The Commissioner will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance. However, the Commissioner may consider the alternatives available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances. In such cases the Commissioner may adjust the consideration charged in the controlled transaction based on the cost or profit of an alternative as adjusted to account for material differences between the alternative and the controlled transaction, but will not restructure the transaction as if the alternative had been adopted by the taxpayer. See paragraph (d)(3) of this section (factors for determining comparability; contractual terms and risk); §§ 1.482-3(e), 1.482-4(d), and 1.482-9(h) (unspecified methods) ...

Under Article 9 of the OECD Model Tax Convention, the fact that a business restructuring arrangement is motivated by a purpose of obtaining tax benefits does not of itself warrant a conclusion that it is a non-arm’s length arrangement. The presence of a tax motive or purpose does not of itself justify non-recognition of the parties’ characterisation or structuring of the arrangement. However, tax benefits at a group level do not determine whether the arm’s length principle is satisfied at the entity level for a taxpayer affected by the restructuring (see previous paragraph). Moreover, as indicated in paragraph 1.142, the fact that a MNE group as a whole is left worse off on a pre-tax basis may be a relevant pointer in determining the commercial rationality of the restructuring ...

There can be group-level business reasons for an MNE group to restructure. However, it is worth re-emphasising that the arm’s length principle treats the members of an MNE group as separate entities rather than as inseparable parts of a single unified business (see paragraph 1.6). As a consequence, it is not sufficient from a transfer pricing perspective that a restructuring arrangement makes commercial sense for the group as a whole: the arrangement must be arm’s length at the level of each individual taxpayer, taking account of its rights and other assets, expected benefits from the arrangement (i.e. any consideration of the post-restructuring arrangement plus, if applicable, any compensation payments for the restructuring itself), and realistically available options. Where a restructuring makes commercial sense for the group as a whole on a pre-tax basis, it is expected that an appropriate transfer price (that is, any compensation for the post-restructuring arrangement plus, if applicable, any compensation payments for the restructuring itself) would generally be available to provide arm’s length compensation for each accurately delineated transaction comprising the business restructuring for each individual group member participating in it ...

Business restructurings often lead MNE groups to implement global business models that are hardly if ever found between independent enterprises, taking advantage of the very fact that they are MNE groups and that they can work in an integrated fashion. For instance, MNE groups may implement global supply chains or centralised functions that may not be found between independent enterprises. This lack of comparables does not mean that the implementation of such global business models is not arm’s length. Every effort should be made to determine the pricing for the restructured transactions as accurately delineated under the arm’s length principle. A tax administration should not disregard part or all of the restructuring or substitute other transactions for it unless the exceptional circumstances described in paragraph 1.142 are met. In those cases, the guidance in Section D.2 of Chapter I may be applicable. The structure that for transfer pricing purposes, replaces that actually adopted by the taxpayers should comport as closely as possible with the facts of the actual transaction undertaken whilst achieving a commercially rational expected result that would have enabled the parties to come to a price acceptable to both of them at the time the arrangement was entered into. For example, where one element of a restructuring arrangement involves the closing down of a factory, the structure adopted for transfer pricing purposes cannot ignore the reality that the factory no longer operates. Similarly, where one element of a restructuring involves the actual relocation of substantive business functions, the structure adopted for transfer pricing purposes cannot ignore the fact that those functions were actually relocated ...

In assessing the commercial rationality of a restructuring under the guidance for non-recognition under Section D.2 of Chapter I, the question may arise whether to look at one transaction in isolation or whether to examine it in a broader context, taking account of other transactions that are economically inter-related. It will generally be appropriate to look at the commercial rationality of a restructuring as a whole. For instance, where examining a sale of an intangible that is part of a broader restructuring involving changes to the arrangements relating to the development and use of the intangible, then the commercial rationality of the intangible sale should not be examined in isolation of these changes. On the other hand, where a restructuring involves changes to more than one element or aspect of a business that are not economically inter-related, the commercial rationality of particular changes may need to be separately considered. For example, a restructuring may involve centralising a group’s purchasing function and centralising the ownership of valuable intangible property unrelated to the purchasing function. In such a case, the commercial rationality of centralising the purchasing function and of centralising the ownership of valuable intangible property may need to be evaluated separately from one another ...

