While taxation problems arising from international investment are not new, they have become more important in recent years as a consequence of the growing internationalisation of economic activities. One characteristic of this process is the development of so-called ” multinational enterprises ” (by which is usually meant groups of associated enterprises operating across national frontiers) which have increasingly become powerful economic entities each with a large degree of common strategy. However, such an international economic entity generally operates in a legal framework which has remained national; it has therefore to conform with the varied and sometimes conflicting national laws of the countries in which it operates. This increasingly common phenomenon of related companies operating in a group with some degree of centralised management, yet with the individual members of the group operating under different national laws, has given rise to important problems regarding the taxation of corporate profits.
In a multinational enterprise (MNE) many transactions normally take place between members of the group – sales of goods, the provision of services, the licensing of patents and know-how, the granting of loans and so on. The prices charged for such transfers do not necessarily represent a result of the free play of market forces, but may, for a number of reasons and because the MNE is in a position to adopt whatever principle is convenient to it as a group, diverge considerably from the prices which would have been agreed upon between unrelated parties engaged in the same or similar transactions under the same or similar conditions in the open market (hereafter referred to as ” arm’s length prices “). Tax factors may affect the nature and the amount of the payments since it is likely that MNEs will be more concerned with the total of their net earnings after tax than with the forms which these earnings take – whether for example they are received as royalties, cost charges, service fees, profits from intra-group sales, or dividends from their affiliates etc. On the other hand it has to be recognised that in many instances tax considerations are unlikely to be paramount where, for example, enterprises are subject to conflicting pressures from various government departments – in the home as well as the host countries – including customs authorities, exchange or price control offices and others, or where the different entities of a group face the scrutiny of minority shareholders, Divergences from arm’s length prices will not necessarily always occur: in some MNEs the members have a considerable amount of autonomy so that they can and often indeed do bargain with each other in a manner similar to that of independent entities – local managers wanting to show a good profit record for their subsidiaries may resist fixing excessive transfer prices for goods, services, rights etc. if their local subsidiaries’ profits would thereby be reduced. There may be other factors tending to cause their prices to approximate to arm’s length prices.
Multinational enterprises may adopt transfer prices which are not arm’s length prices in order to minimise tax (for example, by selling goods to a subsidiary in a tax haven country at less than arm’s length prices) or they may adopt them for other reasons but, whatever the reason, whenever intra-group transfers are not carried out at arm’s length prices, the result is likely to be that profits are shifted from one company to another company in the group and the tax liability of the relevant companies distorted in consequence. Since national tax authorities need to determine the proper level of taxable pr<;>fits of the affiliated enterprises operating within their respective jurisdictions, the transfer pricing policies of MNEs are of great importance to them, and, particularly where there are grounds for believing that the taxable profits reported by a member of such a group are unduly low, the relevant national tax authority may have to examine the possibility that this is due to the transfer pricing policy applied by the group. It is gene rally acknowledged that, in taxing the profits of an enterprise which engages in transactions with associated enterprises outside the juris diction of the relevant taxing authority, the profits should be calculated on the assumption that the prices charged in these transactions are arm’s length prices. This is the underlying assumption in Article 9 (1) of the OECD Model Double Taxation Convention on Income and Capital (1977) on transactions between associated enterprises. In this context, it may be noted that the arm’s length approach, which under lies this report, has also been endorsed by the United Nations Group of Experts on Tax Treaties between Developed and Developing Countries 1, and that there is a broad consensus among governments of developed and developing countries and MNEs that arm’s length pricing is the appropriate approach to adopt in arriving at profits for tax purposes. Modern bilateral double taxation conventions between OECD Member States and between OECD Members and other States have accordingly adopted this principle. It is important to bear in mind, moreover, that the need to adjust the actual price to an arm’s length price, in order to arrive at a proper level of taxable profits, arises irrespective of any contractual obligation undertaken by the par ties to pay a particular price or of any intention of the parties to mini mise tax. Hence, the consideration of· transfer pricing problems should not be confused with the consideration of problems of tax fraud or tax avoidance, even though transfer pricing policies may be used for such purposes.
In the organisation of their intra-group relations MNEs are necessarily confronted with transfer pricing problems – essentially a price has to be charged for every transaction. Even in seeking, itself, to fix its transfer prices on the arm’s length basis, a multinational enterprise will face problems and the process will be all the more difficult if, as may happen, it is confronted with differing, perhaps conflicting requirements by different administrations (perhaps even within the same country). One of these problems could be the danger of double taxation, if national tax authorities differ in their approach for tax purposes. It is therefore of importance to multinational enterprises also that common approaches to the resolution of transfer pricing problems should be developed.
The main objectives of the report are to set out as far as possible the considerations to be taken into account and to describe, where possible, generally agreed practices in determining transfer prices for tax purposes. It is hoped that, by doing so, the report will not only help tax officials to approach more effectively the problems presented to them by the transfer prices of multinational enterprises but will also help the enterprises themselves by indicating ways in which mutually satisfactory solutions may be found to those tax problems. The basic point of reference in all the various chapters of this report is the arm’s length price. The report can be seen in fact as an attempt to set out the considerations to be taken into account, and the means available, for determining an arm’s length price in the widely varying circumstances which arise in practice in connection with transactions between associated enterprises. What is set out in the main body of the report must necessarily be regarded, however, as only a general guide setting out principles that may be relevant and appropriate to apply in most cases to the different circumstances arising. The report does not and cannot lay down rules that are appropriate to every aspect of every case: it is an essential feature of the problem that it is always necessary to have regard to the particular facts of each case.
