Separate Accounts and the Arms Length Fiction

1. Separate Accounts and the Arms Length Fiction

The separate legal personality of an incorporated company poses recurrent problems for business regulation, not least for the administration of direct taxes on income or profits. From the earliest days of direct taxation, tax administrators and legislators were reluctant to allow parent and subsidiary companies to be treated in the same way as independent entities for tax purposes, since related companies have the power to structure transactions between them so as to reduce the overall tax liability of the group. Hence, measures quickly emerged in tax codes, administrative regulations or court decisions, to prevent such avoidance. Two approaches are possible in this context: to require consolidation of the accounts of companies under common ownership; or to adjust accounts between related companies. 1.a The US: From Consolidation to Adjustment of Related Company Accounts In the US from 1917, affiliated corporations were required to file a consolidated return. 1 The courts supported the logic of consolidation: The purpose of requiring consolidated returns was ... to impose the war profits tax upon the true net income and invested capital of what was, in practical effect, a single business enterprise, even though conducted by means of more than one corporation. Primarily, the consolidated return was to preclude the reduction of the total tax payable by the business, viewed as a unit, by redistribution of income or capital among the component corporations by means of inter­company transactions. Burnet, CIR v. Aluminum Goods Manuf. Corp. 1932, p.547. However, consolidation required the elimination of all inter­affiliate transactions, and the inclusion as income of the proceeds of sales only once made outside the group. It was particularly difficult to consolidate the income of foreign affiliates not doing business in the US, which were not liable to US tax. For these reasons the emphasis shifted to ensuring correct taxation of related corporations by adjusting the accounts between them if necessary. Initially, Congress authorised the Revenue to prepare consolidated returns for businesses under common control only where necessary to compute their `correct ¶ tax liability Revenue Act 1921 s.240d. This was revised in s.45 of the 1928 Act, which instead gave a very 1 Articles 77 and 78 of Regulation 41 made by the Commissioner of Inland Revenue under the Revenue Act 1917, for the wartime excess profits tax, required information to be filed on all inter­ company relationships, and provided that this tax could be levied on the consolidated returns of affiliated corporations. This was confirmed by the Revenue Act 1918 s.240, which extended consolidation to the corporation income tax. Some anomalies were caused by the application of corporation income tax in 19171918 to separate companies, while requiring consolidation of affiliated companies accounts for the excess profits tax. see Aluminum Co. of America v US 1932. broad power to adjust accounts of related corporations. 1 The House Ways and Means Committee identified the problem as being that `subsidiary corporations, particularly foreign subsidiaries, are sometimes employed to `milk ¶ the parent corporation, or otherwise improperly manipulate the financial accounts of the parent company; the intention of s.45 was therefore to provide the powers `necessary in order to prevent evasion by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of `milking ¶, and in order clearly to reflect their true tax OLDELOLW\¶ 2 Section 45 of the 1928 Act, later enacted with minor changes as s.482 of the Tax Code, has remained in force since that time: 3 In any case of two or more [add: organizations,] trades or businesses whether or not incorporated, whether or not organised in the United States and whether or not affiliated owned or controlled directly or indirectly by the same interests, the Commissioner [subst.: Secretary or his delegate] is authorised to [subst.: may] distribute, apportion, or allocate gross income, deductions [add: credits or allowances] between or among such [add: organizations,] trades or businesses , if he determines that such distribution, apportionment or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such [add: organizations,] trades or businesses. The omission in the 1928 wording of any reference to the consolidation of accounts underlined the separate taxability of members of a group under common control, while giving the Revenue very broad powers to adjust accounts. The breadth of the Revenues discretion was confirmed by court decisions. The power was held to apply to prevent any avoidance or reduction of tax liability, and not only to criminal tax evasion: Asiatic Petroleum v. CIR 1935. This case resulted from a manoeuvre by Royal Dutch Shell to transfer profit out of the US through the sale