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1.1 OECD: Confrontation And Compromise 1.2 OECD: Selected Issues General Tenor Transactional Profit Methods Arm's Length Principle Choice Of Method Transfer Price Methods Arm's Length Range Market Entry, Defence, And Expansion Strategies Intangible Assets Intra-Group Services Procedural Matters
THE 1995 OECD GUIDELINES
1.1 OECD: Confrontation And Compromise
The deliberations leading up to publication of the first five chapters of the OECD Guidelines in July 1995 were difficult and at times heated. They centred around the issues posed by the new American transfer pricing concepts discussed above. The most contentious points were the two new profit-oriented transfer pricing methods introduced in the U.S. regulations under section 482 IRC. Certain countries, notably Germany, France, Sweden, Belgium, Switzerland, and Austria, wished to exclude these methods from the report, whereas Great Britain, Australia, the United States and Japan wished to see the methods officially sanctioned. In particular the United States threatened to walk out of the talks if the profit-oriented methods were rejected and even intimated that it would consider adoption of a unitary tax system if operation of its new transfer pricing system was blocked by a majority of OECD nations. Another bone of contention was the no-fault penalty system of the United States under section 6662 IRC. Here again the United States blocked a general statement rejecting no-fault penalties. However, its delegates did indicate that the penalty system would be revised in some way to make it less objectionable to the majority of the OECD member states. (The final regulations under section 6662 (e) IRC issued in February 1996 are, however, not substantially different from the previous temporary regulations.)
The end result of the OECD talks is a voluminous paper in which there is something for everybody. The preferred interpretation in Germany at least is that the OECD has, while avoiding an open break with the U.S. transfer pricing philosophy, produced a set of guidelines which are more taxpayer-oriented than is the harsh U.S. regime. Fundamentally, a majority of OECD nations, especially the European members, see no need for major departures from the basic principles under which they now operate. They accordingly sought to insert language in the Guidelines which recalls these basic principles and admonishes both taxpayers and tax administrations (especially the IRS) to avoid extreme positions on transfer pricing.
In view of the development in the U.S. position in the course of the deliberations and also the changes made in certain aspects of the U.S. regulations in response inter alia to the report published by the OECD Committee on Fiscal Affairs in December 1992, it would be going too far to say that the European protest has fallen on deaf ears. Still, the OECD Guidelines skirt direct conflict with the U.S. principles and, to the extent the Guidelines are nuanced so as to indicate a more liberal approach to transfer pricing, it must be recalled that the Guidelines are binding on no one. The most that can be said for them is that they are a sort of official commentary on the transfer pricing article (Article 9) of the OECD Model Treaty and as such must be given weight in interpreting this article. Even this argument applies best to treaties concluded in the future, where failure to take exception to the Guidelines may be construed as assent thereto.
A more pessimistic view of the OECD Guidelines is that the United States made concessions largely of form, not of substance, and ensured that the language of the Guidelines was vague or contradictory enough to be arguably in agreement with the American position. And where this may prove not to be the case, the United States may well just ignore the Guidelines.
The consensus is that, while the OECD Guidelines adequately reflect the European middle-of-the-road approach to transfer pricing and show sufficient regard for the legitimate interests of international businesses, it remains to be seen whether countries such as the United States will accept the guidance offered or force a major international transfer pricing confrontation by making adjustments to the U.S. income of European businesses which are unjustified in the view of the European tax administrations and therefore not qualified for corresponding adjustments.
At least in the literature there is considerable enthusiasm for avoiding such a showdown by timely implementation of a binding arbitration system similar to that which went into effect in the European Union at the start of 1995. Prospects for this appear slight, however. More realistic is the hope that a major clash can be avoided at the latest in a mutual agreement procedure. It is noted that, at least between Germany and the United States, mutual agreement procedures have almost always led to a settlement in the past. Obviously, mutual agreement procedures, with or without binding arbitration, are an expensive solution at best.
1.2 OECD: Selected Issues
The Guidelines are conciliatory in general tenor and seek to foster understanding on the part of taxpayer and tax administration for the difficulties each faces. Of the two, the authors of the Guidelines appear to think that it is the tax administration which most needs counselling on this subject. "Tax administrations should not automatically assume that associated enterprises have sought to manipulate their profits", the Guidelines explain at their outset (par. 1.2). "Transfer pricing is not an exact science." "Even the best intentioned taxpayer can make an honest mistake". The tax authorities should "not demand from taxpayers in their transfer pricing a precision which is unrealistic under all the facts and circumstances" (Guidelines par. 4.8, 4.9). "Tax administrators should hesitate from making minor or marginal adjustments" (par. 1.68).
Transactional Profit Methods
The OECD Guidelines distinguish between the three traditional "transactional" methods (comparable uncontrolled price, resale price, and cost-plus methods) and two "transactional profit methods", called the "transactional net margin method" and the "profit split method". The Guidelines (par. 3.49 ff.) state that the traditional methods have "to date" been adequate to solving most transfer pricing problems and that they are to be preferred to the profit methods. However, in certain cases of "last resort," recourse can be had to the profit methods. Situations in which sufficient information for application of the traditional methods is lacking are mentioned as perhaps appropriate for a profit method. Of the two, a weak preference is expressed for the profit split method. The transactional net margin method resembles the controversial American comparable profits method. The new name was apparently chosen to emphasise the need to compare profit from like transactions, as opposed to making a loose comparison of profit in two similar enterprises, but it is unclear how different the OECD method really is from its American counterpart.
