Explanatory Memorandum to COM(2023)529 - Transfer pricing - Main contents
Please note
This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2023)529 - Transfer pricing. |
|---|---|
| source | COM(2023)529 |
| date | 12-09-2023 |
1. CONTEXT OF THE PROPOSAL
• Reasons for and objectives of the proposal
This proposal is part of the package known as ‘Business in Europe: Framework for Income Taxation’, or ‘BEFIT’. The package includes, next to this transfer pricing proposal which integrates key transfer pricing principles into EU law with the aim of putting forward certain common approaches for Member States, a second separate proposal which lays down a common set of rules for computing the tax base of large groups of companies in the EU.
Transfer pricing refers to the setting of prices for transactions between associated enterprises (i.e. members of the same Multinational Enterprise - MNE) involving the transfer of property or services. A significant volume of global trade consists of international transfers of goods and services, capital and intangibles (such as intellectual property) within an MNE; such transfers are called “intragroup transactions”.
The “intragroup transactions” are not necessarily governed by market forces but may largely be driven by the common interests of the group as a whole. Since tax calculations are generally based on entity-level accounts, the prices or other conditions at which these intragroup transactions take place will affect the relevant entities’ income and/or expenses in relation to those transactions, and as a consequence, will impact on the amount of profit each group entity records for tax purposes. A higher price increases the seller’s income and decreases the buyer’s income. A lower price decreases the seller’s income and increases the buyer’s income. The transfer price therefore influences the tax base of both the country of the seller and the country of the buyer involved in a cross-border transaction.
It is therefore important to establish the appropriate price, called the “transfer price”, for intragroup transfers. “Transfer pricing” is the general term for the pricing of transactions between related parties.
According to the current international standards, which have been developed by the Organisation for Economic Cooperation and Development (OECD)1, cross-border transactions between related entities of a multi-national group must be priced on the same basis as transactions between third parties under comparable circumstances. This is known as “arm’s length principle” and is reflected in Article 9 (Associated Enterprises) of the OECD Model Tax Convention on Income and on Capital2.
However, Article 9 does not set out detailed transfer pricing rules. Over time the OECD has developed the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations3 (OECD Transfer Pricing Guidelines) which provide guidance on the meaning and application of the arm’s length principle. Those guidelines have been developed as a non-binding instrument with the aim to assist MNEs and tax authorities in finding solutions to transfer pricing cases that minimize conflicts and limit litigation. The OECD Transfer Pricing Guidelines were first published in 1995 and are regularly updated.
Article 9 of the OECD Model Convention is not considered to create a domestic transfer pricing regime if the arm’s length principle has not been incorporated in the national law. In fact, it is generally understood that article 9 is not “self-executing” as to domestic application. However, jurisdictions normally have in place domestic legislation that ensures some harmonization on basic principles, in accordance with the arm’s length standard, even if the application is not identical around the globe. Further, jurisdictions may have in place their own administrative guidance and/or regulations to better explain the national provisions and provide guidance on their interpretation.
The rationale of this proposal derives from the fact that almost all Member States are also members of the OECD4 and therefore committed to follow the OECD principles and recommendations. However, despite the political commitment by the majority of Member States, the status and role of the OECD Transfer Pricing Guidelines currently differs from Member State to Member State. In addition, at the level of the Union, transfer pricing rules are currently not harmonized through legislative acts, although all Member States have in place domestic legislation that provides for a common approach to the basic principles. Yet, this is not fully aligned. The fact that each Member State enjoys large discretion in interpreting and applying the OECD Transfer Pricing Guidelines gives rise to complexity and an uneven playing field for businesses.
For example, domestic legislation of Member States shows differences in the definition of ‘associated enterprises’ and in particular, on the notion of ‘control’ which is normally the pre-condition to apply transfer pricing. Certain Member States apply a threshold of 25% while others apply a threshold of 50% shareholding when it comes to determining whether the control criterion is met. It translates into businesses facing tax uncertainty, high compliance costs as well as frequent, time-consuming legal disputes leading, amongst others, to considerable amounts of legal fees and creating barriers to cross-border operations and high risks of double and/or over-taxation.