MNEs are free to organise their business operations as they see fit. Tax administrations do not have the right to dictate to an MNE how to design its structure or where to locate its business operations. In making commercial decisions, tax considerations may be a factor. Tax administrations, however, have the right to determine the tax consequences of the structure put in place by an MNE, subject to the application of treaties and in particular of Article 9 of the OECD Model Tax Convention. This means that tax administrations may make, where appropriate, adjustments to profits in accordance with Article 9 of the OECD Model Tax Convention and other types of adjustments allowed by their domestic law (e.g. under general or specific anti-abuse rules), to the extent that such adjustments are compatible with their treaty obligations ...

Company S1 conducts research activities to develop intangibles that it uses to create new products that it can produce and sell. It agrees to transfer to an associated company, Company S2, unlimited rights to all future intangibles which may arise from its future work over a period of twenty years for a lump sum payment. The arrangement is commercially irrational for both parties since neither Company S1 nor Company S2 has any reliable means to determine whether the payment reflects an appropriate valuation, both because it is uncertain what range of development activities Company S1 might conduct over the period and also because valuing the potential outcomes would be entirely speculative. Under the guidance in this section, the structure of the arrangement adopted by the taxpayer, including the form of payment, should be modified for the purposes of the transfer pricing analysis. The replacement structure should be guided by the economically relevant characteristics, including the functions performed, assets used, and risks assumed, of the commercial or financial relations of the associated enterprises. Those facts would narrow the range of potential replacement structures to the structure most consistent with the facts of the case (for example, depending on those facts the arrangement could be recast as the provision of financing by Company S2, or as the provision of research services by Company S1, or, if specific intangibles can be identified, as a licence with contingent payments terms for the development of those specific intangibles, taking into account the guidance on hard-to-value intangibles as appropriate) ...

Under the guidance in this section, the transaction should not be recognised. S1 is treated as not purchasing insurance and its profits are not reduced by the payment to S2; S2 is treated as not issuing insurance and therefore not being liable for any claim ...

Company S1 carries on a manufacturing business that involves holding substantial inventory and a significant investment in plant and machinery. It owns commercial property situated in an area prone to increasingly frequent flooding in recent years. Third-party insurers experience significant uncertainty over the exposure to large claims, with the result that there is no active market for the insurance of properties in the area. Company S2, an associated enterprise, provides insurance to Company S1, and an annual premium representing 80% of the value of the inventory, property and contents is paid by Company S1. In this example S1 has entered into a commercially irrational transaction since there is no market for insurance given the likelihood of significant claims, and either relocation or not insuring may be more attractive realistic alternatives. Since the transaction is commercially irrational, there is not a price that is acceptable to both S1 and S2 from their individual perspectives ...

The criterion for non-recognition may be illustrated by the following examples ...

The structure that for transfer pricing purposes, replaces that actually adopted by the taxpayers should comport as closely as possible with the facts of the actual transaction undertaken whilst achieving a commercially rational expected result that would have enabled the parties to come to a price acceptable to both of them at the time the arrangement was entered into ...

The key question in the analysis is whether the actual transaction possesses the commercial rationality of arrangements that would be agreed between unrelated parties under comparable economic circumstances, not whether the same transaction can be observed between independent parties. The non-recognition of a transaction that possesses the commercial rationality of an arm’s length arrangement is not an appropriate application of the arm’s length principle. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured. It should again be noted that the mere fact that the transaction may not be seen between independent parties does not mean that it does not have characteristics of an arm’s length arrangement ...

This section sets out circumstances in which the transaction between the parties as accurately delineated can be disregarded for transfer pricing purposes. Because non-recognition can be contentious and a source of double taxation, every effort should be made to determine the actual nature of the transaction and apply arm’s length pricing to the accurately delineated transaction, and to ensure that non-recognition is not used simply because determining an arm’s length price is difficult. Where the same transaction can be seen between independent parties in comparable circumstances (i.e. where all economically relevant characteristics are the same as those under which the tested transaction occurs other than that the parties are associated enterprises) non-recognition would not apply. Importantly, the mere fact that the transaction may not be seen between independent parties does not mean that it should not be recognised. Associated enterprises may have the ability to enter into a much greater variety of arrangements than can independent enterprises, and may conclude transactions of a specific nature that are not encountered, or are only very rarely encountered, between independent parties, and may do so for sound business reasons. The transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction. It is also a relevant pointer to consider whether the MNE group as a whole is left worse off on a pre-tax basis since this may be an indicator that the transaction viewed in its entirety lacks the commercial rationality of arrangements between unrelated parties ...

