OECD looks beyond the arm’s-length principle

The BEPS project set out to rethink the international tax system, yet it never quite settled the question of what to do about the arm’s-length principle (ALP) – until now.

Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration, announced on January 29 that the Inclusive Framework had reached a consensus on the working hypothesis to move away from the ALP and consider alternative approaches to transfer pricing. The approved proposals that “go beyond” the ALP means new rules for profit allocation and taxing rights.

“It’s extremely useful for most transactions, but on the residual profit – the biggest chunk of profit – the three proposals [agreed upon] will explore new methods which may go beyond the arm’s-length principle,” Saint-Amans explained.

The OECD’s tax chief claimed that the new methods should not result in double taxation, nor should these measures result in taxation of non-profitable enterprises. This is a matter of principle for tax policymakers and a major concern for digital service platforms like Airbnb and Uber.

One head of tax compliance at a UK-based bank told TP Week that it’s about time this issue of methodologies was discussed. “The OECD dodged this question for a long time and just assumed that the [arm’s-length] principle is still up to scratch,” he said.

It wasn’t long ago that the OECD was not taking a position on the future of the ALP. “The OECD is agnostic on the ALP,” Saint-Amans said in September 2018, but added that “the largest economy in the world seems to have passed a vote of no confidence in the current system”.

This is why Alex Cobham, chief executive of the Tax Justice Network, tweeted: “The three pages of text in this [OECD] policy note may be more significant than the thousands that made up the BEPS project.”

One tax executive at a European bank told agreed. “All of the BEPS actions on TP jumped the gun,” the executive told TP Week. “The OECD hadn’t thought it all through and they just assumed it was all about royalties, interest, dividends and hard-to-value intangibles (HTVIs). But the basic question was the arm’s-length principle and whether it’s fit for purpose.”

The Inclusive Framework has approved two pillars for the proposals. The first pillar concerns nexus and profit-allocation rules, including the so-called ‘significant economic presence’ nexus discussed in the BEPS Action 1 report.

The second pillar consists of dealing with what the note described as “remaining BEPS issues”, in particular the right of jurisdictions to tax profits held in a low-tax country. Saint-Amans suggested that the OECD will look towards US tax reform as a model for a minimum corporate tax rate.

However, the leading proposal that may be most likely to be approved is for a destination-based apportionment of taxing rights, based on the number of users in the jurisdiction. The US has forged an unlikely alliance with China in backing this proposal. This may be the end of the ALP.

The European bank tax executive suggested that the world might be moving to a hybrid model, not quite arm’s-length and not complete formulary apportionment either. However, this will be little comfort to businesses trying to plan their future transactions.

“The arm’s-length standard is interesting, but it’s all hypothetical,” the tax executive said. “It fails to recognise that there are plenty of things that companies in a corporate group do that a third party would never do.”

Jeffrey Owens, director of the tax centre at the Vienna Institute, takes a different view. He argued that the principle could be a part of a new settlement on international tax.

“It’s important to remember that [the ALP] was developed for commercial reasons, not for tax purposes,” Owens said. “It was a way of calculating how profitable your subsidiaries were and tax professionals figured out it could be adapted. That’s what we have to do today.”

“I know very few tax commissioners who want to abandon the principle,” Owens continued, who was the director of tax at the OECD from 2001 to 2012. “It’s like Brexit, you can’t abandon ship without a clear plan or credible alternative.”

For many tax justice campaigners, NGOs and think tanks, the creditable alternative is a minimum corporate tax rate based on formulary apportionment. The Inclusive Framework may be moving towards a version of this, but there are still many questions around its feasibility.

“Formulary apportionment is a pragmatic approach, but it’s not a principle-based solution,” Owens said. “Any alternative to the arm’s-length principle has to meet three tests: Is the alternative principle-based? Is it feasible in administrative terms? Can you reach a consensus on making it policy?”

The OECD hopes to find a way of basing its apportionment on principles, which can be translated into policy. The number and location of users will serve as an allocation key, but there are risks that this could end up being a blunt tool.

It would potentially hit traditional TP arrangements hard. Companies with structures in places like Ireland and the Netherlands could face challenges to justify their practices. This could potentially open up a new level of risk and uncertainty for taxpayers.

Where MNEs operate locally through subsidiaries, market jurisdictions might seek to wage a tax claim on the income of such multinationals. But such MNEs working with local businesses on a contractual basis are unlikely to see their profits re-allocated to that jurisdiction.

It is possible that formulary apportionment could apply to certain transactions and not others. This would create a dual set of approaches to transfer pricing. It would still be a tremendous shift in international tax. The result for taxpayers would be more complexity and more risk.

The US and China are driving this agenda, alongside Brazil and India. This is despite the fact that Donald Trump, Xi Jinping, Jair Bolsonaro and Narendra Modi are all nationalist leaders. The preference for a multilateral solution clears the way to oppose unilateral action.

Many European countries are, meanwhile, rushing to find a workable levy on the digital economy. Austria, France, the UK and Spain have approved proposals or are planning to impose special measures against the high-tech sector.

It’s quite likely that the initiative will benefit countries with a large consumer base, whereas smaller countries like Ireland, the Netherlands and Luxembourg stand to lose out. This would be a reversal of fortunes.

“Ireland has benefited from its relatively low tax rate, its highly educated workforce and the English language,” one tax director at a software company said. “They’ve benefited from the status quo, so they naturally don’t want it to change.”

“Whereas France, Spain and Italy feel that the Irish are eating their lunch,” the tax director said. “That’s the driving factor here.”

US and Chinese multinationals like Apple and Huawei have much to lose, which is why China and the US have more to gain from taking the lead. Indeed, the US, China, Brazil and India have immense populations and a destination-based tax model could work in their favour .

There is a more cynical reading of the situation though. The best way to offset the threat of unilateral action might be to set the bar higher and aim for a multilateral consensus that never takes shape.

“The OECD operates on the basis of consensus, but not total unanimity like the EU,” the director explained. “This often results in things being watered down and kept open-ended to allow a lot of room for different interpretations of the guidelines.”

This could mean that the final report will leave enough open for countries to take their own approach to the same recommendations. Meaning countries like Ireland and the Netherlands will still be left to take their own path.