Elaborating the Arms Length Principle

manner. Since most such adjustments take place as part of informal negotiations with tax examiners in one country, the firm may find a way to adjust the related companys accounts informally, perhaps even without any need for negotiations with the authorities in the related country. 1 On the other hand, if it were explicitly accepted that the aim was to ensure taxation of a `fair ¶proportion of the profit by each national tax authority, it would require explicit international agreement on the definition and allocation of the tax base of the company group. Instead of opening up this broad question, the Arms Length criterion served the purpose of confining the allocation issue to a case­by­case negotiation of specific pricing by individual companies.

2. Elaborating the Arms Length Principle

It was not until the 1960s that the problem of transfer pricing began to surface again in public discussion. Despite the broad powers which many states gave their tax authorities in the 1920s and 1930s, international businesses did make use of transfer price manipulations to transfer profits internationally, not least in order to avoid what they considered unfair or double taxation. For example, British firms with subsidiaries in the US stated, when pressing the government for a tax treaty in 1944, that high US taxes on dividends had forced them to repatriate profits by `unsatisfactory expedients such as invoicing goods at higher prices ¶see Chapter 2 section 1 above. The spread of the network of bilateral tax treaties helped to stimulate the rapid post­war internationalization of business, especially of American TNCs. As has been recounted in previous chapters, the rapid growth of foreign direct investment reawakened discussion of the fairness of international tax arrangements. Business groups and capital­importing countries argued for home country exemption of foreign profits, but the main capital­exporting countries, in particular the USA and the UK, would only concede a limited deferral of tax on foreign retained earnings. An international tax planning industry emerged to assist international business to maximise tax deferral, which led to the exploitation of the opportunities for tax avoidance and arbitrage. 2.a The US Regulations of 1968 It was in this climate that there was a renewal of concern about the possibilities for tax avoidance offered by transfer price manipulation. This was felt first and most strongly by the US, whose firms were the most active in expanding abroad. Also, since US tax law exempted foreign subsidiaries while under British law companies managed and controlled from the UK could be considered resident and taxable there US TNCs could more easily escape all US tax on foreign retained earnings see 1 This is the likely explanation for the puzzle noted by US officials RIDVXEVWDQWLDOCJDS¶EHWZHHQ potential and actual Corresponding Adjustment cases: Coates and Kanakis, in Competent Authorities 1986, p.602. It is likely that in many cases where the US authorities have effected a s.482 adjustment, the firm is able to adjust its related company accounts either without reference to the foreign authorities concerned, or by private agreement with them. Chapter 5 above. Thus, when the US Congress rejected the proposals of President Kennedys administration in 1962 to end tax deferral for foreign subsidiaries, it nevertheless gave strong support for more active enforcement of controls over transfer pricing. Indeed, the House approved an amendment to section 482 which would have allowed formula apportionment of taxable income between affiliates unless the tax­payer could show arms length transfer prices for tangible property based on comparable market transactions; also, income could not be allocated to any foreign affiliate whose facilities were `grossly inadequate for its business outside the United States ¶ Although these proposals were omitted from the final bill, the reason given was that section 482 already provided sufficiently strong powers to allocate income and deductions; and the Treasury was urged to explore new guide­lines and regulations to ensure this. 1 In fact, the IRS had already responded to the concern to ensure adequate taxation of the foreign earnings of US TNCs, by initiating an international enforcement programme in 1961 reactivating s.482 Bischel 1973 p.492. Thus, for example, the advertising agency Young Rubicam was subjected to a s.482 adjustment for having understated its US income in 1960 by failing to charge its overseas subsidiaries for management and administrative services performed by the parent; however, the adjustment was eventually overturned by the courts, on the grounds that the Revenue could not show that specific managerial services had been performed for specific subsidiaries Young Rubicam v. U.S. 1969. Exposed to the increasing use by tax examiners of the wide powers of the section, taxpayers themselves were pressing for new regulations to ensure more uniformity Tillinghast 1979, p.271. The s.482 Regulations were finally approved in 1968, and provided the basis for the US IRSs monitoring of transfer pricing for two decades without substantial changes, although dissatisfaction with them was continually expressed on all sides. 