transfer pricing dilemma arm's length vs formulary apportionment. is there an optimal solution?...

Advisor: Siciliano Gianfranco

Second Advisor: Prencipe Annalisa Discussant: Mondin Lorenzo

Thesis:

Transfer Pricing dilemma:

Arm's-length principle VS Formulary apportionment.

Is there an optimal solution?

The OECD, US and Brazil approaches

Università Commerciale L.Bocconi Corso di Laurea in Economia e Legislaiyone d’Impresa CLELI

Mondin Lorenzo

Contacts: [email protected] [email protected] .

mailto:[email protected]

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Agenda

3/31/2014 Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?


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Transfer Pricing at a glance

A common recognized pillar: the Arm’s-length principle

The Formulary apportionment

The dilemma: which approach is the best for Transfer Pricing?

Current Situation Arm’s Length based Hybrid system

U.S. - OECD - Brazil Transfer Pricing Approaches

Conclusions

Transfer Pricing at a Glance

Definition – Why is important – Which topics affect



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Transfer Pricing relates to the process of the determination, implementation and assessment of the prices applied in transactions undertaken between related parties. Transfer Pricing is recognised as the top tax priority for both MNEs and Tax Administrations Main Topics other than Corporate Income Tax VAT and Custom Valuation a conflict of interests and a need of cooperation Business restructuring and Transfer Pricing influence on Tax Effective Supply Chain Management Transfer Pricing as a tool to fight the Base Erosion and Profit Shifting


Transfer Pricing Assessment Steps



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Investigation and data collection

Economic analysis

Financial and descriptive information

Recommendations and conclusions

Identify important

intercompany pricing

issues

Questionnaires

Interviews

Documentation

collection

Functional analysis

Selection of transfer pricing

method and comparables,

Analysis of company and

industry data

Application of comparables

to relevant entities

Arm’s length transfer price

computation

Preliminary

recommendations

Financial ratios tests

Business plan analysis

ETR analysis

Overall Conclusions in

relation to the Transfer

Pricing policies implemented

by the MNE


How MNEs can take advantage from transfer prices



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Group X in which there are only two companies: the Parent company located in Country A with a Corporate Income Tax (CIT) of 40% and the Subsidiary (Sub) located in Country B with a CIT of 10% The fact that the Group has two different CIT rates (40% and 10%) opens an opportunity for the implementation of a Tax Effective Supply Chain Management (TESCM). The TESCM model basically aim to allocate in the most tax efficient way the activities of the Group in order to achieve the lowest ETR maintain the operatively levels needed by the Group.


How MNEs can take advantage from transfer prices



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As Is Situation

To Be Situation

A common recognized pillar: the

Arm’s-length principle



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“A transaction settled at Arm’s Length conditions is a transaction entered into by two parties freely and independently of each other, without special relationship, such as being a relative, having another deal on the side or one party having complete control of the other”. Separate entity approach and the comparability analysis Focus on the nature of the transactions between the related parties and on whether the conditions of the transactions incurred differ from the conditions that would be obtained in comparable uncontrolled transactions. To ensure this is performed the comparability analysis: which should prove that in a related parties transaction it has been achieved the arm's-length condition through the use of comparables. Practical difficulties: due to specific characteristics of the item traded, contractual framework and arrangements, function performed by the parties, risk assumed and asset used.

Limits and critics to the Arm’s-length

principle



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Main critics made from academic exponents, mainly from the U.S in relation to the effectiveness of the Arm's length mainly on two points: First is on the economical level: the Arm's Length contradicts the economic reality

of intra-firm transactions by effectively treating the relatedness of the parties as incidental, rather than integral to the transaction

Second on the administrative level: an hypothetical arms-length transfer price does

not correspond to economic reality, it suffers from a lack of administration feasibility symptomatic of a dysfunctional regulatory framework with burdensome compliance requirements, multiple layers of subjective judgment about allocation, and a lack of correspondence to any reasonable measure of how the global corporate tax base ought to be allocated.

The Formulary apportionment



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Formulary apportionment is a methodology for the allocation of the MNE's profit to a particular tax jurisdiction in which the MNE has a taxable presence. The Formulary apportionment attributes the MNE total worldwide profit to each jurisdiction, based on a predetermined formula which is tailored in a way to allocate all the profits in the different tax jurisdictions based on several factors such as the proportion of sales, the assets used, the headcounts etc. Globalization make hard to determine where the income is created e.g. Cloud Computing Industry, hard to have a clear tax structure in MNEs most common practices includes the so called “Irish double sandwich”, “double dip”, “fiscal transparency”, “treaty shopping” etc. The implementation of a Formulary apportionment would remove the current artificial incentives to shift reported incomes These measures are far more difficult to manipulate for tax purposes than the location of income establishing a common set of rules eliminating the high component of current uncertainty.

