the desirability of the arm’s length
TRANSCRIPT
The desirability of the arm’s length
principle in the 21st century.
J. Pleune
ANR: 666258
Master thesis
International Business Tax Economics, Tilburg School of
Economics and Management, Tilburg University
Supervisors:
dr. C.A.T. Peters
Prof. dr. P.H.J. Essers
June - 2017
Acknowledgement
There are some people I would like to thank for making this thesis possible. Their help and support have
made the process of writing a lot easier, and this thesis would not have been the same without them.
First of all, I would like to thank my thesis advisor, dr. Cees Peters of the School of Economics and
Management. You allowed this thesis to be my own work, but steered me in the right direction whenever
you thought I needed it. I appreciated the honesty of the advice when certain things might have been
interesting to add to my research, but might not work out the way I anticipated. This really helped me to
stay within the scope of the subject of this thesis. Moreover, I learned to look at issues from different
perspectives, which has been an important tool in order to increase the framework of my thinking. Moreover,
thank you for the time reading the draft versions and to discuss your observations and critical notes,
especially in the final stages of the process.
Additionally, I want to thank my fellow students at Tilburg University. While this thesis has been an
individual project, it has greatly benefited from your knowledge and assistance. The best of luck and many
thanks go out to Rens de Zwart, Reno Nabben, and Charis Papalampros for your help and advice on the
thesis. I am glad you were there to listen whenever I ran into issues or whenever I had a question about my
thesis. I hope I have returned the favor. I wish you all the best in your professional lives.
Finally, I would like to express my gratitude to my parents and brothers for providing me the support and
continues encouragement throughout my years of studying at Tilburg University. Your confidence in me
has made this accomplishment possible. Thank you.
Jelle Pleune, Tilburg, June 19, 2017
Table of Contents 1. Introduction ................................................................................................................................... 1
2. Transfer pricing ............................................................................................................................. 5
2.1 Introduction ............................................................................................................................. 5
2.2 Transfer Pricing Goals ............................................................................................................. 7
2.3 Transfer Pricing Mismatches .................................................................................................... 8
2.4 Functions of taxation ................................................................................................................ 8
2.4.1 Function 1: Revenue ......................................................................................................... 9
2.4.2 Function 2: Distribution .................................................................................................... 9
2.4.3 Function 3: Regulation ................................................................................................... 10
2.4.4 Function 4: Simplification .............................................................................................. 10
2.4.5 Function 5: Robustness ................................................................................................... 11
2.5 Summary ............................................................................................................................... 11
3. The Arm’s Length Principle ........................................................................................................ 12
3.1 Introduction ........................................................................................................................... 12
3.2 The origin of the arm’s length principle .................................................................................. 13
3.3 Separate entity approach ........................................................................................................ 14
3.4 Comparability analysis ........................................................................................................... 15
3.4.1 Commercial and financial relations ................................................................................. 15
3.4.2 Comparable transactions ................................................................................................. 17
3.5 Transfer pricing methods ........................................................................................................ 17
3.5.1 Traditional transaction methods ...................................................................................... 18
3.5.2 Transactional profit methods .......................................................................................... 18
3.6 Criticism on the arm’s length principle ................................................................................... 19
3.6.1 Reflecting economic reality: comparability ..................................................................... 19
3.6.2 Reflecting economic reality: integration .......................................................................... 20
3.6.3 Feasibility ...................................................................................................................... 21
3.6.4 Opinion OECD ............................................................................................................... 22
3.7 The Benchmark ...................................................................................................................... 22
3.7.1 Benchmarking the arm’s length principle ........................................................................ 24
3.8 Summary ............................................................................................................................... 25
4. Intangibles .................................................................................................................................... 26
4.1. Introduction ........................................................................................................................... 26
4.2 Defining Intangibles ............................................................................................................... 26
4.3 Intangibles at arm’s length ..................................................................................................... 27
4.4 Typical IP Structures .............................................................................................................. 29
4.4.1 Mobility ......................................................................................................................... 30
4.4.2 The basic structure .......................................................................................................... 30
4.5 The Double Irish Dutch Sandwich .......................................................................................... 31
4.5.1 The complex structure .................................................................................................... 32
4.5.2 Low tax payment on the initial IP transfer ....................................................................... 33
4.5.3 Setting high royalty payments ......................................................................................... 33
4.6 New Guidance ....................................................................................................................... 33
4.6.1 Information asymmetry .................................................................................................. 34
4.6.2 Cost approach ................................................................................................................. 35
4.6.3 Benchmarking the DEMPE-method ................................................................................ 37
4.7 Summary ............................................................................................................................... 38
5. Alternative approaches ................................................................................................................ 39
5.1. Introduction ........................................................................................................................... 39
5.2. Destination-based cash flow tax ............................................................................................. 39
5.2.1 Criticism ........................................................................................................................ 41
5.2.2 Benchmarking ................................................................................................................ 42
5.3. Formulary of apportionment ................................................................................................... 43
5.3.1. Criticism ........................................................................................................................ 44
5.3.2. Benchmarking ................................................................................................................ 45
6. Conclusion and recommendations............................................................................................... 47
Reference list ....................................................................................................................................... 49
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1. Introduction
Big multinational corporations are often named and shamed by NGO’s, journalists and news channels for
not paying their fair share.1 These multinational corporations are blamed for having an immoral and non-
transparent strategy that consists of reducing the global tax burden of the group. By transferring profits
from one country to the other, multinational enterprises (MNEs) are notorious for allocating profits to
countries that levy less or no corporate tax.
The role of international companies in world trade has increased a lot in the last two decades.2 This increase
of globalization has also increased the number of transactions between entities belonging to the same
multinational group, as they become more integrated with one another.3 This increase of intercompany
transactions, in turn, leads to an increase of complexity of issues regarding the allocation of profits that
derive from their intercompany transactions.4 Due to this increased complexity of group structures, a group
structure may be exposed to certain risks associated with the taxation of corporate income. The worst risk
for an MNE is that the same income may be taxed twice in different jurisdictions. On the other hand, a
group structure may also offer great opportunities for tax planning, where for instance income may be not
taxed at all.
In order to make use of this double non-taxation, MNEs use transfer pricing within their tax policies. This
means that MNEs use intercompany trade to shift money between parents, subsidiaries, and affiliates
operating in different countries.5 Governments try to counter this behavior, so that profits derived from
these intercompany transactions are allocated in a fair manner. However, as globalization tends to increase
the complexity of transfer pricing, and because of the lack of harmonization between countries,
governments have a hard task to achieve a fair allocation of taxing rights. Therefore, transfer pricing
implications of business structures and supply chains have been a focus area of recent public debate.6 In
fact, today, there are few issues more controversial than international transfer pricing.7
It may be hard to grasp the size of transfer pricing issues at first, but its size is enormous. According to
UNCTAD8, in the early 1990s, there were about 37,000 international companies with 175.000 foreign
subsidiaries. In 2004 these numbers increased to 64,000 and 870,000 respectively. 9 Moreover, the US
1 See for example Devereux & Fella (2014) p. 11. 2 OECD (2015) Action 8-10 final reports, p.9. 3 Lohse et al. (2012) p.2. 4 Radolović (2012) p.30. 5 Baker (2005) p.30. 6 Beer & Loeprich (2015). 7 Mura et al. (2013) p. 483. 8 UNCTAD is a permanent intergovernmental body established by the United Nations General Assembly. 9 The Economist (2004).
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Consensus Bureau reported that in 2014, 51% of the goods imported in the US came from related
companies.10 The trade that these MNEs conduct with related parties is highly sensitive to transfer pricing.11
It is expected that cross-border trade between related companies will continue to increase both in absolute
numbers and as a percentage of world trade.12 Moreover, for many MNEs, exaggerated transfer pricing is
standard procedure and forms a major part of the global strategy to minimize taxes.13 Transfer pricing
manipulation has been said to be one of the easiest ways to avoid taxation and is, therefore, one of the most
common techniques of tax avoidance.14 Other recent studies also suggest that a major fraction of income
shifting is achieved specifically in MNE’s that hold intangible property.15 Especially in times of recession,
countries are afraid to lose tax revenue and aim to counter tax avoidance by MNEs by implementing stricter
regulation.16 However, as transfer pricing often involves many jurisdictions, this issue challenges the tax
systems worldwide.17 Therefore, an adequate solution may not be easy to achieve.
The current transfer pricing legislation is based on a principle that looks at companies within an MNE in a
separate and independent manner. This may have suited the economic reality of a century ago, but as a
consequence of globalization, European integration, the rise of MNEs, and the increased value of intangible
assets the world of a century ago has changed significantly.18 However, the issue is that the current principle,
which was developed in the 1920s, is still governing the allocation of taxable profits today. Especially as a
consequence of globalization and the fact that intangible assets of MNE’s have gained so much in value, I
argue that reconsideration of the foundations of the current transfer pricing regime is necessary.19 Due to
more globalization, we cannot simply rely on the foundations that have been laid a century ago. As a
consequence, I believe the international tax regime to be in dire need of reform.20
Therefore, in this thesis, I have tried to explore the reasons for the current transfer pricing regulation and
see whether its foundations are still adequate in the current global economy. The research question that has
10 See US Census Bureau (2014) 11 Cools et al. (2008). 12 See for example: Oguttu (2006) p.41; Becker (1996). 13 Baker (2005) p.30. 14 Schoueri (2015) p.690; Auerbach et al. (2017) p. 27. 15 Tran et al. (2016) p.28. 16 Lohse & Riedel (2013) p.2: Ever more countries require corporations to submit detailed documentation to the tax
authorities to justify their intracompany prices and the profit distribution amongst affiliated companies. Failure to
provide adequate documentation would trigger penalties in many countries. The authors find that profit shifting is
reduced with about 50% when countries tighten transfer pricing documentation. 17 Lohse et al. (2012). 18 De Wilde (2015) p.5. 19 See for example for the effects of intangible assets in MNEs: Adams (2015) page 91; Auerbach et al. (2017) p. 27. 20 Devereux & Vella (2014) p. 11.
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been my starting point is: What shortcomings does the arm’s length principle have regarding the
valuation of intangibles and which alternatives might be desirable?
The objective of this thesis is twofold. First, I will explain the flaws of the foundation of transfer pricing
regulation in the well-developed and high-tech 21st century. Secondly, by focusing more specifically on
intangible property, I will investigate whether there may be other approaches that would be more desirable
as a foundation for transfer pricing regulation.
To conduct my research I had to look at transfer pricing from several perspectives, specifically from a legal
and economic perspective. There is a strong interrelationship between these two fields regarding transfer
pricing. The economic consequences of the transfer pricing practices by MNEs have led to reactions of
regulatory bodies, and regulation has led to change in transfer pricing policies of MNEs. Therefore, I believe
it is imperative to combine both perspectives in this thesis in order to address the issue of transfer pricing.
By focusing on practical problems and the regulatory solutions to these problems, I will argue whether or
not the arm’s length principle is still the most appropriate basis for transfer pricing. By means of a
systematic review, I have collected and critically analyzed the literature on the matter. Moreover, I have
used the arguments obtained in my review to establish a benchmark. This benchmark was used accordingly
to test the desirability of the arm’s length principle and the alternative approaches. This has provided me
with sufficient knowledge of the current literature relevant to be able to answer my research question.
Thus, this thesis will deliver a contribution to the current discussion on base erosion and profit shifting
(BEPS), especially by focusing more on the current globalized world, in which intangible assets are
becoming an ever-more important value driver for MNEs. By focusing on the strengths and weaknesses of
transfer pricing approaches in light of the 21st century, I believe this thesis contributes to developing a new
international tax system. In this line of reasoning, I argue that the current transfer pricing regulation should
be reconsidered.
The limitation of this thesis is that it relies heavily on academic literature and there is a lack of empirical
data to substantiate my point. Even though I have tried to support my arguments with data, this data was
not obtained by myself but gathered from existing sources. Therefore, the economic effects of my proposed
policy recommendations are uncertain and have to be researched further. Furthermore, I focus on the basis
of transfer pricing regulation and not so much on the documentation requirements as recently imposed by
the OECD member countries. However, I do believe that a bottom-up approach for transfer pricing
regulation is much more useful than a top-down approach, as I believe that the foundation of transfer pricing
regulation is on shaky ground due to the increased importance of intangible assets. Therefore, it is not my
goal to come up with a well-defined alternative international tax regime. Instead, I have sought to discover
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the flaws of the current system and tried to provide an alternative framework to base transfer pricing
regulation on.
In order to answer my research question in a logical order, this thesis is divided into 6 chapters, with the
introduction of the subject being the first chapter. In Chapter 2, the concept of transfer pricing is thoroughly
explained. This chapter shows the logical development of distrust in the current international tax system as
the functions of taxation are in danger as a consequence of mismatches that exist between countries. Whilst
Chapter 2 has a more economic and descriptive approach, Chapter 3 will deal with the legal basis of transfer
pricing regulation; the arm’s length principle and the separate entity approach. In Chapter 3, special focus
is given to the rules initiated by the OECD member countries. After discussing the arm’s length principle
in Chapter 3, I have developed a benchmark in this Chapter based on the strengths and weaknesses of the
arm’s length principle. This benchmark will be used to compare the alternative approaches of Chapter 5
with. Chapters 4 and 5 form the core of my thesis. These chapters focus more on the current globalized
world and the practical complications of the arm’s length principle concerning intangibles and the flaws of
international taxation in this context. Moreover, in Chapter 5, attention will be given to alternative
approaches of the arm’s length principle, and their desirability will be tested against the benchmark formed
in Chapter 3. Finally, in Chapter 6, my research is concluded and policy recommendations regarding the
foundations of transfer pricing regulation will be made.
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2. Transfer pricing
2.1 Introduction First, I believe some knowledge on the basis of transfer pricing is required. A transfer price is a price that
is charged for a cross-border transfer of goods and services. Transfer pricing only deals with international
transactions within the same Multinational Enterprise (MNE). An MNE consists of at least a parent
company in one country and one subsidiary in another country (see the figure below).
Figure: Basic figure of an MNE, with Parent company (P) in one country and subsidiary 1, 2 and 3 in another country.