The process of establishing an arm’s length price is often com plex and difficult and the difficulties are likely to be greater for both taxpayers and tax authorities if there is a lack of a common approach to the matter. The 1963 OECD Draft Double Taxation Convention on Income and Capital 1 laid a foundation for such a common approach in providing a common concept and a common language but the need now is to develop practical means for applying one. It is another purpose of this report therefore to establish as far as possible such an approach with the objective not only of enabling the interests of the national tax authorities involved to be protected but also of enabling the double taxation of the enterprises involved to be prevented. The aim is also to provide guidance of universal validity and it is considered that the conclusions. in the report are equally applicable, for example, whether the relevant transactions are between entities in developed countries or entities in developed and developing countries.
This report discusses the determination of acceptable prices for the purposes of establishing taxable profits when transfers of goods, ‘ services or technology etc., take place or loans are made between associated enterprises situated in different countries. The report covers not only transfers between parent and subsidiary companies but also those between other enterprises under common control 1 though the problems arising specifically from transactions between companies under common control have not been dealt with and indeed some countries would regard such transactions as passing through the common parent insofar as the price deviates from arm’s length. It was not thought necessary for the purpose of the report to define such expressions as ” associated enterprise” or ” under common control “. A broad basis of common understanding of what is meant is assumed. Nor was it thought necessary to define precisely the expression” multinational enterprise ” (MNE) which is frequently used.
1. Whereas the principle of arm’s length pricing is valid also for the taxation of permanent establishments, the considerations set out in this report need to be applied with care to the taxation of permanent establishments because of the special factors involved (for example, because of the limitations normally recognised on the acceptability for tax purposes of loan or royalty contracts between permanent establishments and the remainder of the enterprise of which they form part – see Commentary on Article 7 of the OECD Model Double Taxation Convention).
2. In this connection, reference is made to the OECD Guidelines for Multinational Enterprises, paragraph (8), which says :
“A precise legal definition of multinational enterprises is not required for the purposes of the guidelines. These usually comprise companies or other entities whose ownership is private, State or mixed, established in different countries and so linked that one or more of them may be able to exercise a significant influence over the activities of others and, in particular, to share knowledge and resources with the others. The degree of autonomy of each entity in relation to the others varies widely from one multinational enterprise to another, depending on the nature of the links between such entities and the fields of activity concerned.”
The report covers in some detail some of the more important types of transfer which, in practice, take place between associated enterprises. It should be sa1a at the outset that some subjects have been treated in a way which may seem to be comparatively superficial and others have not been discussed at all. The reason for this is either that the report concentrates on the more pressing problems or that the topics are so case-oriented that satisfactory generalisation is not possible. Among topics omitted altogether from the report are certain types of transfers which seemed of lesser or less general importance – for example sales as distinct from transfers of the right to use patents and know-how, transfers of literary and artistic copyrights, transactions in real estate and transactions in securities such as shares and bonds. Also outside the scope of the present report, since the aim has been as far as possible to set out general principles, is any attempt to deal with special transfer pricing problems relating to particular industries or special types of enterprise. Finally no mention is made of the treatment of corresponding adjustments (as referred to in Article 9 (2) of the OECD Model Double Taxation Convention), which is a related problem but outside the scope of this report. However a common approach based on the considerations set out in this report should help to reduce the need for any such corresponding adjustment.
A special working group of experts under the aegis of the Committee on Fiscal Affairs of the OECD has studied this problem over a number of years. In addition the group has held technical discussions with representatives of multinational enterprises under the aegis of the Business and Industrial Advisory Committee to the OECD and also with representatives of the Trade Union Advisory Committee to the OECD. Consultations have also taken place with the Secretariat of the Customs Co-operation Council. The report was unanimously adopted by the Committee on Fiscal Affairs in January 1979 and was the subject of a Recommendation of the Council on 16th May, 1979 – see the Annex on page 95.
Chapter I of the report summarises some of the problems, Chapter II deals with transfers of goods, Chapter III with transfers of patents, know-how and trademarks, Chapter IV with transfers of certain services and Chapter V with intra-group loans. Most of the considerations and methods discussed in Chapter I apply to all of the types of transfers. Although the general considerations are set out in Chapter I, more explicit details of what is meant by the arm’s length principle and what methods can be employed to arrive at arm’s length prices are given in Chapter II in relation to transfers of goods. They are therefore taken up in a less detailed manner in the later Chapters, which therefore should be read in conjunction with Chapters I and II.
Making a judgement whether a particular transfer price conforms to the arm’s length principle would ideally require direct reference to prices in comparable transactions between enterprises independent of each other or between the group and unrelated parties. This method is frequently referred to as the ” comparable uncontrolled price ” method and in principle it is the most appropriate to use and in theory the easiest. In practice, however, it often happens that such evidence is not available or it is impracticable to collect it together or there is argument about whether the prices quoted are comparable or not. Other methods may therefore need to be used to obtain an arm’s length price.
There will be many cases where no useful evidence of uncontrolled transactions will be available because, for example, the goods or services etc. which are supplied are so special to the group that there is no open market in them and they are not supplied to independent enterprises. This may be particularly the case for example for semi-finished products or in relation to transfers of technology. In other cases the transactions within the group may not be satisfactorily comparable with those between the group and independent third parties, for example because they take place at a different stage in the chain of production or distribution or because the independent third party is too small a customer to claim the discounts for volume which an entity within the group might be big enough to achieve if it were independent. In such circumstances it will often be necessary, in order to establish an arm’s length price, to use either the cost plus method or the resale method, the cost plus method starting from the cost of, providing the goods or services etc. and adding whatever cost and profit mark-up is appropriate and the resale price method starting from the final selling price and subtracting the cost and an appropriate profit mark-up.
