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Arm’s length pricing in an imperfect world
Businesses continue to rely on the arm’s-length principle, but concerns over how to apply the standard in a globalised economy have reached unprecedented heights.

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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