In order for there to be possible transfer pricing issues, two requirements have to be fulfilled. First, transfer
pricing issues can only occur in international situations. Transfer pricing between subsidiaries of an MNE
which are all resident of one jurisdiction usually poses little to nihil tax avoidance problems since the
relevant national law is the same for all these subsidiaries.21 Think of the following domestic example based
on the figure above. Entity S1 and S2 are both located in the Netherlands and conduct business with each
other. S1 sells semi-final goods to S2 for a price of EUR 10, with the costs of goods sold of EUR 5. In a
fair market, the selling price of this semi-final good would be EUR 15. S2 then sells these goods onwards
to a third party in another country for EUR 20. Therefore, S1 receives a profit of EUR 5 (EUR 10 – EUR
5), and S2 receives a profit of EUR 10 (EUR 20 – EUR 10). The total profit that will be taxed in the
Netherlands is EUR 5 + EUR 10 = EUR 15, regardless of the fair market price of the semi-final good. From
a Dutch tax perspective, therefore, it does not matter how the profits are allocated between entities in a
purely domestic situation.22
21 Oguttu (2006) p. 138. 22 It only matters to the extent that two companies can make use of the lower corporate rate twice, instead of once.
See for example Article 22 of the Dutch Corporation Income Tax 1969.
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However, internationally it does matter, as states wish to execute their rights of taxation based on the
allocation of jurisdictions.23 Picture the following example where company P is established in Germany
and Company S1 is established in the Netherlands and both companies belong to the same group. Company
P sells goods to Company S1. When company P sells goods for a price that is much higher than normal
market prices, the effect is that profits of Company P are increased and so are the costs of company S1.
This also means that Germany can tax over a higher tax base, whereas the Netherlands is left with a smaller
piece of the pie. Therefore, transfer pricing issues may occur in international situations.24
The second requirement for transfer pricing issues is that it only concerns affiliated companies.25 The ratio
behind the requirement of affiliation is that there is wide consensus in economic literature that independent
parties would never conduct trade that would be disadvantageous to them. 26 In the example above,
Company P owns 100% of the shares of its subsidiaries. Such ownership makes it possible for the
shareholder to influence the decisions made by the subsidiary. This means that, as a consequence of the
relationship between the two entities, the price of the goods may be set at higher or lower prices compared
to the market price. Or as Schoueri puts it correctly:
“Taxpayers carrying out a controlled transaction have sufficient power to misprice the operation,
thereby jeopardizing the taxation of income. This would lead to a situation in which the entities of an
MNE were taxed less than independent parties would be, even if they undertook the same transaction.”27
In the above example, when tax rates would have been lower in Germany and higher in the Netherlands,
MNEs would like to have as much profit taxed in Germany instead of the Netherlands, in order to reduce
their total tax bill.28 Affiliated companies within an MNE group may, therefore, have an incentive to use
transfer pricing in a way to manipulate profits to have most of the profits taxed in countries with lower tax
rates and thereby reducing their tax burden.29 However, this leads to international transfer pricing issues, as
countries wish to execute their power of sovereignty and make sure that profits are not shifted outside their
jurisdiction and to keep their tax base from being eroded.30
23 De Wilde (2015) p.51; Graetz (2001) p.278. 24 See for example Palmer (1989) p.3: the author says that the difficulty lies in specifying the income over which a
nation should have jurisdiction. 25 Parties are seen as associated parties when an entity directly or indirectly holds capital, management or oversight
in another entity. The first mentioned entity must be able to influence the other entity. I.e. the entity must have
sufficient control to influence the prices set in associated transaction (>50% of the voting rights). 26 See for example Avi-Yonah (2007) p. 17; OECD Transfer Pricing Guidelines (2010) paragraph 1.38. 27 Schoueri (2015) p. 695. 28 Baker (2005) p.30; Tran et al. (2016) p.28. 29 Oguttu (2006) p. 140. 30 OECD (2015). BEPS Final Reports, Action 1 – 15.
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2.2 Transfer Pricing Goals Transfer pricing is becoming ever-more important to MNEs in a globalized economy where their operations
involve countries with different tax regimes and regulations.31 The main goals for an efficient transfer
pricing policy are to maximize consolidated profits and to minimize tax liabilities.32 By maximizing
expenses in a high-tax jurisdiction and maximizing income in a low-tax jurisdiction, the overall tax bill is
logically reduced.33 Another study shows that the effective tax rate of MNEs that focus on minimizing taxes
is on average 6.6% lower compared to an MNE that is more focused on tax compliance instead.34 Therefore,
it seems that transfer pricing strategies pay off.35
Research shows that differences in tax rates between tax jurisdictions play a significant role in an MNE’s
strategy when setting transfer prices.36 Other tax-related objectives for transfer pricing may be to utilize
other attributes, such as tax incentives, subsidies or the use of losses that would otherwise expire after a
certain number of years.37 An opinion that exists in literature is that tax can also be seen as a normal cost
of doing business, and as businesses are constantly looking to increase revenue and save costs, naturally a
good manager will try to manage the tax bill as well as any other bill.38
It must be noted that transfer pricing is not only driven by tax incentives, simplicity is also a very important
argument for MNEs to commence transfer pricing. It is easy to have all the supporting functions, financing,
IT, know-how etc. centralized in one entity, instead of being spread out across many companies. Other
objectives of designing efficient transfer pricing policies may be to increase the market share and reduce
the impact of economic constraints.39 Therefore, transfer pricing is not always driven by tax economic
reasons but may be justified by business economic reasons as well.
31 Baker (2005) p.30; Cools et al. (2008) p. 605. 32 Sikka and Wilmott (2010) p.7. 33 PwC (2009). 34 Klassen et al. (2016) p. 455. 35 Baker (2005) p.30. 36 See for example Behrens et al. (2014) p.652; Tran et al. (2016) p.41: the authors have proven that companies set
low transfer prices when the foreign tax rate is larger than the home tax rate, and the reverse is also true. 37 Kobetsky (2008). 38 Sikka and Wilmott (2010) p.7. 39 Radolovic (2012) p.30
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2.3 Transfer Pricing Mismatches In the previous paragraphs, we have seen that the effects of transfer pricing can be very advantageous for
MNEs.40 However, there is another – darker – side of the same coin. When transfer pricing does not reflect
market forces, the expenses and revenues, and as consequence, the profit and tax liabilities of the affiliated
companies could be distorted.41 Or how Malesky puts it:
“Transfer pricing becomes a concern when it is incorrectly applied to lower profits in a division of an
enterprise that is located in a high-tax jurisdiction and to raise profits in a country that levies no or low
taxes.” 42
This ‘artificial’ transfer pricing leads to mismatches and leaves countries with the perception that the most
valuable links in the value chains of MNEs are ‘missing’. Therefore, it is believed that these artificial
schemes and abusive transfer pricing policies are to blame for the lack of tax revenue in jurisdictions.43
Especially in times of recessions or depressions or when developing countries are concerned, such blaming,
naming and shaming finds global political appeal. 44 Therefore, tax authorities in many countries are
modernizing their legislation in order to safeguard the collection of a fair amount of tax in their
jurisdiction.45 Viewed in this context, transfer pricing rules have been regarded as a necessary tool to stop
MNEs from easily avoiding or reducing taxation by shifting profits to low-tax jurisdictions. 46 As a
consequence, transfer pricing has become a very controversial topic and ever-more professionals and public
officials are engaged in establishing and revising the rules of transfer pricing.47
2.4 Functions of taxation This political reaction to tax avoidance seems logical when taking into account the fact that transfer pricing
directly affects the taxes a jurisdiction may levy upon corporate profits.48 The revenue of these taxes is used
to finance public expenses, which explains the aversion of the society when people read about MNEs that
might not pay their fair share of taxes.49 Therefore, paying corporate tax can be seen as a contribution to
40 Klassen et al. (2016) p. 455. 41 OECD (2010) Transfer Pricing Guidelines. Page 32. 42 Malesky (2015). 43 Tavares and Owens (2015) p. 591. 44 For example in Papua New Guinea in the forestry business alone, it is estimated that in 1999, between $ 9 million
and $ 17 million was lost in tax revenues due to transfer pricing practices. This amount far exceeds the country’s
education and healthcare budget. These are lost revenues that are vital for the economic development of developing
countries. This shows that transfer pricing mismatches can seriously harm the economic development of countries
and that these mismatches have to be countered. Christian-Aid (2008). 45 Elliott and Emmanuel (2000) p. 216. 46 Brauner (2008). 47 It is a complex game with many actors; MNEs, lawyers, accountants, consultants, tax authorities, governments,
the OECD, the UN, NGO’s etc. 48 Sikka and Wilmott (2010) pp. 3-4. 49 See for example: Escribano (2017) p.250.
9
social development or as a return on the investment made by the jurisdiction to facilitate business
activities.50 Below I will briefly describe the most important functions of taxation. For each of the functions,
I will indicate whether or not I believe the function is important from a transfer pricing perspective.
Moreover, the useful functions will be used in the next chapter to develop a benchmark in order to test
transfer pricing regulation against.
2.4.1 Function 1: Revenue
The first and foremost goal of taxation is to raise revenue in order to fund the necessary governmental
functions, such as providing public goods or services.51 Even though people tend to disagree about what
functions of government are truly necessary, and what size of government is appropriate, there is a
widespread agreement that a government is indeed needed.52 I believe that the revenue function of taxation
is very important, as a government simply needs the money to function. However, I do not consider it to be
of major importance in the context of transfer pricing. The reason is that transfer pricing as such, is not a
tax, and therefore it cannot create wealth for a government. Based hereon I consider this revenue function
to be a secondary goal from a transfer pricing perspective. In my opinion, transfer pricing regulation should
merely make sure the corporate income tax laws are executed in a fair manner.
2.4.2 Function 2: Distribution
The second function of taxation is to redistribute wealth, especially to reduce the unequal distribution
between the poor and the rich. According to Vogel, this distributive function can be viewed from two
perspectives.53 First of all, the tax burden has to be fairly distributed among the taxpayers of a jurisdiction.
The ability-to-pay-concept has been regarded as an acceptable standard for the fair distribution of tax
burdens within a jurisdiction.54 States often believe a citizen’s income is the key figure to calculate one’s
ability to pay.55
However, as discussed, transfer pricing is a purely international issue, and therefore the collection of tax
has to be distributed between states as well. 56 The competence of states to tax the profits of MNEs does not
extend beyond the borders of a country. In other words, the fiscal sovereignty which states need to levy tax
50 Countries invest in infrastructure, education, healthcare etc. which are factors businesses directly benefit of. This
benefit principle is a very important principle in taxation. 51 Herrington & Lowell (2017) p. 5. The authors say that the budget of each jurisdiction in which an MNE conducts
business operations incurs expense for providing public services, such as safety, fire and police protection, roads,
hospitals, national defense, and education. 52 Dennis (2002) p.3. 53 Vogel (1977). 54 Schoeuri (2015) p.695. 55 Schoeuri (2015) p.695. 56 Vogel (1977).
10
is limited to economic activities that take place within their territory.57 Therefore, the principles upon which
countries agree upon to allocate tax revenues are critical for the global tax environment.58 I believe that the
latter is very important when designing transfer pricing approaches. Especially as today’s world economy
is ever-more globalized and dominated by MNEs, I believe that there must be harmony in the distribution
of tax jurisdictions. 59
2.4.3 Function 3: Regulation
The third goal of taxation is its regulatory function. Taxation can be used to steer the activities of the private
sector in the directions that are desired by governments.60 For example, by encouraging or discouraging
certain behavior, and to correct market imperfections, taxation is used to give direction to the society.61 De
Wilde believes this function is irrelevant as far as corporate taxation is concerned. He argues that the sole
purpose of corporate taxation should be to fund government spending, and not to steer business decisions,
not in a positive, nor negative way.62 I agree with him and I believe this function to be less relevant from a
transfer pricing perspective.
2.4.4 Function 4: Simplification
According to Klaus Vogel, a fourth function should be added to the levying of taxes. He calls it the
Vereinfachungsfunktion, i.e. the simplification of the tax system.63 This encompasses that the system should
be able to comprehend so that taxpayers can figure out how much time and effort they have to invest in
complying with the tax system.64 Personally, I believe that rules should be clear, and any uncertainty should
be minimized. In the absence of clear rules, neither the taxpayer or tax authority can know in advance the
likelihood of the tax burden and tax revenue, respectively.65 An efficient system should not contain a
complexity of exemptions, deductions, and tax credits.66 However, in the current tax environment, MNEs
are surrounded by transfer pricing risks due to uncertainties, and these uncertainties have to be managed
within the MNE.67 I believe taxes should impact business decisions as little as possible, and every distortion
should be minimized.68 Therefore, I believe this fourth function to be very important from a transfer pricing
57 De Wilde (2015) p.51 58 Herrington & Lowell (2017) p.6. 59 De Wilde (2015) p.51; Herrington & Lowell (2017) p.6. 60 Avi-Yonah (2006) p. 3 61 See for example: Bird and Zolt (2005) p. 1630. 62 De Wilde (2015) p.37 63 Vogel (1977); see also: Avi-Yonah (1996): The structure of International taxation: A proposal for simplification. 64 Rabuschka (2000) p. 4. 65 Avi-Yonah (2007) p.25. 66 Rabuschka (2000) p. 4. 67 Rossing (2013) p. 177. 68 De Wilde (2015) p. 54: the author says it basically requires the tax system produces as little red tape as possible.
11
perspective. Especially considering the fact that every country should be able to implement the regulation,
and every MNE should be able to understand the rules.
2.4.5 Function 5: Robustness
I would like to add a fifth function as I believe that the possibility of abuse should be kept at a minimal
level when introducing new rules concerning taxation. The European Commission argues that the world
has treated tax planning as a legitimate practice, but that over time, structures are becoming too aggressive.69
As mentioned in my introduction, transfer pricing has indeed become standard procedure for the tax
planning activities of many MNEs.70 Moreover, combatting tax avoidance through affiliated companies
was one of the original motives to enact transfer pricing rules in the first place.71 Also, Eden says that the
main purpose of transfer pricing regulation is to combat tax avoidance by MNEs.72 However, regulation
cannot be effective if either creates profit shifting incentives or if fails to combat tax avoidance. For these
reasons, I believe that this fifth function is very important to keep in mind when designing transfer pricing
policies.
2.5 Summary In this chapter, I introduced the concept of transfer pricing. The main goals for MNEs to commence efficient
transfer pricing policies are to maximize consolidated profits and minimizing tax liabilities. However,
transfer pricing is not always driven by tax economic reasons but may be justified by business economic
reasons as well. Unfortunately, transfer pricing has become a concern for jurisdictions, because transfer
pricing is incorrectly applied in order to artificially reduce taxation. Therefore, governments by
implementing transfer pricing regulation. In order for this regulation to be effective, I argued that regulation
should distribute taxing rights in a fair manner, rules must be easy to understand, and tax avoidance should
be minimized.
