By Janice McCart and Scott Wilkie
Blake, Cassels & Graydon LLP
For most businesses today, transfer pricing and, more recently, tax risk management associated with developing a transfer pricing strategy occupy a top spot on the priorities list when it comes to international tax issues. Transfer pricing, a phrase that has in recent months achieved common parlance status, is, at its most basic, a corporate tax issue. It is an issue that arises when “goods” or “services” are transferred between a local company and one or more other, non-resident members of its group giving rise to “non–arm's length” transactions. Tax authorities (including in Canada) routinely examine these types of transactions to determine whether amounts paid or received in the inter-corporate transaction differ from those that third, or “arm's-length,” parties in the market would have paid or received. Transfer pricing is “regulated” by local law in taxing statutes but the application and direction of that law is significantly influenced by the global consensus on underlying principles expressed, since the 1970's, in the published work of the Organisation for Economic Co-operation and Development (“OECD”), notably, the Transfer Pricing Guidelines.
INFLUENCES AND CHANGES — A “NEW” TRANSFER PRICING?
“Transfer pricing” is now entering the most mature phase of its modern existence as a sub-discipline within tax practice. This phase is framed by the G-20 inspired examination by the OECD of “Base Erosion and Profit Shifting” (“BEPS”). It is also prominently reflected in other recent work of the OECD including its transfer pricing – focused examination of the origination, sharing and transfer of “intangible” value within corporate families.1
Much of the discussion in the transfer pricing world for which the OECD's BEPS and “intangibles” studies are the catalyst focuses, not surprisingly, on “technical” features of transfer pricing analysis. However, three aspects of this work and the pattern that they form, are potentially profound and in any event, are certainly directional of transfer pricing's contemporary significance as the encapsulation of international taxation. These concern (i) transfer pricing as a primary instrumentality of perceived “base erosion and profit” shifting cited in the OECD's BEPS report, (ii) a continuing evolution of the meaning of the “arm's-length standard” evident in the OECD's approach to intangibles and related transfer pricing analysis and documentation, and (iii) a systemic and coordinated expectation among tax authorities that in applying their tax systems to evaluate the taxation of corporate income they should have ready and unrestricted access to the same information, on more or less the same basis, that taxpayers themselves compile and use to plan, conduct and monitor the performance of their businesses as “firms” or global enterprises.
It may take some time for legislative changes, should they be considered necessary, to be made and for specific changes in international guidelines to be implemented with broad international acceptance to give full prescriptive voice to the sorts of changes in approach and outlook foreshadowed by the present debate. But there is an evident pattern in these directional changes, and political force behind them, no doubt inspired at least in part by countries' needs to marshal their fiscal resources to sustain their public obligations. The mere fact that serious discussions about transfer pricing are taking place, visibly and with such momentum, among taxpayers, tax advisors, tax regulators and tax policy makers will, and should, affect each constituency's outlook even on the application of prevailing transfer pricing regulation.
TRANSFER PRICING REDUX
Transfer pricing regulation is nothing more than the validation of a corporate taxpayer's reported income with reference to the circumstances of similarly situated third or, in tax terminology, “arm's-length” parties according to the so-called “arm's-length standard” or “arm's-length principle”. The goal is to detect and correct situations in which a taxpayer's reported tax income objectively seems to have been affected by other than commercial dealings with other members of the commonly controlled corporate group because of the opportunity offered by controlling all the relevant aspects of transactions to also control where income comes to rest and is taxed (or not).
From a taxpayer's perspective, transfer pricing fundamentally is about taking the initiative to explain, in an accurate but compelling way with the insight that can only come from actually “doing the business,” how its income is earned taking account of the advantages of conducting business as an integrated, global group which are not afforded to unconnected enterprises. It is the underlying enigma of transfer pricing that the business performance of enterprises organized to avoid various competitive and other limitations of arm's-length dealing – global “firms” in the microeconomic sense – would be evaluated and might be found wanting according to “arm's-length” strictures. This irony – in economic terms the measurement and distribution within a multinational group of the “value delta” attributable to conducting business as a commonly controlled global enterprise – underlies transfer pricing and the arm's-length standard in all of phases of its evolution. The present global debate is unique in drawing direct attention to this issue, and making it prominent as an important international fiscal issue from a political perspective which the BEPS initiative does. This solution of tax, economics and politics means, necessarily, that even if the language and apparent methodology of transfer pricing continues, their connotations are likely to change, as must taxpayers' and tax advisors' approach to constructive transfer pricing analysis, reporting and controversy resolution.
