Avon Cosmetics s.r.o. paid 6% of its net sales in royalties/licences for the use of intangible assets to a Group company in Ireland. The Irish company in turn was contractually obliged to pay 5.68% of Avon Cosmetics s.r.o.’s net sales as royalties to its US parent company. In the opinion of the tax authorities, the beneficial owner of the royalties was not the Irish company but the US parent and therefore the royalty payments were not exempt from withholding tax. An assessment of additional withholding tax was therefore issued. Decision of the Supreme Administrative Court The Supreme Administrative Court upheld the decision of the tax authorities and found that the US parent company was the beneficial owner of the royalties. Excerpt in English “[32] The interpretation of the concept of beneficial owner, including in the context of the OECD Model Tax Treaty relied on by the complainant, was dealt with by the Municipal court in the judgment referred to in N Luxembourg 1 and Others, which, although it dealt with preliminary questions relating to the exemption of interest from income tax, its conclusions can be applied without further ado to royalties, given the similarity of the legislation. In that judgment, the CJEU stated: “The concept of ‘beneficial owner of interest’ within the meaning of the Directive must therefore be interpreted as referring to the entity which actually benefits from the interest paid to it. Article 1(4) of the same directive supports this reference to economic reality by specifying that a company of a Member State is to be regarded as the beneficial owner of interest or royalties only if it receives them for itself and not for another person as an intermediary, such as an agent, trustee or principal. [paragraph 88] … It is clear from the development of the OECD Model Tax Treaty and the related commentaries, as described in paragraphs 4 to 6 of this judgment, that the concept of ‘beneficial owner’ excludes conduit companies and cannot be understood in a narrow and technical sense, but in a sense which makes it possible to avoid double taxation and prevent tax avoidance and evasion. [… Article 1(1) of Directive 2003/49, read in conjunction with Article 1(4) of that directive, must be interpreted as meaning that the exemption from any tax on interest provided for therein is reserved only to the beneficial owners of such interest, that is to say, to the entities which actually benefit economically from that interest and are therefore entitled to determine freely how it is used. [paragraph 122]’. [33] The Supreme Administrative Court reached similar conclusions in its judgment of 12 November 2019, no. 10 Afs 140/2018-32. In doing so, it also relied on the commentary to Article 12(4.3) of the OECD Model Tax Treaty cited by the complainant. In that judgment, the Supreme Administrative Court concluded that “the recipient of the (sub)royalties is the beneficial owner of the royalties only if it can use and enjoy them without restriction and is not obliged by law or contract to pass the payments on to another person”. In the present case, the Supreme Administrative Court finds no reason to depart from those conclusions in any way. [34] The answer to the question whether the complainant meets the statutory conditions for the exemption of royalty income from income tax therefore depends on an assessment of whether the complainant is the beneficial owner of the royalties, i.e. whether it actually benefits economically from them, is free to determine how they are used and is not obliged by law or contract to pass the payments on to another person. [35] At this point, the Supreme Administrative Court recalls that the administrative proceedings concerned the applicant’s application for a decision granting an exemption from the royalty income paid exclusively by ACS. The complainant attached to that application an extract from the commercial register, according to which she is the sole shareholder of ACS. In support of its application, the complainant attached a trademark and trade name use agreement dated 9 October 1993 between API and ACS, under which ACS, as licensee, is obliged to pay, as remuneration for the licensed rights (trademarks, trade names, copyrights and patents of AVON), a royalty of 6 % of the net sales of products, in US dollars, within 30 days of the last day of each calendar quarter of the term of the agreement. The Complainant also submitted a license agreement dated June 30, 2016, which it entered into with API and AIO as licensors. By this agreement, the Complainant licensed the use and exercise of API’s proprietary rights (API’s rights relating to technical information, patent rights and commercial rights – trademarks, industrial designs, trade names, copyrights) and the right to receive royalties under the current license agreements (including the aforementioned agreement with ACS) and agreed to pay a royalty of 5.68% of its and its sublicensees’ net sales, in U.S. dollars, within 60 days of the last day of each calendar quarter of the term of this agreement. These findings of fact were made by both the defendant and the municipal court. [36] It follows from the foregoing that the plaintiff, by entering into the agreement with API and AIO, acquired both the authority and the obligation to collect royalties from ACS, while contractually obligating itself to pay royalties to AIO for the same licensed rights. Thus, within 30 days of the end of each calendar quarter, the Complainant collects royalties from ACS at the rate of 6% of its net sales, and if it receives payment from ACS only on the last day, it then has 30 days to pay AIO royalties including an amount equal to 5.68% of ACS’s net sales. The complainant therefore pays 94.6667% of the royalties it collects from ACS to AIO. In essence, this is a contractual obligation to pass on the vast majority of the royalty payment received to another party. [37] The Supreme Administrative Court agrees with the Municipal court and the defendant that the ...

