UK: Transfer Pricing And Electronic Commerce

The impact of electronic commerce on transfer pricing received attention at the OECD Ottawa Conference on electronic commerce in 1998. The Discussion document prepared by the Fiscal Affairs Committee (Electronic Commerce: A Discussion Paper on Taxation Issues (OECD 17 September 1998)) for the conference noted that, to date, electronic commerce has presented neither fundamentally new nor categorically different problems for transfer pricing. However, it has the potential to make some of the more difficult transfer pricing problems more common. In addition, as a result of the nearly instantaneous transmission of information and the effect of the removal of physical boundaries, it may become significantly more difficult for tax administrations to identify, trace, quantify and verify cross-border transactions.

Specifically, electronic commerce and the development of internal private networks within multinational groups may be seen as putting significant pressure on the traditional approach taken to deal with non-arm’s length transfer pricing, even though the basic nature of the problem has not changed. The paper also identifies the growth of the use of these new communications media to small and medium-sized enterprises.

The difficulty lies in the application of internationally accepted methods to the special factual circumstances created by electronic commerce activities. These are, in particular, the increased possibility for specialisation, integration of common functions, and co-operation between different locations and legal entities within a multinational group.

The OECD identifies five of the most significant potential difficulties as:

1. applying the transactional approach;
2. establishing comparability and carrying out a functional analysis;
3. applying traditional transaction methods;
4. the tax treatment of integrated businesses;
5. determining and complying with appropriate documentation and information reporting requirements.

Experience amongst tax administrations in dealing with transfer pricing matters in the field of electronic commerce is fairly limited so far. They, therefore, find it difficult to come to firm conclusions without a close examination and a factual description of the elements of electronic commerce. The OECD notes that it may be difficult for tax administrations to perform a detailed examination of the factual background at such an early stage in the development of the business of electronic commerce.

The preliminary conclusion of the OECD Committee on Fiscal Affairs is that the existing guidance in the transfer pricing guidelines (OECD: Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the "Guidelines")) is capable of being applied to the special factual circumstances of multinational groups conducting their business through electronic commerce. As a result, traditional transaction methods are still to be preferred as a means of establishing arm’s length prices. However, they accept that where such methods cannot be applied reliably because there is insufficient data on uncontrolled transactions, or such data is considered unreliable, or because of the nature of the business situation, transactional profit methods could be used.

Some of the difficulties in applying transaction based methods to individual transactions may be alleviated by applying the existing guidance on evaluating combined rather than separate transactions. In addition, in order to be able to identify, trace, quantify and verify transactions undertaken in the course of electronic commerce, it will still be necessary to follow the existing guidance concerning appropriate documentation.

The recommendation of the Committee on Fiscal Affairs is that revenue authorities should monitor developments in electronic commerce to see whether additional guidance on the application of the guidelines is necessary. They raise specifically the question whether existing guidance on documentation requirements needs to be revised for businesses engaged in electronic commerce in order to ensure the necessary availability of verifiable information on transactional data.

In the United Kingdom, these approaches are reflected in the Inland Revenue and Customs and Excise Joint Policy document setting out their approach to the taxation of electronic commerce.

The OECD represents the views of governments and tax administrations. While they may be content (and, indeed, it may be prudent for them to do so) at this stage to sit back and see what develops, taxpayers cannot afford to do the same. Taxpayers large and small engaged in international business are required to address these issues at a practical level in order to set appropriate terms for intra-group transactions to generate appropriate documentation and ensure that those decisions stand up to scrutiny by tax authorities. In particular, this will affect small but rapidly expanding e-commerce businesses which rely on technological innovation to penetrate foreign markets.

The balance of this article considers the five significant difficulties identified by the OECD in dealing with transfer pricing and electronic commerce by applying existing notions of the arm’s length principle as laid out in the OECD Transfer Pricing Guidelines.

