Efficiency of the tax system provides for preconditions to all other tax principles.156 The core requirement of the efficiency of taxation is that compliance costs for businesses and administrative costs for tax authorities that arise from effectively collecting the tax should be minimised.157 The effectiveness of a tax system increases in parallel with fiscal yield, if direct costs and negative externalities, i.e., distortions in economic behaviour, remain low in comparison.158
As has been discussed above, complex tax rules affect tax certainty, but they strongly relate to the efficiency of a tax system, too. Increased complexity renders the operational framework difficult to understand, which results in additional costs of compliance for businesses; these costs may entail consuming both financial and social resources. Often increased complexity also results in larger administrative burden for tax authorities,
155 This is evidenced by the fact that the notion of aligning taxation with value creation is a core component of BEPS, which in turn is a landmark project on tax cooperation, if measured by the extent of international approval across states. See, Hey, supra n. 127.
156 R. Knuutinen, Verosuunnittelun oikeudelliset ja yhteiskunnalliset rajat (Alma Talent 2020) at 298;
Mirrlees et al., supra n. 109, at 23.
157 OECD, Final Report, supra n. 3, at 20.
158 Mirrlees et al., supra n. 109, at 3.
34 although administrative and compliance costs and be balanced against each other to some extent – for the benefit of one and detriment of the other.159
Neutrality of the tax system minimises distortions in economic behaviour and deadweight costs to welfare that would otherwise occur.160 When tax is neutral, it treats similar activities in a similar manner.161 With reference to international taxation, the elimination of double taxation is likely to be the single most important principle, as double taxation causes significant distortions in economic behaviour by increasing the cost of global business compared to operating domestically, and causing havoc to neutrality.162 Neutrality affects both fairness and efficiency positively, and as such, compromises on neutrality can have wide ranging effects on the functioning of a tax system.163
With reference to the substance based carve-outs of Pillar One and the aim to tax residual profits of highly profitable businesses engaging in ADS or CFB, it must be noted here, that when taxation is simply directed to what is easily taxed, the outcome is inevitably short of neutral.164
***
The set of principles that has been discussed above, albeit arguably separate and self-standing, epitome relatively similar approach to taxation and, at the minimum, are not prima facie contradictory – even if they cannot all be concurrently exercised to their fullest. But international tax law contains other principles too; ones which are highly relevant under the current rules. Separate entity approach is enforced through the arm’s length principle. Yet, Pillar One sets forth a proposal for consolidated taxation based on group revenue. Both of these approaches might fit in well with the above principles; but they also seem to contradict each other blatantly. The following chapters analyse the content of both the ALP and the Formula. Final discussion in chapter five then evaluates how these compare to each other and within the framework of principles identified here in chapter three.
159 E.g., Scherleitner, supra n. 122, at 138 and references therein.
160 Mirrlees et al., supra n. 109, 28 et seq.
161 Ibid.
162 Helminen, supra n. 109, at 73.
163 Mirrlees et al., supra n. 109, at 48.
164 Ibid, at 48.
35
4 Arm’s Length Principle
4.1 DefinitionOrigins of the arm’s length principle date back to the interwar period of substantial fiscal needs, specifically to 1930’s when the principle was first adopted by the League of Nations.165 Mitchell B. Carroll, at the time a Treasury official of the United States,166 was tasked by the League of Nations to examine the national legislations of total 27 countries, to discover the optimal way to allocate MNEs’ income among relevant operating countries while preventing double taxation. As a result of Carroll’s inquiry, the arm’s length principle was introduced as means to enforce separate entity accounting in the taxation of multinationals.167
In 1935, the United States, as the first state to do so, enacted legislation for the assessment of transfer prices and introduced the arm’s length standard as a primary mechanism to enforce separate accounting method in cross-border taxation.168 Decades later, in 1963, OECD introduced the provision in Article 9 of its Model Tax Convention which confirmed the status of ALP and the right of states to make transfer pricing adjustment on the profits of associated enterprises, should they not comply with the principle.169
Today, as a broadly endorsed international standard,170 the arm’s length principle is stated in Article 9(1) of the OECD Model Tax Convention, and it reads as follows: … where conditions are made or imposed between [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of
165 Arm’s length principle emerged almost 20 years after the adoption of first transfer pricing rules, which happened for the first time in 1915 in the United Kingdom. See, UK: Section 31(3) of the Finance (No. 2) Act of 1915. In comparison, the United States approved legislation on transfer pricing in 1917, US: 1917 War Revenue Act, Regulation 41, Articles 77-78.
