TRANSFER PRICING PROBLEMS & THE ARBITRATION CONVENTION February 19, 2004 Module 3: European Tax Law M.Sc. European Business Law EDHEC Business School,

TRANSFER PRICING PROBLEMS

& THE ARBITRATION

CONVENTION

February 19, 2004Module 3: European Tax Law

M.Sc. European Business LawEDHEC Business School, Nice

© A. Pediaditaki, EDHEC, 19.2.2004 2

I N T R O D U C T I O N

Transfer pricing is :• a major issue in the international tax arena • an important taxation problem within the Internal

Market. Market operators emphasize the ever increasingimportance of the issue, citing:• unduly high compliance costs• clear instances of double taxation which is the appropriate way of « dividing the tax

cake » within the EU?


Transfer pricing in the Internal Market

• In 1992, the Ruding report on direct taxation identified transfer pricing as one of the most important areas for the future of international taxation and for the Internal Market and made recommendations.

• The expotential growth of intra-group cross-border trade call for a thorough analysis of the situation and the adoption of appropriate and realistic solutions.

• As the taxation of transfer pricing is one of the most complex issues of international taxation, a useful basis is the explanation of the basic concepts according to the OECD guidelines on the transfer pricing.


1. The OECD guidelines

The arm’s length principleIt is generally recognized that affiliated companies conducting cross-border business for tax purposes must do this on market principles = they must act as if the business was being conducted between independent companies. Therefore, the price charged for goods and services (: the transfer price) has to be in accordance with the arm ’s length principle. Basis: SEPARATE ENTITY APPROACH= Each affiliated company in a group is for tax purposes treated as a separate entity and taxed individually on the basis that it conducts business with other group members at arm’s length.


The OECD guidelines: The arm’s length principle

• Article 9 of the OECD Model Tax Convention• Analytical interpretation in the OECD

« Transfer Pricing Guidelines for Multinational Entreprises and Tax Administrations » (1995)


The arm’s length principle: BASIS

– Comparison of the conditions of the controlled transactions (i.e. transactions between affiliated companies) with the conditions of (uncontrolled) transactions between independent parties. The latter transactions are referred to as comparables.

– Comparables transactions can be either :• a) internal transactions between the company group

and a 3rd party• b) external transactions between 2 independent

parties– Factors determining comparability include:

characteristics of the property transferred or services provided, functions performed, risks assumed, contractual terms and economic circumstances and business strategies.

– The Guidelines recognize that comparability analysis is not an exact science, but requires an element of judgment.


The arm’s length principle: METHODS Different methods can be applied to establish whether controlledtransactions are in accordance with the arm ’s length principle. The OECD guidelines mention 5 transfer pricing methods falling into2 categories:A. Traditional transaction methods:

1. Comparable uncontrolled price (CUP)2. Resale Price Method (RPM)3. Cost Plus Method (CP)

B. Profit based methods:4. Profit Split Method (PSM)5. Transactional Net Margin Method (TNMM).

The transactional methods are, if applicable, preferred to theprofit methods, which are - therefore - only methods of lastresort. 2 reasons for that: a) independent parties, only rarely (if ever) establish their

prices on a profit method.b) profit margins or splits can be affected by factors irrelevant to the setting

of the transfer pricing (eg. management inefficiencies)


Traditional Transaction Methods 1. COMPARABLE UNCONTROLLED PRICE (CUP) compares the

price for property or services transferred in a controlled transaction to the price agreed for property or services in comparable uncontrolled transactions. If applicable, this method is likely to be the most direct and liable method and therefore it is preferred over all other methods.

2. RESALE PRICE METHOD (RPM) is based on the price at which a product purchased from an affiliated company is resold to an independent entreprise. The gross margin on a controlled transaction is compared with the gross margin of comparable uncontrolled transactions. The resale price to a third party is then reduced by the resale price margin and the remainder constitutes the arm ’s length price at which the product is deemed to have been purchased from the related company, i.e. this method compares gross margins.