In setting out its statement on the arm’s length principle, the OECD Guidelines make it clear that adjustments of profits are by reference to conditions which would have been obtained between independent enterprises in comparable transactions and comparable circumstances (Guidelines Chapter 1 para. 1.6). There can be no adjustment in the absence of a transaction. The main difficulty in the context of electronic commerce that appears to challenge the transactional approach is in identifying precisely what the transaction is.

The OECD Guidelines indicate that ideally in order to arrive at the most precise approximation of fair market value, the arm’s length principle should be applied on a transaction by transaction basis (Guidelines Chapter 1 para. 1.42). However, they note that there are often situations where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis. A number of examples are given where it may be more reasonable to assess the arm’s length terms for two items together, rather than individually. The Guidelines also note that some transactions need to be evaluated together as a package (Guidelines Chapter 1 para. 1.43).

It may be helpful to look at how the United Kingdom has addressed the question of defining what a "transaction" is in its new modernised transfer pricing legislation. ICTA 1988 Schedule 28AA Paragraph 1 requires that a provision be made or imposed between affected persons by means of "a transaction or a series of transactions".

The meaning of a series of transactions is expanded in Paragraph 3(2). This includes a number of transactions each entered into, whether or not one after the other in pursuance of or in relation to the same arrangement. An arrangement is defined as any scheme or arrangement of any kind (whether or not it is or is intended to be legally enforceable) (Paragraph 3(5)).

The new UK rules refer to "provisions" which the Inland Revenue have explained equate to "conditions" in Article 9 of the OECD Model and extend to all terms and conditions of arrangements between related parties. The effect of these provisions may mean that minute dissection of transactions may not always be appropriate. The OECD Guidelines do however indicate that taxpayers must be prepared to show that a package deal reflects appropriate transfer pricing.

Application of the arm's length principle is essentially based on a comparison of the conditions in a controlled transaction with the conditions in transactions between independent enterprises. In order for such comparisons to be useful, the economically relevant characteristics of these situations must be sufficiently comparable in determining the degree of comparability. An understanding of how unrelated companies would evaluate the potential transaction is required. This may give rise to particular issues as more and more businesses migrate from traditional to electronic commerce.

Attributes that may be important in determining whether transactions are comparable include the characteristics of the property or services transferred, the functions performed by the parties (taking into account assets used and risks assumed), the contractual terms, the economic circumstances of the parties and the business strategies pursued by the parties.

Differences in the characteristics of particular property or services that form commercial activities may account in part for their value in the open market. Comparisons of these features may be useful in determining the comparability of controlled and uncontrolled transactions (Guidelines Chapter 1 para. 1.19). How does electronic commerce impact on this? One of the most important developments in this regard is dematerialisation. Dematerialisation is the adaptation of information technology to convert products that were previously supplied in physical form into digital form. Current examples include music, films and packaged software.

How does digitisation affect comparability? Is it possible to compare transactions involving the physical delivery of a CD or cassette with music recorded on it, which is enclosed in a plastic package with an attractive cover and delivery of the same music by downloading it from a website onto the acquirer's computer? Is it possible to compare a film that is delivered by video cassette or in digital form such as video on demand or pay per view television?

The conversion of tangible property to intangible property does give rise to a number of changes. Durability is one factor. A video or CD may be used many times. Digitised products are subject to management by the supplier, for example in relation to duration. It is possible to supply music or video on demand for a single use. On the other hand, the ease with which digitised products may be copied, whether legally or not, may affect their value.

In dealings between two independent enterprises, compensation will usually reflect the functions that each enterprise performs, taking into account assets used and risks performed. As a result, in determining whether controlled and uncontrolled transactions are comparable, a comparison of the functions taken on by the parties is necessary. This comparison must be based on the significant activities and responsibilities undertaken or to be undertaken (Guidelines Chapter 1 para. 1.20).

The attempt to identify and value the components of a business transaction entails a step-by-step analysis of the transaction. This has been referred to as a "concept to customer process" (see Robert G. Rianslad in Transfer Pricing Handbook at 116; edited by Robert Feinschreiber - John Wiley & Sons Inc. 1993) and is not limited by geographical or corporate structures. It crosses traditional boundaries that have separated various commercial activities within the same group and starts with the original product concept and ends up with the ultimate sale to a third party customer including after-sale support. Along the way, functional analysis will identify all value added activities. These are ones which move the product forward.