At issue was whether or not a proportionate share of management and general administrative expenses incurred by the head office in Spain should be allocated to its PE in Algeria. The tax authorities (appelante) argued that, in general, these expenses cannot be individualised and, therefore, a proportional criteria should be used to determine the amount to be allocated to the Algerian PE. Compañía Española de Petróleos, S.A. argued that only management and general administrative expenses related to the purposes of the Algerian PE should be attributed to it. According to the company, the tax authorities had not carried out an appropriate analysis when examining what percentage of these expenses related to the Algerian PE. Judgement of the Supreme Court The Supreme Court decided in favor of Compañía Española de Petróleos S.A. Excerpts (English translation) “The tax authorities point out that in commercial groups there are activities and services that do not always generate transactions and consequent expenses in all the entities of the group, but which are useful and beneficial for them and their permanent establishments. From this perspective, certain corporate expenses are allocated to management and general administrative expenses (management of information systems, presidency, institutional relations, etc.), the costs of which should, in the Inspectorate’s opinion, be partially allocated to Algeria’s PE in a certain proportion. Once the total amount of expenditure corresponding to these cost centres has been quantified, the Inspectorate proceeds to calculate a percentage obtained by relating the net investment in Algeria to the total net tangible fixed assets recorded in the consolidated accounts of the commercial group. However, this method of allocating management and general administrative expenses has been rejected by this Court in respect of the appellant in relation to the financial years 2000 and 2004, in which the tax authorities allocated expenses for the same items using the same method as applied in the financial years in question.” “Contrary to what the appellant maintains, it does not follow from its wording that it is necessary to individualise the management and general administration expenses for each SOE, but rather that the Inspectorate will have to carry out a prior “selection” of the expenses in order to determine those which, being truly general and related to the purposes of the SOE, can be proportionally imputed to it. In other words, and in the terms used by the Court of First Instance in the judgment to which it refers, “it would be necessary to analyse these expenses more rigorously, to check which of them, because they are truly general, are suitable for being passed on and, once this need to pass them on has been determined, to then discuss the proportionality rule and on what magnitudes it would be admissible […]”. The problem, therefore, does not derive from the application of a proportionality criterion to determine the management and general administration expenses that can be charged to the PE, but rather from an earlier step, i.e. from the prior selection of the expenses, given that only those expenses which, it is reiterated, because they are truly general and related to the PE’s purposes, can be charged proportionally.” “In this regard, it should be recalled, on the one hand, that although the Commentaries to Article 7.3 (paragraph 3.27) of the OECD Model Convention and the Interpretative Commentaries thereto may be valid as interpretative criteria in relation to Article 7.3 of the Spanish-Algerian DTT, they are not valid in relation to Article 22 TRLIS, cited as being infringed, as the respondent in cassation points out. On the other hand, this Court has repeatedly stated that the OECD rules, models or comments that normally inspire the drafting of conventions – among the states whose governments belong to that organisation, presumably – are not normative sources that condition or bind our criteria, nor can they be invoked as infringed in cassation…” Click here for English translation Click here for other translation ...

