There has been a shift in thinking when it comes to the arm’s-length principle (ALP), but this change is not isolated given the importance of arm’s length to a huge amount of transactions worldwide. Transfer pricing makes up a large chunk of global trade and the ALP is its foundation.
Lionel Nobre, vice president of tax for Latin America at Dell Technologies, stressed the shift in thinking about the ALP. “This is a fundamental issue that we, as companies, face with form and substance,” he said.
“What should we do in a situation where you can do it legally but it might be challenged,” Nobre said. “Overall the transaction seems artificial and it seems unnatural for a company to structure its business in this way. It seems like the only driver would be taxes.”
He stressed that the tax authorities in certain Latin American countries would be particularly aggressive in chasing down such a transaction. The region faces a great deal of technological innovation in tax collection, but also greater scrutiny – especially in Brazil.
Few businesses doubt that the standard is facing changes, but some fear it may erode the ALP and exacerbate its flaws. Others are willing to play the game by slightly different rules.
“It’s important that in view of what this new arm’s-length principle is, we don’t just do things for tax reasons,” Nobre said. “The business should be driving what we’re doing … It shouldn’t be the tail that wags the dog”.
The pace of change in policy means that taxpayers face unprecedented levels of uncertainty. Yet the OECD’s efforts to untangle the difficulties around substance may have created more problems for taxpayers.
“There is a significant shift in thinking in relation to the arm’s-length principle on form and substance,” said Richard Collier, senior advisor at the OECD.
“Some of the emerging thinking on the digitalisation issue reflects enduring concerns on precisely the issues on form and substance in the ALP,” he said.
However, all policy issues have a history. This is why Collier described the role of the OECD’s 1995 TP guidelines in the early part of this shift. The guidelines laid out two exceptional circumstances:
- Where economic substance of a transaction differs from its form, the substance is to be followed in the event of a clash;
- Where the form and substance appear to be in alignment, but the arrangements seem irrational in commercial terms.
The BEPS project recast the first circumstance as an integral part of how transactions should be construed (not ‘constructed’?) for the purposes of the TP guidelines; the circumstances went from being exceptional to being the norm. This was a game-changer for many companies.
“There is to be a significant reduction in deference to taxpayer contracts,” Collier said, describing the impact. “A mandate is effectively given to tax authorities to look behind the contracts, to the conduct of the parties; where there are gaps and inconsistencies these are to be resolved by reference to conduct,” he added.
The tax authorities will follow the contract if, and only if, it’s aligned with taxpayer conduct. “This has been a real transformation in bringing in the substance or conduct test into the mainstream of how we do transfer pricing on an everyday basis,” he said.
The TP guidelines recognise that there are separate legal entities within a multinational group and that associated enterprises can enter into more transactions than third party companies. Nonetheless, this does not give taxpayers free reign.
The second circumstance may not look like a substance versus form issue because it’s about whether the company and its subsidiary are behaving in a commercially rational way; but what counts as rational can be contentious.
“There is a technical tension here,” Collier said. “Arguably, this tension has not been resolved in the transfer pricing guidelines.”
This test of commercial rationality is an attempt to police the rules. It can be extremely difficult to evaluate a transaction in terms of commercial rationale. For example, it’s possible that making a loss on a certain transaction might be rational, given the risk profile of the parties involved.
It’s difficult to judge what third parties would do in a given transaction when it is exactly the kind of arrangement third parties would not take part in. This touches on a wider problem for tax professionals when it comes to applying the ALP.
Collier was clear about the best way forward. “The test is what parties have actually done, what they have actually contributed,” he said, adding, “Not what third parties might hypothetically have done.”
“I believe that in the world we live in, with the ALP as it is, we have to engage with these issues because we’re in a system that recognises the separate entity in the group, in the income allocation exercise, that has historically had deference to legal contracts and did not deal with the problems of intermediary entities,” Collier said.
“If we have the ALP in this current form, whether we like it or not we have to engage with these issues,” he said.
Tony Pagone, who served on the Federal Court of Australia from 2013 to 2018, described the OECD’s changing position as “radical”.
“There is a really dramatic change in the way in which tax might be applied in the context of non-arm’s length dealings,” the former judge said. “We may well be moving away from the application of the rule of law to engaging in some form of risk management.”
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