The risk of double taxation and over-taxation for businesses operating cross-border leads to a lack of tax certainty due to possible tax disputes5 between tax administrations of different Member States in cases where they take different views in relation to the treatment of a specific transaction within their corporate tax system. In a continuously more globalised and competitive world economy there is an increased need for more tax certainty in the Single Market. Thus, to increase tax certainty regarding their tax affairs, some businesses seek to obtain tax rulings from a tax authority in respect of the treatment of certain transactions. However, if the tax ruling is unilateral, other Member States concerned may still challenge the agreed treatment of such transactions. Therefore, even when a unilateral tax ruling is obtained, there is a real risk of tax disputes and possible double or over-taxation.
Contents
- The complexity of the transfer pricing rules and their different implementation in national law of Member States gives rise to a number of other problems:
- The impact assessment, as revised following the recommendations from the RSB, examined the baseline option (i.e. no change) and two policy options:
The complexity of the transfer pricing rules and their different implementation in national law of Member States gives rise to a number of other problems:
- Profit shifting and tax avoidance6: transfer prices can be easily manipulated to shift profit and be used in the context of aggressive tax planning schemes.
- Litigation7 and double-taxation8: transfer pricing is more subjective than other areas of direct and indirect taxation and, for this reason, sensitive to disputes as tax administrations do not always share a common interest and interpretation. This is because, to prevent double taxation, a well-founded primary (upward) adjustment by one tax administration should ideally be followed by a corresponding (downward) adjustment by the other. This implies that the second tax administration would have to reduce its tax base accordingly, which is most probably an option that a tax administration would preferably avoid taking.
- High compliance costs: Double taxation is already a considerable cost for businesses operating cross-border. In addition, also the tax compliance costs9 related to transfer pricing are significant. These costs result from the obligation on businesses to determine what prices could be regarded as arm's length, conducting studies and compiling and maintaining/updating the related documentation.
These tax barriers for businesses impede the proper functioning of the Single Market and hamper the prospect for achieving its potential in terms of efficiency gains. As a result, the competitiveness of the Single Market is undermined.
This proposal aims at simplifying tax rules through increasing tax certainty for businesses in the EU, thereby reducing the risk of litigation and double taxation and the corresponding compliance costs and thus improve competitiveness and efficiency of the Single Market. A clear outcome from both the targeted and public consultations was the business desire for tax, and more broadly, legal certainty. Tax certainty has always been a high priority for business, often highlighted as a more important concern than the tax rate. This has become an increasingly critical issue due to the vast number of ambitious reforms in international corporate taxation over the recent years.
This objective is achieved by: (1) incorporating the arm’s length principle into Union law; (2) harmonizing the key transfer pricing rules; (3) clarifying the role and status of the OECD Transfer Pricing Guidelines; and i creating the possibility to establish, within the Union, common binding rules on specific transfer pricing subjects within the framework of the OECD Transfer Pricing Guidelines.
The proposal would provide a gradual development of common and consistent approaches among Member States’ tax authorities to the interpretation and application of transfer pricing rules through the incorporation of the arm’s length principle into Union law and the clarification of the role and status of the OECD Transfer Pricing Guidelines. Furthermore, the prospect for establishing common binding rules for Member States on specific transactions within the framework of the OECD Transfer Pricing Guidelines should improve businesses’ resilience in the Union, reduce distortions and contribute towards a level playing field in the Single Market.
• Consistency with existing policy provisions in the policy area
This proposal for a Directive is fully consistent with existing EU policies in the field of direct taxation. It follows up to the Commission’s and Union’s efforts as part of its tax policy agenda to create a robust, efficient and fair tax framework, which delivers solid revenues and is conducive to growth as set out in the Business Taxation in the 21st century Communication in 202110. This policy initiative aligns with the efforts to provide business with tax certainty and a level playing field, while ensuring that national governments can access fair and stable corporate tax revenues.
In 2016, the anti-tax avoidance directive (ATAD)11 was adopted to ensure coordinated implementation in Member States of key measures against tax avoidance stemming from the internal Base Erosion and Profit Shifting Project actions and to lay down a number of specific and general anti-tax abuse rules. It was amended in 2017 to include further anti-avoidance rules regarding mismatches between tax systems12.
In parallel, the directive on administrative cooperation (DAC)13 has, since its adoption in 2011, been revised and expanded on several occasions to allow a large-scale and timely exchange of tax related information between tax authorities across the Union to support the enforcement of Member States tax laws.