3. COST PLUS METHOD (CP) starts with the gross costs incurred by the supplier of the property or services in a controlled transaction. A cost plus mark is added to this cost in order to raise the price to the level at which the product would have been sold in an uncontrolled transaction. The mark up must be consistent with marks up in comparable uncontrolled transactions. Consequently, the CP also compares comparable gross margins on costs. This method is most relevant for production companies or service providers.


Profit Based Methods 4. PROFIT SPLIT METHOD (PSM) identified the combined profit to

be split between associated entreprises from a controlled transaction, and then splits this profit between the associated entreprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. This method differs from all other transfer pricing methods, including the TNMM, as according to the Guidelines it does not necessarily require the use of comparables. PSM is also especially relevant when one or several of the parties hold valuable intangibles.

5.TRANSACTIONAL NET MARGIN METHOD (TNMM) examines the net profit margin relative to an appropriate base (e.g. cost, sales, and assets) that a taxpayer realises from a controlled transaction. TNMM is therefore largely similar to the Resale Price Method (RPM, see 2) and Cost Plus Method (CP, see 3), the difference being that the first compares net margins, the latter gross margins. TNMM was a new development introduced in the Guidelines and has the advantage,compared to RPM and CP, that it does not require the same amount of detailed information concerning the cost base, i.e. direct costs and indirect costs.


Other Profit Based Methods ?

Different profit based methods, in addition to the 5 explicitly mentioned, although not specified in the Guidelines, may also be used provided that they are consistent with the specified profit based methods (4 and 5).E.g. COMPARABLE PROFIT METHOD (CPM) which is originated in the USA. This method is to a large extent similar to the TNMM, the difference being that the TNMM stresses profit per transaction (product line etc.), whereas CPM can be used on a more aggregate basis.


The « arm’s length » range

The Guidelines introduce the so-called arm’s length range. This implies that often comparables transactions will produce a range of figures, which are relatively reliable, and that tax authorities should not make adjustments provided that the transfer prices are within the range. According to the Guidelines « practical information has shown that the majority of cases, it is possible to apply traditional transaction methods ». [ Global formula apportionment methods: they work by allocating profits of a multinational entreprise on a consolidated basis among each group member according to a formula fixed in advance. ]


Documentation requirements for the application of the arm’s length principle

The Problem: What kind of documentation a group company needs to prepare in order to demonstrate it has applied the arm ’s length principle?The Solution: According to the Guidelines « the taxpayer should not be expected to provide more documentation than the minimum necessary to permit tax administrations to audit transfer prices and to verify if the taxpayer has applied the arm’s length principle »The Objective: maintain the BALANCE between the right of the tax administration to obtain from tax payers as much information as possible to ascertain whether the price is or is not of an arm’s length nature, and the compliance cost that any documentation rules imply for the taxpayer.


Documentation requirements according to the OECD’s Guidelines

According to the Guidelines: • the taxpayer should make reasonable efforts at the time the transfer

prices are set, to determine whether the principle is satisfied • the tax authorities can expect or require tax payers to maintain

documentation to support this• However, the amount of documentation required should be in

proportion to the circumstances of each case. In this context, the Guidelines introduce the concept of the

« PRUDENT BUSINESS MANAGER » = the process of considering transfer prices should be carried out in accordance with the same prudent business management principles as would govern the process of evaluating any other business decision of similar complexity and importance.

• The entreprises are not required to use more that one transfer pricing method

• It is acceptable that the supporting documentation only on request from the tax authorities.