The complexities of real life business situations may put many conceptual and practical difficulties in the way of the application of the methods referred to above. A mixture of these methods, or other methods still, may sometimes therefore have to be used. Any method which is used will involve problems of judgement and the evaluation of evidence and it has to be recognised that the object of using it is to produce a figure which is acceptable for practical purposes. Experience shows that the difficulties can in general be satisfactorily dealt with and acceptable prices agreed.
Proposals for radical reformulations of the approach to intra group transfer pricing which would move away from the arm’s length approach towards so-called global or direct methods of profit allocation, or towards fixing transfer prices by reference to predetermined formulae for allocating profits between affiliates, are not endorsed in this report. The use of such alternatives to the arm’s length principle is incompatible in fact with Articles 7 and 9 of the OECD Model Double Taxation Convention. Such methods would necessarily be arbitrary, tending to disregard market conditions as well as the particular circumstances of the individual enterprises and tending to ignore the management’s own allocation of resources, thus producing an allocation of profits which may bear no sound relationship to the economic facts and inherently running the risk of allocating profits to an entity which is in truth making losses (or possibly the contrary). A number of such methods are sometimes advocated, allocating profits in some cases in proportion to the respective costs of the associated enterprises, sometimes in proportion to their respective turnovers or to their respective labour forces, or by some formula taking account of several such criteria. They are all however to some degree arbitrary. For example, it does not follow that profit is uniformly related to cost at all stages in an integrated production and marketing process. Indeed the problem of allocating costs could well be no easier than in using the cost plus method to arrive at an arm’s length price. Nor does it follow ,that labour costs are the same for the same labour in different countries, or that profits are necessarily related to any simple combination of such factors. To allocate profits by such methods in a way which reduced the arbitrariness of the results to’ a negligible degree would necessitate a complex analysis of the different functions of the various associated enterprises and a sophisticated weighing up of the different risks and profit opportunities in the various different stages of manufacturing, transportation, marketing and ·SO on. Nor would the information necessary for such an assessment be readily available or, in many cases, available at all. The need would be for full information about the total activities of the whole MNE. While the widest range of such information may be available to the tax authorities in the country of the parent company in a group even those tax authorities will be limited to some extent in the information which they can compile. The tax authorities of the country in which a subsidiary is situated will on the other hand be in no position to acquire even this amount of information without imposing on the MNE itself a possibly intolerable administrative burden, or a similar burden on the tax authorities of the parent company’s country if they seek to get the information by way of exchange of information provisions under double taxation agreements. Nor can it be generally assumed that the tax authorities of the country of the subsidiary should in any case be entitled to quite such a wide range of information about the group’s worldwide activities. In practice moreover the information may simply not be available to those authorities. Even if the information were available, however, the varied activities of any MNE and the varied circumstances and situations in which they are carried on must make it impracticable for the tax authorities of the country in which one subsidiary is situated to judge in any satisfactory manner the profitability of any of the other parts of the group situated elsewhere. Moreover, problems would still arise in the comparison of figures produced in different countries by different accounting methods and different legal requirements. Another major disadvantage of any attempt to use such global methods of profit allocation as an alternative to the arm’s length principle is that their uncoordinated use by the tax authorities of several countries would involve the danger that, overall, the MNE affected would suffer double taxation of its profits. This is not to say, however, that in seeking to arrive at the arm’s length price in a range of transactions, some regard to the total profits of the relevant MNE may not be helpful, as a check on the assessment of the arm’s length price or in specific bilateral situations where other methods give rise to serious difficulties and the two countries concerned are able to adopt a common approach and the necessary information can be made available.
The starting point for scrutinising transfer prices would frequently be the appearance of a discrepancy between the profits returned by an associated enterprise and those which might be expected to be made by comparable enterprises in the uncontrolled situation. Since the assessment of an arm’s length price depends very often on careful judgement and the resolution of many, perhaps conflicting, considerations by negotiation between the tax authorities and the enterprise concerned, it follows that if the prices actually paid can be substantiated by acceptable evidence as being arm’s length prices there would be no justification for seeking to make merely minor or marginal adjustments to them for tax purposes. Similarly a tax authority should hesitate to disturb without good reason a pricing arrangement reasonably and consistently operated between associated enterprises if it is also reasonably and consistently operated in comparable dealings with independent parties. Moreover, as a general principle, tax authorities should base their search for an arm’s length price on actual transactions and should not substitute hypothetical transactions for them, thus seeming to substitute their own commercial judgement for that of the enterprise at the time when the transactions were concluded (though there may be some circumstances where the form of transaction has effectively to be ignored – see paragraphs 23 and 24).
At this point it may be helpful to consider whether limits of tolerance could be formulated in advance by tax authorities and made known to enterprises by what are sometimes known as safe haven rules, indicating that prices falling within certain ranges would be accepted without question. The report makes no recommendation on this topic. Whilst such an approach may be useful to both taxpayers and tax authorities within a particular country in minimising disputes over the determination of a proper arm’s length price, such safe havens are likely to be arbitrary since they will rarely fit exactly the varying circumstances even of enterprises in the same trade or business. The minimisation of this arbitrariness would be difficult and would involve a considerable, expenditure of skilled labour in collecting, collating and continuously revising a pool of information about prices and pricing developments. Another point is that safe havens in one country may create difficulties in other countries and further problems would arise if it were a question of seeking to fix a safe haven range of prices acceptable to a number of countries. In any event, it would be necessary to revise periodically the range of prices or rates of interest to reflect changes in market conditions. Moreover, the general use of safe haven ranges for tax purposes could affect the prices charged in the open market. More important perhaps in practice they could open an undesirable scope for tax avoidance.