Every effort should be made to determine pricing for the actual transaction as accurately delineated under the arm’s length principle. The various tools and methods available to tax administrations and taxpayers to do so are set out in the following chapters of these Guidelines. A tax administration should not disregard the actual transaction or substitute other transactions for it unless the exceptional circumstances described in the following paragraphs 1.142-1.145 apply ...

In performing the analysis, the actual transaction between the parties will have been deduced from written contracts and the conduct of the parties. Formal conditions recognised in contracts will have been clarified and supplemented by analysis of the conduct of the parties and the other economically relevant characteristics of the transaction (see Section D.1.1). Where the characteristics of the transaction that are economically significant are inconsistent with the written contract, then the actual transaction will have been delineated in accordance with the characteristics of the transaction reflected in the conduct of the parties. Contractual risk assumption and actual conduct with respect to risk assumption will have been examined taking into account control over the risk (as defined in paragraphs 1.65-1.68) and the financial capacity to assume risk (as defined in paragraph 1.64), and consequently, risks assumed under the contract may have been allocated in accordance with the conduct of the parties and the other facts on the basis of steps 4 and 5 of the process for analysing risk in a controlled transaction as reflected in Sections D.1.2.1.4 and D.1.2.1.5. Therefore, the analysis will have set out the factual substance of the commercial or financial relations between the parties and accurately delineated the actual transaction ...

Following the guidance in the previous section, the transfer pricing analysis will have identified the substance of the commercial or financial relations between the parties, and will have accurately delineated the actual transaction by analysing the economically relevant characteristics ...

The main activity in a Danish branch of a German group was development, licensing and services related to engines that were being produced by external licensees. Under a restructuring of the group, it was decided that royalty income for a particular engine type previously received by the Danish branch should be transferred to the German company. The Danish branch received a compensation corresponding to the net earnings for a two-year notice period. The tax administration increased the taxable income of the branch claiming that the branch had made valuable contributions to the development of the type of engine in question and thereby obtained co-ownership. The Tax Tribunal found that valuable intangible assets had been transferred, The decision was based on prior contractual arrangements and conduct of the parties.  Click here for other translation ...

Under Article 9 of the OECD Model Tax Convention, the fact that a business restructuring arrangement is motivated by a purpose of obtaining tax benefits does not of itself warrant a conclusion that it is a non-arm’s length arrangement. The presence of a tax motive or purpose does not of itself justify non-recognition of the parties’ characterisation or structuring of the arrangement. However, tax benefits at a group level do not determine whether the arm’s length principle is satisfied at the entity level for a taxpayer affected by the restructuring (see previous paragraph). Moreover, as indicated in paragraph 1.122, the fact that a MNE group as a whole is left worse off on a pre-tax basis may be a relevant pointer in determining the commercial rationality of the restructuring ...

There can be group-level business reasons for an MNE group to restructure. However, it is worth re-emphasising that the arm’s length principle treats the members of an MNE group as separate entities rather than as inseparable parts of a single unified business (see paragraph 1.6). As a consequence, it is not sufficient from a transfer pricing perspective that a restructuring arrangement makes commercial sense for the group as a whole: the arrangement must be arm’s length at the level of each individual taxpayer, taking account of its rights and other assets, expected benefits from the arrangement (i.e. any consideration of the post-restructuring arrangement plus, if applicable, any compensation payments for the restructuring itself), and realistically available options. Where a restructuring makes commercial sense for the group as a whole on a pre-tax basis, it is expected that an appropriate transfer price (that is, any compensation for the post-restructuring arrangement plus, if applicable, any compensation payments for the restructuring itself) would generally be available to provide arm’s length compensation for each accurately delineated transaction comprising the business restructuring for each individual group member participating in it ...