The functions that need to be identified (Guidelines Chapter 1 para. 1.21) will include concept design, research and development, manufacturing, assembling, servicing, purchasing, distribution, marketing, advertising, transportation, financing and management. One party may provide a large number of functions relative to that of another in the transaction. It is the economic significance, however, of these functions in terms of their frequency, nature and value to the respective parties that is important.

Functional analysis in the context of electronic commerce requires a close understanding of particular business functions. The impact of electronic commerce in this area will be very much dependent as a result on the use to which electronic commerce is put. Thus, in the context of those using the internet to deliver content, the manner in which intangibles are delivered, whether they are subject to copyright or not, whether it is used only for advertising or for actual trading, whether it is used to provide services or to manage group facilities will be relevant.

An important emerging issue in the context of electronic commerce is disintermediation. This is the removal of middlemen from a system of distributing goods or services which traditionally relies on them for collecting information and reporting. The ability of original producers of goods or services to provide them directly to customers may diminish the role of wholesalers, brokers, agents and advisors from the system. The absence of such value added activities in the chain might result in less profit overall. Where it does not, it means that a higher value will be added to other functions.

A question that will be on the minds of taxpayers and tax authorities is where this value is added. In particular, can it be added by the use of servers for example located in a low tax jurisdiction? Alternatively, does it mean that as electronic distribution eliminates certain forms of intermediary, the value of the distribution function itself ought to be downgraded?

On the other hand, the providers of the infrastructure of electronic commerce face a separate set of issues such as the relative value of internet access, transmission facilities, servers and other infrastructure hardware. Other inputs such as server management services and related support activities need to be considered.

Functional analysis also requires consideration of the assets that are employed in the transaction (Guidelines Chapter 1 para. 1.25). This should consider the type of assets used such as plant and equipment, the use of valuable intangibles, and the nature of assets used such as their age, market value, location and the protection given to intellectual property rights. Again, the application of these principles will vary enormously depending upon the industry sector involved.

In the case of infrastructure providers, there may be considerable investment in tangible and intangible assets. Again, if expensive infrastructure is relevant to the allocation of income on transactions, the extent to which there is flexibility as to where the assets are located will have a significant impact. On the other hand, rapid obsolescence and comparative vulnerability of intellectual property rights on the internet may require a lower value to be placed on such assets.

It may also be relevant and helpful to consider risks assumed by the respective parties (Guidelines Chapter 1 para. 1.26). Assumption of increased risk should be compensated by an increase in the expected return. Are the risks in electronic commerce significantly different from those in more traditional areas? While traditional risks, such as market risks, cost and sales fluctuation, may continue, there may be particular risks associated with electronic commerce at the present time.

These might include increased risks in the success or failure of research and development, risks in relation to systems that may have increased vulnerability to fraud, system failures or software bugs. Risk can often be allocated contractually. The OECD Guidelines, however, regard the conduct of the parties as the best evidence concerning true allocation of risk. In many cases, arm's length dealings are characterised by risk borne by the party which has relatively more control over the particular risk factors.

In arm's length dealings, the contractual terms of a transaction will define how the responsibilities, risks and benefits are divided between the parties (Guidelines Chapter 1 para. 1.28). This will continue to be the case in the context of electronic commerce, although evidence as to what the terms of a contract might be may be problematic in some cases. In addition, where the parties are associated, it is necessary to examine their conduct in order to determine whether they have followed the contractual terms or not. Lack of identification may be a relevant feature of electronic commerce. If internet business leaves no paper trail, there may be difficulty in identifying transactions or indeed the parties.

It is sometimes argued that electronic commerce does not lend itself to the application of traditional transaction methods. These are the comparable uncontrolled price method, the resale price method and the cost-plus method (Guidelines Chapter 2 para. 2.1). It is inappropriate to attempt to examine the full impact of these methods. However, there is also no particular reason to abandon them in this context. Each must be examined regarding its potential applicability to the industry sectors that are relevant to electronic commerce. Important questions as to the number of stages in the value chain involving connected parties need to be considered. This may be shortened in the context of electronic commerce.