166 H. Hamaekers, ‘Arm’s Length – How Long?’ (2001) International Transfer Pricing Journal, 31.
167 League of Nations: Fiscal Committee, Report to the Council on the Fourth Session of the Committee, 26 June 1933, Geneva.
168 US: 1935 Treasury Regulations, Sec. 45-1(b); M. B. Carroll (ed), Taxation of Foreign and National Enterprises (League of Nations 1933).
169 H. Hamaekers, supra n. 166, at 31.
170 EY, Worldwide Transfer Pricing Reference Guide 2019-20, available under
https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/tax/guides/ey-worldwide-transfer-pricing-guide-10-september-2020.pdf?download.
36 the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.171
In the realm of tax treaty law, the interpretation of ALP is guided by the purpose of the Article itself, OECD’s Transfer Pricing Guidelines (hereinafter ‘Guidelines’)172 and guidance on the attribution of profits to permanent establishments,173 as well as the general objective of the Model Tax Convention, as set forth in the Vienna Convention on the Law of Treaties.174 However, double tax conventions do not have the authority to impose more invasive rules on taxation than is provided in the applicable national laws; tax treaties can only limit a state’s right to tax certain income. In Finland, the Arm’s Length Principle is stated in the 31§ of the The Finnish Tax Assessment Procedure Act (1558/1995, as amended), and guidance on its interpretation is provided by the Finnish Tax Authority.175 Description of the internationally agreed practises in determining transfer prices for tax purposes has been compiled by the OECD in the guidelines on transfer pricing of multinational enterprises. The first Transfer Pricing Guidelines were issued in 1995, replacing the 1979 Report on Transfer Pricing and Multinational Enterprises.176 The Guidelines have been revised and modified throughout the years, with the latest update welcoming fundamental changes through implementing new rules on transfer pricing agreed upon the BEPS project. Most often, the Guidelines are not legally binding in nature, although in some countries the Guidelines have been directly adopted into of the national legislation.177 Despite lacking official authority as a binding source of law, the Guidelines reflect the common will of member states on the matter and, in practise, are generally considered as the most important source of interpretation concerning the ALP.178
The idea of associated enterprises operating in internal transactions in a similar manner as independent companies would, under comparable circumstances, is relatively easy to
171 OECD, Model Tax Convention 2017, supra n. 6.
172 OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (OECD Publishing, Paris 2017) http://dx.doi.org/10.1787/tpg-2017-en.
173 OECD, Report on the Attribution of Profits to Permanent Establishments (OECD Publishing 2010).
174 The Vienna Convention on Law of Treaties, 22 May 1969, Article 31.
175 Finnish Tax Authority, Siirtohinnoittelun dokumentointi – syventävät vero-ohjeet, d:no A68/200/2018.
176 OECD, Transfer Pricing and Multinational Enterprises, Report of the OECD Committee on Fiscal Affairs, 1 June 1979, OECD, Paris. https://doi.org/10.1787/9789264167773-en
177 M. Raunio and J. Karjalainen, Siirtohinnoittelu (Alma 2018) 38.
178 In Finland, OECD Guidelines have been consistently regarded as an important source of interpretation in transfer pricing matters. See rulings of the Supreme Administrative Court of Finland: KHO 2013:36, KHO 2014:119, KHO 2017:146, KHO 2018:173 and KHO 2020:34.
37 comprehend. Yet, conforming to its requirements in practise may often prove difficult, even with extensive guidance provided on behalf of the OECD and national tax authorities.
Compliance with the arm’s length principle is demonstrated by applying the most appropriate transfer pricing method to relevant transactions. Transfer pricing methods that are incorporated in the current version of the Guidelines are briefly discussed in the following.
4.2 Application of the Arm’s Length Principle
The hierarchy of transfer pricing methods was omitted upon the 2010 update of the Guidelines. Previously, traditional transfer pricing methods were preferred to transactional methods and, more specifically, the method relying on comparable uncontrolled price was to be used whenever possible. Today, it is recognised that none of the methods are applicable in every case, and both taxpayers and tax administrations alike should use the most appropriate method that can be reliably applied to the transactions at hand.179 The use of any specific transfer pricing method is second to actually operating at arm’s length.180
4.2.1 Traditional transfer pricing methods
Comparable uncontrolled price method (CUP)
CUP method makes use of uncontrolled transactions as means to establish an arm’s length price for internal transactions of goods or services. If CUP method is available, meaning comparable transactions can be found, it can be applied with a high degree of reliability.