by Asiatic, a Delaware corporation, of the stock of a subsidiary at cost to its Dutch affiliate Bataafsche, which resold at a profit back to another US affiliate. The courts rejected a determined legal onslaught on s.45, including the claim that it was an unconstitutional deprivation of property without due process of law. Another landmark decision held that the Revenue is entitled to make any adjustments necessary and proper `clearly to reflect the income ¶even to transactions having a sound motivation not primarily 1 The House Ways and Means Committee, which initiates revenue bills, considered that consolidation was too favourable to corporations, and especially that foreign affiliates, whose income could not be consolidated, could be used for tax avoidance. The House therefore eliminated consolidation altogether from the 1928 Finance Bill; but it was restored by the Senate Finance Committee, although only for domestic corporations within an affiliated group. However, the reference to consolidation was dropped from the anti­avoidance provision s.240, which was enacted in broader language as s.45 of the 1928 Act. 2 Report 350, 67th Congress, 1st session, p.14, cited in Asiatic Petroleum Ltd Delaware v. CIR 1935; see below. 3 Some minor subsequent amendments are indicated in square brackets: for the much more important DPHQGPHQWRILQWURGXFLQJWKHCFRPPHQVXUDWHZLWKLQFRPH¶VWDQGDUGVHHVHFWLRQIEHORZ related to tax saving Central Cuba Sugar Co. v. CIR 1952. 1.b France: Taxing Profits Transferred to a Foreign Parent While the American authorities were concerned about subsidiaries, especially those formed abroad, being used to milk parent companies, some European countries identified the reverse problem: that local foreign­owned companies might be `dummies ¶ formed to comply with protectionist commercial requirements or preferences, but transferring their profits to the parent. The most radical approach was taken by the French Treasury, which could impose the tax on income from securities `impôt sur le revenu des valeurs mobilieres ¶, on the proportion of the dividends distributed by a foreign parent company represented by the value of its holdings in the French branch or subsidiary in relation to its total assets. This was resented by foreign investors and their governments as being both extraterritorial and double taxation. The French rejected these arguments, since French companies were also subject to taxation both on their commercial profits and on the dividends paid to their owners. Although France agreed to mitigate any double taxation by concluding bilateral treaties, the resulting half­dozen treaties generally preserved the French right to tax both the profits of the French establishment and a `deemed dividend ¶ represented by any diverted profits see Chapter 1 section 4 above and Carroll 1939 p.49, League of Nations 1933, p.115. Thus, the French tax treaties concluded in 1931 with Belgium and Italy and in 1932 with the USA included a provision empowering each state to reallocate any profits or losses transferred between related enterprises due to their relationship being conducted in conditions other than those which would apply between independent enterprises. The French authorities therefore refocussed on the `diverted profits ¶ which should be reattributed to the local subsidiary. 1 Hence, a very general provision was enacted in 1933 empowering such diverted profits to be restored to the accounts of the local subsidiary. The 1933 provision remains in almost exactly the same wording as s.57 of the Code General des Impôts: In assessing the income tax due by undertakings which are controlled by or which control enterprises established outside France, the income which is indirectly transferred to the latter, either by increasing or decreasing purchase or sale prices, or by any other means, shall be restored to the trading results shown in the accounts. 1 Loi du 31 mai 1933, art. 76; codified in art. 20, Decree of 20 July 1934: Recueil Dalloz Periodique et Critique 1934 p.172. The same procedure is followed with respect to undertakings which are controlled by an enterprise or a group of enterprises also controlling undertakings located outside France. The condition of control or dependence is not required when the beneficiary of a transfer is established in a country or a territory with privileged tax status as defined in Article 238­A para.2 of this Code added by Finance Act 1982 Art. 90­II. Should specific data not be available for making the adjustments provided in the foregoing paragraph, the taxable profits shall be determined by comparison with the profits of similar undertakings normally managed. 