Next year is the 85th anniversary of
the adoption of the arm’s-length standard (ALS) by the U.S. government as the
norm to be used for pricing transactions among related parties for the purpose
of calculating their U.S. corporate income tax (CIT).
The 1935 U.S. Treasury Regulations in tax code Section 45-1(b) (later
renumbered as Section 482) defined the ALS as: “The purpose of section
45 to place a controlled taxpayer on a tax parity
with an uncontrolled taxpayer, by
determining, according to the standard
of an uncontrolled taxpayer, the true net income from the property and business
of a controlled taxpayer.” In other words, the purpose was
to determine what the taxpayer’s
net income from its property or business would have been if all
of its transactions had been conducted with unrelated parties rather than
with other affiliates in the multinational enterprise (MNE). The U.S. Congress
feared that MNEs would engage in income
shifting to lower tax jurisdictions outside of the U.S. through
mispricing of related party
transactions. The ALS was designed to prevent this by ensuring that transfer prices would clearly reflect MNE income and deter tax evasion.
Over the past 84 years, our
understanding of the ALS has been clarified and codified through multiple U.S.
Treasury Regulations and U.S. Tax Court decisions. Transfer pricing
professionals now view the ALS as requiring related party transactions to be priced
as if they had been negotiated between unrelated (arm’s- length) parties
engaged in the same or similar transactions under the same or similar facts and
circumstances. In other words, “What would independent enterprises have done?”
Answering this hypothetical question therefore requires a detailed
comparability analysis and adjustments to ensure that sufficiently similar
transactions took place under sufficiently similar facts and circumstances.
The simple sentence adding the ALS to
U.S. tax law in 1935 has now spread and diffused around the world. Canada was
an early adopter; Section 23B was added to the Income Tax Act in 1939 and the first Information Circular was
published in 1987. Mexico followed later. The ALS was added to the Mexican
Income Tax Law in 1976; enforcement was added in Article 64A in 1992.
Worldwide diffusion of the ALS has
been primarily through the efforts of the Organization for Economic Cooperation
and Development (OECD), which included the ALS in Article 9 (associated
enterprises) of the 1964 draft (finalized in 1977) Model Tax Convention and
issued its first Transfer Pricing
Guidelines in 1979. The United Nations included the ALS in its 1977 draft
Code of Conduct on Transnational Corporations and its 1978 Model Tax
Convention. With the active encouragement of the OECD and UN, the number of
countries with detailed transfer pricing laws, regulations, and rulings based
on the ALS has tripled since 2003 and doubled since 2010, from 40 countries in
2003 to 59 countries in 2010 to 124 countries in 2019
(EY 2003:
3, 2010: 2, 2019a: 2).
With an 85th anniversary just around
the corner, one might be expecting transfer pricing professionals to be getting
ready to celebrate. However, that is not the case. The ALS now appears to be in
retreat. Many transfer pricing experts argue the ALS is “dead.” Shepherd (2012:
467), for example argued that, “The
transfer pricing guidelines are a sorry vestige of a system that will be gone
in 10 years.”
Criticisms of the ALS have been longstanding,
going back at least to 1986 (Bird
and Brean, 1986; Langbein, 1986; 1992). The criticisms fall into two broad categories. First
there are concerns, most prominently argued by non-governmental organizations such as the Tax Justice
Network and Christian Aid, that MNEs have been deliberately
engaging in abusive transfer pricing
that is extensive, unfair and draining
development. The second criticism is that the transfer pricing rules are too difficult
to implement for various reasons, of which
the two most important reasons are
that arm’s-length comparables often do
not exist (e.g., hard-to-value intangibles) and that MNEs benefit from
synergies not available to unrelated parties.
Elsewhere, in Eden (2016), I have addressed the second
criticism: the ALS is unworkable due to lack of comparables and MNE synergy benefits. I
assessed the criticism from both theoretical and practical bases, concluded
that the transfer pricing rules can be salvaged,
and made several recommendations for fine- tuning the ALS.
Interested readers are directed to that article. In this piece, I
want to address the first criticism: the ALS should
be abandoned because MNEs are misusing the
ALS to engage in extensive
income shifting. My goal is
to show that the ALS is not the problem.