In particular, DAC314 and DAC615 are of specific relevance to this proposal due to their connection to transfer pricing. Under DAC3, national competent authorities, amongst others, exchange automatically information related to so-called Advance Price Agreements (APAs)16. DAC6 regulates the automatic exchange of information on reportable cross-border arrangements which have been reported by intermediaries or by the relevant taxpayer. The reportable cross-border arrangements are identified on the basis of a number of “hallmarks”, which include different indicators of a potential risk of tax avoidance. Hallmark E relates to arrangements relevant to transfer pricing.
The proposal is also consistent with the past output of the Joint Transfer Pricing Forum (JTPF)17, an expert group which was set up by the Commission in 2002 to propose pragmatic, non-legislative solutions to practical problems posed by transfer pricing practices in the Union. The JTPF worked within the framework of the OECD Transfer Pricing Guidelines and operated on the basis of consensus. Building on the work done by the JTPF, the Commission initiated a set of co-ordinated measures, either guidance or recommendations, which were all subsequently endorsed by the Council. One of these is the Code of Conduct on transfer pricing documentation for associated enterprises in the European Union (EU TPD)18, which is broadly followed by Member States. The mandate of the JTPF expired in March 2019 and it was not renewed.
The Arbitration Convention19 is also complementary to the proposal. It establishes a procedure to resolve disputes where double taxation occurs between enterprises of different Member States as a result of an upward adjustment of profits of an enterprise of one Member State. Whilst most bilateral double tax treaties include a provision for a corresponding downward adjustment of profits of the associated enterprise concerned, they do not generally impose a binding obligation on the Contracting States to eliminate the double taxation. The Arbitration Convention provides for the elimination of double taxation by agreement between the contracting states including, if necessary, by reference to the opinion of an independent advisory body. The Arbitration Convention thus improves the conditions for cross-border activities in the Internal Market.
In addition to the Arbitration Convention, the taxpayers can rely on the new rules on tax dispute resolution which apply since 1 July 2019. They are laid down in Council Directive on tax dispute resolution mechanisms in the European Union20 and bring a significant improvement to resolving tax disputes, as they ensure that businesses and citizens can resolve disputes related to the interpretation and application of tax treaties more swiftly and effectively. The new rules also cover issues related to double taxation which occurs when two or more countries claim the right to tax the same income or profits of a company or person. This can happen, for example, due to a mismatch in national rules or different interpretations of the transfer pricing rules in a bilateral tax treaty.
Finally, in July 2020, the Commission committed to develop, together with interested Member States, an EU Cooperative Compliance Framework, commonly called European Trust and Cooperation Approach (ETACA)21. Its purpose is to provide a clear, EU-wide framework for a preventive dialogue between tax administrations and business taxpayers in order to stimulate a preventive dialogue leading to the performance by the tax administrations of a high-level risk assessment of the transfer pricing policy adopted by large multinational enterprises. As a result, companies receive support in their internationalisation in order to avoid double taxation issues and reduce tax compliance costs. A pilot phase of the program has been concluded in March 2023 and the Commission services are currently evaluating whether and how to roll forward the program on a permanent basis.
Lastly, the Commission continues to support the implementation of its agenda for fair and simple taxation, such as the Directives mentioned above through its Technical Support Instrument22 and other Union programmes.
• Consistency with other Union policies
This proposal for a Directive is in line with the Commission’s SME strategy on taxation and SMEs23. Most SMEs consider taxation matters to be the most burdensome policy area that affects them. SMEs have many difficulties regarding tax matters, for example: direct taxation (income, capital, double taxation etc.), tax compliance costs and the administrative burden that arises from tax rules. Since our proposal aims at creating a common approach towards transfer pricing and thus create more tax certainty in this area across the Union for companies regardless of their size, SMEs will also benefit from a more harmonised approach which could lead to a reduction of compliance cost as well as increased certainty vis-à-vis tax authorities in the different Member States.
2. LEGAL BASIS, SUBSIDIARITY AND PROPORTIONALITY
• Legal basis
The legal basis for legislative initiatives on taxation is Article 115 of the Treaty on the Functioning of the European Union (TFEU). Although no explicit reference to direct taxation is made, in this article, it does refer to issuing directives for approximating national laws that directly affect the establishment or functioning of the single market. It follows that, under Article 115 TFEU, directives are the appropriate legal instrument for the Union in this field. Based on Article 288 TFEU, directives will be binding as to the result to be achieved upon Member States but leave the choice of form and methods to the national authorities.