1.c The League of Nations and Arms Length The international discussions in the League of Nations reaffirmed the principle of the adjustment of the accounts of local affiliates, based on the criterion of independent enterprises dealing at arms length. The 1935 draft Convention on allocation provided that where, between companies owned or controlled by the same interests, there were commercial or financial relations different from those which would have been made between independent enterprises, any `diverted ¶ item of profit or loss must be re­ attributed 1935 Allocation Convention Art. VI, see Chapter 1 section 5 above. However, the League studies were primarily concerned with the problem of branches of the same company; and agreement was reached that a branch, provided it fell within the definition of a Permanent Establishment, should be taxed on the basis of separate accounts and the criterion of `independent persons dealing at arms length ¶ Thus, Article III of the 1935 Convention, dealing with Permanent Establishments, was much more detailed than Article VI, on enterprises under common control: the phrase `dealing at arms length ¶ was used only in Article III. Significantly, Art.III permitted as a fall­back the `percentage of turnover ¶method, and even the allocation of the total income on the basis of `coefficients ¶. No doubt it was easier to accept that these profit­apportionment methods could be used in the case of a single company which already had consolidated accounts, than to permit or require consolidation for separate but related companies. Both provisions have been incorporated into subsequent model treaties: Article III, substantially modified, is still the basis for Article 7 of the OECD and UN models, while Article VI remains in virtually identical wording in Article 9 of the Models. Article 72 requires the attribution to a permanent establishment of `the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment ¶ Although the article itself no longer refers to the `percentage of turnover ¶ method, it is still accepted as a fall­back method, and discussed as such in the Commentary to the OECD model para.23. This can still be important, especially for financial firms such as banks and insurance companies, which often operate abroad through branches. 1 In this connection, a disagreement has arisen about the `percentage of turnover ¶ method. The OECD Committees report on taxation of multinational banking indicated that while the majority of the committees members considered that the `appropriate coefficients ¶required a comparison with other similar enterprises in the same country, Japan and the United States considered that industry standards could be used which might be international OECD 1984­II, paras.64­67. While historically the provision intended national comparisons, a good case can be made that this would not be adequate today for a global activity such as banking see section 3a below. Article 74 of both the OECD and the UN models still allows a global apportionment method to be used for permanent establishments, although only where this has been used traditionally and only if `the results are in accordance with the principles ¶of the article. 2 Article 9 of the model treaties is the key provision for taxation of international company groups; yet although its wording is obscure the OECD 1977 commentary provided virtually no elucidation, merely stating `It is evidently appropriate that adjustments should be sanctioned in such circumstances and this paragraph [Art.9 para. 1] seems to call for little comment. ¶ Nevertheless, the US by reservation stated its belief that `this Article should apply to all related persons, not just an enterprise of one contracting state and a related enterprise of the other Contracting State, and that it should apply to ³income, deductions, credits or allowances ¶ QRW MXVW WR³SURILWV ¶. To ensure this, the US model treaty includes a third paragraph which permits application of provisions of national law for any adjustments necessary clearly to reflect the income of any related persons. 1.d The UK: Profit Split and Arms Length The League provisions were also substantially influenced by British rules, which dated back to 1915. These aimed to prevent avoidance of high wartime taxes by foreign companies trading in the UK through branches or subsidiaries. 3 Hence, the 1915 Finance Act provided that a foreign non­resident person doing business through a local branch or agent could be taxed in its name; similarly, 1 Thus, the UK has since 1915 taxed foreign life assurance companies doing business in the UK on the basis of the proportion of the UK to world premiums applied to their world income from investments, less a deduction in the same proportion for management expenses. Although this method has been held to be contrary to the basic arms length provision of Article 72 of the model treaty Ostime v. Australian Mutual Provident Society 1960 it was considered to be preserved by the proviso in Article 74, especially when interpreted in accordance with paragraph 24 of the OECD commentary: Sun Life Assurance Co. of Canada v. Pearson 1984. 