“Z Pipeline” is a limited partnership which operates a network of pipelines. The network runs through Germany, Belgium and the Netherlands. During the year in question, “Z Pipeline”‘s administrative HQ was in Germany. Operational control of the pipeline was exercised by an ‘operations centre’ located in the Netherlands. It was not disputed that the pipeline constituted permanent establishments in Germany, Belgium and the Netherlands and that the profits should be allocated between the tree countries. The question was how the profits should be allocated. The tax authorities came to the conclusion that the profit should predominantly be allocated to the German permanent establishments. In accordance with the low functions and risks, only a low profit was to be allocated to the respective permanent establishments in Belgium an the Netherlands. The profit allocation was calculated using a cost-plus 30% due to industry and company-specific features. “Z Pipeline” disagreed with the method applied by the tax authorities and held that it was more appropriate to allocate the profits on the basis of the indirect method. Judgement of the Tax Court The Court decided in favour of “Z Pipeline”. Excerpt “66 VI.) Since the profit differentiation carried out by the defendant [tax authorities] cannot be used as a basis for taxation, the total profit achieved by the plaintiff [Z Pipeline] must be divided into domestic income within the meaning of § 15, para. 1, sentence 1, no. 2 of the Income Tax Act and into income that is tax-exempt according to double taxation agreements. In this respect, the Senate follows the apportionment made by the plaintiff, which results in domestic income from trade in the amount of €…. 67 The apportionment made by the plaintiff, which is essentially based on which part of the company’s assets (pipeline) generated which turnover, is consistent with Article 5, para. 2 DBA-NL 1959 / Article 7 DBA-Belgium. The defendant has not raised any comprehensible objections as to why the apportionment method, which the plaintiff also applied in a comparable form in the assessment periods up to and including 2009 and which withstood several external audits during this time, should be improper as of 2010. Insofar as he refers to the fact that the apportionment is already inappropriate because in Belgium, instead of the Belgian share of profits determined by the plaintiff, only a lump-sum taxation according to turnover has taken place, he fails to realise that the appropriateness of the profit apportionment has nothing to do with the subsequent taxation of the income and that, moreover, the lump-sum taxation according to turnover has taken place with the consent of the Belgian tax authorities. 68 In the opinion of the Senate, the apportionment chosen by the plaintiff also presents itself as a suitable and appropriate method for the apportionment of profits for the year in dispute 2011. In particular, the plaintiff applied an appropriate method for the apportionment of revenue by apportioning the fees from the transport of goods according to the extent to which the pipelines in Germany, Belgium or the Netherlands were actually used for the respective transport and by allocating the remuneration from the management of the foreign pipeline networks to Germany alone. The allocation of costs is also appropriate. Costs directly attributable to an operating facility (such as repair costs for a specific pipeline section) were allocated to the respective state of location, the costs for the Dutch operating centre responsible for monitoring the entire pipeline network were distributed among the three countries according to pipeline kilometres, and the remaining expenses were distributed according to various objective apportionment keys depending on the type of costs (including a country’s percentage share of the total investment costs or of the total revenue). As these apportionment keys had already been applied for many years and no specific objections had been raised by the tax authorities either in previous external audits or in the present legal action, the Senate had no reason to doubt the appropriateness of the apportionment keys. 69 This also applies to the plaintiff’s approach of allocating all administrative costs (personnel costs, etc.) to the German parent company and, in return, recognising fictitious service revenues for the administration of the foreign network share at the parent company (i.e. in the domestic income) determined according to arm’s length principles. Admittedly, neither this approach nor the calculation formula used by the plaintiff is without alternative. However, since no clearly more suitable yardsticks for the apportionment of administrative/personnel costs are apparent, the calculation can be followed. The fact that the apportionment method does not lead to an inappropriate result (from the perspective of the German tax authorities) is already shown by the fact that it results in higher domestic income in the year in dispute. The fictitious domestic service revenues (… €) are higher than the share of administrative costs that would be allocated to the foreign permanent establishments according to the general allocation formula (-… €) and is now taken into account as expenses in Germany. 70 The income from the supplementary balance sheets is also to be allocated to the individual countries – as undertaken by the plaintiff. The defendant’s allocation of the income from the supplementary balance sheets to Germany alone, which is not substantiated in detail, is not comprehensible. The income is directly related to the hidden reserves contained in the individual assets at the time of the acquisition of the shares in the company and is therefore attributable to the foreign permanent establishment, insofar as the respective asset – in particular the pipeline – belonged to its business assets. The plaintiff proved that a) the supplementary balance sheets were formed on the occasion of changes in shareholders in 2002 and 2005, b) both in the calculation of the capital gains for the departing shareholders and in the calculation of the top-up amounts entered in the supplementary balance sheets, a domestic share of 39,81% and a foreign share of 60.19% and c) the apportionments made by it were examined both in the external audit ...