Transfer pricing as a management tool MULTINATIONAL ENTREPRISES are usually organized in relatively autonomous divisions which are responsible for the (non-strategic) commercial decision-making. This often includes responsibility of the division management for their own profits (profit centre structure). This implies that :a) every division must be able to decide whether buying a certain (semi-finished) product from third parties or from another related division>> profitability of division-level b) it must be ensured that the objective of profitability of the division level does not hamper the profit-maximising objectives of other divisions or the overall group. A fully developed tranfer pricing system of a multinational entreprise would have to motivate divisional management and link its remuneration to it, be perceived as fair by both the selling and the purchasing unit to allow for an optimal allocation of resources within the group. It is often difficult to find a transfer price that meets all these objectives. For e.g. if there is an unused production facility it would make sense, in an overall group perspective, to instruct the supplying unit to transfer its output to the down-stream affiliate at only marginal or variable cost. This means, however, that the supplier cannot recover its fixed cost and will incur a loss on this transaction. Thus, the objective of maximising the group profit conflicts with the objective of maximising the divisional profit. Questions like this have received extensive attention in the management literature. They show that: transfer prices that are set for commercial reasons (business reasons: effectiveness, performance measurement..) are not necessarily identical to the arm’s length price that is usually requested for taxation purposes.


Profit shifting through transfer pricing

To a multinational group of companies as a whole, the transfer price does not make much difference as long as the goods or the services do not leave the group. Indeed, a real transaction profit or loss to the group occurs only after the goods or services are sold to third parties. Due to differences in tax base and especially in tax rates between different countries, the pricing of intra-group transactions out of one national jurisdiction into another may have significant consequences for the overall tax position of the group. As associated entreprises do not need to deal with each other « at arm ’s length » (like independent parties), they may agree on conditions that would not normally have been agreed upon between independent parties, solely for the purpose of shifting transaction results from a high-tax jurisdiction to a lower-tax jurisdiction. National tax administrations therefore scrutinize cross-border pricing by multinational groups of companies.



EXAMPLE:– A multinational group of companies operates a production plant A in

country A – The company A imports the textiles needed from the company B, in

country B, which is part of the group also. – The corp. tax rate are: 40% in country A and 20% in country B. – It is clear that it is tax efficient for the group to shift taxable income

from A to B. – This can be achieved by transferring the textiles from B to A for a

price very much higher than cost (--> this leaves a large profit margin in country B and only a very small profit margin in A): taxation of profits with just 20% instead of 40%.

– However, the tax administration of A will not simply accept the transfer prices billed, and will correct the purchasing price of A downward if it finds that the price billed differs from the price that would have been agreed upon different parties concluding the same or a similar transaction.



EXAMPLE (continued…)– However, this price adjustment in country A may not be

followed by a corresponding adjustment in country B. The tax administration of B may well feel that the price actually billed was adequate.

in that case, the group faces double taxation: the same profit item is taxed in 2 different countries (A, B) simultaneously.

– Furthermore:• heavy documentation requirements• risk of penalties• costs of having to finance (temporarily or permanently) the same tax

burden twice• increased auditing by tax authorities



CONCLUSION:– We do not need to feel sympathy for groups of companies who choose

such artificial tax planning methods in order to manipulate prices in order to avoid taxes, but reasonable pricing should be accepted by both administrations.

– The main headache of multinationals groups’ tax departments is not avoiding double taxation (About 60% of multinationals ’ tax managers, asked to identify the main tax problem, pointed to transfer pricing)

– Moreover, price manipulation in bad faith and arbitrary double taxation are the two sides of the same coin.


The provisions of the OECD Model Tax Convention

Article 9§1 retains for the contracting States the right to adjust, for tax purposes, trade conditions between associated companies, which differ from those which would be made between independent entreprises.Article 9§2 provides that if one State makes such adjustment, the other State shall make a corresponding arrangement. If necessary, the 2 States involved should consult each other to agree on the arm ’s length price. ** Similar problems: Art. 7§2 (attribution of profits to permanent establishments)However, this does not lead necessarily to satisfactory results: Often authorities from different tax jurisdictions do not share each other ’s views on the arm’s length price nor on the method to determine this price.


The provisions of the OECD Model Tax Convention

Article 25 requires States « to endeavour » to solve the problem by mutual agreement, but sometimes, they do not bother to enter into a mutual agreement procedure, and in any case, there are no time limits and there is no obligation to reach a solution abolishing double taxation. Since:

– the 2 States involved do not have a financial interest themselves in settling the dispute (on the contrary, one of them, or both, would have to waive tax revenue), and

– the associated entreprises involved are not parties to the mutual agreeement procedure between States mutual agreement may become bogged down and the associated entreprises may be left with the financial consequences. Solution?