In assessing the commercial rationality of a restructuring under the guidance for non-recognition under Section D.2 of Chapter I, the question may arise whether to look at one transaction in isolation or whether to examine it in a broader context, taking account of other transactions that are economically inter-related. It will generally be appropriate to look at the commercial rationality of a restructuring as a whole. For instance, where examining a sale of an intangible that is part of a broader restructuring involving changes to the arrangements relating to the development and use of the intangible, then the commercial rationality of the intangible sale should not be examined in isolation of these changes. On the other hand, where a restructuring involves changes to more than one element or aspect of a business that are not economically inter-related, the commercial rationality of particular changes may need to be separately considered. For example, a restructuring may involve centralising a group’s purchasing function and centralising the ownership of valuable intangible property unrelated to the purchasing function. In such a case, the commercial rationality of centralising the purchasing function and of centralising the ownership of valuable intangible property may need to be evaluated separately from one another ...

Business restructurings often lead MNE groups to implement global business models that are hardly if ever found between independent enterprises, taking advantage of the very fact that they are MNE groups and that they can work in an integrated fashion. For instance, MNE groups may implement global supply chains or centralised functions that may not be found between independent enterprises. This lack of comparables does not mean that the implementation of such global business models is not arm’s length. Every effort should be made to determine the pricing for the restructured transactions as accurately delineated under the arm’s length principle. A tax administration should not disregard part or all of the restructuring or substitute other transactions for it unless the exceptional circumstances described in paragraph 1.122 are met. In those cases, the guidance in Section D.2 of Chapter I may be applicable. The structure that for transfer pricing purposes, replaces that actually adopted by the taxpayers should comport as closely as possible with the facts of the actual transaction undertaken whilst achieving a commercially rational expected result that would have enabled the parties to come to a price acceptable to both of them at the time the arrangement was entered into. For example, where one element of a restructuring arrangement involves the closing down of a factory, the structure adopted for transfer pricing purposes cannot ignore the reality that the factory no longer operates. Similarly, where one element of a restructuring involves the actual relocation of substantive business functions, the structure adopted for transfer pricing purposes cannot ignore the fact that those functions were actually relocated ...

MNEs are free to organise their business operations as they see fit. Tax administrations do not have the right to dictate to an MNE how to design its structure or where to locate its business operations. In making commercial decisions, tax considerations may be a factor. Tax administrations, however, have the right to determine the tax consequences of the structure put in place by an MNE, subject to the application of treaties and in particular of Article 9 of the OECD Model Tax Convention. This means that tax administrations may make, where appropriate, adjustments to profits in accordance with Article 9 of the OECD Model Tax Convention and other types of adjustments allowed by their domestic law (e.g. under general or specific anti-abuse rules), to the extent that such adjustments are compatible with their treaty obligations ...

Company S1 conducts research activities to develop intangibles that it uses to create new products that it can produce and sell. It agrees to transfer to an associated company, Company S2, unlimited rights to all future intangibles which may arise from its future work over a period of twenty years for a lump sum payment. The arrangement is commercially irrational for both parties since neither Company S1 nor Company S2 has any reliable means to determine whether the payment reflects an appropriate valuation, both because it is uncertain what range of development activities Company S1 might conduct over the period and also because valuing the potential outcomes would be entirely speculative. Under the guidance in this section, the structure of the arrangement adopted by the taxpayer, including the form of payment, should be modified for the purposes of the transfer pricing analysis. The replacement structure should be guided by the economically relevant characteristics, including the functions performed, assets used, and risks assumed, of the commercial or financial relations of the associated enterprises. Those facts would narrow the range of potential replacement structures to the structure most consistent with the facts of the case (for example, depending on those facts the arrangement could be recast as the provision of financing by Company S2, or as the provision of research services by Company S1, or, if specific intangibles can be identified, as a licence with contingent payments terms for the development of those specific intangibles, taking into account the guidance on hard-to-value intangibles as appropriate) ...

Under the guidance in this section, the transaction should not be recognised. S1 is treated as not purchasing insurance and its profits are not reduced by the payment to S2; S2 is treated as not issuing insurance and therefore not being liable for any claim ...