YOLT Services s.r.o. is active in distribution of TV programmes and paid royalties/license for use of these programmes to its parent company in Romania and subsidiaries in Hungary and Slovakia. These companies were contractually obliged to pay royalties received on to the producers of the programmes. According to the tax authorites, the beneficial owners of the royalties were not the group companies, but rather the producers of the programmes. On that basis the royalty payments were not excempt from withholding taxes. An assessment of additional taxes was issued where withholding taxes had been calculated as 15% of the royalties paid by YOLT services. Judgement of the Regional Court The court upheld the decision of the tax authorities in regards of the producers – and not the group companies – beeing the beneficial owners of the royalties. But the court referred the case back to the to the tax authorities in regards of the withholding tax percentages applied, as these followed from the Double Tax Treaties entered with the relevant jurisdictions of the producers. Excerpt “It follows from the above that the mere forwarding of royalties through an intermediary entity does not imply the impossibility of applying the FTAA concluded by the Czech Republic with the country of tax residence of the beneficial owner of the income. Provided that other conditions are met, the tax authorities may not only apply the international treaty to the matter covered by the treaty, but are obliged to apply such treaty (Article 37 of the Tax Code in the relevant wording; see also the judgment of the Supreme Administrative Court of 25 May 2013, No. 9 Afs 38/2012-40).” Click here for English Translation Click here for other translation ...

A Hungarian company had a permanent establishment (PE) in Germany. The PE provided installation and assembly services to third parties in Germany. Following an audit of the German PE for FY 2017 the German tax authorities issued an assessment of additional taxabel income calculated based on the cost-plus method, cf. section 32 of the BsGaV (German ordinance on allocation of profits to permanent establishments). Not satisfied with the assessment a complaint was filed with the Tax Court. Judgement of the Tax Court The Court decided in favour of the PE and set aside the tax assessment. Excerpt (English translation) “Pursuant to Section 1 para. 1 sentence 1 AStG, the following applies: If a taxpayer’s income from a business relationship abroad with a related party is reduced by the fact that the taxpayer bases its income calculation on different conditions, in particular prices (transfer prices), than would have been agreed between independent third parties under the same or comparable circumstances (arm’s length principle), its income must be recognised as it would have been under the conditions agreed between independent third parties, irrespective of other provisions. This provision shall apply accordingly in accordance with Section 1 (5) AStG if the conditions, in particular the transfer prices, on which the allocation of income between a domestic company and its foreign permanent establishment or the determination of the income of the domestic permanent establishment of a foreign company is based for tax purposes for a business relationship within the meaning of paragraph 4 sentence 1 number 2 do not comply with the arm’s length principle and the domestic income of a limited taxpayer is reduced or the foreign income of an unlimited taxpayer is increased as a result. In order to apply the arm’s length principle, a permanent establishment must be treated as a separate and independent company, unless the affiliation of the permanent establishment to the company requires a different treatment. The criteria of Section 1 para. 5 sentence 1 in conjunction with Section 1 para. § Section 1 para. 1 sentence 1 AStG are not fulfilled in the case in dispute insofar as there are no transfer pricing issues in particular. There are no indications apparent to the court and no such indications were presented by the tax office that the service relationships between the Hungarian parent company and the domestic permanent establishment as the taxable entity were overcharged or would not stand up to a third-party comparison in any other way. Insofar as the domestic permanent establishment made payments to the parent company (e.g. payments to the Hungarian social security fund), these were merely cost reimbursements in the year in dispute, which were passed on to the branch without any mark-up. In particular, the court does not agree with the tax office’s view that fictitious mark-up rates should be applied in relation to the service relationships between the Hungarian parent company and the domestic permanent establishment. Such factual treatment cannot be inferred from the provisions of the AStG.” (An appeal has later been filed by the tax authorities with the BFH (I R 49/23). Click here for English translation Click here for other translation ...

The foregoing principles concerning the taxation of MNEs are incorporated in the OECD Model Tax Convention on Income and on Capital (OECD Model Tax Convention), which forms the basis of the extensive network of bilateral income tax treaties between OECD member countries and between OECD member and non-member countries. These principles also are incorporated in the Model United Nations Double Taxation Convention between Developed and Developing Nations ...