When examining the transfer prices adopted within a multinational enterprise, it is always useful to begin by analysing the functions of the various entities which are comprised in the relevant MNE ” Some familiarity with the structure and organisation of the group and some knowledge of which entities undertake the risks and responsibilities for the various activities are essential for tax authorities to help them in assessing when a profit is likely to arise and roughly what sort of profit it is likely to be. It may be important not only to find out which entities perform the different functions of manufacturing, assembling, research and development, servicing, distribution, marketing and selling, transportation, advertising, etc., and which entities own the trademarks and other intangible property, but also to ascertain in what capacity they perform these functions – whether for example with regard to selling activities as principal (accepting all the risks and entitled to all the profits of the activity) or as agent (with limited risks and for a limited return).
It is clearly easier for tax authorities and MNEs to agree tax liabilities if charges for goods, services, etc., are made direct to the appropriate customer. MNEs may, however, arrange some transactions in a less direct manner (particularly intra-group services and transfers of technology, through interposed affiliates). This may be done for purely business reasons, but such a strategy could also be part of a tax avoidance scheme. Such practices may raise the question how far a real benefit has in fact been conferred on the related party which is ostensibly paying for it and how far such a transaction affects other entities. Problems of this kind are likely to arise where a variety of alleged benefits are charged for in one package deal.
The report gives separate consideration to four main types of intra-group transactions for the convenience of the analysis of the problems presented by intra-group transfer pricing. But it must be borne in mind that, in practice, MNEs quite frequently make package deals in which a single charge is made for a variety of benefits. In theory at least a parent company might licence patents, know-how and trademarks to a subsidiary, undertake to provide it with various technical and administrative services, and even sell or lease production facilities to it, all for an undifferentiated payment. Such comprehensive packages would be unlikely to include sales of goods, however, although the price charged for sales of goods may cover some accompanying services. While it may, in some circumstances, be convenient to treat the package deal as in effect one transaction with its own arm’s length price, this will often not be feasible. It has to be borne in mind that package deals even between unrelated parties may create intricate problems for the tax authorities concerned. For example, the tax treatment of the separate ingredients may differ either under domestic law or under a double taxation agreement; payments for ser vices for instance are generally not required to be made under deduction of tax in the country of source whereas royalties or interest may be subject to a withholding tax and so on. It may be necessary therefore for the tax authorities, for one reason or another, to insist on appraising the different items of the deal separately. Tax authorities will need to examine a package deal between associated enterprises and its elements in the same way as they would analyse similar deals between unrelated parties. The report aims to provide the foundation for such an analysis insofar as it is necessary to make one.
Another situation which it may be necessary to consider arises_ when a benefit provided to one enterprise within a group is balanced to some degree by different benefits provided by that enterprise in return, with the consequence that the enterprises claim that the benefit received should be set off against the benefits provided as full or part payment for those benefits so that only the net gain or loss (if any) on the transaction needs to be taken into account in assessing the tax liabilities of the enterprises. An enterprise may, for example, license another enterprise to use a patent in return for the provision of know how in another connection and claim that the transaction results in no profit, no loss. This kind of Arrangement is encountered sometimes between unrelated parties and it could not be argued therefore in principle that it is unacceptable between associated enterprises.
Set-offs may vary in size and complexity from a simple balance of two specific transactions (such as a favourable selling price for manufactured goods in return for a favourable purchase price for the raw material used in producing the goods) to an arrangement for a general settlement balancing all benefits accruing to both parties over a period. Unrelated parties would be very unlikely to consider such set-off arrangements unless the benefits could be accurately quantified in advance, the likelihood of an adequate balance ascertained and the contract made in advance. In any other circumstances, independent parties would normally prefer to allow their receipts and disbursements to flow independently of each other in the ordinary way taking any profit or loss which resulted as part of normal trading, hoping actually to benefit if, for example, market conditions change in their favour.
Even if such an arrangement is in principle acceptable, the question which has to be asked in all cases, however, is whether the benefits do in fact balance each other over an appropriate period to the extent claimed. It may well be necessary for the tax authority to analyse the arrangement and the transactions in order to satisfy itself of this and the final judgement will then depend on a reasonably acceptable assessment of what would be an arm’s length price for all the relevant transactions. It should also be remembered that provisions regarding set-off between related parties in international transactions may not be fully comparable with those regarding set-offs between domestic enterprises because of the differences in the tax treatment of the set-off under different national tax systems or differences in the treatment of the payment under double taxation agreements. For example, withholding tax would complicate a set-off of royalties against sales receipts.
In general, the approach which is adopted in this report to the adjustment of transfer prices for tax purposes is to recognise the actual transactions as the starting point for the tax assessment and not, in other than exceptional cases, to disregard them or substitute other transactions for them. The aim in short is, for tax purposes, to adjust the price for the actual transaction to an arm’s length price. Similarly, it is considered that transactions between associated enterprises should not be treated differently for tax purposes from similar transactions between independent parties simply because the parties to the transaction are related. The report does, however, recognise that it may be important in considering, for example, what is ostensibly interest on a loan to decide whether it is an interest payment or, in reality, a dividend or other distribution of profit.
Associated enterprises are, however, able· to make a much greater variety of contracts and arrangements than can unrelated enterprises because the normal conflict of interest which would· exist between independent parties is often absent. Associated enterprises may and frequently do conclude arrangements of a specific nature that are not or are very rarely encountered between unrelated parties (cost contribution arrangements for research and development expenditure as discussed in Chapter III of the report would be one example). This may be done for various economic, legal or fiscal reasons dependent on the circumstances in a particular case. Moreover, contracts within an MNE could be quite easily altered, suspended, extended or terminated according to the overall strategies of the MNE as a whole and such alterations may even be made retroactively. In such instances tax authorities would have to determine what is the underlying reality behind an arrangement in considering what the appropriate arm’s length price would be.