2 These regulations defined five categories of related party transactions, and specified rules to be used in determining appropriate pricing for each category. The five categories were: loans or advances; the performance of services; the use of tangible property i.e. leasing; the transfer or use of intangible property i.e. rights to technology and know­how; and the transfer of tangible property. 3 1 See US Treasury 1988 p.9, and reports therein cited. 2 The initial draft regulations of 1965 were withdrawn following widespread comments, and a revised draft of 1966 was finally approved in 1968. Proposed changes drafted in 1971 were not implemented, apparently on the grounds noted by a 1978 memorandum, that they would benefit large firms at the expense of small business, and `condone the non­arms length pricing of inter­ FRUSRUDWHWUDQVDFWLRQV¶ US General Accounting Office 1981, 48­9. Yet the Gordon report in 1981 again recommended a study of the regulations with a view to revisions to reduce uncertainty and subjectivity: US Treasury 1981, pp.129­132. 3 Income Tax Regulations, Code of Federal Regulations para. 1­482; referred to hereafter as ITR. The related regulations for allocating the costs or deductions of a single corporation between domestic and foreign source income, although originally proposed as a package with the s.482 regulations, were not finally adopted until 1977: `The relationship between the two sets of regulations is not easy to grasp DQGPD\ZHOOEHLQKDUPRQLRXV¶6XUUH\S7KLVUHODWLRQVKip was subsequently changed in some significant respects by the Tax Reform Act 1986, adding s.864e to the Tax Code, and by the regulations enacted under it. The regulations specify, for each category of transaction, that the primary test should be the Comparable Uncontrolled Price CUP: the amount that was charged or would have been charged in independent transactions with or between unrelated parties dealing at arms length. Relevant circumstances should be taken into account in determining comparability for particular transactions: for example, for loans, the period of the loan, any security, the credit standing of the borrower and prevailing interest rates; for leasing, the type and condition of the property and its investment and maintenance costs. Despite the emphasis on the primacy of the CUP, the regulations offered alternatives for each type of transaction. A `safe harbour ¶ was defined for three types of transaction, loans, services and leasing: as long as the supplier is not in the business of providing such services to unrelated parties, the arms length price is specifically defined. For loans, the `safe harbour ¶ interest rate was originally 4­6; it was occasionally changed as rates rose, but this procedure was criticised as too slow US GAO 1981, p.15 and eventually, in 1988, the safe harbour rate was defined in relation to Federal rates, which are specified monthly US Treasury 1988, p.74. For services and leasing, the `safe harbour ¶was defined on the basis of a cost formula; but the leasing safe harbour option was removed in 1988. In the case of intangibles intellectual property and know­how, no specific alternative was provided for CUP, but the Regulations listed a dozen factors that should be taken into account in fixing an arms length price ITR 1­482­2­d­2iii. Finally, for the pricing of tangibles goods, the regulations provided a 4­tier hierarchy of methods: first, CUP; then, Resale Price Minus an appropriate profit markup; third, Cost of production Plus an appropriate profit markup; and only where none of these methods can reasonably be applied may `fourth methods ¶be used ­ i.e. `some appropriate method of pricing other than those described ... or variations on such methods ¶ITR 1.482­2­e­1­iii. By attempting to control the broad discretion in s.482 to adjust related company accounts, the 1968 Regulations significantly transformed the Arms Length rule. Instead of treating Arms Length as a general principle for ensuring that the allocation of overall profits and costs between related companies was broadly fair, the US approach set out on the steep slope of attempting to define rules for the pricing of specific transactions. At the same time, the US authorities were keenly aware that such rules should not be unilaterally established, but must as far as possible be internationally agreed. Professor Stanley Surrey, the influential US Treasury Assistant Secretary, recognised the international implications of US transfer price adjustments. He and his colleagues were active in international meetings, both of professional bodies e.g. Surrey Tillinghast 1971 and intergovernmental organizations Langbein 1986, p.647­8. 2.b International Concern about Transfer Price Manipulation. Nevertheless, the continuing efforts at defining internationally agreed principles for pricing intra­firm transactions have had relatively little success. The starting point was the Arms Length principle based on separate accounts since, as pointed out above, the leading states had by the 1930s adopted price adjustments based on arms length rather than try to establish internationally­agreed criteria for allocation. 