2 The OECD Committee, in the Multinational Banking Enterprises report, stressed that the global apportionment approach permitted in Article 74 was for use in exceptional cases only, and as a subsidiary method; it should not be confused with the separate enterprise standard laid down as the norm in both Articles 7 and 9. The majority of the Committee deduced from this that it is inappropriate to allocate the global costs of a firm by formula in attributing expenses, specifically, in deciding the true costs of interest to a multinational bank: OECD 1984­II para.69, and section 3.c.iii below. 3 Since a foreign subsidiary of a UK parent company could be treated as resident and taxable in the UK see Chapter 1.2 above, it was presumably thought unnecessary to deal with that case. where the foreign non­resident was doing business with a UK resident and `owing to the close connection and ... to the substantial control exercised by the non­resident RYHU WKH UHVLGHQW¶, business was carried on between the two in such a way as to produce to the resident person a profit lower than that which might be expected, the non­resident person should be chargeable to tax in the name of the resident person as agent. 1 Whether operating through a local branch, agent or subsidiary, the foreign parent could be assessed using the same rule: if the `true amount ¶of the profits made by the foreign parent could not be `readily ascertained ¶ the non­resident parent could be charged to tax on the basis of a percentage of the turnover of the business of the parent done through the UK entity Rule 8. 2 Thus, there was a broad power to raise an assessment based on the foreign parents profits, and the problem of enforcement jurisdiction was evaded by treating the local subsidiary as an agent. These measures were undoubtedly taken in response to moves by foreign companies to minimise their exposure to UK tax. For example, the Gillette company of Boston set up a UK subsidiary in 1908, but then wound it up in 1912 and transferred its UK business to a separate subsidiary in Massachussets, which as a non­resident of the UK would have been taxable only on its UK business. In 1915 Gillette went further, ceased to trade directly in the UK, and instead licensed its UK business to a new company set up by its former UK Managing Director. Nevertheless, the Revenue tried to treat the new UK company as `under the control ¶ of Gillette in Boston, although their link was only contractual; but this was firmly rejected by the High Court as `arbitrary taxation gone mad ¶ Gillette Safety Razor Co. v. Commrs. of Inland Revenue 1920. Thus, from 1918 the Revenue had broad powers to adjust the profits of local branches or subsidiaries of foreign firms. This approach was re­evaluated after 1945, when the UK adopted the League of Nations London model as the basis for negotiating bilateral treaties see Chapter 2 section 1a above. In 1951 a new statutory provision was enacted to deal with international inter­affiliate transactions. 3 This applied to any two bodies of persons under common control, replacing the previous rule allowing a 1 Finance No.2 Act 1915 s.31 3 4 5; re­enacted in Income Tax Act 1918, All Schedules Rules 7­ 9. In Australia a similar section was enacted in 1922, which became s.136 of the Income Tax Act, applying to international transactions until 1981. Since this was fairly easily avoided by interposing a second Australian company to hold the shares of both the resident and non­resident company, it was replaced by the more comprehensive provisions of Division 13 of the Income Tax Assessment Act 1982. 2 A modification was introduced in 1918 for sales of goods manufactured abroad by the parent: the tax charge could be limited to the profits which might reasonably be expected to have been earned by a merchant or ... retailer: Rule 12, All Schedules Rules, Income Tax Act 1918, now TMA 1970 s.81. 7KLVZDVWKHFRQFHSWRIPHUFKDQWLQJSURILW¶VHHHDJXHRI1DWLRQVSS­4. 3 Finance Act 1951 s.37, re­enacted as Income Tax Act 1952 s.469, replacing Rule 7 of the 1918 Rules. The section was introduced when it was realised that s.51 of the Finance No.2 Act 1945, which provided for the conclusion of tax treaties, was insufficient to empower the adjustment of accounts between related entities, although there was considerable suspicion of it as a socialist measure: House of Commons debates 1950­1 vol.488, cols.2454­2466, vol.489, cols.2071­2098, esp. col.2076. non­resident to be treated as doing business through a local branch or agent where the close connection produced less than ordinary profits to the resident; but the remaining rules dealing with a non­resident doing business in the UK through a branch or agent continued in force; and in such cases, the `percentage of turnover ¶method, with the proviso for a `merchanting profit ¶ for resales of foreign manufactures, still apply today. 