The flexibility of arrangements available to MNEs may, however, create a problem for them as well as for tax authorities. If the transactions are not adequately evidenced by contemporary documents it is clearly more difficult for the MNE to convince the tax authorities that they took place in the form and manner claimed or that the transactions compare properly with particular transactions between unrelated parties. Retroactive agreements would justifiably be rejected moreover as inadequate to explain transactions taking place before the agreements. This is not to say that evidence can con sist only of written contracts or agreements or that documentary evidence should be required in relation to every transaction. It is clearly desirable to avoid burdening MNEs with unnecessary documentation requirements. It would be reasonable, however, to require MNEs to provide in support of any important contention either the relevant legal documents and explanatory material or at any rate sufficient information to allow the tax authorities to arrive at an informed judgement in the matter.
The prices charged for goods, services, etc. transferred bet ween associated enterprises in different countries may be affected by, for example, Government interventions in the form of price control, or subsidies to particular sectors, or by exchange control or exchange rate policies. It should be observed that the same considerations would apply to transactions between unrelated enterprises and that they would usually influence the prices in such transactions.
Of these constraints, exchange controls have given cause for more particular comment. Problems may arise for example because exchange controls effectively prevent an associated enterprise which has received a loan from transferring abroad the interest payments as they fall due, thus possibly throwing doubt on the treatment of the interest for tax purposes. While there may be room for more than one solution in both the country of the borrower (which may or may not regard the un-transferred interest as having been paid) and the country of the lender (which may or may not be deemed to have received interest not transferred) it is considered that there is no justification for treating blocked payments differently for tax purposes when they occur, between associated enterprises from the way in which they would be treated if they occurred between unrelated enterprises. It is however considered that exchange control regulations in a country should not preclude the deduction for tax purposes, for either associated or unrelated enterprises, of payments due to persons outside that country, although it is recognised that the tax authorities of the other country may have to take the effects of these regulations into account.
It cannot be envisaged that over a long period an independent enterprise can continue to remain in business and make losses and this has to be taken into account in the attitude of the tax authorities towards associated enterprises which make losses over long periods. It may be recognised that in an arm’s length situation start-up losses may occur, or that, due to a weak market, a profitless situation may last for a relatively long period of time in the anticipation of future compensating profits. Nevertheless, if losses are consistently made over a period in an associated enterprise, the tax authorities will have to address themselves to the question whether these losses are not being made with a view to transferring taxable profits to an associate in another country, or in the financial interest of the group as a whole rather than the associated enterprise in question. This will normally require a closer examination of the whole operations of the group. This examination may well show that the decision to keep going a loss making business has been dictated by constraining political or social reasons; when evidence of such reasons is given, a profit adjustment may or may not be justified.
Customs administrations, broadly speaking, also apply the principle of arm’s length pricing and use it also to provide a neutral standard of comparison between values attributable to goods imported by associated enterprises and values for similar goods imported by third parties. Since customs and income tax administrations are not always looking at the same sort of transfers (customs being concerned with transfers across borders, with or without change of ownership, and income tax administrations being concerned with transfers between entities),. and since customs administrations have traditionally examined goods at the time of importation while income tax officials consider the price at the transfer of ownership sometime after the transaction has taken place, and for other reasons, the approaches of the two administrations have sometimes differed. In more recent years, however, a number of customs administrations have found it increasingly impracticable to consider imports by MNEs on a consignment by consignment basis and have begun to apply methods analogous to those described in this report to reach an acceptable price for a range of imported goods. Co-operation between income tax and customs administrations in reaching such a price is becoming more common and this should help to diminish the number of cases where customs values are found unacceptable for income tax purposes or vice versa.
(See Article VII of the General Agreement on Tariffs and Trade and the Convention on the Valuation of Goods for Customs Purposes signed in Brussels on 15th December, 1950 which is based on that article.)
It happens frequently when transactions with an associated enterprise take place over frontiers that the tax authorities need information concerning the associate in the other country or possibly some other associate in order to be able to determine the appropriate taxable profit in their own country. Often the tax authorities will not have possession of this information. In this context it is appropriate and may be helpful to refer to the OECD Guidelines for Multinational Enterprises which have been promulgated by Member Governments and, in particular, to the first Guideline on taxation and the Guideline on disclosure of information which are reproduced below.
As indicated above, in addition to paragraph 8 of the introduction to the OECD Guidelines for Multinational Enterprises quoted in footnote (2) to paragraph 7 above, other parts of the OECD Guidelines, as well as Article 9(1) of the OECD Model Double Taxation Convention, are of relevance to the subjects dealt with in this report. The relevant texts are as follows :
a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or
b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,
and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly “.
b) OECD Guidelines on taxation
c) OECD Guidelines on disclosure of information
” Enterprises should, having due regard to their nature and relative size in the economic context of their operations and to requirements of business confidentiality and to cost, publish in a form suited to improve public understanding a sufficient body of factual information on the structure, activities and policies of the enterprise as a whole, as a supplement, insofar as necessary for this purpose, to information to be disclosed under the national law of the individual countries in which they operate. To this end, they should publish within reasonable time limits, on a regular basis, but at least annually, financial statements and other pertinent information relating to the enterprise as a whole, comprising in particular :
i) the structure of the enterprise, showing the name and location of the parent company, its main affiliates, its percentage ownership, direct and indirect, in these affiliates, including shareholdings between them ;
ii) the geographical areas 1 where operations are carried out and the principal activities carried on therein by the parent company and the main affiliates ;
iii) the operating results and sales by geographical area and the sales in the major lines of business for the enterprise as a whole ;
iv) significant new capital investment by geographical area and, as far as practicable, by major lines of business for the enterprise as a whole;
v) a statement of the sources and uses of funds by the enterprise as a whole ;
vi) the average number of employees in each geographical area ;
vii) research and development expenditure for the enterprise as a whole;
viii) the policies followed in respect of intra-group pricing ;
ix) the accounting policies, including those on consolidation, observed in compiling the published information. “
(For the purposes of the guideline on disclosure of information the term ” geographical area ” means groups of countries or individual countries as each enterprise determines is appropriate in its particular circumstances. While no single method of grouping is appropriate for all enterprises or for all purposes, the factors to be considered by an enterprise would include the significance of operations carried out in individual countries or areas as well as the effects on its competitiveness, geographic proximity, economic affinity, similarities in business environments and the nature, scale and degree of inter-relationship of the enterprises’ operations in the various countries.)