1 However, the general arms length principle had been used as a means of ensuring a `fair ¶ profit allocation, and administrators certainly used profit comparisons as a check. The problem was that by embarking on a system based on detailed rules to be applied to individual transactions the US was introducing a degree of specificity on which it was very difficult to obtain international agreement. In the 1970s, pressure to reach international agreement on transfer pricing rules became increasingly intense. Yet, although report after report reaffirmed the importance of the arms length principle, there was a complete failure to reach any agreement on specific pricing rules. Initially, the transfer pricing issue was not treated as a matter of great urgency, although it appears that the OECD Fiscal Committee, at the request of the US, set up a working group as early as 1965 to examine the problem. However, by the 1970s the power of `the multinationals ¶was becoming a highly politicised issue. Of particular concern was the ability of TNCs to move both short­term liquid funds and longer term investment capital between countries and currencies, partly by the adjustment of payment terms between affiliates. In this period of transition from the fixed exchange rate system to floating rates, the TNCs primary need was to minimise their exposure to currency fluctuations; and the devices they used, such as `leads and lags ¶in intra­ firm international payments, in turn contributed to currency instability. The issues merged into a generalised debate about the power of international capital vis­a­vis the state. Not only did a leading academic economist announce that `the national state is just about through as an economic unit ¶Kindleberger 1969 p.207, the Governor of the Bank of England in a published speech referred to public concern about whether the power of multinational enterprises `is such as to represent a significant reduction in the sovereignty of the host government ¶ and discussed in detail their effects on national economic policy­making Governor of the Bank of England 1973. Some of this generalised concern was brought to a head by the cause célèbre of Hoffmann La Roche. A report by the British Monopolies Commission in 1973 revealed that Roche UK was paying grossly inflated prices to its Swiss affiliate for the active ingredients for drugs to be packaged for sale; these drugs were 1 7KLVZDVWKHUHIRUHQRWD86FDPSDLJQWRCH[SRUW¶WKHDUP VOHQJWKFULWHULRQDVDUJXHGE\DQJEein 1986; indeed, as Langbein acknowledged, Surrey in his published writings accepted some of the limitations of Arms Length and kept open the possibility of other approaches. librium and valium, wonderful new non­barbiturate tranquillisers, sold on prescription and therefore mostly paid for by the National Health Service. Roches transfer price was £370 a kilo for librium and £922 for valium, while the same active ingredients could be obtained from small companies in Italy where Roches patents were not protected for £9 and £20 per kilo respectively. The company told the Monopolies Commission that its pricing policy for drugs was based on what the market would bear in each country, although in the UK the price was negotiated with the government under the then­voluntary price regulation scheme for pharmaceuticals. The British subsidiarys accounts showed direct payments to its parent company for overheads, especially for the heavy research programme in its Swiss and US laboratories. These were determined by what the Inland Revenue would allow by comparison with similar UK pharmaceutical firms ­ about 12 of sales. But Roches UK business was concentrated on a few, highly­profitable items ­ tranquillizers and vitamins. Thus, Roche argued that it was not fair to look at the profitability of individual drugs, especially such highly successful ones as librium and valium, since these must finance the companys overall research effort. However, it refused to provide the Commission with data on its world­wide activities UK Monopolies Commission 1973. The dispute was eventually settled by the payment of an agreed sum to the NHS; but the case led to investigations in many other countries of Roches pricing policies. It is not publicly known whether the Inland Revenue had itself taken any action on Roches transfer prices under its own powers, or did so subsequently. However, the case undoubtedly created political pressures in Britain and other countries to set up a more active policing of transfer pricing. The British Inland Revenue in 1976 established a special central unit within the Technical Division to train and advise inspectors on international transfer pricing questions. The concern about the power of multinational enterprise became sufficiently politicised for the United Nations to become involved, and eventually led to the establishment of the UN Centre on Transnational Corporations. In practice however the UN has proceeded very cautiously. The first major study, the Report of the Group of Eminent Persons to study the impact of multinational corporations on development and on international relations, was notably conservative on international tax questions. It rejected, in a few brief sentences, the idea of allocation of world­wide profits for taxation based on an agreed formula, but provided no new ideas to resolve the problems of transfer pricing or tax avoidance, merely urging further work by the Group of Experts on Tax Treaties UN 1974A, pp 91­4. This body had already produced its Guidelines for tax treaty negotiation, but in subsequent meetings in 1976 and 1978 it considered transfer price adjustment issues, in the context of the