Perhaps one of the most interesting and most common areas where e- commerce impacts on transfer pricing is likely to be in the area of managing group facilities. Closer integration of the management of multinational groups and the sharing of services is likely to be enabled by information and communication technology developments, particularly of intranets.

One consequence of electronic commerce is in relation to business relocation. The internet may offer certain businesses opportunities to relocate non-physical activities to different jurisdictions, particularly resulting in shifting profits out of high tax jurisdictions. Another aspect of this, which is perhaps more important, is the ability to shift physical activities to low cost jurisdictions. The ability to provide services at a place other than where the recipient is located is becoming of increasing importance. Thus, a variety of services can be provided to multinational companies from remote locations. The range of possibilities will increase, both where human intervention is required and those that are provided electronically, such as help pages on the internet or intranets. These might include administrative services such as planning, co-ordination, financial advice, accounting, auditing, legal, factoring, computer and financial services. Typically, such services are dealt with under cost-plus arrangements or under cost-sharing arrangements. Where cost-plus is appropriate for services of this kind and the activities are shifted to low cost jurisdictions, the profit allocation will be reduced proportionally.

Where information and communications technology is able to offer reductions in transaction costs, corporate trading behaviour may be altered, both within multinational groups and in relation to third parties. The replacement of traditional purchasing to low cost internet based methods is likely to develop further. Thus, back-end transactions involving processing and financial reporting functions are as important as the front-end of on-line ordering.

The development of enterprise resource planning software makes it possible for all stages of a commercial transaction from order placement through to billing and payment to be completed on-line. This is usually at a fraction of the cost of more traditional methods.

The OECD Report on the Economic and Social Impact of Electronic Commerce expects that distribution costs will be cut by about 5 per cent. However, it notes that these savings will only lead to lower consumer prices if there is fiercer competition. This may mean a shift towards an increase in value of intangibles such as customer lists which may be owned and developed relatively easily in low tax jurisdictions.

If the cost savings are passed on to end-users in some form, then the overall allocation of profits may not change. Where the profitability is retained, this may mean that profits are effectively allocated to other functions. In other words, efficiency gains may properly be allocated to intangibles or other value adding functions.

The OECD Report considers that the number of jobs threatened by electronic commerce to be roughly balanced by those created by the growing demand for products and services available on the internet. However, many of the new jobs would be for more highly skilled workers. This may also have an impact on profit allocation where the input of highly skilled individuals may be regarded as contributing more significantly to profitability than low value work that has disappeared.

The OECD has identified that electronic commerce may require special treatment because of the highly integrated nature of the activities. Difficulties in dealing with highly integrated businesses have already been considered by the OECD in their discussion paper on `The Global Trading of Financial Instruments' published in 1997. In that context, it was noted that trading, marketing, management and major supporting activities should share in profits to the extent that they are regarded as integral to the realisation of profits. Difficulties arise as to when an activity becomes so integral that it should be rewarded by a share of global profits under a profit split method, rather than by a traditional method.

One of the difficulties found in the area of global trading is that although the concepts are clear, in practice their application is less obvious. Even where activities are highly integrated, the OECD paper on financial instruments indicates that less integrated functions should be stripped out of the equation first by application of traditional methods. This might leave some general sales or back-office functions out of the integrated process and taxed on a cost-plus basis with the residual profit or loss attributable to the performance of the globally integrated functions.

The subject of documentation, even in more traditional areas of commerce, is itself problematic. There are many unresolved issues. In the context of electronic commerce, the nature of documentation and test of relevance will take on new perspectives. The manner in which systems are designed and operate will likely come under scrutiny. The necessity of producing software programs and material relating to their development as a central part of relevant documentation may become of importance. As the tax authorities develop their own technology to interrogate computer systems directly, the battle lines and parameters are likely to be drawn quite differently from those who view documentation in a more traditional framework.