It is not easy to estimate accurately the percentage of total international trade in goods relating to transactions within MNE’s. Difficulties arise because of variations in the definitions of multinational enterprises which are used and because of deficiencies in data collection etc. A United Nations publication 1 gives some indications of the proportion of particular countries’ intra-group trade. It states that ” approximately 40 % of imports to the United States in 1974 were intra-firm transactions … Roughly 50 o/o of United States exports in 1970 were within transnational corporate systems. ” The United Nations document notes that ” there are also data to indicate that 29 % of Swedish exports in 1975, 30 % of United Kingdom exports in 1973 (a rise from 26 % in 1970) and 59 per cent of Canadian exports in 1971 were on an intra-firm basis. ” The document continues that ” these figures are based on sampling procedures and are, therefore, prone to error, but the errors are likely to be small in comparison to the magnitude of the base figures. ” Amounts of the kind indicated above are clearly sufficient to render the proper assessment of the profits arising from transnational intra-group trade a matter of considerable importance. Special problems arise for tax authorities from the fact that the terms and conditions of sales of goods between members of an MNE are not necessarily governed by economic factors alone but may, among other things, be used as a means of profit shifting to alleviate the overall tax burden of the group. The proper assessment of these profits is also important, however, to the MNEs themselves because they may suffer unrelieved double taxation if different tax authorities take different views of the adjustments which ought to be made for the purposes of computing tax liability. Problems may also arise for MNEs as a result of conflicting requirements and evaluations made by customs authorities, price control officers and anti-trust authorities etc., and these problems may have an influence on the transfer pricing policies which they adopt.
(Transnational Corporations in World Development : A re-examination, United Nations, 1978, page 43.)
This Chapter seeks to elucidate some of the problems facing tax authorities in relation to transfer prices for goods. It concentrates on sales of raw and processed materials, semi-manufactured products and finished manufactured products including mass-produced goods and custom-made products, but does not deal with problems relating to certain items of tangible property, such as immovable property and shares and bonds. Nor does it deal with the special problems which may arise in relation to ores and: minerals. Leasing contracts and similar arrangements are not dealt with either though there may be cases where long-term leasing contracts are very similar to sales.
Another feature of the transfer of goods which is not dealt with in this report except incidentally is the provision, which is not unusual in some branches of industry, of entire production facilities and their plant and equipment. Such transactions may present special problems because the provision of such facilities may be linked with the transfer of intangible property such as patents and know-how and with general service contracts as well as engineering contracts and long-term supply agreements. Also the value of the provision to both contracting parties may be primarily related to the benefits expected to arise from the long-term economic exploitation of the plant rather than to the original price and installation costs, so that the transaction has some analogy with investment in real estate or perhaps shares or bonds
It may happen that a transaction which is in law a sale of goods may on close examination appear to be more akin to the provision of services. For example the functions of some distributors may be so minimal and the risks and responsibilities which they undertake so small that their profit is more akin to an agency fee or commission than the profit on a sale. Similarly the production and sale of a turn key factory may have involved the seller in fact in no more than the organisation of the project, the risks and responsibilities being carried elsewhere. In such circumstances too it may be more appropriate to measure the profit on the transaction on the basis of treating the payment as if it were a payment for services.
Section I deals with the arm’s length principle in general and with its application in special situations. Problems such as supply of goods for less than normal payment, sustained losses, pricing for market penetration and Government interventions in the market are dis cussed in this context. The different methods of estimating the arm’s length price are discussed in Section II.
As in other areas of transfer pricing the arm’s length principle as expressed in the OECD Model Double Taxation Convention has to be followed in the evaluation for tax purposes of transfer prices for goods. Following this principle, prices paid for goods transferred bet ween associated enterprises should be, for tax purposes, those which would have been paid between unrelated parties for the same or simi lar goods under the same or similar circumstances.
In applying this rule, however, there are a number of general points which have to be borne in mind. One is that it should not be assumed that the prices actually charged within an MNE will never be arm’s length prices. The transfer pricing policies of multinational enterprises may in fact be market-oriented and, where the different entities within such groups have their own profit responsibility, they may be free to contract either with an associated enterprise or with a third party with the result that there is a degree of bargaining within the group which produces a price effectively indistinguishable from an arm’s length price. (The full implementation of such a policy may, however, be difficult when, for example, components or semi-finished products are sold within the group which are not available on the market). Another point which it is necessary to bear in mind is that the transactions within MNEs may not be directly comparable with those which take place between independent enterprises so that allowances have to be made in comparing their transfer prices with the prices payable between independent enterprises. For example, entities within MNEs tend to render a wide range of additional technical and management and other services to their associates in connection with the sale of goods – a feature which is less common in transactions bet ween independent enterprises. Similarly, the production facilities of a group may be largely integrated with the consequence that the production arrangements are divided up among different group members in a way which would not be paralleled by independent enterprises. For example, these arrangements may involve long-term buy and supply agreements or agreements to use combined production plants under an obligation to buy from them (” joint facility arrangements “).