Moreover, I believe that
many of the OECD’s BEPS (Base Erosion and Profit Shifting) reforms go a long way to remedying the
worst income- shifting excesses of the past 20 years. On the
eve of the 85th anniversary
of the ALS, there is much
to celebrate—although more remains to be done.
Quick Review of International Income
Tax Principles
The current international tax system
as set out in the OECD and UN Model Income Tax Conventions and bilateral income
tax treaties is based on the residence
and source principles whereby different types of income are allocated to
either to the residence country (where the owner resides) or the source country
(where the income is earned). Typically the source (or host) country is given first crack at the corporate income tax
base and the country of residence—assuming it taxes its MNEs’ foreign source
income— provides tax room for the source country through a foreign tax credit
or deduction of foreign income and withholding taxes up to the level of the
residence country tax rate. Foreign subsidiaries are treated as separate entities for tax purposes, that
is, as standalone legal entities in the host country using separate accounting. Foreign branches may also be treated as de
facto separate entities if they meet the permanent
establishment test.
Because foreign
subsidiaries and permanent establishments (branches) are treated as separate
from their parent firm,
their profits are determined on a country-by-country basis. Transactions
among the MNE parent and its foreign affiliates
can therefore affect where
the MNE’s group profits are declared and taxes paid.
Over-invoicing (under-invoicing) of exports
shifts profits into (out of) the exporting
affiliate; the reverse is true for
the importing affiliate. The ALS is therefore
necessary as a backstop to the international tax system.
The ALS prevents MNEs from engaging
in tax avoidance and evasion strategies designed to shift
income to lower taxed activities and jurisdictions by requiring that transfer prices clearly reflect the income earned by the separate entities within the MNE.
The Tax Design Problem
I believe
the first critique made by professionals and academics who would
like to scrap the ALS is misplaced. The excessive income shifting
among tax jurisdictions that we have witnessed over the past 20 years is not
a transfer pricing problem but rather an income tax design
problem. I believe the criticism is a good example of “shooting
the messenger” rather than facing up to and addressing the underlying problem. Abusive transfer pricing is caused by perverse
incentives—set in place by governments—that encourage MNEs to manipulate transfer prices to take advantage of differences in tax rates across
jurisdictions. This is not a transfer
pricing problem but an international tax regime “design”
problem. It is best
handled by fixing the gaps in the international tax system rules. If
governments, NGOs, and the general public
do not like the way that
multinational firms are allocating
their taxable income among countries and
the amounts of tax (or lack
of tax) they are paying, the
problem should be laid at the
feet of governments, not the MNEs. The prescription
should be: Physician heal thyself!
Arguing that the OECD, UN, and national
tax authorities should scrap the
ALS is misplaced and misguided.
The international tax system has
gaping holes that provide many
legal opportunities for MNEs to engage in regulatory
arbitrage. Moreover, the rules have become ever more complicated and complex, both in terms of the
length and variety of regulations and the number of countries with these rules, making it ever more difficult for MNEs to keep up with national
regulations.
The best solution would be to
re-establish the principles of international equity and efficiency that underpin
the international tax system by tightening and eliminating the tax loopholes
that create the incentives for transfer mispricing. While there will always be
firms that will push the envelope in terms of tax aggressiveness—moving across
the “bright line” from tax avoidance into tax abuse and possibly tax
evasion—the majority of MNEs pay their taxes and follow the rules that have
been laid down for them by national governments.
To end abusive transfer pricing, the
first step must be to reduce the incentives that governments have put in place
to encourage and enable MNEs to engage in these income shifting activities.
Here I discuss three possible alternatives. The first is a simpler
international tax system—one based on the classical system of residence
taxation of foreign source income (FSI) with foreign tax credits for
source-based taxation on an accrual basis. If large OECD home countries were to
adopt such a system, it would eliminate most of the incentives for abusive
behavior that riddle the current international tax regime. The second
alternative— closing the tax loopholes—is well underway with the OECD’s BEPS
project and the new Multilateral Instrument. The third alternative—replacing
the current system with source-based taxation using global formulary
apportionment (GFA)—would, I believe, be a disastrous mistake.
