Reclaiming Market Dynamics

In a recent interview with the Financial Times, Pierre Gramegna, finance minister of Luxembourg, rejected the European Commission’s criticism vis-à-vis the state aid cases, saying the commission’s approach was problematic. “If the European Commission can make its own interpretation of the transfer pricing rules, others can too. This is worrying for companies and we live in a globalised world”, he said. I agree. 

However, tax authorities’ “own” interpretation of the transfer pricing rules is not a new phenomenon; nor is less-than-thorough analytical work on the side of “defense file” authors. Examples include close-to-default remuneration levels based on “high level functional analyses”, extremely aggregated transactions with no link to business reality, and clumsy auto-pilot applications of the TNMM.

Actual cases-in-point from the recent hall of horrors include: ranges of simple distributor net margins from negatives up to double-digit positives “explained” simply by the inexactness of transfer pricing; a critically important value-based service provider remunerated at cost plus with no economic references; and an interquartile range described as the arm’s length range, effectively disregarding all other percentiles than the 25th and 75th for no reason but habit.

Similarly, in a very recent tax audit, a tax administration argued that different distributors in different countries in different years all should earn the exact same net margin, claiming this to be arm’s length. Ironically, applying the arm’s length principle in such a manner is to assume that arm’s length behavior should approximate a planned economy rather than market dynamics.

In short, both advisors and tax administrators are often guilty of interpreting transfer pricing rules to suit their own objectives. In this context, are the BEPS Project outcomes welcome? Like much in life, it depends.

Oftentimes the BEPS Project has been perceived as producing more compliance burdens on the shoulders of tax-payers. This is true. But at the same time the report “Aligning Transfer Pricing Outcomes with Value Creation” (OECD, October 2015) provides a great arsenal of arguments against lazy practitioners (advisors and tax administrations alike) who believe they can make their own interpretation of transfer pricing rules with little or no argumentation.

Just a few examples:

Applying the arm’s length principle in a post-BEPS world is to apply the arm’s length principle as it should have been applied all along: thoroughly. However, a thorough analysis will be more expensive for both corporates and tax administrations and a greater level of detail may introduce a greater level of subjectivity and interpretation (i.e. scope of controversy).

In conclusion, BEPS Project outcomes should help reclaim market dynamics, accepting the direct price that must be paid now in doing “better analysis” and the indirect price to be paid in terms of more “audit activity” and “controversy” to come.