Having introduced the concept of transfer pricing in this chapter, I will now focus more on the arm’s length
principle, currently being the underlying principle of transfer pricing regulation.
69European Commission (2012) Recommendation on Aggressive Tax Planning, C(2012) 8806 Final, p. 2. 70 See for example: Barker (2017); Baker (2005) p.30; Bartelsman & Beetsma (2003). 71 See Avi-Yonah (2007) p. 3. He refers to the direct predecessor of Section 482 of the Code which dates back to
1921, when the IRS was authorized to consolidate the accounts of affiliated corporations "for the purpose of making
an accurate distribution or apportionment of gains, profits, income, deductions, or capital between or among such
related trades or business."; OECD (2010) Transfer Pricing Guidelines, at page 31. 72 Eden (1998) p.104.
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3. The Arm’s Length Principle
3.1 Introduction As discussed in the previous chapter, transfer pricing policies of MNEs may be detrimental to the execution
of the taxing rights of states. Firms may achieve income shifting results by using prices for intragroup sales
that depart from fair market conditions, by for example agreeing on; excessive management or overhead
fees, or costs for IT services, that an independent party would never agree upon.73 The fact that differential
tax regimes exist among states, gives MNEs the incentive to engage in income shifting by means of transfer
pricing.74 The distribution of taxing rights has, therefore, become one of the most important functions of
international taxation.
In order to distribute taxing rights, the arm’s length principle was introduced a century ago and still, lies at
the basis of transfer pricing legislation.75 It was first defined in US corporate tax legislation in 1935 as a
standard that an uncontrolled taxpayer would always deal at arm’s length with another uncontrolled
taxpayer.76 This principle provides an international yardstick to judge whether transfer prices are correct
from a tax perspective. As Brauner correctly describes in my opinion, this principle is still the “…heart,
spirit and foundation of the current international transfer pricing system”.77 OECD countries have agreed
upon this principle and it is used to counter income shifting, tax base erosion and double taxation. 78
However, the arm’s length principle should not be mistaken for an anti-tax avoidance rule. 79 Indeed, it is
merely a means to base anti-tax avoidance rules on; it is not an objective as such.80
The OECD has adopted the principle in Article 9 of the OECD Model Convention.81 In the wording of the
OECD, we can conclude that prices affiliated companies charge to each other should be the same as when
two unrelated parties would transact with one another. In other words, sales between affiliated enterprises
should represent fair market prices. From the same article of the OECD Model Convention, we can also
conclude that it is the foundation for the comparability analysis because it initiated the requirement of:
73 Weichenrieder (2009) p.2. 74 Cools et al. (2008) p. 605. 75 De Wilde (2015) p.6: “In these early days of international taxation the League of Nations, as the ‘predecessor’ of
the United Nations and the OECD, drafted the first Model Tax Conventions on Income and Capital.” 76 Eden (200) p. 675. 77 Brauner (2008) p.96. 78 Wittendorff (2011) p.227. 79 Pankiv (2016) p.463 80 See Schoeuri (2015) p. 704: The mere fact that over 4,000 tax treaties are currently in force that adopt the arm’s
length principle, makes this principle important for tax avoidance purposes. 81 See Schoeuri (2015) p. 704: over 4,000 tax treaties based on the OECD Model Tax Convention are currently in
force that adopt the arm’s length principle.
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“A comparison between conditions (including but not only prices) made or imposed between associated
enterprises and those which would be made between independent enterprises, in order to determine
whether the determination of profits is at arm’s length.”82
Although the arm’s length principle has been used to provide for fairness in the distribution of tax revenues
among countries, its original intent was the need for equality between affiliated and unrelated firms, as can
be concluded from the wording of the OECD.83 By doing so, it aims to avoid creating tax advantages that
would distort the relative competitive positions of either type of entity.84 The ratio behind the comparing
against independent enterprises is that when independent parties deal with each other, the conditions of the
transactions ordinarily are determined by market forces. Due to opposing interest of both parties, one may
expect a fair market price will rule the transaction. On the other hand, when affiliated companies deal with
each other, the conditions of the transactions may be not directly affected by market forces in their dealings
with each other.85
3.2 The origin of the arm’s length principle There is some doubt as to where the arm’s length principle found its origin, but the principle has originated
from the domestic laws of each state. 86 The OECD has developed the Transfer Pricing Guidelines
(hereafter: the Guidelines) in the past three decades to standardize these different national interpretations
in order to make the principle more suitable for international use.87 Nowadays, however, domestic rules are
reshaped in order to align them with the Guidelines. Today, the Guidelines represent a new way for
regulating global tax issues to correct the problems that arise when unilateral approaches are unable to solve
transfer pricing issues.88 Already in 2011, there were more than 60 countries which had implemented laws
and regulations regarding transfer pricing, based on the Guidelines. By 2016, over 85 countries
implemented transfer pricing regulation.89
The general idea behind the arm’s length principle is to allocate the profits to each part of the value chain
that attributes to the value of the chain. This should ultimately lead to the point where each country in the
value chain can levy a tax based on a tax base, which is equivalent to the actual value created in that specific
country.90 Therefore, the arm’s length principle is believed to serve the distributive function very well.
82 OECD (2010) Transfer Pricing Guidelines, at p. 34, paragraph 1.7. 83 Schoueri (2015) p. 695. 84 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.8, p. 34. 85 OECD (2010) Proposed revisions of Chapters I-III of the Transfer Pricing Guidelines; or for the reasons
mentioned in paragraph 2.2. 86 See for example Calderón, J. (2007) p.8. 87 OECD (2010) Transfer Pricing Guidelines. 88 See for example Rossing, P.R. (2013) p. 176 or Eden, L (1998); Calderón (2007) p.12. 89 According to KPMG (2016) Global Transfer Pricing Review. 90 OECD (2015) Actions 8-10, Final Report, at p. 10.
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3.3 Separate entity approach The OECD member countries have selected the separate entity approach as the most appropriate way to
achieve fair allocation results.91 Generally, this means that each enterprise within an MNE group is treated
as a separate entity. The objective of this approach is to identify the taxable entity that has affected
transactions, even if those transactions are undertaken within a single MNE.92
OECD countries believe that this approach is the most reasonable means for achieving the best result for
the allocation of tax bases between nations and minimizing the risk of double taxation.93 When applying
this approach, each group member is the subject of profit taxation that arises in that specific company. This
means that each company is treated as a separate taxable subject, irrespective of their function within an
integrated group. As a result of this, transactions undertaken between affiliated companies are also
recognized for tax purposes.94 This might seem an ideal situation in theory, but the risk of this approach is
that it creates an incentive to increase profit shifting, as an MNE may allocate profits to the countries where
its entities are located.95 This profit shifting is believed by the OECD to be corrected by the functioning of
the arm’s length principle.96
As MNEs have become more prominent in the global economy, and ever-more integrated, it is not that easy
to adequately use the separate entity approach anymore.97 In other words: members of an MNE group
cannot always be seen as separate economic actors in the 21st century. Financial accounting already ignores
affiliates and treats the MNE group as a single entity, in the sense that it only has to make one consolidated
financial statement. According to Vann, this is a strong argument that transfer pricing should also evolve
from a transactional to a more “whole of the enterprise approach”.98
From a tax perspective, it may also be argued that the separate entity approach may be losing its
significance. Hafkenscheid argues that countries apply an extensive set of rules already to circumvent the
unwanted side-effects of the separate entity approach.99 For example, controlled foreign company (CFC)
rules that require the parent company of a CFC to treat the income as fictitiously distributed to the parent,
91 OECD (2010) Transfer Pricing Guidelines, at p. 33. 92 De Wilde (2017) p.8. 93 See OECD (2010) Transfer Pricing Guidelines, at p. 18. 94 De Wilde (2017) p.8. 95 Escribana (2017) p. 253; Avi-Yonah (2009). 96 OECD Transfer Pricing Guidelines (2010) p. 18. 97 Radolovic (2012) p.30; Lohse et al. (2012) p.2. 98 Vann (2003) p.134. 99 Hafkenscheid (2017) p. 21.
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or rules that subject the consolidation of corporate profits into the parent’s profit.100 These rules show that
the separate entity approach is not always the norm anymore for taxation purposes.
Moreover, the whole point of integration within an MNE is that the group is seen as a group instead of
separate entities. Not even MNEs regard each subsidiary as a separate entity that must trade with other
subsidiaries on an arm’s length basis. The very existence of integrated MNEs may be evidence that the
arm’s length principle does not reflect economic reality. This argument is based on the fact that MNEs try
to achieve economies of scale, something that cannot be achieved by separate economic actors.101
3.4 Comparability analysis Based on the separate entity approach, affiliated companies should act in the same manner as independent
companies do. Therefore, an affiliated company should be comparable to an independent entity. As
mentioned earlier in Paragraph 3.1, the comparability analysis finds its foundation in the OECD Model
Convention.102 This comparability analysis lies at the heart of the arm’s length principle.103 The ratio is that
independent enterprises will only enter into a transaction if they believe the transaction is not going to make
them worse off than their next best option.104
To analyze the comparison between affiliated and independent companies, two aspects are of major
importance. First, the commercial and financial relations between the affiliated companies within an MNE
group and the relevant economic circumstances have to be clearly defined. The second aspect is to find
comparable transactions between independent enterprises on the open market and to compare these
conditions and circumstances with the transactions of affiliated companies.105
3.4.1 Commercial and financial relations
Before comparing the transaction between affiliated companies with a comparable situation of unrelated
entities, it is vital to identify the relevant characteristics of the transaction. 106 The OECD lists five
comparability factors, which are seen as most important to accurately define the controlled transaction.
First, the contractual terms of the transactions have to be identified. A transaction is often formalized in a
100 See for example: the US Treasury Regulations under sec. 1501 Internal Revenue Code and arts. 15-15aj Dutch
Corporation Tax Act 1969. 101 Avi-Yonah (2007) p.24. 102 See OECD Model Convention On Income and Capital (2014) Paragraph 1 of Article 9: A comparison between
conditions (including but not only prices) made or imposed between associated enterprises and those which would
be made between independent enterprises, in order to determine whether the determination of profits is at arm’s
length. 103 OECD Transfer Pricing Guidelines (2010) paragraph 1.6 104 OECD Transfer Pricing Guidelines (2010) paragraph 1.38. 105 OECD Transfer Pricing Guidelines (2010) paragraph 1.33. 106 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.36.
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contract, covering the responsibilities, obligation, and rights of both parties.107 However, contracts alone
often do not provide all the relevant information for an adequate transfer pricing analysis. Additionally, the
OECD requires a functional analysis to be made. This analysis seeks to identify the significant activities
performed, the assets used in the process and the material risks assumed by the parties of the transaction.108
In practice, this analysis may be difficult or even impossible, especially when it comes to intellectual
property (IP). According to Picciotto, IP and risks are spread throughout the entity as a whole, and therefore
very hard to delineate to a certain entity.109 Moreover, BASF, a multinational chemical company responded
to this functional analysis approach of the OECD and concluded that it is often very hard indeed to identify
who ‘controls’ the relevant functions within an MNE. The chemical company says that decision-making is
multi-layered and can often not be delineated as such. Especially relating to intangible returns, BASF
believes the functional analysis should not be decisive.110
As can be concluded from the Guidelines, risk delineation forms a significant part of the functional
analysis.111 However, this may create new profit shifting possibilities instead of combatting tax avoidance.
By ‘simply’ shifting risks, profits may be shifted to low-tax jurisdictions.112 Therefore, risk allocation has
become an important aspect of tax planning from MNEs, especially because from an economic perspective,
the transfer of risk has little consequence for the MNE as a whole.113
As a third comparability factor, differences in the characteristics of the product or service transferred often
account for differences in the value of the product or service in the open market. It depends on the transfer
pricing method chosen by the MNE, whether or not this factor should be given much weight.114 Four,
economic circumstances may be relevant as arm’s length prices may differ across markets even when the
107 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.42. 108 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.52-1.58: The significant activities performed reflects
the actual physical contributions of each party. The assets used should contain the use of valuable intangibles,
financial assets, plants, and equipment etc. In an open market; the material risks assumed would usually be
compensated by an increase in expected return. 109 Picciotto (2015) p. 755. 110 BASF (2013) submission on the Revised Discussion Draft on Transfer Pricing Aspects of Intangibles. 111 OECD (2010) Transfer Pricing Guidelines, at p.239: An examination of the allocation of risks between associated
enterprises is an essential part of the functional analysis. 112 Devereux & Vella (2014) p.7. 113 Durst (2012). 114 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.107The CUP-method heavily relies on the
comparability of characteristics. For the transactional profit methods, this comparability factor plays a less
significant role.
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exact same property or service is transferred.115 And finally, the OECD requires business strategies to be
examined when defining the transaction and determining the level of comparability.116
3.4.2 Comparable transactions
Once a comparability analysis has been completed, the second step is to find adequate comparable
independent companies in the market. The search for comparable companies plays an important role to
guarantee that independent companies enjoy the same market, level of technology and levels of efficiency
that are similar to the ‘tested’ associated company. This information can often be obtained from commercial
databases.117 However, it might not always be easy to establish these fair market prices. For raw materials,
where prices are established by the global market, prices may easily be obtained from the commodities
exchange markets. Or if other highly comparable goods exist on the global market, comparable prices may
be fairly easily obtained. However, for many goods, prices are harder to obtain, as market prices for intra-
group transfers, due to their unique nature, rarely exist. 118 This comparability analysis therefore,
immediately poses a threat to intangible assets. The market-based comparability approach will most likely
only provide an adequate outcome if transactions are highly comparable. Developed, high-tech markets
usually have no or very little comparable transactions, and therefore comparability is a major issue.119
3.5 Transfer pricing methods Based on the comparability analysis, the OECD has described methods that can be used to establish whether
the conditions imposed between affiliated enterprises are consistent with the arm's length principle.120 I will
not go into too much detail regarding the various methods, as I regard it to be of minor importance for this
thesis, however, some understanding is fruitful.