Alternative 1:
Return to First Principles—International Tax Equity and Neutrality
Alternative 1 is probably the least
likely to happen, particularly since the 2017 U.S. Tax Cuts and Jobs Act (TCJA)
has moved in exactly the opposite direction. Still, it is useful to explore
this option.
To reduce the incentives for MNEs to
engage in abusive transfer pricing, residence countries should tax foreign
source income (FSI) on a worldwide basis as earned, with no deferral provided
for income kept offshore. Common residency definitions should be adopted so
that MNEs cannot exploit differences in definition across countries so as to
become stateless and tax free (for example, as Ireland did for many years with
its two definitions of MNE residency).
I am not alone in this view. For example, Avi-Yonah (2016)
argues that OECD governments should return
to the traditional way of taxing MNE
profits: home country taxation of
the MNE’s worldwide income on an accrual
basis coupled with foreign tax credits
for foreign source income taxes. He recommends
that “Each OECD member country impose tax
at its normal corporate rate on the
entire profit of multinationals that are
managed and controlled from headquarters within it, with a foreign tax credit for taxes imposed by other jurisdictions “ (Avi-Yonah
2016: 114).
Developing
countries would benefit from this policy change
because it would enable their
governments to re-establish corporate
income and withholding taxes, creating a revenue stream that could be used for social
and other domestic purposes. Developing countries would not have to
worry about the potential loss of inward foreign direct investment
(FDI) due to competition from tax havens and other
lower taxed jurisdictions. In effect, the OECD countries would provide an “umbrella”
level of corporate income taxation
under which developing countries could “shelter” their own corporate income taxes, protected from evisceration by mutually destructive rate cutting.
The “first crack” principle would enable developing countries to
raise their taxes on inward FDI income,
knowing that these taxes were creditable up to the level of the home country tax.
Figure 1 illustrates the impact of
the umbrella effect and first crack principle. Assume country A (the home or
residence country) has a CIT rate of 30%. Multinationals resident in A have
foreign affiliates in countries B, C, and D where CIT rates range from 10% to
25%. Assume country A taxes the worldwide income of its MNEs on an accrual
basis (no deferral), with a foreign tax credit up to the level of A’s CIT rate.
In this situation, A’s MNEs pay a 30% worldwide CIT rate regardless of where
their foreign affiliates are located.
As a result, countries B, C, and D
are free to set their own CIT and withholding tax rates up to the creditable
level in country A without fear of a negative impact on inward FDI from country
A. In effect, country A provides a “tax umbrella” or ceiling of 30% for its
host country partners, under which these governments can shelter their own
rates.
Figure 1: How to End Abusive
Transfer Pricing—First Crack and the Umbrella Effect
 |
For many years the U.S. has one of
the world’s highest statutory corporate income tax (CIT) rates at 35%. The U.S.
taxed worldwide income of its MNEs; however, the U.S. also practiced tax deferral whereby FSI was not taxed
until it was repatriated. As a result, most U.S. MNEs kept their FSI offshore
to avoid the additional U.S. tax that would have been due on repatriation.
Still, the situation
pictured in Figure 1 did
apply to offshore income earned by controlled foreign corporations (CFCs) if
that income qualified as passive income under Subpart F of the U.S. corporate income tax. That income was taxed at the U.S. rate, with a foreign
tax credit for the host income tax. The umbrella
effect of a high U.S. CIT together
with the Subpart F provision
discouraged MNEs from shifting passive income to low-tax jurisdictions. This situation remained in place until the “check the box” provision permitted
MNEs to avoid Subpart F through creating
hybrid structures.
U.S. from a
worldwide to a territorial system, exempting FSI (whether repatriated or kept
offshore) from
U.S. taxation. Thus, not only did the
U.S. reduce its CIT rate, shifting the umbrella downwards; in addition, the
U.S. exempted all FSI from taxation, in effect, removing the umbrella.
We can
see this in Figure 1. Assume
country A does not tax FSI (i.e., country A follows a
territorial system of exempting FSI from taxation). Then the three host countries B, C, and D, which
are competing for inward FDI from country A, will offer A’s multinationals
very different tax rates. While CIT
rates are typically not the most
important factor affecting FDI location, they do matter. Tax competition could
precipitate a CIT war, leading to a “race to the bottom.”
As Figure 1 suggests, differences in
host country CIT and withholding rates should now have more impact on FDI
location; they could also encourage abusive transfer pricing between the host
countries.