Seven Seas Technologies under a software license agreement purchased software from a US company – Callidus software – for internal use and for distribution to local customers. Following an audit, the tax authorities found that Seven Seas Technologies had not been paying withholding taxes on payments in respect of the software license agreement with Callidas. An assessment was issued according to which these payments were found to by a “consideration for the use and right to use copyright in the literary work of another person” as per section 2 of the Income Tax Act, thus subject to withholding tax under Section 35 (1)(b) of the Kenyan Income Tax Act. Seven Seas Technologies contested the assessment before the Tax Appeals Tribunal where, in a judgement issued 8 December 2016, the tribunal held that Seven Seas Technologies had acquired rights to copyright in software that is commercially exploited and that the company on that basis should have paid withholding tax. A decision was issued in favor of the tax authorities. Unsatisfied with the decision of the tribunal Seven Seas Technologies Ltd moved the case to the High Court. In the appeal filed in 2017 Seven Seas Technologies Ltd argues that a payment may only be deemed a royalty where it results in the transfer of copyrights which grants rights as set out in Section 26 (1) of Copyright Act 2001. In the case at hand, a transfer of such rights had not taken place under the software license agreement and the payments are therefore not subject to withholding tax. Judgement of the High Court The High Court granted the appeal and decided in favor of Seven Seas Technologies Ltd. The additional tax assessment and the decision of the tribunal – was set aside. During the proceedings the High Court sought additional evidence, including evidence of experts. The expert witness for the Appellant pointed to the decision in the case of Tata Consultancy Services vs State of Andhra Pradesh (277ITR 401) 2004 Pg 99-122 wherein the Indian Supreme Court held that software, when put in a medium, is goods for sale, not copyright. The High Court relied on the Indian Supreme Court decision of 2 March 2021 in the case of Engineering Analysis Centre of Excellence Private Limited v. Commissioner of Income Tax. The Court extracted the finding that “What is licensed by the foreign, non-resident supplier to the distributor and resold to the end-user or directly supplied to the resident end-user is, in fact, the sale of a physical object which contains an embedded computer program and is, therefore, the sale of goods.” Excerpt “The upshot of the above excerpts and the case is that the Appellant in this case paid the license fee did not acquire any partial rights in copyright and thus not subject to royalty as argued by the Respondent. In addition to the above, the OECD Model Tax Convention on Income and on Capital provides that in such transactions, distributors are paying only for the acquisition of the software copies and not to exploit any right in the software copyrights. Therefore, payments in these types of transactions should be dealt with as business profits and not as royalties. The Tribunal erred in failing to consider that the Appellant is a vendor of copyrighted material and not the user of a copyright and in this regard does not receive any right to exploit the copyright. Disposition It is therefore right to conclude that the Appellant was not subject to pay royalties and in turn not liable to pay Withholding tax to the Respondent with regard to the distribution of the computer software. For these reasons the Appeal is allowed and the decision of the Tribunal set aside.” ...

At issue in the case of India vs. Engineering Analysis Centre of Excellence Private Limited, was whether payments for purchase of computer software to foreign suppliers or manufacturers could be characterised as royalty payments. The Supreme Court held that such payments could not be considered payments for use of the underlying copyrights/intangibles. Hence, no withholding tax would apply to these payments for the years prior to the 2012. Furthermore, the 2012 amendment to the royalty definition in the Indian tax law could not be applied retroactively, and even after 2012, the definition of royalty in Double Tax Treaties would still override the definition in Indian tax law. Excerpt from the conclusion of the Supreme Court “Given the definition of royalties contained in Article 12 of the DTAAs mentioned in paragraph 41 of this judgment , it is clear that there is no obligation on the persons mentioned in section 195 of the Income Tax Act to deduct tax at source, as the distribution agreements/EULAs in the facts of these cases do not create any interest or right in such distributors/end-users, which would amount to the use of or right to use any copyright. The provisions contained in the Income Tax Act (section 9(1)(vi), along with explanations 2 and 4 thereof), which deal with royalty, not being more beneficial to the assessees, have no application in the facts of these cases. Our answer to the question posed before us, is that the amounts paid by resident Indian end-users/distributors to non-resident computer software manufacturers/suppliers, as consideration for the resale/use of the computer software through EULAs/distribution agreements, is not the payment of royalty for the use of copyright in the computer software, and that the same does not give rise to any income taxable in India, as a result of which the persons referred to in section 195 of the Income Tax Act were not liable to deduct any TDS under section 195 of the Income Tax Act. The answer to this question will apply to all four categories of cases enumerated by us in paragraph 4 of this judgment.” ...

This full version of the OECD Model Tax Convention contains the full text of the Model Tax Convention on Income and on Capital as it read on 21 November 2017, including the Articles, the Commentaries, the non-OECD economies’ positions, the Recommendation of the OECD Council, the historical notes and the full text of a number of background reports adopted after 1977 ...

