On 12 September 2023, the European Commission released a legislative proposal for a Council Directive that integrates key TP principles into EU law, as part of the BEFIT package.
Based on the proposal all Member States must apply the at arm's length principle for corporate income tax purposes in accordance with the OECD TP Guidelines and are bound to specific provisions in respect of corresponding or compensating adjustments including a "fast-track" procedure to resolve double taxation. It also includes the obligation to apply the most appropriate TP method and the burden of proof in relation to the application of other methods seems stricter than the selection process and burden of proof in relation hereto laid down in the OECD TP Guidelines and in many Members States.
This proposal harmonizes both TP principles and documentation requirements within the EU, which will impact the TP approach of MNEs across all Member States. If adopted, Member States must apply the provisions as per 1 January 2026.
The proposed Council Directive laying down rules to harmonize the key transfer pricing (TP) principles across the EU (the TP Directive), aims to increase tax certainty, reduce compliance costs, and mitigate the risk of double (non) taxation. Member States currently have a large discretion in interpreting and applying the OECD TP Guidelines for Multinational Enterprises and Tax Administrations (OECD TP Guidelines). According to the European Commission this gives rise to tax barriers for businesses undermining the competitiveness of the Single Market. The TP Directive seeks to harmonize TP norms within the EU through the incorporation of the arm's length principle into EU law and the clarification of the role and status of the OECD TP Guidelines. To ensure a common application of the arm's length principle, the 2022 version of the OECD TP Guidelines will be binding when applying the arm's length principle in the Member States. The TP Directive enables the European Commission to propose common binding rules and safe harbours to specific transactions. If adopted by unanimity in the EU Council, Member States must apply the provisions as per 1 January 2026.
Below, we will highlight the most important aspects of the proposed TP Directive and its implications for taxpayers.
Arm's length principle
Under the arm's length principle in the TP Directive, when the terms and conditions of cross-border intragroup transactions are not at arm's length, they must be adjusted to reflect the terms and conditions that would have been established between independent parties and the profits will be taxed accordingly. The TP Directive uses a broader term of "associated enterprises" than certain Member States and may therefore increase the number of transactions that have to comply with the OECD TP Guidelines.
Pursuant to the TP Directive an associated enterprise means a person that is related to another person (through a legal or natural person) who:
- participates in the management of another person by being able to exercise a significant influence over the other person;
- participates in the control of another person through a holding that exceed 25% of the voting rights;
- participates in the capital of another person through a direct or indirect ownership right that exceeds 25%; or
- is entitled to 25% or more of the profits of another person.
Furthermore, in contrast to the domestic legislation of certain Member States, under the TP Directive a permanent establishment (PE) is treated as an associated enterprise. Thus, the internal dealings between head office and PE must be determined in accordance with the arm's length principle. A PE is defined in the TP Directive as a "fixed place of business" based on the respective tax treaty. This PE definition seems more restrictive than the definition in most tax treaties that also cover for example dependent agent PEs.
Corresponding adjustments and compensating adjustments / fast track procedure
The TP Directive provides for a mechanism to enable Member States to conditionally make a corresponding adjustment when a primary adjustment is made in another EU or treaty country. The TP Directive facilitates this mechanism by including that Member States may not limit the granting of such corresponding adjustments in the context of a double tax treaty or mutual agreement procedure (MAP) pursuant to the Arbitration Convention or Council Directive on tax dispute resolution. This should also be possible under a "fast-track" procedure when there is no doubt that the primary adjustment is well founded or in case this results from a joint audit. Such "fast-track" procedure must be concluded within 180 days, without the need to open a MAP.
In addition, in the absence of a primary adjustment, Member States are allowed to perform a downward adjustment under certain conditions. The most important conditions are that an amount equal to the downward adjustment is to be included in the profit of the associated enterprise in the other jurisdiction and that such downward adjustment is communicated to the tax authorities of the other jurisdiction.
The TP Directive also provides strict conditions under which Member States should recognize a "compensating" adjustment (being an adjustment that is initiated by the taxpayer and that differs from the price that is actually charged between the associated enterprises). Not all Member States (for example Belgium) have provisions for downward compensating adjustments in their domestic legislation. The TP Directive may therefore be helpful for entities located in these countries. On the other hand, this provision may be more complex and burdensome for entities located in countries that already have such downward compensating adjustment mechanism (for example the Netherlands).
The TP Directive prescribes the five common TP methods included in the OECD TP Guidelines and prescribes that the at arm's length price is determined by applying the most appropriate TP method (like the "best method" rule in the United States). The TP Directive further prescribes that any other valuation method or technique can only be applied if it can be demonstrated that (i) none of the approved methods can be reasonably applied, and (ii) such other method produces a result consistent with that which would be achieved by independent enterprises. The obligation to apply the most appropriate TP method and burden of proof in relation to the application of other methods seems stricter than the selection process and burden of proof in relation hereto laid down in the OECD TP Guidelines and in many Members States.
Arm's length range
The arm's length range must be determined using the interquartile range (from the 25th to the 75th percentile of the results derived from the uncontrolled comparables). No adjustment can be made by Member States when a result falls within the interquartile range. If a result falls outside the interquartile range, tax administrations must make an adjustment to the median. However, in both scenarios the taxpayer or the tax administration may prove that a different position in the range is justified by the facts and circumstances of the specific case. Although these rules have the benefit of clarity, they seem to go beyond the OECD TP Guidelines and domestic legislation in many EU Member States in which the use of the interquartile range (instead of the full range) is not imposed.
The TP Directive requires taxpayers to have sufficient TP documentation and may therefore lead to an additional burden for certain taxpayers. The exact content of this TP documentation will be specified by the Commission at a later moment. Introducing mandatory transaction-level TP documentation will have a significant impact in those Member States that currently do not impose OECD based local file documentation (for example Belgium) and will apply to all taxpayers in the absence of a revenue threshold.
Mandate European Commission
The European Commission seems to strive for a larger influence on future TP legislation as the TP Directive proposes to allow the EU Council, acting based on a proposal from the European Commission, to lay down further rules on almost all kind of intercompany transactions. These further rules by the EU Council do not seem to require unanimity, but approval of 55% of the members of the EU Council, comprising at least fifteen of them and representing Member States comprising at least 65% of the population of the EU, would generally be sufficient. The EU Council will also adopt any further amendment to the OECD TP Guidelines by this qualified majority to incorporate them into the TP Directive.
Once the EU has formally approved the TP Directive, Member States will have to include the provisions of the TP Directive in their domestic legislation. Following adoption, MNEs active in Member States will have to consider whether their TP policies need to be adjusted and whether their current documentation complies with the new rules. They will also be confronted with specific provisions for corresponding or compensating adjustments including the "fast-track" procedure that require careful review. Following implementation, the Court of Justice of the EU will become the highest instance to decide on the application of the at arm's length principle as set out in the TP Directive.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.