Company S1 carries on a manufacturing business that involves holding substantial inventory and a significant investment in plant and machinery. It owns commercial property situated in an area prone to increasingly frequent flooding in recent years. Third-party insurers experience significant uncertainty over the exposure to large claims, with the result that there is no active market for the insurance of properties in the area. Company S2, an associated enterprise, provides insurance to Company S1, and an annual premium representing 80% of the value of the inventory, property and contents is paid by Company S1. In this example S1 has entered into a commercially irrational transaction since there is no market for insurance given the likelihood of significant claims, and either relocation or not insuring may be more attractive realistic alternatives. Since the transaction is commercially irrational, there is not a price that is acceptable to both S1 and S2 from their individual perspectives ...

The criterion for non-recognition may be illustrated by the following examples ...

The structure that for transfer pricing purposes, replaces that actually adopted by the taxpayers should comport as closely as possible with the facts of the actual transaction undertaken whilst achieving a commercially rational expected result that would have enabled the parties to come to a price acceptable to both of them at the time the arrangement was entered into ...

The key question in the analysis is whether the actual transaction possesses the commercial rationality of arrangements that would be agreed between unrelated parties under comparable economic circumstances, not whether the same transaction can be observed between independent parties. The non-recognition of a transaction that possesses the commercial rationality of an arm’s length arrangement is not an appropriate application of the arm’s length principle. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured. It should again be noted that the mere fact that the transaction may not be seen between independent parties does not mean that it does not have characteristics of an arm’s length arrangement ...

This section sets out circumstances in which the transaction between the parties as accurately delineated can be disregarded for transfer pricing purposes. Because non-recognition can be contentious and a source of double taxation, every effort should be made to determine the actual nature of the transaction and apply arm’s length pricing to the accurately delineated transaction, and to ensure that non-recognition is not used simply because determining an arm’s length price is difficult. Where the same transaction can be seen between independent parties in comparable circumstances (i.e. where all economically relevant characteristics are the same as those under which the tested transaction occurs other than that the parties are associated enterprises) non-recognition would not apply. Importantly, the mere fact that the transaction may not be seen between independent parties does not mean that it should not be recognised. Associated enterprises may have the ability to enter into a much greater variety of arrangements than can independent enterprises, and may conclude transactions of a specific nature that are not encountered, or are only very rarely encountered, between independent parties, and may do so for sound business reasons. The transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction. It is also a relevant pointer to consider whether the MNE group as a whole is left worse off on a pre-tax basis since this may be an indicator that the transaction viewed in its entirety lacks the commercial rationality of arrangements between unrelated parties ...

Every effort should be made to determine pricing for the actual transaction as accurately delineated under the arm’s length principle. The various tools and methods available to tax administrations and taxpayers to do so are set out in the following chapters of these Guidelines. A tax administration should not disregard the actual transaction or substitute other transactions for it unless the exceptional circumstances described in the following paragraphs 1.122-1.125 apply ...

In performing the analysis, the actual transaction between the parties will have been deduced from written contracts and the conduct of the parties. Formal conditions recognised in contracts will have been clarified and supplemented by analysis of the conduct of the parties and the other economically relevant characteristics of the transaction (see Section D.1.1). Where the characteristics of the transaction that are economically significant are inconsistent with the written contract, then the actual transaction will have been delineated in accordance with the characteristics of the transaction reflected in the conduct of the parties. Contractual risk assumption and actual conduct with respect to risk assumption will have been examined taking into account control over the risk (as defined in paragraphs 1.65-1.68) and the financial capacity to assume risk (as defined in paragraph 1.64), and consequently, risks assumed under the contract may have been allocated in accordance with the conduct of the parties and the other facts on the basis of steps 4 and 5 of the process for analysing risk in a controlled transaction as reflected in Sections D.1.2.1.4 and D.1.2.1.5. Therefore, the analysis will have set out the factual substance of the commercial or financial relations between the parties and accurately delineated the actual transaction ...

Following the guidance in the previous section, the transfer pricing analysis will have identified the substance of the commercial or financial relations between the parties, and will have accurately delineated the actual transaction by analysing the economically relevant characteristics ...

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 ...

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 ...

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 ...