The foregoing principles concerning the taxation of MNEs are incorporated in the OECD Model Tax Convention on Income and on Capital (OECD Model Tax Convention), which forms the basis of the extensive network of bilateral income tax treaties between OECD member countries and between OECD member and non-member countries. These principles also are incorporated in the Model United Nations Double Taxation Convention between Developed and Developing Nations ...

A move away from the arm’s length principle would abandon the sound theoretical basis described above and threaten the international consensus, thereby substantially increasing the risk of double taxation. Experience under the arm’s length principle has become sufficiently broad and sophisticated to establish a substantial body of common understanding among the business community and tax administrations. This shared understanding is of great practical value in achieving the objectives of securing the appropriate tax base in each jurisdiction and avoiding double taxation. This experience should be drawn on to elaborate the arm’s length principle further, to refine its operation, and to improve its administration by providing clearer guidance to taxpayers and more timely examinations. In sum, OECD member countries continue to support strongly the arm’s length principle. In fact, no legitimate or realistic alternative to the arm’s length principle has emerged. Global formulary apportionment, sometimes mentioned as a possible alternative, would not be acceptable in theory, implementation, or practice. (See Section C, immediately below, for a discussion of global formulary apportionment) ...

While recognizing the foregoing considerations, the view of OECD member countries continues to be that the arm’s length principle should govern the evaluation of transfer prices among associated enterprises. The arm’s length principle is sound in theory since it provides the closest approximation of the workings of the open market in cases where property (such as goods, other types of tangible assets, or intangible assets) is transferred or services are rendered between associated enterprises. While it may not always be straightforward to apply in practice, it does generally produce appropriate levels of income between members of MNE groups, acceptable to tax administrations. This reflects the economic realities of the controlled taxpayer’s particular facts and circumstances and adopts as a benchmark the normal operation of the market ...

Both tax administrations and taxpayers often have difficulty in obtaining adequate information to apply the arm’s length principle. Because the arm’s length principle usually requires taxpayers and tax administrations to evaluate uncontrolled transactions and the business activities of independent enterprises, and to compare these with the transactions and activities of associated enterprises, it can demand a substantial amount of data. The information that is accessible may be incomplete and difficult to interpret; other information, if it exists, may be difficult to obtain for reasons of its geographical location or that of the parties from whom it may have to be acquired. In addition, it may not be possible to obtain information from independent enterprises because of confidentiality concerns. In other cases information about an independent enterprise which could be relevant may simply not exist, or there may be no comparable independent enterprises, e.g. if that industry has reached a high level of vertical integration. It is important not to lose sight of the objective to find a reasonable estimate of an arm’s length outcome based on reliable information. It should also be recalled at this point that transfer pricing is not an exact science but does require the exercise of judgment on the part of both the tax administration and taxpayer ...

In certain cases, the arm’s length principle may result in an administrative burden for both the taxpayer and the tax administrations of evaluating significant numbers and types of cross-border transactions. Although associated enterprises normally establish the conditions for a transaction at the time it is undertaken, at some point the enterprises may be required to demonstrate that these are consistent with the arm’s length principle. (See discussion of timing and compliance issues at Sections B and C of Chapter III and at Chapter V on Documentation). The tax administration may also have to engage in this verification process perhaps some years after the transactions have taken place. The tax administration would review any supporting documentation prepared by the taxpayer to show that its transactions are consistent with the arm’s length principle, and may also need to gather information about comparable uncontrolled transactions, the market conditions at the time the transactions took place, etc., for numerous and varied transactions. Such an undertaking usually becomes more difficult with the passage of time ...

A practical difficulty in applying the arm’s length principle is that associated enterprises may engage in transactions that independent enterprises would not undertake. Such transactions may not necessarily be motivated by tax avoidance but may occur because in transacting business with each other, members of an MNE group face different commercial circumstances than would independent enterprises. Where independent enterprises seldom undertake transactions of the type entered into by associated enterprises, the arm’s length principle is difficult to apply because there is little or no direct evidence of what conditions would have been established by independent enterprises. The mere fact that a transaction may not be found between independent parties does not of itself mean that it is not arm’s length ...

The arm’s length principle is viewed by some as inherently flawed because the separate entity approach may not always account for the economies of scale and interrelation of diverse activities created by integrated businesses. There are, however, no widely accepted objective criteria for allocating the economies of scale or benefits of integration between associated enterprises. The issue of possible alternatives to the arm’s length principle is discussed in Section C below ...