In principle, the OECD requires an MNE to select the most appropriate transfer pricing method to the
circumstances of the case.121 In principle thus, the taxpayer seems to be free to choose a method of his
115 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.110: Economic circumstances that may be relevant to
compare markets include: the geographical location, the level of competition, the size of the market, the levels of
supply and demand, and consumer purchasing power, etc. 116 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.14: Business strategies would include: innovation, the
degree of diversification, risk aversion, duration of arrangements, etc. 117 OECD (2010) Transfer Pricing Guidelines, at p. 115: commercial databases have been developed by editors who
compile accounts filed by companies with the relevant administrative bodies and present them in an electronic
format suitable for searches and statistical analysis. Care must be exercised with respect to whether and how these
databases are used, given that they are compiled and presented for non-transfer pricing purposes. 118 Rossing (2013) p. 176. 119 Brauner (2008) p. 105; OECD, Actions 8-10 Final Reports, at paragraph 6.35: The OECD acknowledges this and
says that the use or transfer of intangibles may indeed challenge the comparability analysis. 120 OECD (2010) Transfer Pricing Guidelines, at p. 59. 121 OECD (2010) Transfer Pricing Guidelines, at paragraph 2.76.
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liking. The methods prescribed by the OECD fall in either of two categories; traditional transaction methods
and transactional profit methods, both will be briefly described in the paragraphs below.
3.5.1 Traditional transaction methods
Traditional transaction methods can be regarded as the most direct means of establishing the at arm’s length
conditions of a certain transaction. These traditional methods were first implemented in the US tax
legislation in 1968.122 The traditional transaction methods are predominantly used for transactions that are
simpler of nature.123 Therefore, one may wonder how applicable the methods are for transactions involving
intangible assets, as they are complex per definition. The OECD admits that from a practical point of view
it is very hard to find a transaction between independent enterprises that is similar enough to a transaction
between affiliated companies.124 In practice, many times these methods are indeed rejected because they
cannot match one of the comparability criteria as established in the previous paragraphs.125
3.5.2 Transactional profit methods
If the traditional transaction methods are rejected, the transactional profit methods may be used instead. In
cases where each of the parties makes unique and valuable contributions in relation to the controlled
transaction, or where different group members are all related in highly integrated activities, a transactional
profit method may be more appropriate.
Another reason for adopting the profit method is the lack of available data on open-market prices, which is
required for a comparability analysis.126 As the most intellectual property is unique, reliable comparables
may not exist in the world.127 The transactional profit methods were originally given the name “basic arm’s
length return method”, which means that arm’s length principle does not only focus the prices of
transactions as such but that the principle may be applied through the examination of profits as well.128 This
means that the determination of an arm’s length price or result may be justified without direct reference to
the comparability analysis.129
122 Eden (2000) p.676. 123 Hughes & Nicholls (2011). 124 OECD (2010) Transfer Pricing Guidelines, at paragraph 2.15. 125 See for example Hughes & Nicholls (2010). 126 See Hughes & Nicholls (2010); and paragraph 3.4.1. 127 Rossing (2013) p. 176. 128 Mura et al. (2013). 129 Robillard (2015) pp. 447-448.
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3.6 Criticism on the arm’s length principle I believe that no approach for transfer pricing can be perfect, as transfer pricing is not an exact science. 130
However, as may be concluded from the paragraphs above, applying the arm’s length principle seems to be
imperfect, and not easy to administer. Transfer pricing policies of MNEs are often based on judgments
made from by the MNE as well as the tax authority on how the arm’s length principle should be applied.131
One can also wonder about the name ‘arm’s length principle’ itself. The wording already constitutes
ambiguity, i.e. how long is an arm, really? Because of this ambiguity, tax authorities in different countries
may differ in regulatory standards and the way these standards should be interpreted and applied by MNEs.
However, the main objections to the arm’s length principle can be categorized into two groups. First, the
principle has been criticized for not reflecting economic reality and second, its feasibility has come under
great scrutiny.132 Regarding the economic reality, scholars argue that the arm’s length principle may not be
adequate anymore to determine the geographic location of a business activity and as a consequence.
Moreover, it is believed that the principle does not achieve anymore what it was designed to do, which is
to allocate taxing rights in a fair manner.133
3.6.1 Reflecting economic reality: comparability
It may be argued how adequately the arm’s length principle reflects the economic reality, especially in the
current economic environment, where intangibles are becoming an ever-more dominant value driver for
MNEs.134 First of all, the arm’s length principle is a legal fiction, as controlled transactions are deemed to
have been dealt with in accordance with the arm’s length principle.135 This means that the OECD depends
on a comparable transaction with independent entities. However, most of the intellectual property is unique,
and as such, reliable comparables may not exist in the world.136 Indeed, there may be a lack of third-party
comparables and a lack of comparability between the intangibles in question. Moreover, the legal ownership
of intangibles might be separated within the MNE and there is difficulty in isolating the impact of a
particular intangible on the MNE group’s income.137
Especially from 1975 onwards, reliable comparables were becoming harder to find in the market and
disputes between tax authorities and taxpayers concerning transfer pricing were becoming more common.
I believe that this increase in litigation may already constitute an indication that the arm’s length principle
130 OECD (2010)Transfer Pricing Guidelines p. 29. 131 Rossing, C. (2013) p. 176. 132 Schoeuri (2015) p. 698. 133 See for example: Avi-Yonah & Benshalom (2011); Fleming et al. (2014). 134 Adams (2015) p 91. 135 Schoueri (2015) p.697; Actions 8-10 Final Reports, at paragraph 2.88. 136 Rossing (2013) p. 176. 137 See Actions 8-10 Final Reports, at paragraph 6.33.
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might not be practical anymore.138 As a consequence of the changed world-market, inadequate comparables
may be used for the application transfer pricing. Therefore, the arm’s length principle may actually lead to
very unrealistic results from an economic perspective. 139
There is a wide consensus among scholars that the fact that no independent party would never transfer
intangibles to an unrelated party without any payment. However, any attempt to find a proper royalty rate
may be very hard as no reliable comparables may exist.140 For example in the Bausch & Lomb transfer
pricing case concerning intangibles, the court judged a 5% royalty rate based on net sales too low. However,
the court was unable to find a “sufficiently similar transaction involving an unrelated party” and it
consequently constructed an arm’s length itself, arriving at a 20% royalty rate instead.141
3.6.2 Reflecting economic reality: integration
Moreover, affiliated companies and independent companies are very much different from each other by
definition.142 The reason is that MNEs may be created because they tend to generate greater returns by
combining entities than can be obtained from separate market transactions. The arm’s length principle does
not take into account these synergies effects of a group. I believe that a group of companies may pursue a
goal that does not directly benefit each member of the MNE separately but does benefit the MNE as a
whole.143 Therefore, I believe that an MNE group may not simply be divided into separate entities but has
to be seen as a whole.144
Hence, the arm’s length principle cannot define what the costs would be when unrelated parties would have
transacted with one another because the goal of setting up an MNE was to save costs by avoiding such
unrelated party transactions.145 The following example may illustrate things more clearly. It is very likely
that unrelated parties would have more distrust towards one another compared to affiliated companies and
as a consequence, independent parties would spend much more hours on meetings, or on their legal advisors
when drafting up important agreements. Therefore, there is an immediate profit when trade is conducted
amongst affiliated companies, something that the arm’s length principle doesn’t take into account. MNEs
138 Avi-Yonah (2007) p.10. 139 Avi-Yonah (2007) p.10. 140 Avi-Yonah (2007) p. 17 141 See Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582 (1989). 142 Avi-Yonah & Benshalom (2011) p. 379. 143 Fleming et al. (2014) p.3. 144 See for example: Vann (2003) p.134. 145 Avi-Yonah & Benshalom (2011) p. 379.
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especially flourish in those industries where the ability to integrate functions in different countries enables
them to reduce certain costs146 by taking advantage of synergy benefits.147
In the Guidelines, the OECD does try to take these synergies into account. However, the burden lies with
the taxpayer, as the OECD states that taxpayers would have to document these anticipated synergies when
applying the arm’s length principle.148 Then there remains another problem. When affiliates realize a
synergy gain from integration, such gain cannot be attributed to either of the affiliated companies in
isolation. Even if the synergy rents are well documented and the taxpayer is able to isolate the added value
of the synergy, it is theoretically still defensible to make any allocation of the surplus at will.149 Therefore,
I believe it to be not pragmatic, or even impossible to identify and determine an adequate key allocating
such synergy profits once these synergy profits are isolated.
3.6.3 Feasibility
Next to the belief that the arm’s length principle does not reflect economic reality, the feasibility of the
arm’s length principle may be questioned as well. For one there is the challenge of finding meaningful
comparable transactions amongst unrelated parties.150 Moreover, the process of finding comparable data
required for taxpayers, and the evaluation by tax authorities can be very burdensome, as may also be
concluded from Paragraphs 3.4 and 3.5.151 Scholars argue that very elaborate regulation and enforcement
measures have been implemented to counter tax avoidance, but those attempts seem to be futile against the
administrative burden it produces.152 This compliance burden results from the need to apply the arm’s
length principle on a factual, case-by-case basis and there is a lack of general rules.153 Therefore, when a
transfer pricing case goes to court, it is often very burdensome, time-consuming and expensive for all parties
involved; i.e. there is no clear winner, just losers.
For example, in 1993, Chevron delivered 1.3 million pages of documents to the IRS.154 This resulted in
huge enforcement costs for the tax authority. Therefore, even though the arm’s length principle actually
imposes a limited degree of restraint on income shifting and tax avoidance, it does so by putting a substantial
burden on both taxpayers and tax authorities. Moreover, the amount of restraint achieved is somewhat
146 These costs include research and development costs, transactions costs, information-obtaining costs, managerial
costs and finance costs. 147 Avi-Yonah & Benshalom (2011) p. 379. 148 OECD (2010) Transfer Pricing Guidelines, at paragraph 9.57. p.254. 149 Kane (2015) p.292. 150 Avi-Yonah & Benshalom (2011) p.377. 151 Schoueri (2015) p.705. 152 Devereux & Auerbach (2017). 153 Avi-Yonah (2007) p.25. 154 See Bureau of National Affairs, Tax Management Transfer Pricing Report, 135-36 (July 7, 1993).
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modest.155 This cannot be the intention of policy makers, as I believe this is very much in contrast with the
beliefs of Adam Smith. This great economist namely said that the collection of taxes should involve the
lowest cost possible for the taxpayer.156 Therefore, I believe this administrative burden to be undesirable as
the application of the arm’s length principle may go beyond the understanding of most tax directors. This
can force taxpayers to use resources to employ economists or statisticians for example, instead of focusing
on their core business. Thus, the arm’s length principle has lost its feasibility in my opinion and poses a
threat the simplification function, which I believe to be one of the most important functions of transfer
pricing regulation.157
3.6.4 Opinion OECD
Despite the challenges formulated above, the OECD believes that applying the arm’s length principle can
in most cases, yield an appropriate allocation of returns, even for intangible property. And therefore, OECD
member countries continue to use the arm’s length principle to govern the evaluation of transfer pricing
between associated enterprises.158 The OECD considers that the experience from the application of the
arm’s length principle has become sufficiently broad and sophisticated to establish a substantial body of
common understanding. Furthermore, the OECD says that this experience should elaborate the arm’s length
principle further in order to refine and improve its functioning.159
As a consequence, the OECD says that other methods other than the arm’s length principle would not be
acceptable in theory, implementation, or in practice. It says that no legitimate or realistic alternative has yet
emerged.160 However, the application of the arm’s length principle is heavily debated by scholars, especially
regarding the inability to control tax-motivated transfer pricing with respect to the shifting of intangibles
within an MNE.161 Therefore, I believe that this principle needs to be reevaluated in the light of the 21st
century. In order to reevaluate the adequacy of the arm’s length principle, I derived a benchmark. In the
next paragraph, I will lay out the benchmark based on the strengths of the arm’s length principle on the one
hand and the criticism on the other hand.
3.7 The Benchmark I believe there are five very important aspects of a transfer pricing approach, which can be deduced from
this chapter and the previous.162 First and foremost, the measure must reflect the economic reality. We
155 Fleming et al. (2014) p.36. 156 Smith (2010) Chapter 2. 157 See paragraph 2.4.4. 158 OECD (2010) Transfer Pricing Guidelines, at p. 36, paragraph 1.14. 159 OECD (2010) Transfer Pricing Guidelines, at p. 36, paragraph 1.15. 160 OECD (2010) Transfer Pricing Guidelines, at p. 36, paragraph 1.15. 161 Fedusiv (2016) p. 483. 162 My criteria are not based on the criteria Auerbach et al. (2017) but it does show similarities with the authors’
criteria. See p.4. The authors test the destination based cash flow taxation against five criteria: (1) economic
23
currently live in a developed world where MNEs are becoming ever-more integrated. Moreover, the
economy has shifted from an in industrial era to a knowledge era.163 The fact that the value of intangible
assets has increased so much in the past decade, proves that we are indeed moving towards an era based on
knowledge. 164 Also, the world is dynamic and changing at such a rapid pace, which makes it quite
impossible to predict the future. Therefore, I believe it is imperative for transfer pricing regulation to be up-
to-date and to be able to cope with economic progress. Once transfer pricing fails to represent the economic
reality, a rule should be amended or replaced to once again reflect the economic reality.
Secondly, the administrative burden for taxpayers and enforcement costs for tax authorities should be
marginal. That tax compliance costs and the risk of double taxation have become a cause for great
concern.165 In order for compliance costs to be acceptable, I believe the rules should be clear and as simple
as possible.166 Complex rules will put a heavy burden on taxpayers as well as tax authorities, with high
costs as a result for both parties. 167 While it is understandable that especially in times of economic
recession, transfer pricing regulation may be tightened, a major drawback of this stricter regulation may be
that it involves high administrative costs for tax authorities and taxpayers. Therefore, the effectiveness of
such administrative burden depends on the level of income shifting it prevents.168 Once a measure creates
disproportionate administrative burdens, I believe it distorts the business decisions as businesses would
have to relocate their resources towards tax compliance. Based hereon, I believe that administrative burdens
should be kept at a low level in order to affect business decisions as little as possible.169
Three, the measure should result in a fair allocation of taxing rights between countries. Tax authorities in
many countries are modernizing their legislation in order to safeguard the collection of a fair amount of tax
in their jurisdiction.170 However, the fiscal sovereignty which states need to levy tax is limited to economic
activities that take place within their territory.171 Therefore, transfer pricing mismatches cannot be solved
unilaterally. As transfer pricing is a purely international issue, transfer pricing has to be able to allocate
taxing rights between states. 172 Theoretically, this could be achieved when nations would mutually
efficiency, (2) robustness to tax avoidance and evasion, (3) ease of administration, (4) fairness, (5) stability. Note,
however, that my criteria are more focused on transfer pricing. 163 Adams (2015) p. 87. 164 Adams (2015) p 91. 165 Schreiber & Fell (2017) p. 11. 166 See paragraph 2.4.4. 167 Avi-Yonah & Benshalom (2011) p.379. 168 Lohse & Riedel (2013) p. 2. 169 This is in line with the beliefs of Adam Smith; De Wilde (2015) p.12. 170 Elliott and Emmanuel (2000) p. 216; According to KPMG (2016): By 2016, over 85 countries implemented
transfer pricing regulation. 171 De Wilde (2015) p.5. 172 Vogel (1977).
