Arm’s length pricing in an imperfect world

Pascal Saint-Amans, head of the OECD’s tax unit, used to put companies on edge saying he was “agnostic” about the arm’s-length principle (ALP). This all changed in January, when the OECD released a short document announcing the need to move “beyond the arm’s-length principle”. Meanwhile companies are keen to defend the role of the ALP and transfer pricing.

“Anyone working in transfer pricing for a company 20 years ago knows how easy it was to get around the rules,” one head of TP at a FTSE 100 retail company told TP Week. “In theory, the arm’s-length principle works. In practice, the principle needs to be policed to make it work.”

One tax compliance officer at a European bank told TP Week: “I remember my days in another bank where we would handle transactions between different entities and we wouldn’t invoke the arm’s-length principle.”

“We never asked ourselves: would we really sell this asset to free up capital at this price? But, if we had, the answer would have been no,” the officer said.

Except this is the post-BEPS era, and these practices are meant to be dying out.

“Over the years it has got more difficult, but it’s still relatively straightforward to trap profits offshore if you really want to run the risk,” the head of TP at the FTSE 100 retail company said.

“In a lot of cases in the past, there was no way the transaction would have occurred if the entities were really independent,” they continued, adding: “we just got away with it.”

Move to formulary apportionment ‘inevitable’

TP Week spoke to John Kay, former director of the Institute for Fiscal Studies (IFS), about the future of arm’s length pricing. He has previously argued that the principle can’t work in a global economy with companies of an unprecedented size and scale.

“If I invent a wonder drug called Kay Cure in country A, I can sell it in country B through my subsidiary Kay Distributors at a much higher price than it cost me to produce it,” Kay said. “But where does the profit arise?”

“The sensible answer is to collect tax on Kay Cure on the basis of where it’s sold, but that’s not the answer you get with the arm’s-length principle,” the economist explained. “If you have a competitive market, the problem of how to allocate the profits might not arise.”

Globalisation and the size and scale of companies like Amazon, Apple and Microsoft  may render the ALP unfit for the modern economy. These corporations would deny they are monopolies, but it is undeniable that they have immense sway in the market.

“The arm’s-length principle was relevant to the economy about 100 years ago when you were producing wool in Australia and selling it in the UK,” Kay said.

Originally, ‘arm’s length’ was a commercial standard and not tax law. It was a way of making sure subsidiaries were profitable. Kay refers to the familiar problem of verifying whether a transaction is at arm’s length when there is a lack of similar transactions with which it can be compared.

The global economy already has a dearth of comparables when it comes to certain intangible assets, and the question of how value intellectual property is still open. This means that arbitrary valuations and mispricing will continue to be a problem.

There are many reasons why critics argue for throwing out the arm’s length principle. One major concern is the narrowing of the tax base in some countries, including the UK, where the corporate tax revenue has hardly changed as a proportion of the base - while payroll and VAT have continued to expand.

“The trouble is we’re not collecting enough tax from companies with complex multinational operations,” Kay said. “That’s a very serious problem.”

“It might be better to not do it at all rather than have a tax system that undermines the legitimacy of the system as a whole,” he added.

There have been debates about how to reform the international tax system for decades. As IFS director, Kay was an early advocate of a cash flow tax and has since come to view formulary apportionment as the best way forward.

“Inevitably, we have to move towards formulary apportionment,” Kay said. “It would have to be some kind of combination based on sales, payroll and assets. But it’s only viable if you have a wide-ranging international agreement.”

The search for solutions

The US has had its own version of unitary taxation for more than a century. It was the only way to deal with the problem of tax collection and distribution in a country of fifty states. Different US states apply different rates and apportion income differently. The Massachusetts formula uses sales, payroll and assets as its keys, for example, whereas the Iowa-Texas formula is based on sales alone.

Twelve states, including California, pushed in the early 1980s to take this system global. The Reagan administration even set up a working group on unitary taxation to look at the prospects for such a system. It would have chimed with the American brand of worldwide taxation based on citizenship. This would have made tax planning much more difficult.

Foreign multinationals lobbied hard against the idea and the US Treasury Department eventually decided to kill off the initiative in 1985. Thirty years later, tax professionals still agree with Kay’s diagnosis: the difficulty with formulary apportionment is in finding international agreement on the formula.

As the TP director of a software company told TP Week: “There would be a very real risk of double taxation everywhere. It’s possible to allocate global profits locally and the compliance isn’t necessarily a problem either. The problem is that the lack of consensus makes it unworkable.”

“It would be very simple to implement such a system assuming governments could actually agree on the details,” the TP director said. “But, from a risk management perspective, it would be a nightmare for businesses.”

“Governments are drifting further apart rather than coming together,” they said. “Everyone wants to tax businesses fairly and attract investment, but few people agree on how to do it.”

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