Functional analysis and related valuation questions, the “stuff” of transfer pricing, fundamentally concern where business activities “take place” – in jurisdictional terms, the “source” of a taxpayer's income and the facilities or presence through which the taxpayer is connected to the source. The “transactions” with which transfer pricing has always been concerned arise from carrying on an integrated business with other members of a commonly controlled group, in circumstances where the parties' commercial self-interest and independence cannot be taken for granted. Commercial dealings between members of a corporate family are not presumed to reflect genuine, objective adversity of commercial and legal interests between unrelated parties and have consequently been under continual and comprehensive review and audit by tax authorities.
Transfer pricing's transaction – oriented analysis has always masked latent questions about whether a group member might be considered to carry on its business and have a business presence other than where intended.2 “Controlled foreign corporation” rules – in Canada's case, the “foreign affiliate” rules – have a clear transfer pricing flavor, notably (but not only) in specific legislative “base erosion” provisions. However, for a long time, these textures and subtleties underlying transfer pricing analysis were unspoken, seen indeed as normative international tax analysis somehow separate and distinct from transfer pricing.
The OECD's BEPS initiative and its examination of “intangible” value transfers are changing the parameters of transfer pricing analysis. They expose not only the inherent complexity and reach of transfer pricing as the platform on which the application of other international tax rules likely will be applied, but also the extension of transfer pricing, at least sympathetically, into these other areas of international taxation, informing and being informed by them. Additionally, there is a strengthening resolve of tax authorities cooperatively to insist on a penetrating understanding of how multinational business actually works and to question, though still within the bounds of transfer pricing's “arm's-length principle,” how the “value” of business combinations should be accounted for among group members. These are not theoretical outcomes. The result will be a more focused, and certainly more rigorous and expansive audit examination, and construction and application of international tax rules, by tax authorities for which transfer pricing will be the entry point.
THE FOUR PHASES OF MODERN TRANSFER PRICING — WHERE WE WERE TO WHERE WE ARE
Transfer pricing has always been concerned with parsing multinational business operations to test the objective alignment of income with where it has been earned. But the intensity and scope of transfer pricing analysis is necessarily affected by the business circumstances to which it is applied, and more particularly the sophistication among observers – taxpayers, tax advisors and tax authorities – in understanding latent elements of industrial organization that the “globalization” phenomenon, including the capacity to conduct business “digitally,” has revealed. Consequently, the scope and significance of transfer pricing – and what the arm's-length standard means and how it will be applied – have changed.
1979 — Transactions, Goods, Services and Prices
In its earliest stage, transfer pricing was seen as a more or less self-contained “tax accounting” exercise thought by many to stand apart from “mainstream” international tax provisions and principles, for example, tax treaties, “controlled foreign corporation” rules, and the plethora of rules governing international acquisitions and reorganizations. There was a clear emphasis on the “price” aspect of readily observable transfers of goods and the performance of services through typical commercial transactions that generally were accepted to be what their overt contractual terms portrayed them to be. The 1979 Transfer Pricing Guidelines of the OECD and countries, relevant legislation and tax practices were largely consistent with this outlook on transfer pricing.