24
coordinate their tax systems.173 Viewed in this context, I believe transfer pricing rules are necessary to help
allocate profits to jurisdictions, especially as the tax sovereignty of states is limited to the boundaries of its
own territory.
Four, the approach should be resilient to tax avoidance. In the past, abusive tax practices and the risk of
base erosion and profit shifting was virtually absent.174 However, in the 21st century, transfer pricing
manipulation has been said to be one of the easiest ways to avoid taxation and is, therefore, one of the most
common techniques of tax avoidance.175 Especially in this knowledge era, income shifting may be fairly
easy achieved in MNE groups that hold intangible property. 176 Therefore, I believe current transfer pricing
regulation should be robust towards relocation of intangible assets and manipulation of transfer prices.177
Moreover, combatting the possibility of international tax avoidance through related company trade was one
of the original motives to enact transfer pricing rules. 178
And five, the approach should be able to be implemented in international corporate tax law in a pragmatic
manner, otherwise, there is no point of introducing the rule in the first place. A major concern is that other
approaches of transfer pricing regulation would need more harmonization, and jurisdictions are notoriously
unwilling to give up more of their sovereignty.179 Therefore, the OECD believes that implementing a new
transfer pricing system might induce double taxation or double non-taxation.180
3.7.1 Benchmarking the arm’s length principle
When applying the above benchmark on the arm’s length principle I conclude the following. First, regarding
the economic reality, the principle might have lost its relevance. The fact that group entities of MNEs are
becoming so integrated, the separate entity approach has become redundant in my opinion. Moreover, arm’s
length principle requires comparables to be found in the market. The reality proves, however, that only in
very few cases may perfect comparables be found for intangibles, due to their unique characteristics.
Secondly, the administrative burden has become too great as a result from the need to apply the arm’s length
principle on a factual, case-by-case basis and there exists a lack of general rules. Third, I do believe the
arm’s length principle is a solid principle concerning the allocation of wealth. I think that the ability-to-pay
173 De Wilde (2015) p.5; Herrington & Lowell (2017) p.6. 174 Brauner (2008) p.102 175 See for example: Schoueri (2015) p.690; Baker (2005) p.30; European Commission (2012) Recommendation on
Aggressive Tax Planning, C(2012) 8806 Final, p. 2. 176 Tran et al. (2016) p.28. 177 Auerbach et al. (2017) p. 27: the authors say that the three most important channels of profit shifting are
currently: debt-shifting, relocating intangible assets that earn a royalty payment in a low tax country, and the
manipulation of transfer prices. 178 See Avi-Yonah (2007) p. 3. 179 Graetz (2001) p.278; This is even reflected in the Bible, See: Matthew 17:25-26 (New International). From whom
do the kings of the earth collect duty and taxes-from their own sons or from others?" "From others," Peter answered. 180 See OECD (2010) Transfer Pricing Guidelines, at paragraph 1.22.
25
principle is very important for the allocation of tax burdens and the distribution of wealth. Four, the fact
that the arm’s length principle is based on a separate entity approach, gives MNEs an incentive to shift
profits to low-tax jurisdictions. While the arm’s length principle is designed to counter this behavior, I
believe it is not effective in doing so. It is actually open to manipulation from MNEs that want to reduce
their tax liability. The administrative burden has become too large for MNEs in relation with the profit
shifting it reduces. Therefore I do not believe the arm’s length principle to be resilient to tax avoidance.
3.8 Summary In this Chapter, I discussed the origins of the arm’s length principle and how it is applied on an international
level. The goal of this principle is to make sure affiliated parties conduct transactions with one another in
the way third parties conduct transactions with one another. OECD countries have agreed upon this
principle with the intention to counter income shifting, tax base erosion and double taxation. Whilst the
arm’s length principle seems to be a fair concept for international taxation, it is criticized a lot by scholars.
Based on the benchmark formed in this chapter, I conclude the arm’s length principle to be outdated and in
need of reform. The most fundamental problems, in my opinion, are that the comparability analysis required
by the arm’s length principle is imperfect for intangibles assets and well-integrated MNEs cannot be seen
as separate entities. Moreover, the administrative burden to correctly apply the arm’s length principle has
become disproportionally high for taxpayers. Therefore, the welfare gain that is achieved with reduced
profit shifting, might be offset against the additional administrative burden for taxpayers.
Despite the criticism, the OECD says that no realistic alternative method to the arm’s length principle would
be acceptable in theory, implementation, or in practice. In the next chapter, I will focus more on intangible
assets and the threat they pose against the arm’s length principle.
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4. Intangibles
4.1. Introduction Hard to value intangibles are becoming ever-more important in the current economic environment. In fact,
in the last decade, intangibles have become the dominant value drivers for many MNEs. As mentioned
before, the economy has shifted from the industrial era to what is now often referred to as the knowledge
era.181 This can be substantiated by the fact that the number of patent applications worldwide more than
doubled (from 88,793 to 202,051) between 1999 and 2013.182 Moreover, in the years from 2010 to 2012,
70-75% of the value of companies acquired in US M&A transactions was booked as intangibles.183 One
famous example was Google’s acquisition of Motorola Mobility. Of the total purchase price of $12.5
billion, $3 billion was acquired cash, over $6 billion was booked as intangible assets and about $3 billion
was booked as goodwill. Especially remarkable is the fact that the intangible assets were not on Motorola’s
books prior to the acquisition, as is often the case with intangible transfers.184 This valuation difference
reflects that there is an enormous information gap in a lot of companies, and intangible property is often to
blame. In many of the cases, intangibles are first developed in high tax jurisdictions and later transferred to
a low-tax jurisdiction to benefit from tax advantages. Therefore, transfer prices regarding intangibles have
become a major point of concern in the international context.185
4.2 Defining Intangibles Not only the valuation of intangibles may be very difficult, but defining intangibles has also been a
controversial topic for many years. Lawyers one the one hand hold that an intangible is required to be
legally protected to be valuable. Accountants, on the other hand, argue that if the intangible is not reflected
on the balance sheet, it does not exist and therefore it can have no value.186
The OECD luckily provides more guidance on the matter and defines an intangible item as:
“Something which is not a physical asset or a financial asset, which is capable of being owned or controlled
for use in commercial activities, and whose use or transfer would be compensated had it occurred in a
transaction between two independent parties in comparable circumstances”.187
Furthermore, the OECD states that intangibles do not have to be legally protected to be valuable. Even
though legal or contractual forms of protection may contribute to the value of an item, the OECD disagrees
181 Adams (2015) p. 87. 182 OECD (2015) available at https://stats.oecd.org/Index.aspx?DataSetCode=PATS_IPC (accessed 23 March,
2017). 183 Adams (2015) p 91. 184 Adams (2015) p. 91 185 Fedusiv (2016) p.483. 186 Wright et al. (2016). 187 See, OECD (2010) Transfer Pricing Guidelines, Chapter VI.
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with the lawyer’s perception by saying that the existence of such protection is not a requirement for an item
to be categorized as an intangible.188 Moreover, items do not necessarily have to be represented on the
balance sheet to be qualified as an intangible asset.189 Therefore, the OECD does not choose the opinion of
either lawyers or economists.
The OECD delineates commercial intangibles as patents, know-how, trade secrets, customer relationships,
designs, and models that are used for the production of a good or the provision of a service.190 Especially
due to the unique characteristic of an intangible asset, these type of goods challenges the efficiency of a
market-based comparability approach that the arm’s length principle requires.191 Therefore the lack of
comparability factors is a major issue for the valuation of intangibles.192
The OECD defines hard to value intangibles as:
“..intangibles or rights in intangibles for which, at the time of their transfer between associated enterprises, (i)
no reliable comparables exist, and (ii) at the time the transactions was entered into, the projections of future
cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing
the intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible
at the time of the transfer.”193
Based hereon, the main issue of intangibles is the difficulty of predicting the value at the time it is
transferred to an associated company.194 Predicting the value can be difficult as intangibles may not be fully
complete at the time of transfer, or an intangible may not be exploited commercially until several years
after the transaction.195
4.3 Intangibles at arm’s length Intangibles are arguably the biggest problem in transfer pricing today. As intangibles may be very hard to
value, the arm’s length principle seems to be an inapplicable approach.196 Recent studies suggest that a
major fraction of income shifting is achieved specifically in MNE’s that hold intangible property.197 Many
188 OECD, Actions 8-10 Final Reports, paragraph 6.8 189 OECD, Actions 8-10 Final Reports, paragraph 6.7. 190 See Chapter VI of the OECD Guidelines: These commercial intangibles are also referred to as trade intangibles.
The OECD also defines so-called marketing intangibles. These include trademarks or trade names, but will not form
a significant definition in this thesis; For more information regarding specific groups of intangibles, I refer to
OECD, Actions 8-10 Final Reports, paragraphs 6.19-6.31. 191 Brauner (2008) p. 107. 192 Brauner (2008) p. 105. 193 OECD, Actions 8-10 Final Reports, paragraph 6.189. 194 Fedusiv (2016) p.484. 195 OECD, Actions 8-10 Final Reports, paragraph 6.1890. 196 Fedusiv (2016) p.483. 197 Tran et al. (2016) p.28.
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chemical companies were a common example of falsified transfer pricing, followed by pharmaceutical
companies. By following the footsteps of the chemical companies; pharmaceutical companies were
sometimes invoicing as much as 10 times for a product compared to the arm’s length price.198
An interesting example is the GlaxoSmithKline Case in 2006. The primary issue was the transfer price at
which the parent company GSK UK sold drugs to its US subsidiary. The IRS held that GSK US overpaid
the British parent for the drugs, and thereby artificially reducing US profits and paying fewer US taxes.199
GSK did not go to court, but settled with the IRS for $3.4 billion instead, which was the largest settlement
in IRS history.200 Unfortunately, because the case was settled, it did little to help MNEs set transfer prices
when intangible assets are involved.201 However, the lesson that we can learn from the GSK case is twofold.
First, it shows that tax authorities are very serious about intangibles used in transfer pricing. Secondly,
documentation of intangible asset is just as important as for tangible assets. GSK might have been able to
support its argumentation concerning the value of the R&D activities if the company had been able to prove
how much it had actually spent for research and development.202
Currently, a shift of attention regarding the intangible assets of big MNE electronic service providers may
be witnessed.203 Scholars argue that this problem has grown to an enormous size and that regulation is
outdated. The issue for intangibles is that the arm’s length principle, which was developed in the 1920s, is
still governing the allocation of MNEs taxable profits today.204 As discussed earlier, the arm’s length
principle was developed in a domestic setting and in a low-tech, bricks-and-mortar economy. Moreover,
the potential of abusive practices and the risk of base erosion and profit shifting was significantly smaller
at the time this principle was developed.205
However, the time has not stood still, and the past century has led towards are more global economy
combined with the evolution of MNEs and the increase of intangibles as an important economic driver.
Today’s international tax system seems to fail to cope with this economic progress, as it provides concepts
which seem to be very outdated.206 However, this economic progress has not resulted in a revaluation of
the basis of the system. Unfortunately, a revaluation of the system is in order as the current system is
believed to be inaccurate and it generates an artificial disadvantage for taxpayers who conduct business
198 Baker (2005) p.30. 199 Gajurathi (2007) p. 751. 200 Burnett and Pulliam (2008) p.40. 201 Burnett and Pulliam (2008) p.40. 202 Burnett and Pulliam (2008) p. 43. 203 Companies like Apple, Google, or Amazon have been scrutinized in recent years by the European Commission. 204 Tavares, (2016) p. 271; De Wilde (2015); Avi-Yonah (2011). 205 Brauner (2008) p.102 206 De Wilde (2015) p. 314
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across borders with related companies. 207 The current system is especially disadvantageous to those
companies whose value depends particularly on intangible assets.208
Instead of a revolution in the transfer pricing system, there seems to be a strong preference from the OECD
countries to simply change the interpretation of the current transfer pricing rules bit by bit in order to keep
up with the dynamic world.209 Brauner calls this approach the “massaging” of rules and concepts and an
almost religious belief that the old concepts must be appropriate if molded in the right shape.210 However,
this may result in a very inefficient system. Due to all the extra rules and concepts to interpret the transfer
pricing regulation, the arm’s length principle has led to high compliance costs for taxpayers and
enforcement costs for governments.211 Therefore, Rabillard argues that:
“Although the arm’s length principle may not be ready for the graveyard, a future death by
thousand cuts may soon be pronounced.”212
Even though this phrase might sound skeptic, it means that it is impossible to save the arm’s length principle
in the current world, and the solutions brought forward by the OECD are becoming too burdensome for
taxpayers. Moreover, by merely hanging on to the traditional rationale behind transfer pricing legislation
would, in my opinion, continue the use of the complex and imperfect use of the arm’s length approach to
combat aggressive tax planning structures.213
4.4 Typical IP Structures The rise of intangibles has led to new possibilities of transfer pricing structures, and the old transfer pricing
standards seem to be unable to cope with this development. The fact that structuring with intangible
property is possible, is because the principle of residency and source lie at the foundation of our
international tax system.214 In principle, this means that the home country of the MNE may tax the
consolidated worldwide profits of an MNE group, but has to either exempt the foreign income from taxation
or give a credit for the foreign taxes paid.215 This basic allocation of taxing rights might be reasonable in a
simple world without MNEs or intangibles, as may have been the case in 1920 when the arm’s length
207 Avi-Yonah et al. (2009) 208 Brauner (2008) p. 103. 209 See for example Brauner (2008) p. 103; Rabillard (2015) p. 453. 210 Brauner (2008) p. 103. 211 See for example: Fleming et al. (2014) p.36; Avi-Yonah & Benshalom (2011). 212 See Rabillard (2015) p. 453. Rabillard refers to the endless revisions of the Guidelines when he writes “a
thousand cuts”. 213 Fleming et al. (2014) p. 31. 214 Bond and Devereux (2002) p.5; De Wilde (2015) p. 443. The author also argues that there are incentives the
incentives to shift taxable profit by shifting corporate investment across tax borders, under the current origin-
oriented international tax regime. 215 Picciotto (2016) p. 755.
