The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
June 8 — The OECD's project to combat base erosion and profit shifting has exposed fundamental weaknesses in transfer pricing, but it hasn't presented a better mechanism for dividing corporate profits among jurisdictions, a U.K. official said.
Mike Williams, director of business and international tax with Her Majesty's Revenue and Customs, was a keynote speaker June 8 at an international tax conference co-sponsored by Bloomberg BNA and Baker & McKenzie LLP.
“There are aspects to transfer pricing that need to be improved, updated to make it fit for purpose,” Williams said.
“I think the message I want to leave with you is I am a critical friend of transfer pricing,” he said. While there are aspects to transfer pricing that need to be improved, it is still the best method to allocate profits of a multinational group among the countries where it does business, Williams said.
“A core advantage of the way it works is that, having divvied up the profits, it is then up to individual countries to decide whether and at what rate to tax the profits that are attributed to them—and that is important in terms of sovereignty. By dividing the profits between countries in a sensible way, it enables countries to exercise their sovereignty in a way that benefits them.”
Transfer pricing also presents a mechanism for avoiding double taxation and reducing distorted incentives, he said.
“A central tenet of English transfer pricing, and a central tenet of the BEPS project, is that profits belong where the economic activity generating them is located,” Williams said.
However, he said, it is much easier to say that than to achieve it.
“We have to recognize before we get into the details that there is no perfect way to divvy up the profits across all sectors,” he said, with a dig at advocates of formulary apportionment. Many who argue that a formula would be better never get into the details of how the formulary approach would work, he said.
“You say it would be better to use a formula. Maybe it would be, if we could agree on what the formula was or how it would be applied,” Williams said.
“It's also quite easy to say many problems with tax avoidance could be minimized if every country imposed a minimum rate of tax. Maybe. But again, what should the minimum rate be? It is easy enough to say, but how do you achieve it?”
Williams said transfer pricing is a long-established, well-tested approach, but acknowledged that it has fallen out of step with the times. The Organization for Economic Cooperation and Development must update its transfer pricing guidelines to keep pace with the way businesses operate in the modern economy, he said.
“Everyone talks about the arm's-length principle, but it is no more than a means to an end,” Williams said. “It is a way of dividing up profits between countries. If countries were to decide there were a more sensible way to divide up profits, then people would want to change to something else.”
One of the principal weaknesses of transfer pricing is that when it comes the transfer of intangibles, it can deliver “some pretty indefensible outcomes, particularly where tax havens are involved,” he said.
When the arm's-length principle was developed under the League of Nations in the 1920s and 1930s, tax havens weren't a factor. Nor were there any real incentives for multinational companies to set up cash boxes in tax havens.
The OECD's BEPS project is an attempt to address those flaws in the system, Williams said.
Transfer pricing doesn't tell you much about the allocation of income within a group, he said; it doesn't tell you where the capital should be in a group.
“You can have a circumstance where a group has a spare billion dollars and it uses that capital to fund a tax haven entity. As a result of its choice, a lot of the capital will then lie in the tax haven entity and that may change the division of the profits between entities in the group. Is that defensible? Again, you can see why that is an issue that we needed to look at as part of BEPS project.”
While the current system isn't perfect, Williams said, it is better than many alternatives. A debate is currently going on among countries about how important controlled foreign company (CFC) rules are as a backup to transfer pricing.
“In the U.K. we’d say, ‘yes, very important as a backup, but not more.' For two reasons: one, if you’re looking at increasingly open economies in a global world, within an economy you’ve got to have as level a playing field as you can between the domestic players, the home-based multinationals and the foreign-based multinationals operating in your territory. CFC rules don’t achieve that because they focus on the home-base players.”
In contrast, transfer pricing focuses on all players on an equal basis, he said.
“It is more likely to get you to a level playing field,” he said. “If what you are trying to do is tax profits related to economic activity in your territory, you are better off trying to do that directly through the transfer pricing rules than waiting until those profits move to a tax haven entity, into a CFC, then grabbing them back.”
Williams likened CFC rules to going home at night—and instead of using a key to unlock the front door—going around back and climbing up a ladder to crawl through an unlocked back window.
“Why go through such a complicated process?” Williams said. “Why would you do that? If you’ve got a means of allocating profit that doesn’t work as well as you’d like it to, should you focus on doing something different, rather than fix the main thing, which I think is transfer pricing?”
In many ways, the BEPS project has been a means of exposing and addressing some of the fundamental flaws in transfer pricing. But it also raises some troubling questions about why those flaws exist in the first place.
The OECD's final report on Actions 8 to 10 under the BEPS project outlines changes to transfer pricing guidelines. A central tenet is that “outcomes should be determined in accordance with the actual conduct of related parties in the context of the contractual terms.”
Thus, if a taxpayer has a cash-rich entity, it must show that it controls the financial risks in order to enjoy the rewards. At the same time, BEPS has demonstrated a need for more effective rules in dealing with high-value intangibles, he said.
“On the one hand, it is good these issues are being recognized,” Williams said. On the other hand, he said, it is surprising that the existing rules don't already require that outcomes be determined in accordance with the actual conduct of the parties.
“In a sense, it is slightly worrying and slightly hard to explain how we got into a position where it was necessary to reaffirm this. You could equally argue that this is reaffirming existing best practice in a number of countries,” Williams said. “But is it not a bit odd that you would not already be determining outcomes in accordance with the actual conduct of the parties?”
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