1995 — Arm's-Length Transactions Split Profits
The next generation of transfer pricing culminated in the OECD's restated 1995 Transfer Pricing Guidelines, the catalyst for which, it is widely acknowledged, was an evolution of United States transfer pricing regulation. Despite continuing adherence to a transaction and price focus, this phase of the Guidelines, and this generation of the arm's-length standard, reflected an underlying realization that the arm's-length standard is in some respects antithetical to the features of the very taxpayers it is meant to test. Profit-oriented methodology, though still considered subordinate in 1995, acquired greater acknowledged respectability, even though ascribing a transactional arm's-length standard to the distribution of “profit” within a commonly controlled global enterprise might seem to extend the arm's-length standard beyond its original connotation. In other words, the arm's-length standard can be seen, in this phase as stretching, and being stretched, to accommodate a dawning reality that “transactions,” themselves, may not reliability determine an appropriate allocation of group profit in line with the expectations of functional analysis.
2010 — The Profit of Groups and Business Migration
The third phase is captured by the 2010 restatement of the OECD Transfer Pricing Guidelines. Two notable changes were made. First, the core perception and associated methodologies of the arm's-length standard were restated in significantly revised Chapters I, II and III. The traditional methodological approaches were preserved as manifestations of the arm's-length standard, but the hierarchy that had favored transaction comparison methods (“CUPs”,” CUTs,” “resale minus” and “cost plus”) was abandoned in favor of a “best method” approach according to which profit splits and comparisons acquired even more respectability. Second, the reality of “business restructuring” was also specifically addressed.3
Under the banner of “business restructuring,” what was clearly in the cross hairs of evolving transfer pricing analysis was the suitability of the arm's-length standard to analyze constellations of corporations separately accounted for according to the separate entity accounting regime that “is” transfer pricing. The new “business restructuring” guidance is cast in the mold of the arm's-length standard, but effectively it addresses the “value delta” that distinguishes the business activities of “connected” and “unconnected” enterprises (and that may not be entirely or reliably captured by traditional transaction analysis), necessarily addressing the contribution made by “intangibles” and the intrinsic features of functional analysis that are not merely physical but also reflective of risk and related entrepreneurial reward. The importance of “contracts” was also affirmed. But there is still a sense of doubt expressed that “contracts” necessarily, by themselves, tell the whole story or in any event should be controlling where their effect is to significantly alter a pre-existing fiscal balance within corporate groups and among the countries in which they ply their businesses, and the objects of those contracts are not obviously associated with the sort of industrial activity that typically had been taken for granted as the foundation of a transfer pricing analysis.
In the 2010 Guidelines, the traditional limits and connotations of the arm's-length standard seem to have been tested, and its role possibly seen more clearly as an aspirational framework, rather than prescriptive guidance in the nature of statutory and regulatory law, as to the expectation that reported tax income should be attributable to meaningful commercial dealings undistorted by the exercise of common control for its own sake. Also evident, though not explicit, was a realization among tax authorities that possibly the separate entity accounting foundation of transfer pricing was wanting, and that a new approach to information gathering and analysis would be necessary to facilitate the kind of analysis and reporting contemplated by Chapter IX of the Transfer Pricing Guidelines.
2011–2013 — Associated Enterprises as “Firms”
This brings us to the fourth phase of transfer pricing's maturity, marked by the OECD's work on “intangibles” and certain undercurrents in BEPS which are clearly connected to the intangibles issue, and the increasing propensity of countries to share information about their taxpayers and to compel taxpayers otherwise not so inclined to explain their global (versus local) business operations to tax authorities more thoroughly and meaningfully with reference to complete documentation. As we observed earlier, this phase may or may not yet be captured by existing law or if necessary, by immediate legislative or other regulatory changes. But its force and the perceptions underlying it are not going to go away and should not be underestimated. Indeed, developments of outlook and analysis featured in this phase have political force among many nations including but not limited to the G-20 countries (including non-OECD countries) whose interests, apart from this, may not always align. That in itself is an indication of how important it is to understand the direction and significance of these changes, which will be felt in even the most typical and mundane aspects of transfer pricing practice.