Arm's Length Principle
The Guidelines are firm in their defence of the arm's length principle. Paragraph 1.10 contains, however, the interesting observation that related parties sometimes engage in transactions from which independent parties would refrain altogether, hence making it "difficult" to apply the arm's length principle. But it has, the Guidelines state, worked effectively "in the vast majority of cases" (par. 1.8). The arm's length principle is the basis of the current international consensus and, the Guidelines imply, cannot be abandoned without threatening this consensus (par. 1.13). Global formulary apportionment ("unitary taxation") is discussed at length but rejected as a possible alternative to the arm's length method (par. 3.58 ff.).
Choice Of Method
As explained above, the traditional methods enjoy preference over the profit-oriented methods when sufficient data exist to apply the traditional methods. The expectation of the Guidelines is that this will usually be the case. While there is no clear statement in the Guidelines that the taxpayer's choice of method is to be respected if reasonable, there is no "best method" rule either. Par. 1.36 implies that the taxpayer's choice of method is generally to be respected when it says that the methods applied by the taxpayer are to be used in examining the transaction "insofar as these are consistent with the methods described in Chapters II and III". It is also said that neither the taxpayer nor the tax examiner is required to perform analyses under more than one method, although this may not apply "when no one approach is conclusive" (par. 1.69). Tax examiners should "begin their analyses ... from the perspective of the method that the taxpayer has chosen" (par. 4.9). Transactions are to be analysed prospectively avoiding the use of hindsight based on the facts and circumstances known or knowable at the time of the transaction (p.1.51), the terms of the actual contractual arrangement (p. 1.28, 1.36), and the actual allocation of risks and functions (par. 1.20 ff.). Recharacterisation of a transaction by the tax authorities is permitted, however, in certain vaguely defined circumstances (par. 1.37).
Transfer Price Methods
The Guidelines in essence recognise the same methods as the U.S. regulations.
Arm's Length Range
The Guidelines accept the concept of an arm's length range, but the emphasis seems to be more on urging the tax authorities to accept transfer prices which fall within this range than on an overly precise determination of exactly what the range is (par. 1.45 ff.).
Market entry, defence, and expansion strategies
The Guidelines regard such strategies as legitimate factors influencing transfer pricing (par. 1.31 ff.) and also explicitly note that the fact that a strategy has failed does not in and of itself justify disregarding the strategy from the start for tax purposes (par. 1.35).
Chapter VI on intangible assets was issued in March 1996. The Guidelines make clear that automatic adjustment of royalties to be commensurate with income is incompatible with the arm's length standard and constitutes an impermissible use of hindsight (par. 6.32, 6.35). However, it is stated that, where reasonable businesspersons would themselves have included some royalty adjustment clause in the license contract, adjustment by the tax authorities is also permitted based on a hypothetical clause to this effect (par. 6.34).
The guidance on this subject is contained in Chapter VII, also published in March 1996. Noteworthy is the opening statement that "nearly every [multinational] group must arrange for a wide scope of services" for its members (par 7.2). This observation is directed at tax administrations which tend to view intra-group services as a device for shifting income to low-tax jurisdictions. While the Guidelines give preference to direct methods of invoicing intra-group services, indirect charge methods are permitted where necessary as a practical matter (par. 7.22, 7,23).
The Guidelines tread softly on procedural matters.
An entire chapter is devoted to the subject of documentation. With regard to materials which, absent tax considerations, would not normally be generated, "the tax administration should take great care to balance its need for the documents against the cost and administrative burden to the taxpayer" (par. 5.6). "Tax administrations should limit the amount of information that is requested at the stage of filing the tax return" (par. 5.15). The chapter contains many similar statements, which may be regarded as polite requests to the United States to relax its requirements.
Concerning the burden of proof (par. 4.11 ff.), it is noted that "divergent rules on burden of proof among OECD countries" may "present serious problems" and, if exploited by jurisdictions in which the burden is on the taxpayer, "set the stage for significant conflict as well as double taxation" (par. 4.14). In mutual agreement proceedings, the Guidelines provide that the State seeking to make an adjustment "must bear the burden of demonstrating to the other State that the adjustment is justified both in principle and as regards the amount" (par. 4.17). The non-binding nature of virtually all mutual agreement procedures of course diminishes the significance of this pronouncement.
Penalties are also discussed at some length (par. 4.18 - 4.28). The "imposition of a sizeable 'no-fault' penalty based on the mere existence of an understatement of a certain amount would be unduly harsh when it is attributable to a good faith error rather than negligence or an actual intent to avoid tax.... [It] would be unfair to impose sizeable penalties on taxpayers that made a reasonable effort in good faith to set the terms of their transactions with related parties in a manner consistent with the arm's length principle" (par. 4.28).
The Guidelines recommend considering "the overall tax system" in each country (par. 4.19). There is considerable sentiment in the German literature that the U.S. tax system, as relates to transfer pricing, is, taken as a whole, unfair because of the combined weight of burden of proof allocation, documentation obligations, no-fault penalties, and an aggressive basic transfer pricing philosophy.
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