The Arbitration Clause in DTCs

Modern bilateral tax treaties sometimes contain an arbitration clause for cases in which the authorities do not succeed in reaching a mutual agreement: e.g. DTCs between USA-Netherlands and USA-Germany Once again, they may not be satisfactory either, because they:

• make initiation of the arbitration procedure conditional upon approval by the authorities,

• allow the authorities to appoint the administrators.

Still, solution is possible:E.g. the DTC between Germany and Austria is a positive exception: it provides for a mandatory referral of the dispute to the ECJ on the basis of art. 239 EC Treaty if the tax authorities do not succeed in reaching an agreement within 3 years.


2. The fundamental tax issues in the Internal Market

• MS ’s legislation generally obliges domestic intra-group transactions to take place at arm’ length.

• In practice, however, transfer pricing is mainly a cross-border issue which creates specific compliance costs and contains the risk of double taxation. Multinational entreprises in the EC framework find themselves confronted the difficulties mentionned [ see slide 17] cross-border flow of goods, intangibles, and services between associated entreprises distort competition in the Internal Market (lack of tax neutrality).


The impact on Tax Authorities

Furthermore, the effect on national authorities should notbe omitted, although it is not directly an obstacle to theInternal Market : • High compliance costs of transfer pricing• Transfer pricing auditing differs from normal auditing:

– more complex– expensive– requires high skilled tax auditors

• Reaction of MS: Reduction of these «difficulties» by the introduction of robust transfer pricing rules , notably in the form of tough documentation rules, backed up by penalties for non-compliance, which transfers the burden to business and to other tax administrations RESULT: risk of race to the top between MS


The Arbitration Convention

For all these reasons, in 1990 all (then) 12 EC MS signed a Multilateral Convention on the Elimination of Double Taxation in connection with the adjustment of profits of associated companies (90/436/EEC).Legal basis: article 293 EC« Member States shall, so far as it is necessary,enter into negotiations with each other with a view to securing for the benefit of their nationals ’(…) [2nd indent] « the abolition of double taxation within the European Community ...».HISTORY:- 1976: first proposal for the adoption of a Directive on the same subject. According to the European Commission, the transfer price adjustments and the resulting international double taxation « directly affect the establishment and functioning of the Internal Market » in the sense of art. 94 EC, so: harmonization of national laws by ways of Directives.- However, the Council felt that the article 293 and not the art. 94 should be the legal basis for the transfer pricing arbitration.


Legal nature of the Convention & Consequences

This Convention is not an EC legal instrument, but a multilateral international public law convention. Result: its application is largely dependent on national law (ratification for entry in force and national jurisdiction are the final judges of the Convention):– unlike a directive, there is no implementation deadline – it does not confer any powers on the ECJ - lack of

jurisdiction to interpret and enforce the Convention provisions.

– the European Commission cannot initiate the infringement procedure (art. 226 EC) against MS ’ failure to comply with the Convention.

it is a POOR MEANS OF INTEGRATION as it:– hardly requires MS to give up tax sovereignty – offers little legal protection to multinational companies

involved.


Principles of the Arbitration Convention

The principles on the division of the « tax cake » (= allocation of profits) are, according to the Convention, those of:– arm ’s length – separate accounting. Profits of: a) associated companies

b) branches and c) their head offices

should be determined as if they were dealing wholly independently from and with each other on the basis of separate tax accounts. These principles form the profit allocation standard of the OECD. The opposite system which is applied for e.g. in the USA, notably for State taxation purposes, is that of UNITARY TAXATION AND FORMULA APPORTIONMENT.