THE “NEW” TRANSFER PRICING — THE “ARM'S-LENGTH STANDARD”INTACT BUT RECALIBRATED
What are the hallmarks of this next generation of transfer pricing? There are three. First, though articulated within the usual bounds of the arm's-length principle, multinational or global enterprises increasingly are seen as “firms” — groups of separate legal entities that form economic units. Transfer pricing is responding, not by abandoning the familiar analytical framework, but by reconditioning it to deal with the realities it encounters as “globalization” has revealed them. This is reflected in, for example, the ability of global business to be conducted electronically such that accepted measures of income and jurisdictional proximity are possibly less reliable. Second, profits are considered to arise from observable activity somewhere, and “somewhere” is where activity of the expected nature can be sustained commercially, organizationally and institutionally. Third, multinational enterprises will be explaining their businesses differently, and comprehensively, as global business with national attachments.
Global Firms — Global Transfer Pricing Analysis
There is an evolving perception of multinational or global corporations as single or unitary “economic firms, even though the transaction-oriented arm's-length standard, and pointedly not “formulary apportionment” or its kin, is still the standard guiding transfer pricing analysis. This is marked by the parallel acknowledgment by the OECD in its intangibles study of property ownership and contractual relations as starting points (only) for discerning how business income should be taxable, and taxed meaningfully “somewhere,” within a corporate group according to a dispersion of and contributions to the “value delta” – in the OECD's present analysis “synergy,” synergistic benefits” and the like as well as “intangibles” – that typify multinational organization and reflect some measure of institutional, as well as business, unity. Despite much that could be said about particular features of the OECD's intangibles work that bear on day-to-day transfer pricing reporting and controversies, it is evident that the OECD strongly believes that tax authorities require a holistic, complete understanding of an entire global business enterprise in order to evaluate the income of its constituent “legal” pieces. There is also a clear focus on identifying specific factors of production and market features that are mobilized within a supply chain, and an expectation that in order to create “value” something more than contractual obligation is entailed – that is, observable, functional activity more often than not involving people, somewhere in circumstances that functionally can sustain the conduct of the relevant productive activities. Among other things this is reflected in the OECD's expectation that in some cases, transfers of employees may entail transfers of intangible value.
There are clear themes in the OECD's current work. The arm's-length standard or principle still governs but what it means may not be what it was once, in a more “innocent” time, thought to mean. Ownership of property and contracts are relevant considerations, but they are not determinative. There is an expectation, flowing from the nature of a “firm” or in transfer pricing parlance “associated enterprises” that contributions to the sort of value that distinguishes one group from another (and from disassociated businesses) are shared, possibly seamlessly, by group members who correspondingly are entitled to share in the differential return that is not available but for the group's existence. And – and this is where the evolution in transfer pricing theory becomes particularly practical – this sort of heightened insight into what transactions mean contrasted with what they are contractually needs to be analyzed and documented as part of a transfer pricing inquiry. These considerations can also be expected to figure prominently in disagreements with and between tax authorities, because the features of this dimension of transaction value and its connection to taxing jurisdictions are far less obvious or readily discernible in the case of “intangibles”. Even if the tendencies of the OECD's approach to “intangibles” emerge to be more limited than at present, it will not surprising if, still, these tendencies affect, in practice, how transfer pricing analysis is approached and transfer pricing legislation, including Canada's section 247 of the Income Tax Act (Canada) is interpreted and applied with appropriate deference to the non-statutory status of the Transfer Pricing Guidelines.4
IS CHANGE A REALITY?
This is where BEPS enters the picture. Unlike how other developments in transfer pricing may occasionally have seemed to some, its present evolution is not merely a professional, tax reporting, tax regulation exercise. Though it is separate from BEPS, it is very much a part of and closely connected to it.5 This means that transfer pricing is closely connected to countries' perceptions that there is material revenue loss to them attributable to uncompensated business activity closely associated with where business activity is commonly thought to occur — for example, where production factors exist and are mobilized, where exponents of a business including employees do what they do including as those functions may create or mitigate risk, and where markets and customers that turn those production factors and risk to account are located. No fewer than seven of the fifteen BEPS Action Items, in the BEPS Action Plan6 directly concern the influence of transfer pricing: Action 6 (“Prevent treaty abuse”); Action 7 (“Prevent the artificial avoidance of PE status”); Actions 8 (“Intangibles”), 9 (“Risks and capital”) and 10 (“Other high-risk transactions”) together (“Assure that transfer pricing outcomes are in line with value creation”); Action 12 (“Require taxpayers to disclose their aggressive tax planning arrangements”); and Action 13 (“Re-examine transfer pricing documentation”) with it being noted that “Transparency also relates to transfer pricing and value-chain analyses.”
