignty with respect to tax policy.9 This
commentary has only scratched the surface and a whole host of
questions remains to be addressed, but the important point is that
the full implications of the arm's-length pricing requirements
contained in the SCM are not yet clear and OECD countries would be
well-advised to tread cautiously in considering "special measures"
outside of the arm's-length principle. As an initial matter,
stability, predictability, and uniformity are all important design
characteristics for any tax system, in order to avoid uncertainty
that may lead to double taxation in practice, hampering
cross-border trade, and, consequently, economic growth. It would
thus not be prudent for the OECD to choose to move towards a
transfer pricing regime based on formulary apportionment so soon
after its 2010 reaffirmation of its commitment to the arm's-length
principle. Additionally, it may well be that OECD members have
already bound themselves irrevocably to the arm's-length principle
in another forum, the WTO, and one which provides mandatory
procedures for settling disputes, backed up by enforcement powers -
maybe not carved in stone, but enforceability through a WTO
enforcement action may be the next best thing. Consequently, it
will be important to address these issues sooner in the process
rather than later to avoid disputes that could require significant
time and resources to address.10 While the
arm's-length principle admittedly has "flaws," formulary
apportionment is not a panacea and raises its own set of
intractable problems,11 which are
beyond the scope of this commentary. Proactively addressing those
problems and evaluating the full extent of the obligation within
the SCM to employ the arm's-length principle may be necessary to
avoid madness and chaos in the international tax world.

This commentary also will appear in the August 2014 issue of
 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
, Transfer Pricing: OECD Transfer Pricing Rules and
Guidelines, and in Tax Practice Series, see ¶3600, Section 482
- Allocations of Income and Deductions Between Related


  1 OECD Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations
, paragraph
1.15, as amended on July 22, 2010:

A move away from the arm's length principle would abandon the
sound theoretical basis described above and threaten the
international consensus, thereby substantially increasing the risk
of double taxation. Experience under the arm's length principle has
become sufficiently broad and sophisticated to establish a
substantial body of common understanding among the business
community and tax administrations. This shared understanding is of
great practical value in achieving the objectives of securing the
appropriate tax base in each jurisdiction and avoiding double
taxation. This experience should be drawn on to elaborate the arm's
length principle further, to refine its operation, and to improve
its administration by providing clearer guidance to taxpayers and
more timely examinations. In sum, OECD member countries continue to
support strongly the arm's length principle. In fact, no legitimate
or realistic alternative to the arm's length principle has emerged.
Global formulary apportionment, sometimes mentioned as a possible
alternative, would not be acceptable in theory, implementation, or

See also Response of the Committee on Fiscal
Affairs to the comments received on the September 2009 draft
Revised Chapters I-III of the Transfer Pricing Guidelines,
paragraph 46, available at

The material in paragraphs 1.16 to 1.32 is substantially
unchanged from the language of the 1995 Guidelines. This reflects
the reaffirmation by the OECD of its commitment to the arm's length
principle and agreement that the theoretical principle represented
by global formulary apportionment should be rejected.

  2 As everyone knows by now, "BEPS" refers to the
OECD's project on Base Erosion and Profit Shifting.

  3 Gregory, "BEPS Could Lead to `International
Chaos' If Not Managed Well, IRS Official Cautions," 84 Daily
Tax Rpt.
 G-7 (May 1, 2014) (quoting Samuel Maruca,
Director, IRS Office of Transfer Pricing Operations).

  4 See, e.g., Bell, "Treasury's Stack,
OECD's Andrus Examine Various Solutions To `Stateless Income' Under
Consideration in BEPS Project," 22 Transfer Pricing
 73 (May 11, 2013) ("[I]t is entirely possible that
the world will look at solutions that are affirmatively
non-arm's-length"); Bell, "BEPS Project Tracking to Meet September
Deadline for Items On Documentation, Intangibles, Treaty Abuse,
Hybrid Mismatches," 22 Transfer Pricing Rpt. 1191
(Feb. 6, 2014) (The arm's-length principle is "not something that
is carved in stone," and if "we come to the point where we
recognize that there is a limit to what we can do with the
arm's-length principle, we may need special measures-either inside,
or even outside, the arm's-length principle-to really address these

  5 SCM Agreement, Article 2, paragraph 2.3.

  6 SCM Agreement, Annex I, Item (e).

  7 The case of Altera Corp. v.
, T.C., Docket Nos. 6253-12, 9963-12, raises
similar, almost philosophical questions with respect to the §482
regulations in the United States, including whether there is a
universal understanding of arm's-length, whether a tax
administration can simply "deem" certain arrangements to be
arm's-length, and the role and necessity (or not) of comparable
transactions between unrelated parties in establishing arm's-length
pricing. See Gregory, "IRS in
Altera Repeats Arguments Used in Xilinx-But
Also Asserts Arm's-Length Standard `Created by Treasury,'" 22
Transfer Pricing Rpt. 847 (Nov. 14, 2013).

  8 See OECD Transfer Pricing
Guidelines for Multinational Enterprises and Tax
, paragraph 1.13 ("[T]ransfer pricing is not an
exact science but does require the exercise of judgment on the part
of both the tax administration and taxpayer.").

  9 For the most recent example,
see Pruzin, "WTO Sets Up Panel to Rule on Complaints
Against Argentine Efforts to Fight Tax Havens," Daily Tax
 I-1 (June 26, 2013), describing the establishment of
a dispute settlement panel at the WTO to address a complaint filed
by Panama against a raft of tax, investment, and services measures
imposed by Argentina against Panama and other countries it
considers "tax havens." Among the anti-tax haven measures enacted
by Argentina are less favorable tax treatment in the collection of
profits taxes, discriminatory tax treatment on funds entering from
the listed countries, discrimination in the valuation of
transactions with persons from the listed countries, and
discriminatory criteria with respect to tax deductions.

  10 Indeed, the challenges to the U.S. tax rules
designed to incentivize exports have been going on for over 40
years, all the way back to 1972, when the EC brought its complaint
against the domestic international sales corporation (DISC) rules
of the Code as violating the export subsidy prohibitions of the
GATT, continued through the challenges brought by the EC to the
DISC replacement regimes (the Foreign Sales
Corporation/Extraterritorial Income legislation), and are still
ongoing, with the EU's current request for a WTO dispute settlement
panel to enforce compliance with its earlier ruling against the FSC

  11 See, e.g., Bittker and Lokken,
Federal Taxation of Income, Estates, and Gifts, §79.1
("Moreover, the advocated substitutions for the arm's length
standard tend to be reminiscent of the old saw that for every
complex problem, there is at least one solution that is simple,
elegant, and just plain wrong.").