Principles of the Arbitration Convention

The Convention does not specify to WHICH arm ’s length method it adheres. The OECD guidelines prefer the Uncontrolled Price Method (UPC) . The drafters of the Convention did not wish probably answer. So they merely stated that profits of individual associated companies must be determined as if the commercial and financial relations between these associated entreprises were those which individual companies would have. This may mean that any method is valid as long as it is based on the fiction of independence of the associated entreprises involved, rather than on blind formula apportionment of the total group profit among the individual companies in the group, as applied in the unitary taxation approach.


Rules of the Arbitration Convention

The Convention contains only two rules of SUBSTANTIVE tax law:1. The arm’s length principle2. The obligation to eliminate double taxationThe rest is PROCEDURAL RULES: – In comparison to most bilateral DTC the Arbitration Convention

goes further, as the MS are prepared to subject themselves to arbitration, even under time limits.

– The Convention confers the right on the entreprises affected by a re-allocation of profits to file a complaint with the competent tax authority.

– Furthermore, it provides for a mutual agreement procedure between States involved.

– If the MS cannot reach agreement it provides for an arbitration procedure to settle the profit allocation dispute in a way that eliminates double taxation.


Interpretation and application of the Convention

The ECJ has no jurisdiction. So, the national judiciaries are the final interpreters and the result is that different interpretations are possible.

• Art. 3§2 states that any term not defined in the treaty between the 2 States involved, shall have the meaning assigned to it under the treaty between them, unless the context concerns otherwise. – And what if there is no such treaty does not exist? Many bilateral

relationships between States are not covered by DTC. – And what if the existing DTC does not contain or define the term?– Finally tax treaties often refer to domestic law of the contracting

states applying the Treaty (eg. the term «entreprise » is not defined in the Arbitration convention nor in the OECD Model tax convention).

– Important tool of interpretation may be in important tool of interpretation.


Minimum standards

The Arbitration Convention rules are a minimum standard.

According to art. 15 national and bilateral rules providing for wider elimination of double taxation are not affected.

However, such rules, if existing, do not usually provide for wider relief.


Scope of the Arbitration Convention

Article 1§1 The Convention covers any situation in which profits of an entreprise of a contracting state, which are included in its taxable income in that state, are also included in the taxable income of an entreprise of another contracting state, on the grounds of the non-observation of the arm ’s length principle by the entreprises involved. --> BUT double taxation resulting from causes other than arm ’s length profits adjustments are not covered. The Convention offers no remedy for cases of international double taxation as a result of recharacterization of income or costs by a national tax administration or as a result of disparities of profit determination rules between MS.


Scope of the Arbitration Convention:a) « Entreprise »

Article 1The term « entreprise of a contracting state » is not definedbut it covers expressly the permanent establishment.Probably the term covers any company and any more or less permanent independent commercial activity carried out on for a profit (= a business). Incorporation is not required. Eg. A is self-employed confectioner owns 2 patisseries, one in each side of the border between countries B and C.Article 4§1 of joint declaration annexed to the Convention: « troisième état contractant » From the French text it is clear that « third country » must be a 3rd EC Member State.


Scope of the Convention:b) Nature of affiliation required

Article 4§1 is a literal rendition of art. 9 §1 of the OECD Model.Affiliation criteria: – VERTICAL: direct or indirect participation by an

entreprise of one MS in the management, control or capital of an entreprise in another MS

– HORIZONTAL: direct or indirect participation by the same persons in the management, control, or capital of an entreprise of one MS and an entreprise of another one MS.

Article 4§2 requires separate accounting between the headoffice and the foreign branch within one entreprise>>literal rendition of art. 7 §2 of the OECD Model. .


Scope of the Convention:b) Nature of affiliation required

Article 1 §3 ensures the application of Convention if due to losses suffered by one or more of affiliated companies, the disputed price adjustment has no current tax effect. MS shall not stall proceedings until problems start to produce effects. The level of effective taxation is IRRELEVANT: the lack of benchmark taxation in the other contracting MS is not an argument to challenge the applicability of the Convention.


Scope of the Convention:c) Which taxes and where?