CUP compares the price used in uncontrolled transactions to those undertaken within an MNE. However, in order to apply CUP method reliably, the products or services under comparison, or the transactions as a whole, can have no material differences.181 The level of similarity required for CUP method is higher than in any other transfer pricing method. To qualify as a comparable uncontrolled transaction for the purposes of CUP method, one of the following requirements must be satisfied: i.) none of the differences (if any) between the
179 OECD, Guidelines 2017, supra n. 172, para 2.2; Supreme Administrative Court of Finland ruling KHO 2018:173, where the Court repealed Finnish Tax Authority’s decision. According to the Court, the Tax Authority had erred in applying transactional profit split method over resale price method, which was selected as the most appropriate method by the taxpayer. Applying inappropriate method would have effectively ignored the operative business model and value chain of the group as a whole.
180 Of course, this does not mean that taxpayers are not expected to use the chosen (most appropriate) method consistently. Change of transfer pricing method should be acknowledged and sufficiently justified in transfer pricing documentation, as necessary per applicable regulations.
181 OECD, Guidelines 2017, supra n. 172, para 2.16.
38 transactions being compared or between the enterprises undertaking those transactions could materially affect the price in the open market; or, ii.) reasonably accurate adjustments can be made to eliminate the material effects of such differences.182
Resale price method (RPM)
Resale price method, along with the cost plus method and the transactional net margin method, is a one-sided transfer pricing method. This means, that the evaluation of comparability takes into focus only one of the parties to a transaction. Reliable application of the RPM necessitates that the entity that acts as a retailer, does not add any significant value to products before they are sold to an external buyer.183 To qualify as a comparable uncontrolled transaction for the purposes of RPM, one of the following requirements must be satisfied: i.) none of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the resale price margin in the open market; or, ii.) reasonably accurate adjustments can be made to eliminate the material effects of such differences.184 The RPM bases comparability on gross margin and the arm’s length compensation, resale price margin, is determined as a percentage of sales.185
Cost plus method (CPM)
Cost plus method is commonly used in transactions that involve semi-finished goods or services.186 The CPM uses gross margin as the denominator to an arm’s length compensation, profit mark-up, which is determined as a percentage of costs to a transaction.187 To qualify as a comparable uncontrolled transaction for the purposes of CPM method, one of the following requirements must be satisfied: i.) none of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions materially affect the cost plus mark up in the open market; or, ii.) reasonably accurate adjustments can be made to eliminate the material effects of such differences.188
182 Ibid, paras 2.14-2.15.
183 Engblom et al. supra n. 2, 668.
184 OECD, Guidelines 2017, supra n. 172, para 2.29.
185 Raunio and Karjalainen, supra n. 177, 116-117.
186 Ibid.
187 Ibid, 121-122.
188 OECD, Guidelines 2017, supra n. 172, para 2.47.
39 4.2.2 Transactional transfer pricing methods
Transactional net margin method (TNMM)
TNMM is the most commonly used transfer pricing method. Its practical strengths are twofold: with TNMM, comparability is assessed on a net profit level, and often this information is relatively easy to obtain from public sources. However, if potential comparables have multiple business lines, it may prove difficult to access sufficiently detailed, business line specific financial information. Nonetheless, the usefulness of TNMM is materially improved by the fact that the degree of similarity does not need to be very high in the products and services of the transaction in question. Instead, functional comparability is emphasised.189 Since TNMM is a one-sided method, only one of the parties to a transaction must be tested, and here that party should be the one that has more simple business model and functions.190 Then, it should be easier to both find the comparable companies against which to determine an arm’s length range of profitability and apply the method in a reliable manner.
Transactional profit split method (PSM)
Transactional profit split method is generally the most appropriate method in cases where both parties to a transaction make unique and valuable contributions.191 Usually these situations involve highly integrated operations to which it is virtually impossible to find comparable uncontrolled transactions.192 PSM can be applied as a residual profit split or by splitting the combined profit of the parties.193 When applying the PSM, first the joint profit of the parties must be determined. Often this takes place on the level of operating profit.194 After determining the amount of allocable (joint) profit, that profit is split among the parties by using specific profit splitting factors or allocation keys.195 Although profit split may be difficult to apply because of its transaction specific approach and detailedness, it provides
189 Ibid, paras 2.64-2.113.
190 Ibid. It should be noted, that TNMM cannot be used in transactions where both parties’ contributions are unique and valuable.
