Big businesses make arm's-length pricing 'hopeless', argues John Kay

There are many barriers to effective tax policy. The IFS held a panel discussion on the future of tax explored the shrinking of the tax base, the impact of globalisation and growing levels of inequality. But economist John Kay narrowed down the problems to one fundamental part of the international system.

Kay, who served as IFS director from 1979 to 1986, argued that the arm’s-length principle (ALP) is what holds back corporate tax policy.

“Corporation tax is not so much a tax on capital income as a tax on the economic rents generated within the corporate sector,” he said. “We’ve increased specific taxes on corporate rents. There are now quite a number of them.”

“Once we say there is an issue of trying to tax rents some problems arise immediately from that,” he explained. “The idea of an arm’s-length principle applied to a tax on economic rent is hopeless because it’s by the nature of economic rent that it’s the product of some kind of monopoly and there can’t be a bone fide arm’s-length transaction.”

Globalisation and the size and scale of companies like Amazon, Apple and Microsoft is what 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.

Originally, ‘arm’s length’ was a commercial standard and not tax strategy. It was a way of making sure subsidiaries were profitable. It’s plausible that it might only be workable in a dynamic market with intense competition. But this isn’t the only reason to question the principle.

Helen Miller, deputy director at the IFS, stressed that it makes little sense to apply arm’s-length pricing to intellectual property and other intangible assets.

“The ALP is based on the idea that it is possible to work out what the equivalent market transactions would be for those transactions that happen within firms,” Miller said. “But many of the transactions that happen within firms have no comparable market-based price.”

“The ALP is not a good way of allocating economic rents,” she told TP Week.

It’s not the first time Kay has questioned the ALP. He surprised the financial press in 2012 when he made the case for a new apportionment of total profits reflecting the scale of operations in different countries. This was his response to the scandal Starbucks faced at the time over its tax affairs in the UK.

“The arm’s-length principle worked in theory,” one compliance officer at a bank said. “It’s possible you just need to police the ALP properly to make sure it works in practice.”

“The truth is that in the past everyone was manipulating the prices and they all thought governments would never pick up on it,” they added.

It’s feasible to attach a tax on economic rent when it’s an extractive industry like oil and gas, where the location is difficult to change. This is why indirect taxes on transactions and consumption might be the best way forward in the future.

Falling tax rates and a shift in tax revenue towards consumption and away from corporate income are two reasons John Kay is optimistic about the future. The world has seen greater fiscal neutrality, flattening out of rate schedules and a move towards transaction-based taxes.

The search for a multilateral consensus on digital tax is still ongoing and it’s set-off a shift on the ALP. The OECD has gone from being agnostic on the ALP to looking beyond its limits. Meanwhile the IMF has been weighing up the alternatives.

“A blank slate might not be a bad thing,” the compliance officer said. “The problem is that countries won’t agree on the details.”

“It’s all or nothing,” they continued. “The international community has to reach an agreement on the rules. Some countries will lose out, that’s unavoidable.”

The lack of consensus is partly what has kept the ALP in place. “There are obviously many people that are unhappy with it – for good reasons – but much of the approach to reform still revolves around modifying how the ALP operates,” Miller said.

For example, the UK’s proposal for a 2% digital services tax will make the British fiscal system even more complex than it already is. The plan would just add new layers of rules to the ALP, and it will not lead to abandoning the principle in its entirety.

“Governments are tearing up the traditional TP rules,” one tax director at a software company said. “They’re looking at a functional analysis and the value of each factor in play. But this is really going to be a new layer of TP rules, it’s going to be transfer pricing 2.0.”

The same was true of the OECD’s BEPS project until it came to digital tax. “The OECD embarked on BEPS with the assumption that the ALP was sacred and it just needed tweaking here and there,” one tax director at a fintech company said. “They’ve changed their position quite radically.”

“The OECD changed its position because governments want to go after tech companies on this issue,” the director told TP Week. “They can see that BEPS did not achieve what the OECD hoped it would.”

Nevertheless, the ALP is unlikely to disappear any time soon. It may turn out that the rumours of arm’s-length pricing coming to an end are greatly exaggerated. In that case, the problems of international tax are set to continue.