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principle was introduced. However, globalization and technological progress have eroded the concepts of
residence and source as of the 21st century.216 The allocation of taxing rights to tax royalty income in the
residence jurisdiction, and taxing business profits in the country of source gives rise to difficult transfer
pricing situations, which Devereux and Vella believe to be the main issue affecting the current international
tax system.217
4.4.1 Mobility
In principle, it is relatively easy for MNEs to ensure that new intangibles are created wherever desired.
However, transferring existing intangibles without adverse tax consequences is much harder.218 This again
shows the limitation of the market-based comparability approach regarding intangibles in my opinion, since
intangibles are almost never transferred separately in the course of normal market transactions.219 This was
also the case in Google’s acquisition of Motorola Mobility as the intangibles were transferred as part of a
whole business acquisition, and not separately.
Moreover, in the current world, the ultimate holding company of an MNE is in principle mobile, which
means it may relocate its headquarters fairly easy.220 Based on the residence principle, MNEs would have
the incentive to relocate its headquarters to a jurisdiction with a more favorable tax treatment. 221 In
particular, MNEs make use of structures to take advantage of international tax standards and domestic tax
systems, which are no longer in line with the changing global economic environment.222 Also, the European
Commission recognizes that the tax planning structures have become ever-more sophisticated and are used
by MNEs to shift taxable profits towards states with beneficial tax regimes. A key characteristic of these
structures is that they may reduce tax liability through legal arrangements, but contradict the intent of the
law. 223
4.4.2 The basic structure
There are many ways of setting up sophisticated tax structures and holding companies are often very
different in form, which means one case may differ a lot from the other. The most basic tax structure
involving IP is the use of a newly created company, whose (sole) objective is to own intellectual property.224
IP which was developed by an operating company may be sold (or assigned) to this new IP holding
company. In order to authorize the operating company to use the IP-rights, a ‘license-back contract’ is
216 Devereux & Vella (2014) p.5. 217 Devereux & Vella (2014) p. 5. 218 Pankiv (2016) p. 470. 219 Brauner (2008) p. 107. 220 Picciotto (2015) p.755. 221 Auerbach et al. (2008) p.50. 222 Piantavigna (2017) p. 503. 223 European Commission (2012) Recommendation on Aggressive Tax Planning, C(2012) 8806 Final, p. 2. 224 Quiquerez (2016) p.6.
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entered into by the holding company and the operating company. This structure may actually have a genuine
business purpose, as long as the arm’s length principle is respected at the time of the transaction. For
instance, the function of this IP holding company may be to protect all of the group’s intangible assets and
as such MNEs may transfer their intangibles to a central entity.225 As a result of this IP-structure, the holding
company owns all the IP rights and will also receive future royalties that are derived from these IP rights.
In this way, IP may be fairly easy transferred to tax havens, which enables, for example, chemical,
pharmaceutical, and software companies to minimize their tax burdens.226 The consequence of this is that
these MNEs report significant profits in affiliated companies that actually contribute very little to the value
of the intangible.227 The figure below displays such a simple IP structure.
4.5 The Double Irish Dutch Sandwich IP structures, however are rarely as simple as the diagram above. Many intermediary or sub-holding
companies are often interposed within the structure. Generally, these additional levels of complexity may
be explained for tax purposes, instead of a genuine business economic ratio.228 Tax planning structures
adopted by many high-tech MNEs have been designed to avoid high taxation on royalties in countries where
R&D work is performed.229 A structure that is widely used by MNEs to reduce their tax liability is the so-
called Double Irish Dutch Sandwich. 230 Google has most effectively used this scheme among other
technology companies, but Apple, Facebook, Microsoft, and Oracle have all used or tried to use a version
of the Double Irish Dutch Sandwich.231 According to Drucker, this structure alone costs the US tax authority
225 OECD (201) Transfer Pricing Guidelines, at paragraph 9.2 of chapter IX; Radolovic (2012) p.30. 226 See for example: Baker (2005); Sheppard (2010). 227 Wright et al. (2016); OECD (2015) Actions 8-10, Final Reports. 228 Loomis (2012) p. 827. 229 Wang (2015) p. 269. 230 Drucker (2010) visited 8 April 2017: https://www.bloomberg.com/news/2010-10-21/google-2-4-rate-shows-how-
60-billion-u-s-revenue-lost-to-tax-loopholes.html/. 231 Loomis (2012) p. 828.
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approximately $60 billion in annual revenue.232 Below I explain the structure of the Double Iris Dutch
Sandwich, as I believe it might be fruitful in order to understand the flaws in the current international tax
system.
4.5.1 The complex structure
The Double Irish Dutch Sandwich structure usually starts with a Company (HoldCo A) located in a
jurisdiction (e.g. the US). In HoldCo A, significant R&D activities are conducted and successful intangibles
have been produced. Additionally, HoldCo A will set up two companies in Ireland. One of these Irish
companies (HoldCo B) is incorporated in Ireland but effectively managed in another low or a state which
levies no taxes at all (e.g. Bermuda). Due to a tax treaty signed between Ireland and Bermuda, the place of
residence of HolCo B may be assigned to Bermuda, which means corporate income taxes may be taxed in
Bermuda. However, Bermuda does not levy any corporate income taxes, so income is not taxed
anywhere.233 The second Irish company (operating company D) is incorporated and also managed in
Ireland, and therefore subject to corporation tax in Ireland. Ireland may be a good choice because of the
intangible-related tax incentives and a well-developed treaty network. 234 Finally, a Dutch Holding
company (HoldCo C) is incorporated in the Netherlands, most likely to avoid withholding taxes on
outbound royalties. The double Irish Dutch structure is depicted in the diagram below.235
232 Drucker (2010) visited 8 April 2017: https://www.bloomberg.com/news/2010-10-21/google-2-4-rate-shows-how-
60-billion-u-s-revenue-lost-to-tax-loopholes.html/. 233 Visited on April 8 2017: https://www.world.tax/comparisons/compare-tax-systems.php 234 Wang (2015) p. 272. 235 This diagram is based on the one provided in OECD, Addressing base erosion and profit shifting, February 2013,
p 74.
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4.5.2 Low tax payment on the initial IP transfer
Often we see that arrangements to transfer intellectual property are concluded at a stage when intangibles
developed by HoldCo A are not yet fully commercialized and profitable, which means that the price paid
by HoldCo B to HoldCo A for the intangibles, is most probably a relatively low arm’s length price.236
HoldCo B typically makes a buy-in payment and concludes a cost-sharing agreement on the future
modification and enhancement of the IP with HoldCo A.237 This arrangement may contain a provision that
HoldCo B does not have to pay any royalties to HoldCo A for exploiting new dew developed intangibles.
As determining an at arm’s length price for the buy-in payment is usually very difficult, due to the partially
developed IP, MNEs have considerable leeway in determining the price.238
4.5.3 Setting high royalty payments
HoldCo B became the owner of the IP after signing the agreement with Holding company A (the original
developer of the IP), which means that royalty payments will be no longer taxed in the US, but in Bermuda.
Holdco B, being the owner of the intellectual property, can now license the IP rights to HoldCo C, which
then sub-licenses the IP to Operating Company D. Operation Company D will pay an at arm’s length royalty
payment to HoldCo C, and HoldCo D will subsequently pay royalties to HoldCo B. Both Operating
company D and HoldCo C may deduct the royalty payments from their taxable base, which leaves just a
small amount of tax subject to Irish and Dutch corporate income taxation.
4.6 New Guidance Due to the transfer pricing issues related to IP-structures as described in the previous paragraphs, it has
become a key topic for the OECD to see which entity within an MNE is entitled to the intangible related
returns. Accordingly, the Base Erosion and Profit Shifting (BEPS) project was launched in July 2013 by
the OECD and combatting form of base erosion and profit shifting by using intangibles was one of the
original action points.239
As discussed, it is hard to predict the value at the time it is transferred to an associated company.240 Action
No. 8 of the BEPS-report provides a number of mechanisms that might be adopted to address the high level
of uncertainty of the price of an intangible at the time of a transaction.241 By introducing Action No. 8, the
OECD wants to take away the information asymmetry between tax authorities and taxpayers that exists due
236 Wang (2015) p. 270; Fedusiv (2016) p.484. 237 Fuest et al. (2013). 238 Fuest et al. (2013). 239 Cui (2016) p.2; OECD (2015) BEPS Final Reports, Action 1 – 15. 240 Fedusiv (2016) p.484. 241 OECD, Actions 8-10 Final Reports, at 108, 109.
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to intangible assets. By giving new tools to tackle the problem of information asymmetry, the OECD wants
to help tax authorities to determine the appropriate pricing arrangement for IP.242
Moreover, the OECD noticed that, generally, the legal owner of the intangible asset also receives the returns
from exploiting these intangibles, even though other group members carry out important functions that
drive the value of the intangible.243 The OECD wants to emphasize in this new guidance that merely having
ownership of intangibles does not determine entitlement for the returns from the exploitation of these
intangibles anymore.244 Instead, members of the MNE group should be remunerated based on the value
they create through the functions they perform, assets used and risks assumed related to the development,
enhancement, maintenance, protection and exploitation (known as DEMPE-functions).245 Even though
legal ownership and contractual arrangements are still respected by the OECD for transfer pricing purposes,
the OECD takes a substance over form approach. In other words, contractual arrangements are not
completely useless now, however, if contractual evidence is not in line with the actual conduct of the MNE,
the contract will be overruled by tax authorities.246
4.6.1 Information asymmetry
Due to the information asymmetry between a tax authority and a taxpayer, it can be difficult to evaluate the
reliability of the information given by the taxpayer regarding the pricing of an intangible.247 First of all,
taxpayers typically control all the information, which means taxpayers may control the flow of information
in order to ensure that tax authorities cannot properly analyze the intercompany transactions. 248
Furthermore, tax authorities may lack the specialized knowledge, expertise, and insight into the business
environment in which the intangible is developed or exploited.249 Therefore, tax authorities must heavily
rely on the information that is provided by taxpayers.250
In order to counter this information asymmetry, an approach has been developed in Action No. 8 which
requires the taxpayer to demonstrate that the price of an intangible is set on a thorough transfer pricing
analysis and leads to an arm’s length outcome.251 This means tax authorities may consider ex-post outcomes
as basis to measure how appropriate the ex-ante pricing arrangements within the MNE are.252 The taxpayer
242 OECD (2017) Public Discussion Draft on BEPS Action 8: Implementation Guidance on Hard-to-Value
Intangibles. 243 See OECD (2015) Actions 8-10 Final Reports, at paragraph 6.33. 244 See OECD (2015) Actions 8-10 Final Reports, at paragraph 6.35; Schreiber & Fell (2017) p.6 245 Petruzzi and Holzinger (2017) p.15. 246 Petruzzi and Holzinger (2017) p.16. 247 OECD (2015) Actions 8-10 Final Reports, page 64. 248 Wright et al. (2016) p. 104. 249 See OECD, Actions 8-10 Final Reports, at paragraph 6.186. 250 Fedusiv (2016) p. 484. 251 Pankiv (2016) p.470; OECD (2015) Actions 8-10 Final Reports, at paragraph 6.186 252 Actions 8-10 Final Reports, p. 64.
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should therefore take into account any foreseeable developments or events at the time the intangible is
transferred.253 In my opinion, this is strange. Ex-ante projections are always accompanied by uncertainty,
and forecasting may be very hard to do, especially with intangibles. Practice shows that businesses may
invest poorly in intangibles, but results may exceed every expectation. However, the reverse may be equally
true.254 As a consequence, in my opinion, it may simply be regarded as a good deal or a bad deal for
entrepreneurs.
Moreover, Action No. 8 requires the taxpayer to add price adjustment clauses in contracts with related
parties when prices of the intangible are highly uncertain at the time of the transaction. The OECD says
that in such cases, enterprises might adopt agreements that include price adjustments. 255 The OECD, for
example, suggests that a royalty rate could be set to increase as the sales of the licensee increase.256
Additionally, the OECD argues that a renegotiation might occur at arm’s length if a royalty rate based on
sales is vastly excessive. However, in practice, commercial contracts rarely contain price adjustment
clauses.257 In my opinion, it is very unlikely that an independent party, which benefited from a difference
between ex-ante projections and ex-post results would agree to renegotiate the price. Therefore, it may be
argued that this new approach of the OECD, actually departs from the arm’s length principle.
4.6.2 Cost approach
Regarding the valuation of intangibles, the OECD has chosen to remain faithful towards the separate entity
approach and the corrective arm’s length principle. The revised chapter of the Guidelines contains:
“An approach consistent with the arm’s length principle that tax administrations can adopt to ensure
that tax administrations can determine in which situations the pricing arrangements as set by the
taxpayers are at arm’s length.”258
From the wording, it may be concluded that the OECD is very reluctant to abandon the separate entity
approach in Actions No. 8.259 However, I believe it may be argued that the OECD goes beyond the arm’s
length principle and promotes the profit split method instead. In essence, the DEMPE-method is a more
formulary-like approach as it aggregates all profits derived from the intangible and distributes them among
the entities that have contributed to generating these profits. The profits are attributed to the entities that
carry out activities concerning the development, enhancement, maintenance, protection, and exploitation
253 Fedusiv (2016) p. 485. 254 Fedusiv (2016) p. 487. 255 OECD (2015) Actions 8-10 Final Reports, at p. 108. 256 OECD (2015) Actions 8-10 Final Reports, at paragraph 6.30. 257 Fedusiv (2016) p. 487. 258 OECD (2017) Public Discussion Draft on BEPS Action 8: Implementation Guidance on Hard-to-Value
Intangibles. 259 Picciotto (2015) p. 754.