The application of the arm’s length principle to the prices charged within MNEs is based on the assumption that prices are determined on the markets in the different countries by ordinary market forces. There may, however, be factors of various kinds, as discussed in the rest of this Section and, more generally, in Chapter I, which modify the operation of the normal rules of a market economy. Each of these factors is considered separately, but it can be expected generally that they would all have a similar effect on sales between unrelated enterprises in similar conditions and tax authorities should take this into account when considering adjustment of transfer prices.
The question has to be considered whether, in an arm’s length situation, goods might be supplied for no payment or an unusually low payment, or might be supplied at a price producing less than the usual profit, or even a loss. It would not be unusual for an independent enterprise to do this if the goods were samples or advertising offers, but associated enterprises are not likely to be in a parallel situation. The question is more likely to arise in connection with goods sold to an associate in financial difficulties when some or all of the payment might be waived. It would be very exceptional for this to occur in transactions between independent enterprises, though the possibility cannot be wholly discounted (for example a supplier might to some extent be prepared to waive payment by an independent customer in temporary difficulties in order to preserve a potentially valuable outlet for his goods). But tax authorities could properly require very convincing proof that this situation would arise before accepting a nil or reduced payment between associated enterprises as equivalent to the arm’s length price. Payment might be deferred in such circumstances in the arm’s length situation but this would normally affect the price or be compensated for under a credit arrangement of some sort.
It may be reasonable in some circumstances to analyse the transfer prices for product lines or other groupings rather than to ascertain an arm’s length price for each individual product or sale. An enterprise may find it necessary to sell some products at less than the market price or even supply them free in order to make a higher profit on its sales of products overall to the same buyer. A clothing enterprise may, for example, make a loss on its small and large garments in order to be able to sell a complete range and make its profits from the medium sizes. An electric appliance enterprise may sell light bulbs at a loss in order to sell electric fittings, lampshades, etc. and make its profits in that way. Likewise, a producer may sell new products at a comparably low price and make his profits on the replacement market or through the repair of the products, or through the sale of auxiliary material, for example film for cameras. In such cases, an unusually low or high price would, however, have to be examined closely and substantiated by cogent evidence, and the prices realised on resale by the buyer could be relevant.
(a) It has to be recognised that a member of an MNE may, like any independent enterprise, sustain genuine losses whether from mismanagement, from unfavourable economic conditions either in its particular market, or more generally, etc. It follows therefore that if losses are made by a member of an MNE it is not necessarily because the transfer prices of the relevant goods are artificially fixed to produce that result.
(b) There are other circumstances too in which tax authorities could find losses acceptable – particularly what may be called ” start-up ” losses or ” market penetration ” losses which would, of their nature, be expected to be sustained only during a short period – see paragraph 43 below.
(c) Where it is claimed that losses have been sustained over a comparatively short period in such circumstances, tax authorities should not therefore have much difficulty in accepting that they are genuine.
(d) Where, however, a multinational enterprise consistently makes losses over a period of several years in a particular country it might seem appropriate to regard the losses as artificial since an independent enterprise which consistently made losses would eventually go out of business. However, it is necessary to bear in mind that an MNE may legitimately hesitate for a long time to wind up the operations of a loss-making member of the group in a particular country if there are strong political or social pressures in that country to persuade them to continue these operations, or even if the capital which the MNE had invested in that enterprise was considerable in amount and there was some prospect of eventually making the enterprise profitable again. It is not to be assumed therefore . that sustained losses are necessarily artificial. But they could certainly be a feature which deserved close examination.
(e) A rather special case of the loss-making enterprise within an MNE would be exemplified by the situation (mentioned in paragraph 41) in which a group of companies produces a range of pro ducts, some of which would be profitable to produce on an arm’s length basis and some not but all of which are needed in order that the group should make a profit overall and a member of the group in one country produces only the loss-making products in the range while the profit-making products are made elsewhere. An independent enterprise could not operate if it could only make losses by selling at an arm’s length price and it would be appropriate in these circumstances to regard the loss-making member of the MNE as producing not for its own benefit but for the benefit of other members of the group and thus as performing a service for which it should be paid an adequate fee.
(f) In all the above cases, satisfactory evidence needs to be received from the enterprise.
Another type of specially low prices which may nevertheless be claimed to be arm’s length prices may be met with where the seller’s object is market penetration. Producers may lower the prices of their goods, even to the extent of temporarily making losses, in order to enter new markets, to increase their share of an existing market, to introduce new products into the market, or to fend off increasing competition etc. One result of this may be to produce a lasting reduction in the normal market price of the relevant goods but in general specially low prices may be expected to be charged for a limited period only, with the specific object of improving the profits of the producer in the long term. Producers may not, however, be alone in this kind of activity; both producing and marketing entities may combine in such an operation, splitting the risk and sharing the profitable outcome, if any, in some way between them. Tax authorities could in principle therefore accept such low prices· charged between associated enterprises as arm’s length prices but only if independent enterprises could be expected to have fixed the prices in the same manner in comparable circumstances.