If this does not provide a clear enough picture that changes in the transfer pricing world are not theoretical abstractions, even if it takes time to translate aspirations into prescriptive guidance, the G-20 September 2013 Leaders' Declaration leaves little doubt about how tax administrations may be expected to redouble their transfer pricing work. The G-20 Leaders said:
Profits should be taxed where economic activities deriving the profits are performed and where value is created. In order to minimize BEPS, we call on member countries to examine how our own domestic laws contribute to BEPS and to ensure that international and our own tax rules do not allow or encourage multinational enterprises to reduce overall taxes paid by artificially shifting profits to low-tax jurisdictions. We acknowledge that effective taxation of mobile income is one of the key challenges.7
Supporting change in this direction will be new expectations of taxpayers in relation to tax authorities, and tax authorities in relation to each other, to share information about taxpayers with a minimum of procedural intervention so that all concerned have a consistent, complete and coherent picture of global supply chains.8
Clearly, countries seemingly are of a mind to make or consider legislative changes, including commitments to a multilateral treaty, to allow the BEPS aspirations to become a practical regulatory reality. At the same time, taxpayers and their advisors will need to pay close attention to how information is exchanged and shared, given the important implications this has for the prosecution of tax disputes and, more generally, the commercial interests of taxpayers.
A CONCLUDING COMMENT
Things are not always what they seem; change is constant and “transfer pricing” is not a fossil. In fact, the tensions of transfer pricing analysis attributable to imposing arm's-length strictures on taxpayers that exist to overcome arm's-length limitations, are being worked out, even exorcised, as the arm's-length standard, despite how it is articulated, is limited less and less in its application by and to narrow transactional manifestations. Today, the standard is contending with the relationship between the economic notion of a “firm” and the legal (organizational and transactional) formulations of global enterprises and how they account for themselves. What is particularly interesting for practical transfer pricing analysis is, to use two relevant industrial economics metaphors, the vertically integrated and concentrated approaches to the tax regulation of supply chains. An effective reformulation of the arm's-length standard or principle may be taking place. There is unprecedented international political and fiscal interest to address profit dispersion within global enterprises in a way that is less concerned with “tax technique” and more attuned to jurisdictional limits and outcomes for which transfer pricing is the framework within which more specific international tax rules affecting income measurement and accountability apply. New reporting and related information exchange machinery support these changes.
These developments are not merely theoretical. To use an overused term, they represent a “paradigm shift” in transfer pricing as it has commonly been understood. The “new” transfer pricing will directly influence important strategic and reporting decisions that taxpayers, with the help of their advisors, will need to make.
- Captured in the OECD's ongoing revision of Chapters I and VI and related provisions of the 2010 OECD Transfer Pricing Guidelines.
- See OECD's Action Plan On Base Erosion And Profit Shifting, 19 July 2013, items 1 and 5.
- Interestingly, not a new but certainly an evolved notion in 2010 the implications of which had come more clearly into view because of increasingly common business changes to the intensity with which business activities and responsibilities (risk).
- The Supreme Court of Canada has recently cast doubt on the legal authority or weight to be ascribed to the Transfer Pricing Guidelines in its decision in GlaxoSmithKline Inc. v. The Queen.
- OECD's Revised Discussion Draft On Transfer Pricing Aspects of Intangibles, 30 July 2013.
- OECD's Action Plan On Base Erosion And Profit Shifting, 19 July 2013.
- Russia G20 – G20 Leaders' Declaration, September 2013, para. 50.
- OECD White Paper On Transfer Pricing Documentation, 30 July 2013.