competent authority mutual agreement procedures. At the same time, the OECD Fiscal Affairs Committee had accelerated its consideration of the question, having been pressed to do so by the OECD Council, which had adopted a Declaration and Decisions on International Investment and Multinational Enterprise in 1976. Appended to these were the OECD Guidelines for Multinational Enterprises, which inter alia urged multinationals to `refrain from making use of the particular facilities available to them, such as transfer pricing which does not conform to an arms length standard, for modifying in ways contrary to national laws the tax base on which members of the group are assessed. The more detailed examination of the matter by the Committee on Fiscal Affairs resulted in the celebrated 1979 report on Transfer Pricing and Multinational Enterprises. The OECD Committee and the UN Group of Experts, working at the same time and with overlapping membership, produced similar conclusions. Their reports were written in a context not only of generalised political concern about transfer pricing, but also of specific pressures generated for tax officials by the issue of Worldwide Unitary Taxation, brought to a head by the dispute over Article 94 of the draft US­ UK treaty see Chapter 9 section 4 below. Both reports generally confirmed the primacy of the Arms Length principle and supported the general approach embodied in the US regulations of 1968. This entailed attempting to elaborate more specific criteria to be used in evaluating the pricing of specific transactions of various kinds. Thus, they confirmed the Comparable Uncontrolled Price as the most appropriate and in theory the easiest method, but they specified further that, in view of practical difficulties, the alternatives of Resale Price Minus or Cost Plus might be useful in the OECD Report these were stated as general alternative methods, not only for tangibles as in the US regulations. Finally, it was conceded that `the complexities of real life business situations ¶might create difficulties requiring a combination of these methods, or other methods still, to be used OECD 1979 para. 13. Nevertheless, proposals for a radical reformulation of the approach by moving away from arms length to `so­called global or direct methods of profit allocation, or towards fixing transfer prices by reference to predetermined formulae for allocating profits between affiliates ¶were firmly rejected OECD 1979, para. 14. Significantly, however, even the OECD report remarked that this did not mean that `in seeking to arrive at the arms length price in a range of transactions, some regard to the total profits of the relevant MNE may not be helpful, as a check on the assessment of the arms length price ¶ibid.. The 1979 OECD report in particular established a general international consensus that the transfer pricing question ought to be taken seriously, and that arms length should be the guiding principle for dealing with it. However, the report did not take the form of a new model treaty, nor even a commentary on the relevant provisions of the existing model; the OECD Council simply adopted a recommendation that member states take into account the considerations and methods set out in the report when reviewing and if necessary adjusting transfer prices. A variety of methods have been used in adopting the principles of the OECD report in the laws and practice of member states. Some countries, for example the Netherlands, continued to rely on general anti­avoidance rules, based on the principle that business profits must fairly reflect the substance of transactions, while publicising their general support for the OECD report. 1 Others found the report lacking in specificity, and enacted detailed regulations. Thus, the West German authorities had used a semi­official Handbook as the basis for enforcement of the general Arms Length adjustment rule enacted in section 1 of the Aussensteuergesetz of 1972 Strobl 1974; but, finding the OECD report inadequate, they issued detailed regulations in 1983. 2 These regulations attempted to provide detailed and specific rules: those parts which interpreted the existing statute were considered binding on the administration, but other parts were considered to be essentially for guidance and therefore binding in the aim to be achieved and not the specific methods indicated Hoeppner 1983, pp.211, 213­5. The Italian Ministry of Finance also preferred to issue its own detailed guidelines. 3 In Japan the legislature had initiated consideration of the question in 1977, but a specific law was not passed until 1986: it was phrased in very general terms, and the administrative regulations subsequently approved were little more specific. The UK has avoided elaborating any regulations, and the outline `guidance notes ¶ issued in 1980 referred only in the most general terms to methods: In ascertaining an arms length price the Inland Revenue will often look for evidence of prices in similar transactions between parties who are in fact operating at arms length. They may however find it more useful in some circumstances to start with the re­sale price of the goods or services etc and arrive at the arms length purchase price by deducting an appropriate mark­up. They may find it more convenient on the other hand to start with the cost of goods or services and arrive