1 In contrast, the provisions on related entities are concerned not with the overall profit but the pricing of specific transactions. The powers they give the Revenue are limited to the adjustment of the price of any transaction if it is fixed at less or more than `the price which it might have been expected to fetch if the parties to the transaction had been independent persons dealing at arms length ¶ In such circumstances a price adjustment can be made, by Direction of the Board of Inland Revenue, to ensure that `the like consequences shall ensue as would have ensued ¶if the transaction had been `a transaction between independent persons dealing at arms length ¶ The power to adjust does not apply if the beneficiary is resident and doing business in the UK: that is, if an undervalued sale results in a lower deduction to a UK­resident buyer, or an over­valued sale increases the profits of a UK­resident seller. 2 The section has remained essentially the same since 1951. 3 Significant amendments in 1975 clarified the `common control ¶ criterion, and added broad powers to require information, including information from foreign subsidiaries if owned 51 or more by a UK resident company. 4 In addition, the Oil Taxation Act of 1975, which brought in a special Petroleum Revenue Tax for oil extraction and exploitation, introduced a specific definition of arms length pricing for such activities. 5 Interestingly, this specifically provides that it shall be assumed in determining the arms length price that both buyer and seller should secure `a reasonable profit from transactions of the same kind carried out on similar terms over a reasonable period ¶ ICTA 1988 s.7716a. 1 Rules 8, 9 and 12 of the 1918 General Rules are substantially re­enacted in the Taxes Management Act 1970 ss. 80­81. In some circumstances a subsidiary in the UK may be treated as the agent of its parent so that some of the parents business may be considered to be carried on in the UK: Firestone Tyre Rubber Co. v. Llewellin 1957. 2 However, the courts have held, partly on the analogy of this provision, that sales at undervalue between two related resident companies are not sales in the course of trade, so can be credited at market value: see Sharkey v. Wernher 1955 and Petrotim Securities v. Ayres 1963. Resident companies, on the other hand, may benefit from exemption of tax on inter­affiliate payments and from group relief on trading losses of affiliates. 3 ICTA 1970 s.485; now with revised drafting ss.770 773 ICTA 1988. 4 Finance Act 1975 s.17. The section had previously defined as bodies under common control two companies either of whom controlled the other or both of whom were controlled by `some other SHUVRQ¶LQUHVSRQVHDSSDUHQWO\WRDGLVSXWHZLWKDWD[­payer, the 1975 amendment specified `for the UHPRYDORIGRXEW¶WKDWWKLVLQFOXGHGFRQWUROE\RWKHUCSHUVRQV¶LQWKHSOXUDOWKLVPHDVXUHZDVUHJDUGHG as tantamount to unfair retrospective legislation by the lawyers involved in the pending dispute: see Capon in Fordham Corporate Law Institute 1976, p. 104. 5 OTA 1975 ss.13­21, Schedule 9, now ICTA 1988 s.771; and see Reg. v. A­G ex parte ICI 1985. These powers to adjust the prices of specific transactions are much more precise than the broad power in the 1918 rules to tax the `true profit ¶of a foreign parent, or for that matter the sweeping provisions of the American s.482 allowing allocation or apportionment of any income or deductions. In practice, however, the US powers have been exercised within the framework of specific regulations to be considered below and a system in which recourse to adjudication is more frequent. By contrast, the British authorities prefer to deal by discreet negotiations and private settlement with the tax­payer. Notably, in the 40­year life of the British `arms length ¶provision, there has been only one litigated case under it, and indeed it appears that there have been very few instances of a formal Direction by the Board to effect a price adjustment. 1 Essentially, the confidential negotiations between the Revenue and the tax­payers professional advisers have been carried out `under the umbrella ¶ of the powers given by the section. 2 Nevertheless, officials may feel constrained by the lack of any administrative rules and their vulnerability to expensive and time­consuming court proceedings. This may explain the remark of a senior Revenue official, on the face of it rather surprising, that in the UK transfer pricing is `not an administrative matter ¶but subject to control by the Special Commissioners and the Courts Hunter in Competent Authorities 1986, p.593. 