Article 2 §2 :Taxes covered: a) corporate income taxes b) individual income taxes

Territorial scope: a) is identical to the territorial scope of EC Treaty (art. 299 § 1)b) exception: French Overseas Territories, Faroe Islands, Greenland (art. 16)


THE PROCEDURES: a) Notification and objections

Notification by the MS of the entreprise concerned. The entreprise is expected to inform its associated entreprise, branch or head office in the other MS, which is, in turn, expected to inform the tax authority of the other MS. 1) If everyone agrees to adjustment, no problemNB. The MS which wants to adjust is under no obligation to defer the adjustment until the reaction of the entreprise and the other MS. 2) if the entreprise does not agree - feels that the adjustment offends the arm ’s length principle, it may submit a complaint to the competent authority of its state (informing if other States are concerned) . Within 3 years of notification. In case of complaint it is the authority of the MS that will notify the authorities of the other MS.


THE PROCEDURES:a) Notification and objections

Domestic legal remedies? YES IN ANY CASE • Submitting a complaint does not bar the entreprise(s) from

recourse to domestic legal remedies . (art. 6: ius de non evocando).

• Vice versa, the non-use of domestic legal remedy (making the adjustment decision final for domestic appeal purposes) does not prevent recourse to the Arbitration Convention procedures (art. 13).

Until this point we do not surpass the domestic level


THE PROCEDURES:b) Mutual agreement

Article 6 § 2: « well-founded complaint » means discretionary power of tax authorities?It is only to exclude manifestly ill-founded applications.

If the competent authorities of the MS reach an agreement, it will implemented irrespective of possible time limits of domestic law after which tax assessments are final and irrevocable.

• Until now we are at the interstate level and the company has no party or status in the mutual agreement between MS.

• Up to this point the obligation is to negotiate, not to settle (art.25 Model Tax Convention)


THE PROCEDURES:c) Arbitration procedure

Art. 7 §1:If failure of agreement between authorities of MS within TWO years, they are required to set up an advisory committee which must give an opinion on how to eliminate the double taxation caused by the price adjustment. How is the 2-year computed? Domestic time limit for appealArt. 7 §2:Referring the case to the advisory committee does not prevent the contracting states from starting or continuing administrative or criminal proceedings on the same issue.If one of the entreprises is liable for a serious penalty , then no obligation to start mutual agreement procedure or set un advisory committee. See definition of « serious penalty » in Unilateral declarations on Art. 8 in an annex to the Convention


The advisory committee

Art. 9 : Composition of the committee...Art. 9 §6: Obligation of SECRECY - breach of secrecy is penalized.

The associated entreprises:- are not parties proper to the proceedings, but they have the right to provide the commission with information, evidence or documents they consider relevant (Art. 10) - have the right to request to be heared before the committee- are obliged to appear or be represented if the committee requests them to be heared before it.


The advisory committee

Art. 11• The commission must deliver its opinion, based on the

arm ’s length principle within SIX MONTHS on the case being referred to it.

• Decision by simple majority of votes• The Convention does not expressly require the commission

to state the grounds for its finding, but since it requires the opinion to be based on the principles stated in art. 4, some expression of motives will be needed in order to show that basis.


Elimination of double taxation

Art. 12:Within SIX MONTHS of the commission delivering its opinion, the competent tax authorities must by common consent eliminate double taxation. They may DEVIATE from the commission ’s opinion, provided that (a) double taxation is eliminatedand (b) their decision is still based on the arm ’s length principle If common consent cannot be reached, the competent authorities must adopt the solution of the commission. The authorities are not required to state the grounds for their decision.


When is the double taxation eliminated?

Art. 14: The double taxation is considered to be eliminated

if the profit item disputed is:• either included in the taxable base in only one State

(exemption method)• or included in the taxable base in both States, but gives rise

to a reduction of the tax due on that item in one State equal to the tax due on that item in the other State (credit method)

Documents

TRANSFER PRICING PROBLEMS & THE ARBITRATION CONVENTION February 19, 2004 Module 3: European Tax Law M.Sc. European Business Law EDHEC Business School,