Where the context is complex, the best option is sometimes the ‘least-worst’ one.
- The arm’s-length principle can be complex to apply and is under pressure due to changing business models.
- Formulary apportionment appears to present a simpler approach to allocating taxing rights globally but is not without its own weaknesses and complexities.
- Formulary apportionment could only work if there was global agreement. However, this is unlikely in the near future, making the arm’s-length principle the ‘least-worst’ solution.
With the globalization of the economy and the rise of multinational corporations, much attention is being paid to the way intra-firm transactions are being priced.
Transfer pricing is one of the most debated aspects of the current international tax system. With the globalization of the economy and the rise of multinational corporations, the volume of international trade within multinational companies has increased. As a consequence, much attention is being paid to the way such intra-firm transactions are being priced.
Today, when establishing prices for intra-firm trades, most countries refer to the OECD Transfer Pricing Guidelines and the arm’s-length principle (ALP). In essence, the ALP states that transactions between companies belonging to the same group should be priced the same (and conducted under the same conditions) as similar transactions between unrelated parties. In this way, the profit earned by each company in the group should reflect the relative value created by their activity.
The origins of the ALP can be traced back to the early 20th century. The principle was formally introduced into internal law by the US and Canada in 1924, then by Sweden in 1928, and subsequently Italy in 1936. An ALP type of provision was included in the 1933 League of Nations Draft Convention for the Allocation of Business Income between States, and then in the first OECD Tax Model Convention in 1963. Sixteen years later, in 1979, it was implemented worldwide for the first time when the OECD published its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
How to compute taxes in international business transactions
In recent years, countries, NGOs, businesses and international organizations have been focusing on how taxes are computed in international business transactions, and also on the strengths and weaknesses of the ALP.
Advocates of the ALP highlight two main strengths — one theoretical and one practical. Economically, when correctly applied, the ALP replicates market conditions in intra-firm trade, not only allocating value where it is created but also minimizing distortions of investment decisions and maximizing global economic welfare. In practical terms, the ALP is currently used by a large majority of countries. Built up over many years, such a large international consensus would — in practical terms — be difficult to replicate if another system were introduced. Supporters of the ALP argue that abandoning the principle would certainly increase instances both of double and less-than-single taxation, damaging the economy overall (and decreasing global economic welfare).
Any formula which may be designed would necessarily imply that some countries will benefit while others will lose out from the Formulary Apportionment system.
The ALP’s critics usually view the principle itself as plainly wrong since it defies reality. They highlight that multinational groups exist for the purpose of generating profit by internalizing transactions that would be more costly if conducted with unrelated parties. Critics also argue that the application of the principle is complex and potentially subject to manipulation, giving companies the possibility of locating their profit in low-tax countries.
Althernatives to the arm's-length principle
Of the various alternatives to the ALP proposed by its critics, the one that most often emerges is a system based on apportionment, where the taxable profit of a multinational group would be allocated to its constituent entities based on pre-determined formulas and factors (often sales, employees and assets — the so-called formulary apportionment or “FA”).
According to its proponents, the use of an FA system would reduce compliance costs for tax administrations and taxpayers alike, as it would only be necessary to compute the multinational group global profit and the value of factors included in the formula. Therefore, in their view, FA would give all involved parties more certainty about the amount of taxes to be paid on international business activities.
While FA is currently used domestically within certain countries, such as Canada and the US, to allocate profit to local taxing jurisdictions, it is not used internationally. Examining how FA is used domestically sheds light on several issues that would need to be considered and addressed to ensure FA is a suitable replacement for the ALP at the international level.
Requirement of global agreement and cooperation
First and foremost, countries would need to agree on the apportionment formula. The agreement would need to specify not only the formula itself, but also the factors and their weightings, how such factors should be defined and what valuation/computation criteria should be used. Reaching an international agreement on all these elements would present many more challenges than agreements at the national level. For example, an international FA would need to allow for foreign exchange fluctuations, which could significantly alter the allocation of profit from one year to the next, regardless of business operations. Another challenging aspect could be deciding how to value assets, if assets are included in the formula. The valuation of intangible assets (particularly important in the knowledge economy) poses its own set of problems: Should such assets be included in the formula together with tangible assets, or would they be ignored?
Any formula that may be designed would necessarily imply that some countries will benefit while others will lose out from the FA system. In particular, developing and developed countries are bound to have conflicting interests when selecting allocation factors, as the former will have activities that are more labor-intensive, built around tangible assets, while the latter will have more sales and activities exploiting intangible assets.
The impact of abandoning ALP
Obviously, abandoning the ALP to implement FA without agreement on the formula and factors would be detrimental to everyone, as it would directly result in widespread double taxation and/or less-than-single taxation. How difficult it would be to reach a consensus on the FA formula can be clearly seen from developments in the US, where FA is used domestically. The allocation of profit to each state was initially based on a three-factor model encompassing sales, tangible property and payroll, all equally weighted.
However, over time, many states have unilaterally changed the formula to a point where, nowadays, there are approximately 10 different formulas for calculating the state apportionment of corporate income. Compounding the differences in apportionment methods, the states have not agreed on a common tax base or the rules for permitting or filing returns on a group basis. Should the same differences happen internationally, this would necessarily imply a proliferation of double taxation and/or less-than-single taxation.
The US example also provides evidence of two other weaknesses of the FA system, which are often underestimated. Firstly, FA would not stop the use of tax competition by countries: policymakers will have an incentive to modify the FA factors in order to attract investments and employment from other countries. At the same time, an FA system would alter business and investment decisions made by companies, with a negative effect on market efficiency and potential losses of global economic welfare. Companies may decide, for example, to outsource certain activities or replace employees with outside contractors in order to lower payroll, or change the location of assets such as inventory by relocating their warehouses. In addition, as for ALP and possibly any other system of taxation, FA could also be potentially subject to misuse and manipulation, for example, by modifying the location where sales are concluded or delivered.
According to its proponents, the use of an FA system would reduce compliance costs for tax administrations and taxpayers alike.
In conclusion, the ALP, while being very complicated to apply in some cases and leading to disputes in others, remains theoretically sound. FA is conceptually simpler but also more arbitrary. While most countries currently accept the ALP, reaching a global agreement on FA does not seem likely in the near term. To some extent, the current debate on the ALP brings to mind Winston Churchill’s famous statement on democracy, as expressed in the UK’s House of Commons in 1947: “Democracy is the worst form of government, except for all the others”.
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Gianni's experience includes global documentation projects, advanced pricing agreements, mutual agreement procedures and audit defense. Prior to relocating to Italy, Gianni worked as a Senior Economist in KPMG in the UK’s London office and with Fidal Paris.He has also been an advisor on secondment to the OECD Transfer Pricing Unit and he was nominated as “alternate” representative at the EU...