1.e. Germany: Organic Unity and Profit Split In German law also, provisions were enacted in the interwar period to deal with 1 The requirement of a Direction was introduced during the passage of the provision in 1951, following criticisms that the power would entail excessive administrative interference in the pricing decisions of companies: House of Commons debates 1950­1, vol.489, col.2094. It has been claimed that no record is kept of such directions: Hansard 1983­4 vol.51 p.222. The only reported case is Commrs. of I.R. v. Lithgows Ltd 1960, in which the Scottish Court of Session upheld a decision of the Special Commissioners, rejecting a Revenue view that there was common control where a majority of the shares of two companies were held by trusts for members of the same family different heirs of Sir James Lithgow, with almost but not exactly the same trustees. 2 This phrase was used by an Inland Revenue official directly concerned with transfer pricing adjustments, in interview; see also Rouse in Fordham CLI 1976. In the case of pricing between related entities in the UK and a treaty country, the much broader provisions of the treaty articles apply, at least to adjustments relieving persons from UK taxation. Under s.7883 ICTA 1988, any arrangements for relief of double taxation have effect over other legislation, inter alia, for determining the income or chargeable gains i of non­residents and their UK establishments; ii of UK residents having `special UHODWLRQVKLSV¶ZLWKQRQ­residents. This would allow adjustments as provided for in the relevant tax WUHDW\LHWRSURILWVDQGQRWMXVWSULFHVDQGQRWRQO\ZKHUHWKHUHLVOHJDOFRQWUROEXWDQ\CSDUWLFLSDWLRQ¶ direct or indirect by one person in both entities. It is not clear, however, whether this can create a charge to tax Davies 1985, para. 14.04: since s.788 provides for the enforcement of arrangements for CUHOLHIIURPGRXEOHWD[DWLRQ¶LWHPSRZHUVWKH5HYHQXHWRDGMXVWLQFRPHVRDVWRUHOLHYHDSHUVRQIURP UK taxation; but it does not appear to permit a unilateral adjustment of income by the UK, even in terms allowed by the treaty, unless the adjustment were agreed by the treaty­partner. Hence, a charge to UK tax must be created by an adjustment to a price, not to income or profit. Inter­affiliate transactions; however, these proved inadequate and were replaced by new legislation in 1972. The high corporate tax rate in the 1920s was an incentive for local subsidiaries of foreign companies to establish pricing arrangements which minimized German tax liability. To combat this, the income and corporate tax laws of 1925 made two provisions. Where a foreign enterprise which would not be fully subject to German tax operated a business through a branch establishment, the income of the local establishment could be assessed by comparison with similar businesses or on the basis of a normal return on the capital employed s.34. In the case of a separately incorporated company which would be fully subject to German tax, if, as a result of a special relationship, there was a `clear disparity ¶in the profits achieved by the German entity by comparison with the normal profit levels in such business, its taxable profit could be fixed at the level of the return normal in that type of business domestically s.33. 1 However, the latter provision applied only if one company directly owned at least one­quarter of the shares of the other, so it could easily be avoided by interposing an intermediary. This problem came before the Tax Appeal Court the Reichsfinanzhof in the famous Shell case in 1930. 2 The Rhenania company, an affiliate of Shell which imported and refined oil and marketed petroleum products in Germany, had shown a loss in 1925 but had been assessed to tax on the basis of a normal rate of return on assets of 14. The court accepted that on a strict construction of the 1925 legislation, s.34 seemed intended to apply where there was no legally separate company, while s.33 only authorised an assessment based on estimated profits where there was a direct ownership relationship, as well as proof of abnormally low profits. These provisions were, however, the first venture by the legislature into a difficult terrain, and should not be interpreted so narrowly as to be easily avoided. Thus, the court was willing to agree that a locally incorporated subsidiary could qualify as the `branch establishment ¶of the foreign enterprise under s.34. This could be so if they formed an `organic unity ¶ Organschaft. However, the `organic unity¶ concept, orginally developed to prevent the `cascade ¶ effect of turnover tax being applied to sales between related firms, required a very close relationship such that the dependent enterprise was totally controlled managerially by its parent; 3 and it was not clear that the relationship between the Rhenania company and Shell was of this type. The court considered that account had to be taken of the development of large global enterprises, in relation to which a looser concept of unity was applicable: it could include related entities under common control if their separate parts could not be adequately understood as autonomous units but whose position in the economy as a whole could only be explained by reference to the combined enterprise. In such 1 Einkommensteuergesetz 1925, ss.33 and 34 Reichsgesetzblatt 1925­I, p.196; Korperschaftssteuergesetz 1925 s.13 ibid. p.211. 