The arm’s length principle has also been found to work effectively in the vast majority of cases. For example, there are many cases involving the purchase and sale of commodities and the lending of money where an arm’s length price may readily be found in a comparable transaction undertaken by comparable independent enterprises under comparable circumstances. There are also many cases where a relevant comparison of transactions can be made at the level of financial indicators such as mark-up on costs, gross margin, or net profit indicators. Nevertheless, there are some significant cases in which the arm’s length principle is difficult and complicated to apply, for example, in MNE groups dealing in the integrated production of highly specialised goods, in unique intangibles, and/or in the provision of specialised services. Solutions exist to deal with such difficult cases, including the use of the transactional profit split method described in Chapter II, Part III of these Guidelines in those situations where it is the most appropriate method in the circumstances of the case ...

There are several reasons why OECD member countries and other countries have adopted the arm’s length principle. A major reason is that the arm’s length principle provides broad parity of tax treatment for members of MNE groups and independent enterprises. Because the arm’s length principle puts associated and independent enterprises on a more equal footing for tax purposes, it avoids the creation of tax advantages or disadvantages that would otherwise distort the relative competitive positions of either type of entity. In so removing these tax considerations from economic decisions, the arm’s length principle promotes the growth of international trade and investment ...

“It is important to put the issue of comparability into perspective in order to emphasise the need for an approach that is balanced in terms of, on the one hand, its reliability and, on the other, the burden it creates for taxpayers and tax administrations. Paragraph 1 of Article 9 of the OECD Model Tax Convention is the foundation for comparability analyses because it introduces the need for: • A comparison between conditions (including prices, but not only prices) made or imposed between associated enterprises and those which would be made between independent enterprises, in order to determine whether a re-writing of the accounts for the purposes of calculating tax liabilities of associated enterprises is authorised under Article 9 of the OECD Model Tax Convention (see paragraph 2 of the Commentary on Article 9); and • A determination of the profits which would have accrued at arm’s length, in order to determine the quantum of any re-writing of accounts.” ...

The authoritative statement of the arm’s length principle is found in paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms the basis of bilateral tax treaties involving OECD member countries and an increasing number of non-member countries. Article 9 provides: [Where] conditions are made or imposed between the two [associated] 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. By seeking to adjust profits by reference to the conditions which would have obtained between independent enterprises in comparable transactions and comparable circumstances (i.e. in “comparable uncontrolled transactions”), the arm’s length principle follows the approach of treating the members of an MNE group as operating as separate entities rather than as inseparable parts of a single unified business. Because the separate entity approach treats the members of an MNE group as if they were independent entities, attention is focused on the nature of the transactions between those members and on whether the conditions thereof differ from the conditions that would be obtained in comparable uncontrolled transactions. Such an analysis of the controlled and uncontrolled transactions, which is referred to as a “comparability analysis”, is at the heart of the application of the arm’s length principle. Guidance on the comparability analysis is found in Section D below and in Chapter III ...

The Committee on Fiscal Affairs, which is the main tax policy body of the OECD, has issued a number of reports relating to the application of these Articles to MNEs and to others. The Committee has encouraged the acceptance of common interpretations of these Articles, thereby reducing the risk of inappropriate taxation and providing satisfactory means of resolving problems arising from the interaction of the laws and practices of different countries ...

The main mechanisms for resolving issues that arise in the application of international tax principles to MNEs are contained in these bilateral treaties. The Articles that chiefly affect the taxation of MNEs are: Article 4, which defines residence; Articles 5 and 7, which determine the taxation of permanent establishments; Article 9, which relates to the taxation of the profits of associated enterprises and applies the arm’s length principle; Articles 10, 11, and 12, which determine the taxation of dividends, interest, and royalties, respectively; and Articles 24, 25, and 26, which contain special provisions relating to non-discrimination, the resolution of disputes, and exchange of information ...

The foregoing principles concerning the taxation of MNEs are incorporated in the OECD Model Tax Convention on Income and on Capital (OECD Model Tax Convention), which forms the basis of the extensive network of bilateral income tax treaties between OECD member countries and between OECD member and non-member countries. These principles also are incorporated in the Model United Nations Double Taxation Convention between Developed and Developing Nations ...