Governments may exert control on prices in a wide variety of ways ranging from simple exhortation through wages control, production subsidies, etc. to direct statutory control of prices. These controls have, in general, to be seen however as conditions of the market in that particular country. Normally it appears to be the final price to the consumer which is the subject of any direct control but the control may operate on prices earlier in the chain of transactions bringing the goods to the consumer’s market. But at whatever stage the control is imposed it will present a problem for tax authorities in deciding what effect the control can be regarded as exerting on the prices paid at the prior stages in the supply of the goods to the market. MNEs may in practice make no adjustments in their transfer prices to take account of s\ich controls, leaving the final seller to suffer any limitation of profit which results, or they may charge prices which share the burden in some way between the final seller and the production organisation. The question which tax authorities have to ask in examining the transfer prices charged in such cases is whether independent parties could be expected to have fixed the prices in the same manner in such circumstances. While the natural assumption might be that, in the arm’s length situation, a seller subject to price controls would not be able to persuade his supplier to moderate his prices, there could be circumstances in which an independent supplier would be ready to do this rather than lose some or all of the business, so that the possibility cannot be ignored. On the other hand, when it is established for example that the products concerned are actually sold on comparable free markets (and under comparable conditions) at significantly higher prices leading to corresponding higher profits, the lower profits of the enterprise in the country with price control will most probably be due to that price control, and to that extent no profit adjustment for tax purposes would be justified. Quite obviously a country with price control cannot easily expect that enterprises selling goods under control would make profits comparable to those which could be realised if no price control existed.
There are a variety of ways of ascertaining arm’s length prices. The main broad methods are as follows :
(a) adopting with any necessary modification the uncontrolled market price for the same or similar goods, or adopting or adapting similarly the prices of the same or similar goods to independent third parties – the comparable uncontrolled price method ;
(b) taking the price at which the goods are sold by the connected purchaser (the reseller) to independent customers and subtracting a mark-up to· arrive at the arm’s length price for the sale by the original vendor – the resale price method ;
(c) taking the vendor’s cost and adding an appropriate mark-up to arrive at the arm’s length price for the sale by the original vendor and thus for the purchase by the reseller – the cost plus method ;
(d) any other method which is found to be acceptable.
The main methods of ascertaining an arm’s. length price in relation to sales of goods are discussed in more detail in the following paragraphs. The question arises whether it is possible to lay down any order of priority in using these methods. Clearly the comparable uncontrolled price method is basically preferable to other methods since it uses evidence most closely related to an arm’s length price, but there may be cases where the evidence of resale profit mark-ups, pro duction costs or other data may be more complete, more conclusive and more easily obtained than undisputable evidence of open market prices. There should always be the possibility, therefore, of selecting the method which provides the most cogent evidence in a particular case. It has to be recognised that an arm’s length price will in many cases not be precisely ascertainable and that in such circumstances it will be necessary to seek for a reasonable approximation to it. Frequently, it may be useful to take account of more than one method of reaching a satisfactory approximation to an arm’s length price in the light of the evidence available.
In considering any one of the methods described, the tax authorities need a substantial amount of reliable information about the activities of the MNE in different ·countries. Sometimes, fiscal authorities may lack certain information when examining intra-group sales. The tax authority assessing the buyer may have more information about transactions and conditions regarding market prices and mark-ups in its own country than in another and consequently may find it easier to rely on these data rather than trying to calculate the cost and profit mark-up of the related seller abroad. The country in which the original vendor is situated may have access to open market prices in the country and to the costs and profit ratios of the producer, but may be ignorant of the resale prices and mark-ups obtained by the foreign subsidiary. But it should always be possible for the taxpayer to introduce evidence from the other country. Equally tax authorities will find it useful to develop their own sources of such evidence. This is an area where there could be more frequent, and more effective, exchanges of information between tax administrations, it being understood that due regard should be paid to the requirements of business confidentiality. It is perhaps worth emphasizing too that the co-operative production of information by the enterprise and the MNE of which it is a member may be helpful in achieving a mutually satisfactory result both to the taxpayer and to the tax authorities.
The comparable uncontrolled price method offers the most direct way of determining an arm’s length price. The transfer price is set by reference to comparable transactions between a buyer and a seller who are not associated enterprises. Uncontrolled sales may include sales by a member of an MNE to an unrelated party and sales to a member of an MNE by an unrelated party as well as sales in which the parties are not related to each other or to the MNE (though they may themselves be members of other MNEs). Uncontrolled sales are, in short, sales in which at least one party to the transaction is not a member of the taxpayer’s affiliated group, but they would include only bona fide transactions and not sales unrepresentative of the market, for example made in a limited quantity at unrealistic prices to an unrelated buyer, for the purpose of establishing an arm’s length price on a larger transaction. The method requires the uncontrolled transactions to be carefully reviewed for comparability with controlled transactions. A number of factors can affect the price; these are discussed in more detail in the following paragraphs.
For the prices of goods to be comparable, it is necessary to look at prices of goods sold on markets which are economically com parable. The progressive liberalisation of international trade which has taken place during the last decades has certainly facilitated access to new markets, but is has not led, even in the countries where this liberalisation is the most extensive, to the constitution of one single market where transactions would be made always and everywhere under the same conditions. Only in very few cases is it possible to determine directly an arm’s length price in one country on the basis of market prices in another country. Geographically different markets therefore can be satisfactorily compared only if the economic conditions are the same or differences in conditions can be easily eliminated. The variety of economic and social structures, of geographical situations and of consumers’ habits means that supply and demand of the same product may vary considerably from one country to another. In practice, market prices do vary from one country to another or even within one country and in addition different country policies in many spheres (for example, value of currency, taxes, competition policy, price or exchange control, size and efficiency of market and degree of concentration) are likely to influence price levels. On the other hand, an enterprise enjoying a monopoly or other dominant position in the market can, and often will, charge uniform prices to all its unrelated customers or to all of them in particular areas, or uniform prices modified only by identifiable market specific factors such as import duties. This situation may be found for example in the pro vision. of certain refill goods or spare parts.
For prices to be readily comparable it is, among other things, necessary to compare goods sold at the same point in the chain from producer to consumer or to be able to quantify easily the different points in the chain. To take perhaps the simplest example, there will be a difference between the wholesale and retail price of a commodity but if the retailer’s mark-up is readily ascertainable, it should not be difficult to make the necessary adjustment.