at the arms length price by adding an appropriate mark­up. But they will in practice use any method which seems likely to produce a satisfactory result. They will be guided in their search for an arms length price by the considerations set out in the OECD Report on Multinationals and Transfer Pricing. UK Board of Inland Revenue 1980. Despite the general agreement on the arms length approach, neither the international studies and reports nor the development of national practice and rules have succeeded in establishing agreed common criteria, still less common rules. The apparent widespread agreement on the Arms Length approach has contrasted starkly with the indeterminacy about the actual content of the arms length rules. The reaffirmation of 1 However, the Dutch Ministry of Finance issued a circular letter containing administrative guidelines on 25th April 1985, following the subsequent OECD report of 1984 on some more specific transfer pricing issues. 2 Bundessteuerblatt 1983, Part I p.218; English and French language versions and a useful glossary of German tax terms are provided in A. Rädler and F. Jacob 1984. 3 Italy, Ministry of Finance 1980. Materials on national transfer pricing rules and practices are most usefully collected in International Bureau of Fiscal Documentation 1987­. Arms Length appears to be more than ever necessary in order to avoid the political difficulties that would be caused by opening up the question of an international basis of allocation of the tax base of TNCs. Thus, a German Finance Ministry official has stressed that the administrative adjustment of transfer pricing would be redolent of `planned economy and sterile bureaucracy ¶ if it were not firmly based on the principle that `Even members of a group of enterprises are supposed to act in their pricing like participants of a free market ¶Höppner 1983, p.212. Yet it is clear that many of the underlying issues have not been resolved. To be sure, overt conflict has been averted and ad hoc solutions have been found, largely through the rapid development of procedures for administrative cooperation and coordination to be discussed in Chapter 10 below. Nevertheless, at least one official who has been continually involved has stated that he has feared for two decades that there might be a `general open clash between tax authorities in the field of arms length pricing ¶Menck in Competent Authorities 1986, p.585. Indeed further public conflict emerged as the 1990s opened with renewed attacks in the US Congress on taxation of TNCs. Hitherto, the Congress had been primarily concerned with the problem of US TNCs taking advantage of deferral to minimise their US tax liability. This led to a modification of the cornerstone of the US transfer pricing regime, s.482 the first substantial change in nearly 60 years since its enactment, made by the 1986 Tax Reform Act; which was followed by proposals in a Treasury White Paper of 1988 for significant modifications in the administration of the section to be discussed in detail in section 3.f below. While this was still under consideration, however, there was increasing concern about the rapid growth in foreign direct investment into the US, especially by Japanese firms US Congress 1990A. Fuelling a general political concern about `unfair competition ¶ a staff study for the Oversight Subcommittee of the House Ways and Means committee in July 1990 highlighted figures showing that 25 Pacific­rim and 11 European­based multinationals with more than 35 billion in retail sales in the U.S. in 1986 paid little or no income tax while handling billions of dollars distributing foreign­made products in the U.S. for their foreign parents. It was stated that the 36 companies accomplished this through `inflated pricing of goods purchased from the foreign parent, or the performance of functions not properly compensated for by the foreign parent. ¶ Senior IRS officials confirmed that close attention was being paid to foreign­ owned firms, which generally showed a lower rate of return on assets, and of net income on gross receipts, than US­controlled domestic corporations; although Treasury officials advised a strengthening of enforcement of existing laws rather than any new initiatives, warning that actions must `withstand the test of fairness and must adhere to international standards if US businesses are to continue to enjoy the benefits of co­operative relationships between the fiscal authorities of other countries ¶ 1 Lobbies on behalf of foreign investors argued strongly that many factors 1 Report in the Financial Times 27.7.90. could account for profitability differences, such as high start­up costs in the US market. Attempting to defuse political pressures, the Chancellor of the Exchequer John Major wrote to the Treasury Secretary Nicholas Brady proposing a joint multilateral study of tax avoidance by multinationals, an offer which Brady gratefully accepted, along with a similar German proposal. 1 What was most striking was that neither the efforts by the US over three decades to develop an effective transfer price regime for US foreign direct investments, nor the work in international bodies especially the OECD since 1975, were regarded as providing an adequate answer to US political concerns about the adequacy of taxation of inward direct investment.

3. The Indeterminacy of Arms Length