Formulary apportionment, limits and

practical issues for implementation



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The main point of the debate around the Formulary apportionment is the formula for the apportionment of the profits among the tax jurisdictions, the common base is the Massachusetts Formula established during the 1950's built around three main variables: group sales, payroll, and property with the same weight A common accepted formula is the main driver of the practical implementation of a Formulary apportionment, the need of a common accepted formula will lead to a great afford of cooperation and harmonization within the tax and accounting systems of the countries in which such formulary apportionment is implemented. Two main categories of issues: A practical one: General Accepted Accounting Principles (GAAP) to be applied most commons used are IAS-IFRS and US GAAP which have different approaches A more abstract one: the limits of sovereignty of each country, in the actual Geo-political framework the only tool that countries have for affirm their sovereignty on their territory is the fiscal policy and a formulary apportionment somehow will limit the flexibility of this tool Consequence is a limited diffusion of the Formulary apportionment increasing the tax burden for tax payers both on the economic side and on the administrative side

The dilemma: Arm’s length principle

or Formulary apportionment?



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Both systems have sound defense lines they are not perfect in practice The effectiveness of the Arm's length have two main inadequacy problems. Economic contraddiction and lack of administrability While a Formulary apportionment will led to double taxation issue for the income of MNEs unless a proper agreement among ALL the tax jurisdictions worldwide on the formula and on the apportionment to be implemented are established. Practical issues of cooperation, harmonization and tax sovereignty of tax jurisdictions. Tax manipulations can be reached leveraging the formula including currency manipulations Compliance costs for tax payers

Current Situation: Arm’s-length based

Hybrid system



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While the OECD openly refuse to apply a Formulary apportionment and keep promoting the Arms’ length as the right approach it is possible to say that the current system for most countries (excluding Brazil and pure formulary jurisdictions) is configured as a hybrid between the two possible approaches. • Safe Harbors: give to tax payers the possibility to apply defined arm's-length margin

remuneration to certain typologies of transactions. (e.g. EU Joint Transfer Pricing Forum)

• Advanced Pricing Agreements Pricing Agreements: APAs are contracts between a taxpayer and at least one tax authority specifying the pricing method that the taxpayer will apply to a defined related-company transaction avoiding the assessment process and the future tax audit.

• Mutual agreement procedure (MAP): the taxpayer is assured that income associated with Covered Transactions is not subject to double taxation.

• Cost Contribution Arrangements (or Agreements) (“CCAs”) are arrangements between companies to share the costs and risks of developing, producing or obtaining assets, services or rights, for which the interests of each participant are determined.

OECD – US – Brazil

Transfer Pricing Approaches



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OECD US Brazil

Tp Guidelines Local Legislation Local Legislation

Arm’s lenght principle Arm’s lenght principle Formulary Apportionemnt

Most suitable method approach

Best Method approach Formulary Apportionemnt

TP Methods: Comparable uncontrolled price (CUP), Resale price Cost plus Profit split Alternative Methods

Services: comparable uncontrolled services price, gross services margin, cost of services plus, comparable profits, profit split

Exports: Average Price of Export Sales Wholesale Price in the Destination Country Less Profits Retail Price in the Destination Country Less Profits Production Cost Plus Profits

Intangible Property: comparable uncontrolled transaction Comparable profits method, Profit splits Imports:

Comparable Uncontrolled Price Purchase Price less Profit method Production Cost Plus Profit Method

, Tangible Property: Comparable uncontrolled price (CUP), Resale price Cost plus Profit split

Conclusions



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Transfer Pricing is a top priority for both tax administrations and tax payers Transfer Pricing is not only a corporate income tax issue (VAT, Restructuring, Strategies etc.) No optimal practical approach both the Arm’s Length and the Formulary apportionment have to cope with lack in applicability or effectiveness. The real system applied is an Arm's length Hybrid system There are opportunities available under a tax efficient structuring point of view,: Developed and developing economies (or countries with no TP culture) are in two different positions: Developed economies have already the tools for fighting illegal tax practices Developing economies do not enough expertise and tools to cope with aggressive tax planning and should find a way to prevent foreign exploitation while protecting their tax base in order to have enough tax income to sustain the development of the economy. Under certain extent and with certain common shared principles Formulary apportionment can be a good starting point for Transfer Pricing systems that then will evolve into an Arm's length based system once the Transfer Pricing expertise are developed in the tax administration Not likely to happen: OECD context Formulary apportionment from both practical and theoretical perspective The number of countries already included in the current system is too high to manage a change of such dimension. The CBCR debate will, however, open a new source of debate around the acceptance o a formulary apportionment among OECD countries