OECD Weighing Importance of Legal Agreements Versus Comparables

In the lead section of today's Transfer Pricing Report, business practitioners and members of the Organization for Economic Cooperation and Development's Working Party No. 6 tackle the question of what weight to give legal agreements between related parties versus third-party comparables. Joseph Andrus, head of the OECD's transfer pricing unit, said he is troubled by the inconsistent positions taken by business interests on this issue.

In some OECD countries, taxpayers and tax authorities use an ex ante approach, pricing a transaction based on “contemporaneous” information—knowledge of assets, functions, and risks, as well as the business's historic price data for particular markets and forecasts and expectations that were reasonably available to the taxpayer when the transaction was undertaken. The alternative is to price the transaction after the event, or ex post, either at period end or at tax return time, through true-ups or transfer pricing adjustments. This approach yields, through the benefit of hindsight, more recent historic data and market and project comparables.

The danger with having two equally favored approaches is that taxpayers--or for that matter, tax authorities--can use whichever yields the better result.

In some cases, taxpayers are able to support a favorable tax treatment with third-party data even when it leads to nonsensical results, one practitioner pointed out. Mak Bronson of Ceteris in Boston pointed to the 2010 case Xilinx Inc. v. Comr. as an example. In the case, the IRS argued the company should have included amount from employee stock options in the cost sharing pool with foreign subsidiaries. Xilinx was able to find agreements between unrelated parties showing that they did not share these costs, and the court ruled in its favor, finding the company need not share otpions costs with subsidiaries.

Bronson pointed out that there were differences between the structure of the intercompany transactions under examination and the third-party agreements used as evidence. “This reliance on arm's-length behavior that can't be finely tuned to the specifics of the agreements that we're using can lead to some nonsensical results, as they did in the Xilinx case,” he said.

The danger of the ex ante approach, on the other hand, is that taxpayers have access to more information than do tax authorities, a U.S. Treasury official said. Michael McDonald, an economist in Treasury's Office of Tax Policy, gave an example in which a taxpayer conducted a valuation of a highly uncertain, risky intangible at “time zero.” When the tax authority looks at the transaction five years later, “lo and behold, the internal rate of return on that intangible was several times the discount rate,” allowing the company to avoid paying tax on a large part of the return. Paragraph 176 of the OECD's June 6 draft on intangibles sums up what McDonald called a fundamental problem of information asymmetry: “the fact that risk is a very mobile thing and taxpayers have more information about how they see risks playing out than tax authorities do at time zero.”

Another business representative--Brigitte Baumgartner, international taxation manager for the Austrian Metallurgical company Plansee Group Services GmbH--urged the working party to consider “the regular taxpayer” that simply wants to comply. For such companies, she suggeted, having a choice between two approaches perpetuates the current uncertainty surrouding the treatment of intangibles transactions.

“If you leave a door open and say ‘We encourage this [method] but if you use the other one, that's all right too,' then we are standing in the same place we were before,” she said.

Those interested in further discussion of these issues are invited to attend the Bloomberg BNA-Baker & McKenzie Global Transfer Pricing Conference in Paris March 11-12. For more information and to register, visit http://bit.ly/UpPfTf.

Molly Moses

Manager, Transfer Pricing Report