191 Ibid, paras 2.65, 2.115.
192 Engblom et al., supra n. 2, 669.
193 OECD, Guidelines 2017, supra n. 172, para 2.124.
194 Raunio and Karjalainen, supra n. 177, 137.
195 OECD, Guidelines 2017, supra n. 172, paras 2.138, 2.140-2.146.
40 much needed flexibility into situations which contain unique operations and that otherwise might be incorrectly and artificially priced at ‘arm’s length’.196
4.3 Evolution under BEPS
The Final Report of BEPS Actions 8-10 on transfer pricing begins by acknowledging one significant weakness of the previous transfer pricing guidelines;197 the strong emphasis of contractual arrangements, especially with regard to allocation of risk, which makes the system prone to manipulation.198 The ability to manoeuvre functions, assets and risks, contractually on paper, to where it is most tax efficient, has eventually allowed the separation of income from the actual business activities that create value.199
The focus on legal formalities with the arm’s length principle, which renders the principle easy to manipulate and exploit, has decreased substantially after the revision of the Guidelines in 2010, where from many of the changes introduced by BEPS originate, too.
Petruzzi has described the transformation of the principle as an evolution from ‘legal fiction to economic reality’.200 He conceives the ALP, and the changes in what the principle stands for, through notions of i.) separate entity approach; ii.) comparability of the transaction; and iii.) relevance of contractual arrangements.201
In contrast to the initial perception that arm’s length transactions represent the outcomes of comparable unrelated party transactions, and as such, embody the separate entity approach, the 2010 version of the Guidelines begun to acknowledge the existence of group synergies in relation to business restructurings.202 Group synergies do not exist beyond MNE setting, which is why the question ‘what would independent companies do’ cannot address synergy benefits. When group synergies derive from deliberate actions of the group, these benefits
196 Ibid, paras 2.118, 2.120. Due to the case specific nature of the PSM, ex ante discussions within the framework of Advance Pricing Agreements (APA) with relevant tax authorities would increase tax certainty in individual cases.
197 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010 (OECD Publishing, Paris 2010).
198 OECD, BEPS Actions 8-10 Final Report 2015, supra n. 111, at 9.
199 See, Andrus and Oosterhuis, supra n. 13, 76.
200 R. Petruzzi, ‘The Arm’s Length Principle: Between Legal Fiction and Economic Reality’ in M. Lang, A.
Storck and R. Petruzzi (eds), Transfer Pricing in a Post-BEPS World (Wolters Kluwer 2016).
201 Ibid, at 11; on the historical development of the arm’s length principle, see more extensively, J.
Wittendorf, Transfer Pricing and the Arm’s Length Principle in International Tax Law (Wolters Kluwer 2010) chapters 2-4.
202 OECD, Guidelines 2010, supra n. 197, chapter IX.
41 should be divided according to respective contributions of the group companies.203 Thus, the separate entity approach must be overlooked, or hypothesised as fictionally applicable, and replaced by group approach, in order to properly allocate group synergies.
The comparability of the transactions in Petruzzi’s tripartition refers to the importance of comparability as means to assess compliance with the arm’s length principle through a comparison of the conditions made or imposed between related and unrelated party transactions.204 As noted above, previously the comparable uncontrolled price method, CUP, was the preferred transfer pricing method, largely because it is the most direct and reliable way to arrive at arm’s length outcome.205 The CUP method also requires very high degree of comparability. Same is true, although to a lesser extent, with other traditional transfer pricing methods, the RPM and CPM. By introducing the concept of the case specific, most appropriate method and omitting the hierarchy between methods, which in the past had preferred traditional methods over transactional ones, the significance of comparability would effectively decrease even more.206 Further implication on the decreasing relevance of comparability is the adoption of a simplified approach in determining the arm’s length price for ‘low value-adding intra group services’.207 By invoking this simplified approach, a profit mark-up of 5% can be applied to these services without any justifications.208
The most fundamental change into the meaning of the arm’s length principle relates to a notion of ‘substance over form’, and to the final segment of Petruzzi’s tripartition, the relevance of contractual arrangements. This gradual shift in transfer pricing practise has taken place mainly through non-recognition of transactions; a right bestowed upon tax authorities to restructure actual transactions in exceptional circumstances.209
203 OECD, BEPS Actions 8-10 Final Report 2015, supra n. 111, paras 1.159, 1.162.
203 OECD, BEPS Actions 8-10 Final Report 2015, supra n. 111, paras 1.159, 1.162.