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The rise of a new transfer pricing order

Even after the EU’s digital tax plan hit a major roadblock, transfer pricing (TP) directors feel the global order shifting away from the arm’s-length principle (ALP) and towards formulary apportionment.

Any kind of digital services tax (DST) would require a fundamental rethink of TP norms. The EU’s proposal for a DST may have been defeated, but this might just mean there will be more unilateral action by nation-states. These changes raise the stakes for taxpayers around the world.

“Taking a light touch approach to forward planning, and assuming a low amount of risk, could get your company killed,” said the chief tax officer at a software company.

Unitary taxation with formulary apportionment could mean multinational companies will face a minimum corporate tax rate and new profit allocation rules. This would spell the end of traditional transfer pricing principles.

“It looked like the EU was moving towards formulary apportionment and away from the arm’s-length principle,” one TP director at a telecoms company told TP Week.

“Some kind of formula would have been crucial for implementing the 3% turnover tax,” the director added. “It can’t just be about the global value of the company. It’s the role of local users which was the key aspect.”

Formulary apportionment would make it much harder for multinationals to book profits in low-tax jurisdictions. By contrast, the ALP allows international taxpayers the space to structure their European operations through, for example, Ireland.

Countries like France, meanwhile, which have comparably higher tax rates, would like to see MNEs pay more in their jurisdiction. But it’s unclear whether doing away with the ALP would dramatically reduce tax avoidance.

“Of course, we won’t be able to check that it has had this effect until there is global public country-by-country reporting by MNEs,” said David Quentin, a senior advisor to the Tax Justice Network, who supports the change.

“A move towards formulary apportionment has to go hand-in-hand with a move towards transparency,” Quentin explained.

Double tax jeopardy

A lack of consensus defeated the EU digital tax plan, but the UK and France are pushing ahead with plans to unilaterally institute their own national DSTs. This will mean new permanent establishment (PE) standards to provide a threshold for taxing online services.

Yet the differences in the developed world might not be the key to these changes. It may be that developing countries are more likely to look for new ways to institute unitary taxation. This would raise the threat of double taxation for some companies.

The head of tax at a mobile phone company told TP Week: “The developing world is much easier to change when it comes to digital tax because the laws are new, often the laws are less complex and there is a lot less case law than in the developed world.”

“The real challenge is overhauling tax law in countries like the UK and Germany due to the level of complexity and the sheer amount of case law that has been amassed over history,” they said.

“The position of developing countries really depends on the governance structures of the global value chains in question,” Quentin said.

Where MNEs operate locally through subsidiaries or PEs, Quentin explained, developing countries might be able to wage a tax claim on the income of such multinationals. But such MNEs working with local businesses on a contractual basis are unlikely to see their profits re-allocated to that jurisdiction.

The ‘race to the bottom’ in corporate tax rates might have made this shift more likely as governments need to raise tax revenue without raising the headline rates. The high-tech sector might be the main target in the developed world, but the developing world is much more likely to target traditional sectors like extractive industries.

Back to first principles

International institutions have a key role to play in this debate, but there are few signs of a consensus. There is no unanimity in the EU on digital tax, while the OECD has avoided taking a position that might further divide its member states.

As Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration, put it in September: “The OECD is agnostic on the ALP, but the largest economy in the world seems to have passed a vote of no confidence in the current system.”

The discord is not confined to the US. “European countries are very much divided,” Saint-Amans added. “Some argue that there should be no change in the allocation of taxing rights, while also saying that tax should be paid where the value is created. There is a fascinating debate to come.”

Richard Goldberg, founder of RG Transfer Pricing Solutions, suggested the erosion of the ALP is well underway. He pointed the blame at the drive towards greater tax revenue.

“The tax authorities in these jurisdictions see an opportunity to raise more tax revenue,” said Goldberg, who previously worked for Citigroup and Mitsubishi. “There’s also a perception that the existing tax rules are obsolescent.”

“They don’t think they’re getting their ‘fair share’ and they’d like to move to formulary apportionment to attribute company profits to a source country,” he stressed.

As the tax world contemplates a move away from traditional TP norms, businesses may have to rethink how it approaches planning – especially when it comes to digital tax. While tax policymakers are going back to first principles, companies have to factor in new risks they never had to in the past.

“Making too many assumptions can be costly in the long run,” said the chief tax officer at a software company. “Everyone assumed that the [UK’s] diverted profits tax was not going to be applied as widely as it has been, or as aggressively for that matter.”

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