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of the intangible.260 Robillard also argues that with regard to intangibles, the arm’s length principle is
“slowly but surely been relegated to the back seat”. 261
Moreover, the DEMPE-method established by the OECD, might be problematic from an arm’s length
perspective. The OECD requires the level and nature of a DEMPE-activity to be in line with the
consideration paid. Whether the consideration paid matches with the level and nature of the DEMPE-
activity, should depend on the functions performed, risks assumed and assets used for each of the DEMPE-
activities.262 Based on this formulation, I assume that the costs incurred for each of the DEMPE-activities
should be the basis of the remuneration received.263 I believe that this may cause problems as the isolation
of the part of the profit that belongs to an intangible asset may be hard to achieve. Moreover, the isolation
of the costs that relate to the development of certain IP may be difficult as well.
An illustration of these difficulties may be helpful in this context. Pharmaceutical or chemical companies,
for example, try to make innovative products, and the rights to develop or produce these products may be
considered to be intellectual property. However, before one product will be entering the consumer market,
often many products have failed to get to this final stage. Many costs that can be attributed to these failed
products can be regarded as sunk costs for the company, and therefore not directly attributable to a specific
IP. However, it seems that the OECD would also want to reward the ‘worthless IP’, based on the mere fact
that they were costly to develop, regardless of what the intangible asset is actually worth. In this context,
CMS, an international law firm responded to the proposal of this new Guidance and concluded the
following:
“…the arm’s length compensation of functions performed may be based solely on the costs incurred by
their performer without consideration of the value of the intangible at stake, whether anticipated or
existing. Therefore, such association may not be relevant depending on the situation examined. We thus
believe that this paragraph would benefit clarification.”264
Although it might be too soon to draw conclusions from the new guidance on intangibles in the BEPS
report, the prominent stand of scholars is that the initiative is superficial and it deals with the symptoms,
but not with the causes, or the foundations of the international tax system. 265 The BEPS report closes some
loopholes by creating a ‘substance’ requirement, but it does not re-examine the fundamental structure of
260 Escribano (2017) p. 254. 261 Robillard (2015) p.447. 262 OECD (2015) Actions 8-10 Final Reports, at paragraph 6.75. 263 OECD (2015) Actions 8-10 Final Reports, at paragraph 6.32. 264 CMS (2013) submission on the Revised Discussion Draft on Transfer Pricing Aspects of Intangibles. 265 Cui (2017) p.2.
37
the system.266 Moreover, the delineating the location of value creation is likely to still be distorted and tax
avoidance opportunities will remain.267 Therefore, even though the BEPS report promised to deliver an
innovative and ambitious approach, it is clear that OECD might have been not as forward-thinking as was
expected.268
4.6.3 Benchmarking the DEMPE-method
By comparing the DEMPE-approach to the benchmark established in Chapter 3, the following conclusions
can be made. First, regarding the economic reality, the DEMPE-method aims to allocate the profits to the
entities that contribute significantly to the value added. Taking this substance-over-form approach makes it
closer aligned with economic reality. Second, the administrative burden for taxpayers is likely to increase.
Especially due to the extensive functional analysis, an MNE would have to document all its DEMPE-
activities more thoroughly and keep good track of the costs incurred in the process.269 Third, I believe this
measure indeed creates a more fair allocation of taxing rights between countries, as the emphasis is placed
on the jurisdiction where the value is created. However, I have strong doubt on how the profits are to be
allocated to the cost bases of each DEMPE-activity. Four, I believe the effect on the robustness towards tax
avoidance is ambiguous. I suppose tax avoidance would occur less since it is harder to reallocate intellectual
property to another country. Therefore, in principle, it should combat the relocating of intellectual property
to tax havens, at least to some extent. However, relying so heavily on the location of where material risks
are assumed may create new profit shifting possibilities, as by ‘simply’ shifting risks, profits may be shifted
to low-tax jurisdictions.270
266 Devereux & Vella (2014). 267 Devereux & Vella (2014) p. 18: The authors believe that the regime will consist of a confused, complex mass of
arcane, arbitrary and sometimes illogical rules, competition will still drive rates down and reliefs up. 268 See for example: Escribano (2017) p. 251; Note: Actions 1, 3 and 15 are believed to be innovative standards;
Picciotto (2015) p. 758: The author says that the BEPS initiative has failed to establish a clear and cogent approach
to the central issue of how to allocate the income of MNEs according to their activities and the value added in each. 269 See Burnett and Pulliam (2008) p. 43 on the GlaxoSmithKline Case. 270 Devereux & Vella (2014) p.7.
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4.7 Summary Transfer prices regarding intangibles have become a major point of concern in international context.271 The
arm’s length principle appears to be very difficult to apply to controlled transactions involving intellectual
property as such property may have a unique character and as such no comparable may exist. It is a fact
that many MNEs have set up abusive structures involving the transfers of intangibles to take advantage of
international tax standards and domestic tax systems.272 As a response, the OECD proposed new guidance
in which it says that MNE group members should be remunerated based on the DEMPE-functions they
perform. Even though the OECD seems to be reluctant to abandon the separate entity approach in the new
guidance, scholars argue that the OECD departs from the arm’s length principle.273 Even though the
DEMPE-method is probably closer aligned with economic reality, the additional administrative burden is
only expected to increase for MNEs. Therefore, even though the BEPS report promised to deliver an
innovative and ambitious approach, it soon became clear that new guidance is somewhat superficial.
Therefore, it seems that the new guidance is inadequate and as a result, the OECD might have to consider
alternative options to the arm’s length principle. In the next chapter, alternative approaches to the arm’s
length principle will be discussed, and they will also be tested against the benchmark.
271 Fedusiv (2016) p.483. 272 Piantavigna (2017) p. 503. 273 See for example: Robillard (2015) p.447; Schoueri (2015) p. 714;
39
5. Alternative approaches
5.1. Introduction As discussed in the previous chapter, intangibles are often firm-specific assets and are not regularly traded.
As a consequence, these intangibles do not fit in the market framework as these specific intangibles are
often hard to value due to the lack of comparability and they are hard to locate due to the level of integration
of MNEs.274 In the new transfer pricing guidance, the OECD still believes the arm’s length principle to be
the best method to counter tax avoidance. However, the Guidelines have proven to be exceedingly complex,
and the BEPS-report of the OECD seems to be not very forward-thinking. 275 Given the practical
complications, some economists suggest that the arm’s length principle should be eliminated for the pricing
of intangibles and are instead in favor of alternative approaches.276 I believe there are two options to choose
from, a destination-based cash flow tax and the formulary apportionment. Unfortunately, the OECD does
not consider a destination-based cash flow method as tax base in the Guidelines. 277 And the formulary
apportionment was mentioned as an alternative to the arm’s length principle but was given a very short
shrift by the OECD.278
I will address the alternative approaches in the next paragraphs to see whether these approaches may
improve or substitute the arm’s length principle. Notably, I will not go into the technical details on how
either of the systems works. The goal is merely to see how suitable these alternatives are for transfer pricing
regulation. To this end, I will again use the benchmark as developed in Chapter 3.
5.2. Destination-based cash flow tax Almost all existing economic theories on the international taxation of companies are based on a model with
only a residence country and a source country.279 However, in the context of increased international capital
mobility, we have seen that based on the residence principle, MNEs would have the incentive to relocate
their headquarters to a jurisdiction with a lower tax rate.280 Moreover, a source-based tax may divert
economic activity to locations where the activities would also face a lower tax rate. Therefore, there is an
incentive to shift profits and investments to low tax countries under the residence and source principle.281
Additionally, because of the globalized world and ever-more integrated MNEs, it is becoming difficult to
locate where the value is added to a product, as is required by the DEMPE-method.282 Therefore, it is
274 Schreiber and Fell (2015) p. 2. 275 See for example: Escribano (2017) p. 251; Note: Actions 1, 3 and 15 are believed to be innovative standards. 276 See for example: Devereux & Vella (2014); Avi-Yonah & Benshalom (2011); Picciotto (2016). 277 Schreiber & Fell (2017) p. 2. 278 Devereux & Vella (2017) p.13. 279 Bond and Devereux (2002) p.5. 280 Auerbach et al. (2008) p.50. 281 Picciotto (2015) p.755. 282 See OECD, Actions 8-10 Final Reports, at paragraph 6.35; Schreiber & Fell (2017) p.6.
40
believed that the concepts of residence and source are being applied to transfer pricing, even though it was
not originally designed for this purpose.283
Based on the eroded foundations, scholars believe a destination-based method might be a better tool for the
job. The destination-based tax is a proposal initially designed to simplify the US corporate tax system and
to eliminate tax avoidance.284 Over the last years, economists have been analyzing this method more
thoroughly, which suggests that a destination-based method may indeed be a promising alternative.285 This
tax system seems to have a number of advantages over the current source-based system, but it should be
noted that research in this system is still work-in-progress.286
Applying this destination-based system would entail giving relief for all exported trade, and it would tax
the imported trade. This means that corporate tax revenues would be higher if a jurisdiction has a trade
deficit, and revenues would be lower if there is a trade surplus.287 In other words, a firm which is specialized
in exporting products would have a negative tax base in his domestic country, because its revenues would
be exempt from taxation. However, the revenues would be fully taxed by the country of destination.288 This
tax would thus divide the worldwide profit of an MNE on the basis of where it makes sales to third parties,
rather than in what countries the output is produced. Therefore, this tax would be more similar to a VAT-
like tax instead of the current corporate income tax system.289
It is believed that this approach would reduce profit shifting to low-tax countries.290 Sales are far less
responsive to tax differentials compared to investments. 291 The reason is that customers are in fact far less
mobile than firms. Therefore, even in high-tax countries firms would have an incentive to sell as many
products as possible.292 Also Bond and Devereux believe that this destination-based cash flow tax would
avoid the possibility of MNEs shifting profits at will. In such a system it would be impossible to allocate
the residual profits to the parent company, holding the IP.293 Since there would be no tax consequences of
an IP transfer under this method, the incentive to relocate intangibles in a low tax country would be
283 Devereux & Vella (2014) p.5. 284 Becker & Englisch (2017) 285 Avi-Yonah (2000) and Bradford (2000) – have raised the possibility of such a tax. But neither of these
contributions offer a rigorous economic analysis of such a tax; Auerbach et al. (2008); Schreiber (2013); De Wilde
(2015); Auerbach et al. (2017) give a more extensive economic analysis of a destination-based tax. Becker &
Englisch (2017) give a more skeptic European view on this system. 286 Becker & Englisch (2017). 287 Auerbach et al. (2008) p.55. 288 Bekcer & Englisch (2017). 289 Auerbach et al (2017). 290 Fleming et al. (2014) p.40. 291 De Wilde (2015) p. 443. 292 Avi-Yonah & Reuven (2009) p.509. 293 Bond and Devereux (2002) p.5.
41
absent.294 Therefore, I believe that this destination-based method can be very helpful regarding the taxation
of intangibles, as a major part of profits nowadays arise from intangibles which cannot objectively be
valued. 295
Another advantage of this approach is the fact it perceives the MNE group from a unitary perspective, i.e.
internal transfers within a corporate group would be ignored. Designating the group as a single taxable
entity is likely to increase neutrality.296 A unitary approach means that the goods transferred to affiliated
companies would not have to be calculated at arm’s length anymore. 297 Therefore, the burdensome
comparability analysis which the arm’s length principle requires, becomes redundant in my opinion. It
would result in a much simpler system in a very complex world where profits from big MNEs arise from
many sources and are allocated to places where no taxation may exist. The current system needs to be
continuously updated in order to combat new transfer pricing strategies of MNEs. This costly process is
believed to be eliminated when a destination-based tax system is implemented.298
5.2.1 Criticism
However, this sales-based, unitary approach is not in line with the OECD’s beliefs on equality between
nations. Jurisdictions where intangibles are developed and used in production processes, will not necessarily
be compensated for these costs.299 Therefore, this approach is quite contradictory to the recently developed
DEMPE-method. Once again, group members that carry out important functions that drive the value of an
intangible, would not be relevant under this approach.300 Naturally, the EU is willing to challenge this
destination-based method.301
Another disadvantage of this system is to find out where the final consumer is located when the sales take
place. The challenge of levying a tax in the place of sale instead of source can be a difficult problem to
tackle for digital products or services, as can be learned from the VAT-literature.302 However, the major
disadvantage of a destination-based system, in my opinion, is its distributary function regarding tax
revenues for countries with, especially smaller consumer markets. The costs of producing goods could arise
in another jurisdiction compared to where those goods are sold.303 The issue would be that a high proportion
294 Auerbach et al. (2017) p. 30; Schreiber (2013) p. 310. 295 Bond and Devereux (2002) p.5. 296 De Wilde (2015) p. 372. 297 Picciotto (2016) p. 756. 298 Auerbach et al. (2017) p. 31. 299 Schreiber & Fell (2017) p. 2: Schreiber and Fell argue that sales-based profit taxation is incompatible with the
OECD’s approach, because jurisdictions where MNEs develop intangibles and use intangibles in the production
process suffer from losses in tax revenue, if only sales jurisdictions tax intangible-related profits. 300 See OECD, Actions 8-10 Final Reports, at paragraph 6.33. 301 Devereux & Auerbach (2017). 302 Auerbach et al. (2017) p. 31. 303 Schreiber and Fell (2015) p. 2:
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of exports consists of sales of semi-finished goods and are therefore not sold to final consumers. 304
Therefore even though businesses may benefit from the expenditures of a state, a business might not
contribute to the revenues of the state where it is located.