Heinemann et al. (2018)
supports these conclusions. The authors find that the TCJA lowered the
effective tax burden on U.S. inward FDI from the EU as well as on U.S. outward
FDI to the EU, with the benefits of
U.S. tax reform being
highest for low-tax EU members (e.g., Ireland) and the costs highest for
high-tax EU members (e.g. Germany). One likely impact is that high-tax
jurisdictions will be forced to follow the U.S. lead, lowering their CIT and
withholding taxes in order to retain inward FDI.
As Gravelle
and Marples (2019) argue, however, lowering the
CIT rate and exempting FSI from
U.S. taxation
were not the only international tax changes introduced in
the TCJA. The U.S. also added a worldwide tax on global intangible low-taxed income (GILTI), a
tax incentive
program for U.S. intangibles (FDII), and a base erosion and anti-abuse tax (BEAT) to
curb profit shifting out of the
U.S.. GILTI effectively imposes a global minimum tax on foreign affiliates (branches and subsidiaries) that have U.S. parents.
FDII encourages U.S. exports of
intangibles and services by taxing their profits at a lower rate. BEAT is an alternative minimum CIT
that can disallow U.S. tax deduction for “above normal” payments to foreign
related parties. The legislation and (coming) regulations implementing TCJA are
highly complex and their long-term impact is unclear. Gravelle and Marples
(2019) suggest that the combination of GILTI, FDII, and BEAT should work to
discourage profit shifting, possibly offsetting the impact of lowering the CIT
rate and moving to a territorial system. What is clear, however, is that
alternative 1—moving to worldwide taxation on an accrual basis—may now be a
non-starter in the U.S. after the 2017 TCJA.
Alternative
2: Closing the Most Egregious Loopholes (BEPS)
A particularly
useful policy invention is the new
Multilateral Instrument (MLI), which is
designed to update thousands of bilateral tax treaties
to include the BEPS
Action Items as they are adopted at
the country level
(Oguttu 2018). Another useful—and
practical—innovation is the new
Tax Inspectors Without Borders initiative,
which has already significantly increased tax revenues for developing countries (OECD/UNDP 2019).
Stronger
anti-avoidance rules for activities with no business purpose would also provide
a backstop against the most egregious activities.
Some examples of proposals that I
support are summarized in Box 1 below. I am not
alone in making these policy recommendations, and many of
them are included in the BEPS
Action Items and now being introduced into the MLI.
Many practitioners and academics have also supported these proposals. For example,
Durst (2016) argues for strengthening controlled foreign corporation
(CFC) rules that prevent income shifting by MNEs, such as the U.S. Subpart F rules.
He provides a nice history of
CFC rules
around the world, and
how they have been eroded through legislation and MNE ingenuity. Durst argues for a “strengthened
international net of CFC rules”
(which I also support), for “self-protective
measures” by developing countries
such as limitation of deductions and reinstatement of withholding taxes (which I also support), and for a move from the ALS to
formulary apportionment (which I do not support). Mehta and Siu (2016:
339) also provide a variety of suggestions for developing countries that would help ensure they receive a “fair deal on tax justice”.
Box 1: Solving the Tax Design
Problem—Eliminate Income Shifting Opportunities
 |
Country-by-country reporting (CbCR)
is already providing additional information would may be helpful for
governments; the greater visibility should also discourage base shifting
activities by MNEs. MNEs must provide much better information about their activities,
both by country and by line of business, in their public reports. Greater
transparency in MNE operations on a worldwide basis would also go a long way to
reducing opportunities for income shifting. One concern, however, is that CbCR
may be misused to “back door” into a formulary apportionment approach to
allocating the MNE’s tax base among countries, as it appears to be doing in the
current BEPS 2 proposals for taxing the digital economy (Eden, Srinivasan, and
Lalapet, 2019).
Alternative 3:
Global Formulary Apportionment Is Not the Answer
I am not in favor of GFA for allocating
the MNE’s global profits
for tax purposes among countries on
a worldwide basis for a variety
of reasons that I spell
out in Eden (1998: 561-583). Twenty years later, I still believe these are key impediments to implementing GFA
on a global—or even on a regional—basis. One of the key reasons is the
simple adage that “an old tax is a good tax.” The ALS has been the global norm for multiple decades. Achieving
international consensus—or even regional
consensus—around another other international tax standard seems highly unlikely. A mixed system with both the ALS and GFA in place would impose huge compliance costs on MNEs and significantly raise the risk of double taxation.