2 Judgment of 30 January 1930, IA 22629, [1930] Reichssteuerblatt p. 148, No. 220. 3 See Chapter 1 section 2aii above. circumstances, instead of the full liability to tax of the German company based on its own accounts, it could be treated as a branch and the tax liability would be on the proportion of the parents profits attributable to the subsidiary. A few months later, the same court went further and held, in the Citroen judgment, that where `organic unity ¶could be shown, the profit attributable to the business in Germany must be proportionate, and they could therefore be computed as a fraction of the income of the whole enterprise. 1 In that case, the German subsidiary assembled automobiles using engines and components supplied from France; and the French parent also supplied the capital and some of the skills. In such circumstances, even if the German companys books appeared to be in order, it should be proved that intra­ firm prices produced a proportionate profit, for example by showing sales of engines at the same prices in similar quantities to independent entities p.758. Otherwise, the income attributable to the German business should be estimated as a proportion of the total. The UK Inland Revenue advised the Foreign Office in 1931 that there were no grounds for objection to these decisions, since the same principles applied under British law PRO file IR40­5674. However, the effectiveness of these provisions was largely undermined, especially in the period 1950­70, by a number of doubts, uncertainties and loopholes. First, the organic unity concept was based on the principle of managerial integration, and could easily be avoided by the interposition of a holding company Chapter 1 section 2aii above. Also, once Germany entered into tax treaties, it was held that the treaty provisions on company residence would override this rule Landwehrmann 1974, p.250. In practice, the `organic unity ¶theory could be used to the benefit of the taxpayer, and was rarely used to its disadvantage. 2 Furthermore, doubts were cast by jurists on the validity of the organic unity theory under international law and thus, under the German Constitution, since it involved an assertion of jurisdiction over foreign companies Weber­Fas 1968, pp. 184­186. 3 Thus, when the avoidance of tax by the use of intermediary companies and tax havens became an issue in the early 1960s, the tax authorities sought initially to establish administrative rules under the general anti­avoidance provisions of the tax law see Chapter 7 section 1a above. When this also proved to provide an uncertain legal foundation, the government finally enacted the Aussensteuergesetz Foreign Tax Law of 1972. Section 1 of this Law gives a broad power, similar to those in the French and US 1 Judgment of 16 September 1930, IA 12930, [1930] Reichssteuerblatt p.757, No. 937. 2 Landwehrmann 1974, p.251; but see the 1963 decision cited in the next footnote. 3 However, in 1963 the Bundesfinanzhof upheld a decision by the tax Commissioner that a 99 owned Japanese subsidiary of Schering could be treated as its Organ and thus resident in Germany Judgment of 18 Dec. 1963 [1964] BStBl III 253; an English translation is provided in Weber­Fas 1968, p.249; the Court held that `there is no single test for what constitutes sufficient contact to establish tax MXULVGLFWLRQ¶VRWKHHUPDQ2UJDQVFKDIWWKHRU\ZDVQRWFRQWUDU\WRLQWHUQDWLRQDOODZDQGZDVWKXV valid under the German constitution. Note that this was prior to the German­Japanese treaty. provisions, to adjust the income of a taxpayer if it has been reduced due to non­arms length transactions with a related entity. 1.f. Other National Provisions Some other countries also made some attempts to deal with the problem in the 1930s. Thus, Belgium enacted a provision in 1938 to allow profits of foreign related enterprises to be taken into account in assessing a company to Belgian tax; this was originally aimed at Luxembourg holding companies, and was amended in 1962 and 1973 Wisselink in Rotterdam IFS 1978, 87­9. Japan, on the other hand, perhaps because its companies did not venture into foreign direct investment until much later, did not enact a transfer pricing law until 1986. Other countries have also slowly introduced either specific legal provisions or administrative regulations based on the arms length rule. Thus, in Brazil a law of 1964 combating tax avoidance by family enterprises was amended in 1977 and 1983 to apply to pricing between related legal entities, in seven types of defined transactions Leite 1991. While the general principle that accounts must fairly reflect a firms business activities is accepted in one form or another everywhere, specific legal and administrative measures for the evaluation of transfer prices have been surprisingly slow to develop. 