5.2.2 Benchmarking
When applying the benchmark on the destination-based cash flow system, I conclude the following. First
and foremost, I believe this tax system represents the economic reality very well. Since MNEs are ever-
more integrated it is difficult to define the exact locations of value creation, therefore the best way to tax
may be the location of the final consumer. A minor drawback is the fact that locations of consumers cannot
always be defined. Secondly, I believe the effect on compliance costs to be ambiguous. For MNEs this
system would probably be much simpler to comply with compared to the current system. For one, a
comparability analysis that is required under the arm’s length principle would be unnecessary, as this
system would take a unitary approach. However, enforcement cost may turn out very high, especially in
the first years of implementation, as replacing the conventional corporate tax system would be a major
challenge.305 In the future, however, a destination-based system might eliminate the need for some of the
most complex transfer pricing rules, which should lower both the compliance costs for MNEs and the
enforcement costs for tax authorities.306
Thirdly, the distributional effects of this system seem to be hard to predict. De Wilde believes this would
depend on the behavioral effects that seem impossible to assess at this time. But as tax havens usually have
small consumer markets, they would probably experience a reduction in tax revenue, where other countries
are likely to gain.307 The benefit principle might be endangered by this method, because a business may
benefit from the expenditures of a jurisdiction, without contributing to it. 308 Moreover, the OECD is
unlikely to accept the fact it contradicts the recently developed DEMPE-method. Four, I believe the
approach is very resilient to tax avoidance. The relocating of intangible property in low-tax jurisdictions
and mispricing inter-company transactions cannot be successful under this system.309 Moreover, this system
may also be resistant to tax competition in tax rates, as an MNE would want to increases its sales in any
jurisdiction, and a consumer is believed to be less mobile than businesses.310 Five, this method might raise
significant implementation issues, as its application differs substantially from the current corporate tax
304 Picciotto (2016) p. 756. 305 Auerbach et al. (2017) p.6. 306 Auerbach et al. (2017) p.31. 307 De Wilde (2015) p.444. 308 Picciotto (2016) p. 756. 309 De Wilde (2015) p. 443 believes that full coordination would adequately put an end to double non-taxation that
arises under the current regime. 310 Avi-Yonah & Reuven (2009).
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system.311 Unilateral implementation might not be a good option as it would probably distort investment
decisions of companies in the jurisdiction that implements this system.312 Moreover, the co-existence of
both a destination based and a source based system would give rise to various double taxation, or double
non-taxation problems, as they are so asymmetrical.313
5.3. Formulary of apportionment The second alternative to the arm’s length principle is the formulary apportionment. Critics of the arm’s
length principle argue that the formulary apportionment would be a better method to counter aggressive
transfer pricing policies.314 Formulary apportionment is currently being practiced by US states to determine
state corporate tax liabilities and has been promoted as an alternative to the arm’s length principle by the
European Commission as part of the project for a common consolidated corporate tax base (often referred
to as the CCCTB).315 The formulary of apportionment is designed to allocate the global profits of an MNE
group among the associated enterprises based on a predetermined formula.316 This approach deals with the
difficulty of determining the source of income and allocates the income to countries using proxies for value
adding activities.317 The CCCTB believes this three-factor formula should be equally comprised of labor,
assets, and sales.318
The results produced under this formula and the arm’s length principle may differ greatly from one another
because the basis of sharing the profits within an MNE differ greatly between these two methods. For
example, the formulary of apportionment hardly takes into account intangibles, whilst the arm’s length
principle puts great emphasis on intangibles.319 This emphasis on intangibles seems to be redundant under
a formulary approach, as it would take away the tools that MNEs use to shift intangible resources to low
tax jurisdictions.320 Moreover, like the destination-based cash flow method, the formulary approach is a
unitary approach, and therefore the MNE is recognized as a single economic entity instead of separate
entities. Therefore, while the arm’s length principle tries to establish the market profit of a single entity, the
311 Auerbach et al. (2017) p. 6. 312 Auerbach et al. (2017) p. 39. 313 Becker & Englisch (2017) 314 See for example: Devereux & Fella (2014) p. 11; Fleming et al. (2014). 315 Proposal for a Council Directive on a Common Corporate Consolidated Tax Base (2016). 316 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.17. 317 Auerbach et al. (2008) p.42. 318 CCCTB (2011) p.13: The formula for apportioning the consolidated tax base should comprise three equally
weighted factors (labour, assets, and sales). The labour factor should be computed on the basis of payroll and the
number of employees (each item counting for half). The asset factor should consist of all fixed tangible assets.
Intangibles and financial assets should be excluded from the formula due to their mobile nature and the risks of
circumventing the system. 319 OECD (2015) Action 8-10, Final Reports. 320 De Wilde (2015) p. 372.
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formulary apportionment does no such thing, but instead looks at the MNE as a whole.321 Formulary-like
transfer pricing alternatives, in fact eliminate the relevance of a comparability analysis, which is the core
of an arm’s length principle. Therefore, the arm’s length principle and the formulary apportionment, are in
sharp contrast with one another.322 Logically, the OECD does not consider this method to be a realistic
alternative.323
The formulary apportionment would provide greater administrative convenience and certainty for taxpayers
as a consequence of increased harmonization.324 If a group of jurisdictions would adopt a formulary system,
the calculation of the income for the source jurisdiction would be much simpler, since the location of profits
would not be determined by difficult accounting and financial arrangements, but would be based on a
predetermined formula.325
Auerbach et al. also propose this system of formulary apportionment as it would be both better suited to an
integrated world economy and would result in a more efficient, equal and simple tax system.326 The focus
of this a formulary approach lies on the allocation of taxing rights between jurisdictions, and discards the
feasibility issues that the arm’s length principle contains. 327 The formulary apportionment would enable
the weaknesses of the arm’s length principle to be eliminated, without creating new weaknesses in
international taxation. 328 A major advantage of the formulary apportionment is that it would not only
replace the complex transfer pricing rules, but would also dispense of elaborate anti-avoidance rules.329
5.3.1. Criticism
I agree with Graetz that we naturally give the preference to our own citizens in setting an international tax
policy. This has always been the case, and will be, as long as there is no global government.330 Therefore
there will be massive opposition in reaching consensus since each country is likely to promote a formula
that is in the best interest of their citizens. And instead of achieving coordination, governments might
compete with the factors of the formula. As a consequence, it is often argued that it would be impossible to
achieve real political agreement on the formulary apportionment. 331 Without a unanimous political
321 Schoeuri (2015) p. 702. 322 Avi-yonah (2008) 323 Devereux & Vella (2017) p.13. 324 See Proposal for a Council Directive on a Common Corporate Consolidated Tax Base (2016) 325 Auerbach et al. (2008) p.42. 326 Auerbach et al. (2008) p.42. 327 Schoueri (2015) p. 702. 328 Robbillard (2015) p. 474. 329 Picciotto (2016) p. 757. 330 Graetz (2001) p.278; This is even reflected in the bible, See: Matthew 17:25-26 (New International). From whom
do the kings of the earth collect duty and taxes-from their own sons or from others?" "From others," Peter answered. 331 See for example: Roin (2008) p.222-229; Wilkins & Gideon (2012) p. 1355.
45
agreement, the level of double taxation would be unacceptable, as rules would not be in harmonization.332
Even if a uniform tax base were possible, governments may actually still have the incentive to engage in
tax competition via adjusting tax rates.333
I agree with the OECD which says that the major disadvantage of the formulary apportionment is the
difficulty in implementing the system in such a way so it avoids double taxation and double non-taxation.334
Moreover, under formulary apportionment some scholars say there would be an incentive for MNEs to shift
income by changing economic decisions. These formulary-like approaches might exclude important and
essential reference points, which are needed to counter double taxation.335 When a formulary approach was
to be implemented, high-tax jurisdictions are likely to see their tax revenues erode, and capital investments
and employment are likely to decrease in these jurisdictions.336 Logically, the OECD member countries are
afraid to lose tax revenue.
However, I believe that formulary-like transfer pricing alternative may actually have a place in transfer
pricing regarding today’s developed world.337 And despite the challenges mentioned by the OECD in the
Guidelines, some scholars believe that the practical problems of imposing a worldwide taxation are indeed
solvable.338 Even if the practical implications would indeed be too large to overcome, a ‘partial’ formulary
approach especially focused on transactions concerning intangibles, might work. 339 Based on these
arguments, it would be very a bold move of the OECD to move towards this method, much bolder indeed
than the introduction of the DEMPE-method.
5.3.2. Benchmarking
When applying the benchmark as established in Chapter 3, I conclude the following. First, regarding the
economic reality, I believe the formulary approach very suitable. The separation and valuation of
intangibles, pose an enormous threat to the arm’s length principle, but not for the formulary approach, as it
looks at the company as a whole. Secondly, the compliance burden of the taxpayer is expected to decrease
significantly, as the calculation of profits would not be determined by an accounting and financial
arrangements, but based on a predetermined formula.340 Moreover, this approach would not only replace
the complex transfer pricing regulation of today but would get rid of the extensive and imperfect anti-tax
332 Avi-Yonah (2007) p.26. 333 Auerbach et al. (2008) p. 43. 334 OECD (2010) Transfer Pricing Guidelines, at paragraph 1.22. 335 Robillard (2015) p.453. 336 Martini et al. (2012) p. 1061. 337 Robillard (2015) p. 453. 338 See for example Fleming et al. (2014) p. 29; Avi-Yonah (2007). 339 Schreiber and Fell (2015) p. 15. 340 Auerbach et al. (2008) p.42.
46
avoidance regulation. 341 As is also the case with this alternative, there would be no need for burdensome
economic studies that try to estimate an arm’s length prince in the absence of any meaningful
benchmarks.342
Three, regarding the distribution of tax burdens, I believe the formulary approach to be ambiguous. High-
tax jurisdictions might lose some tax revenues, capital investments, and employment, but that does not
necessarily make the distribution of tax revenues unfair.343 The distributive power heavily depends on the
weight assigned to each of the factors that comprise the formula. It is therefore impossible to predict the
distributional consequences of this method at this time. Four, I believe the approach to be very robust
against tax-avoidance. The current international tax system is believed to provide tax incentives, and it
rewards aggressive tax planning.344 A formulary approach will not provide this artificial incentive, and
therefore I believe it to be much more resilient to aggressive tax planning. Moreover, this approach would
take away the tools that MNEs use to shift intangible resources to low tax jurisdictions.345 However, a
government may still have the incentive of commencing tax competition by adjusting their tax rates. Finally,
as is also the case with this alternative, the major drawback of this system is its implementation. As long as
there is no global government, every country prefers to treat its own citizens better than foreign citizens. 346
Therefore, a political agreement might be very hard to reach globally, some even argue it to be impossible.
However, others believe that even this enormous hurdle can be overcome.347
341 Picciotto (2016) p. 757. 342 Avi-Yonah & Reuven (2009) p. 511. 343 Martini et al. (2012) p. 1061. 344 Avi-Yonah et al. (2009) 345 De Wilde (2015) p. 372. 346 Graetz (2001) p.278. 347 Fleming et al. (2014) p. 29.
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6. Conclusion and recommendations In this thesis, I have researched the shortcomings of the arm’s length principle regarding the valuation of
intangibles and investigated whether alternatives are available which would be more suitable to serve as a
foundation of transfer pricing regulation.
In order to fight tax avoidance by transfer pricing, the arm’s length principle has been chosen to be the
international standard and still lies at the basis of transfer pricing legislation. This principle might have
been appropriate in the 1920’s when being developed in a low-tech, bricks-and-mortar economy. However,
the evidence laid out in this thesis leads to the conclusion that globalization and technological progress have
eroded the fundaments of the arm’s length principle. Based hereon, I have argued that a re-examination of
the fundaments of transfer pricing regulation is necessary.
I have developed a benchmark in order to test the adequacy of the arm’s principle based on the requirements
of the 21st century. Based on this benchmark, I conclude that the arm’s length principle has lost sight of the
economic reality, especially due to the enhanced integration of MNEs it has become an impossible
challenge to locate where the value is added. Moreover, a market-based comparability approach that is
required by the arm’s length principle seems to be inapplicable on intangibles. Additionally, the
administrative burden has increased to a point where the principle has become unfeasible in respect of
compliance and enforcement burdens. Finally, the arm’s length principle has not proven to be resilient
towards tax-avoidance, which was one of the original motives to enact transfer pricing regulation.
In order to fix the issues of the arm’s length principle, the OECD came up with new Guidance and claimed
it to be a very ambitious approach. However, even though the BEPS report closes some loopholes by
focusing more on substance-over-form requirements, it does not re-examine the fundaments of the transfer
pricing system. Moreover, the location of real economic activity will still be distorted and tax avoidance
opportunities would remain. Therefore, in my opinion, the BEPS report is superficial and deals with some
symptoms, but does not focus on a fundamental reform.
Despite the facts and circumstances of today, the OECD does not consider any other approach than the
arm’s length principle to be adequate for transfer pricing purposes. Even though alternative approaches
might make sense from a theoretical perspective, the real issue seems to be their practical implementation.
It may be argued that every country would promote a formula in their own best interest However, I believe
there to be sufficient proof to conclude that the old system has become too complex, imprecise and it cannot
be molded into the right shape anymore.
48
Therefore, I believe that the next logical step is to consider the new and more ambitious approaches or at
least aspects thereof. Globalization, integration of MNEs and the emergence of intangibles haven’t made it
any easier to identify what the exact source of income is. In my opinion, both the destination-based cash
flow tax as well as the formulary apportionment would be much better aligned with the economic reality.
Therefore I would like the OECD countries to open up for a debate to reform the corporate tax system,
despite the fact a political agreement on these methods might look impossible today. The OECD should
accept that the concepts of residence and source have lost their relevance in this globalized world where
MNEs are more integrated than ever.
Based on this, I recommend considering implementing a more unitary approach where the distribution of
taxing rights is - at least partly - based on sales. I believe it to be somewhat pointless to search for the exact
source of income, as it has proven to be burdensome and imperfect. I believe it would be much more fruitful
to assign taxing rights to the geographical location of an MNE’s customers instead. Sales are far less
responsive to tax incentives compared to investments. Moreover, I argued that intangibles form a major
part of today’s tax avoidance strategies. These tax avoidance strategies would be mitigated if profits were
to be allocated based on destination.
Moreover, I recommend a unitary approach over the separate entity approach. The level of integration and
globalization have made it impossible to divide an MNE into different entities. A unitary approach would
be much simpler to comply with and it would also be more resistant towards tax avoidance practices.
Moreover, the burdensome comparability analysis would be redundant. Elimination of these burdensome
transfer pricing rules should lower both the compliance costs for MNEs and the high enforcement costs for
tax authorities significantly.
Future research has to prove whether or not the proposed alternative methods are feasible from an economic
point of view. As of this moment, I believe the research on the alternative approaches to be more of a
conceptual nature. Additionally, it would be very useful to statistically substantiate the benchmark I created
in this thesis in order to be able to give ‘scores’ on the aspects of the various transfer pricing approaches.
Finally, I believe that the economic effects of the OECD regulation should be closely monitored in the near
future in order to calculate the effectiveness of the new guidance on fixing the arm’s length principle
regarding intangibles. In any case, I believe the OECD should be more open towards new transfer pricing
approaches.
To end this thesis on a positive note, I believe that harmonization is something countries should strive for,
regardless of the complications. Moreover, I believe every hurdle can be overcome.
49
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