Second, GFA is simply too blunt a
tool to achieve the ultimate purpose for which the ALS was designed, that is,
to clearly reflect the true taxable income of the MNE in each of the countries
where the MNE has activities, and to prevent (or at least reduce) the
incentives for income shifting among countries. In addition, the three-factor
formula most likely to be used (sales, labor, and capital (tangible assets))
does not include the “sina qua non” of
the multinational enterprise—its intangible assets, which are the core source
of MNE long run competitive advantage (Eden, Levitas, and Martinez 1997).
A third
reason is both political and practical.
The problematic history of the multi-jurisdictional compact among the U.S. state
governments with sharing of U.S. state-level
CITs provides a sobering example
that should raise a cautionary
red flag to even the most
enthusiastic proponent of GFA. Altshuler
and Grubert (2010) provide us
with good examples of how shifting from assets (origin based) to sales
(destination based) factors can affect the
location of MNE income.
Tangible assets (i.e., property, plant,
equipment and inventories) are a “minority of total assets even
in nonfinancial businesses” (Altshuler and Grubert,
2010: 1179)—and that percentage is expected
to fall in the digital
economy. It is perhaps not
surprising that most of the U.S. states have switched from
assets to sales as the most important factor for allocating state CIT receipts. The situation
is likely to be much worse when national governments—not
sub-federal ones—can use GFA to
play tax competition games. Moreover, many
of the income gaming techniques currently used by MNEs could also be used to shift income among jurisdictions under GFA.
There may be certain areas where the
related-party transactions are so interwoven that they cannot be disentangled,
much less priced such as 24-hour global trading. In these situations, GFA may
be least inappropriate way to determine true taxable income. A partial introduction
of formulas, perhaps as safe harbors or as guaranteed taxable income floors for
the least developed countries, may also be needed. See, for example, the
proposals in Avi-Yonah and Benshalom (2011).
However, I do not believe GFA is the best way forward for the international tax regime, even
in a world dominated by digital MNEs. The OECD/G20 (2019) is currently considering fractional apportionment as one of
three possible methods for attributing income to countries under the Pillar 1 proposal (reallocation of taxing rights involving profit allocation
and nexus rules) for
taxing the digital economy. I believe
the problems outlined above would
also apply if GFA were used for Pillar
1 and am therefore not in favor of this proposal.
Conclusion
The historical
approach to taxing intrafirm transactions of multinational enterprises—the ALS—has been
criticized as unworkable, out-of-date
and on death’s door. Many academics and policy
makers now advocate getting rid of the ALS and shifting to GFA as an alternative. Even the OECD, long a supporter of the ALS and
opponent of GFA, now includes fractional apportionment as a possible method for attributing income among countries under its Pillar 1 proposals
for taxing the digital economy.
My views are different. My preferred
policy response to the income shifting problem is two-fold. First, I believe
that many of the criticisms of the ALS in terms of abusive transfer pricing are
misdirected; the criticisms should be more appropriately aimed at weak
international tax rules that need to be fixed. The OECD’s BEPS project goes a
long way to correcting many of the inconsistencies and loopholes in the
international tax system. As the BEPS Action Items are adopted at the country
level and diffused across countries through the Multilateral Instrument, many
of the most egregious incentives for income shifting should disappear.
Second, assuming
the loopholes in the international tax regime can be fixed, I
believe that the ALS remains the appropriate international norm for
taxing MNEs. New thinking, particularly for the digital
business models that are now starting
to dominate international production,
is probably needed (Srinivasan,
Lalapet, and Eden 2019). It is even possible that new technologies such as blockchain
could make it easier for MNEs to
comply with the ALS (Sim, et al. 2019).
Fine-tuning the ALS for the 21st century
is the appropriate solution.
My
conclusion: The arm’s-length standard is
not the problem. Don’t shoot the messenger!
References
This column does not necessarily reflect the
opinion of The Bureau of National Affairs, Inc. or its owners.
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