1 1.g The Advantages of Adjustment Thus, the generally agreed approach has been to start from the separate accounts of separate branches and subsidiaries of an international corporate group, while providing powers to the revenue authorities to adjust those accounts as necessary to reflect the true profit. In the case of separately incorporated entities, inter­affiliate transactions must be judged by the test of independent entities dealing at arms length. If such transactions have been conducted on a non­arms length basis, the tax authorities have a broad power to adjust the accounts; although the British provisions are somewhat narrower in specifying adjustments to prices of specific transactions rather than adjustments to income and costs generally. In the case of branches the treaty provisions still allow adjustment of profits using `percentage of turnover ¶ or other methods, provided that substantially the same result is reached. The adjustment of separate accounts undoubtedly had advantages over attempting to consolidate the accounts of related companies. First, it is possible to use a much broader definition of `common control ¶for a power to adjust than would be possible for consolidation, which must be based on the related company being wholly or at least majority owned. This is not to underestimate the difficulties of defining `common control ¶and of enforcing the principle effectively against determined 1 A brief general report was compiled on approaches used in taxation of TNCs based on a questionnaire to tax administrations in 34 Commonwealth countries: Commonwealth Secretariat n.d., 1987?. avoidance. For example, intra­firm loans can be routed through an independent third party by using a parent company guarantee, or `back­to­back ¶ loans see section 3 below. In some countries, notably the UK and Japan, the definition looks to formal legal powers of control, and may be easily avoided, as can be seen in the British court decision that related family trusts are not under common control if even one trustee is different Commrs. of I.R. v. Lithgows Ltd 1960. Other laws have a broader definition of common control, including any powers of influence: thus, the German rules of 1983 include connection through `special channels of influence ¶besondere Einflussmöglichkeiten and through `identity of interests ¶ 1983 Rules, para. 1.3.2, see Rädler and Jacob 1984, p.10. Second, the adjustment of accounts of a local affiliate can be done by a national tax authority without proceeding to what would amount to a full examination of the entire group to eliminate all internal transactions; and without delaying the taxation of a profit made on an inter­affiliate sale until the final profit is realised by a sale outside the group. The difficulty with adjustment of accounts lies in establishing criteria for the adjustment. Since the problem was identified as being the `diversion ¶of profits, the intention was to establish the `normal ¶profit, and it seemed natural to define this as the profit which would have been made had the parties been truly independent Surrey 1978, p.414. This was all that was meant, initially, by the Arms Length criterion. There is considerable evidence that what the revenue authorities sought in practice was a fair allocation of the total profit to the local affiliate. This is evident from the various national reports for the League of Nations study: notably, the British Inland Revenue, which strongly favoured adjustment of accounts, stated that only 55 of cases were settled on the basis of separate accounts, and even then, the agreement of the tax­payer to adjustments was greatly facilitated by the availability of the alternative method, assessment based on a percentage of turnover League of Nations 1932, p.191; see Chapter 1 section 5 above. As we have seen, those countries which had already enacted national laws had created powers to adjust the profits of local branches and subsidiaries. For example, the French transfer pricing law of 1933 cited above, specifically provided that price adjustments could be checked by comparing the profits of the local affiliate with those of `similar undertakings normally managed ¶ If the aim of individual tax authorities was to ensure a reasonable profit allocation to the local affiliate, it was nevertheless important in the international context that this be done by adjusting the prices of specific transactions. The reason is plain: a reallocation of `diverted ¶ profit from one affiliate to another will lead to double taxation unless the adjustment of accounts by one tax authority can be followed by a corresponding adjustment acceptable to the other. It appears more legitimate if this is done by an adjustment of prices for specific transactions than by a profit split. In most cases, indeed, the company can merely adjust its internal accounts in some suitable 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