• Subsidiarity (for non-exclusive competence)
In accordance with the subsidiarity principle laid down in Article 5 of the Treaty on the European Union, action at Union level should be taken only when the aims envisaged cannot be achieved sufficiently by Member States acting alone and in addition, by reason of the scale or effects of the proposed action, can be better achieved by the Union.
The cross-border nature of the problem at stake requires a common initiative across the single market. Since transfer pricing is of inherent cross border nature, it can only be tackled by laying down legislation at Union level. This initiative is therefore in line with the subsidiarity principle, considering that individual uncoordinated action by the Member States would only add to the current fragmentation of the legal framework for transfer pricing and fail to achieve the intended results. A common approach for all Member States would have the highest chances of achieving the intended objectives.
A legislative initiative is therefore in accordance with the principle of subsidiarity, as set out in Article 5 of the Treaty on the European Union.
• Proportionality
The envisaged measures do not go beyond the minimum necessary level of protection for the Single Market and are therefore compliant with the principles of proportionality. The Directive ensures a common approach with regard to the core transfer pricing principles and provides targeted rules for specific transactions where most added value for the Union can be created. A common arm’s length principle standard and a more harmonised approach towards transfer pricing should result in a less fragmented application and interpretation of the arm’s length principle across the Union which should reduce disputes, litigation and the overall compliance costs for businesses operating across the Union.
In this light, the proposal for a Directive does not go beyond what is necessary to achieve its objectives and is therefore compliant with the principle of proportionality.
• Choice of the instrument
The proposal is for a Directive, which is the only instrument permissible under the legal basis as prescribed in Article 115 of Treaty on the Functioning of the European Union.
3. RESULTS OF EX-POST EVALUATIONS, STAKEHOLDER CONSULTATIONS AND IMPACT ASSESSMENTS
• Ex-post evaluations/fitness checks of existing legislation
There is no previous existing Union legislation in the field of transfer pricing therefore no ex-post evaluations or fitness checks were performed.
• Stakeholder consultations
A call for evidence and an online survey on the broader BEFIT initiative were published from 13 October 2022 to 26 January 2023. Overall, the consultation activities received 123 contributions. Among those, there are 46 feedback contributions, 77 responses to the public consultation survey, of which 29 included written submissions. All contributions received from stakeholders were considered in the impact assessment.
• Collection and use of expertise
The Commission consulted and received input from various sources during the preparation of the proposal. Among others, the Commission relied on publicly available information, consulted with the OECD secretariat and received input from academics specialised in the field of transfer pricing by organising a virtual panel discussion.
• Impact assessment
An impact assessment was carried out to prepare the BEFIT initiative, of which this proposal is part. The draft impact assessment report was submitted to the Commission’s Regulatory Scrutiny Board (RSB) on 26 April 2023. Following a meeting on 24 May 2023, the RSB delivered a positive opinion with reservations on 26 May 2023, suggesting some areas for further improvement regarding the costs and benefits of the overall BEFIT initiative. No further specific data was updated related to this proposal. The executive summary accompanying the impact assessment has been published under the following link: [to be added later]
The impact assessment, as revised following the recommendations from the RSB, examined the baseline option (i.e. no change) and two policy options:
Option 1: Inclusion of the OECD arm’s length principle and Transfer Pricing Guidelines in EU law
This option is about harmonising the transfer pricing norms within the Union in the form of principles-based legislation. The arm’s length principle would be integrated into Union law. In addition, the law would clarify the status and role of the OECD Transfer Pricing Guidelines and refer to the latest version thereof for the interpretation of the arm’s length principle. By effect, the Guidelines would be turned into a binding tool but this would exclusively concern the (latest) version which would be incorporated in Union law; not any revisions thereof. The aim would be to ensure that Member States follow the same principle and have a common approach to applying transfer pricing.
Option 2: Inclusion of the OECD arm’s length principle and Transfer Pricing Guidelines in EU law alongside the gradual development of common approaches to the practice of applying transfer pricing.
This option builds on Option 1 and would not only aim to ensure that EU Member States apply the same principle but would go a step further into implementing a mechanism which would ensure a coordination of views and interpretations of the OECD Transfer Pricing Guidelines among Member States.
As under Option 1, the arm’s length principle would be incorporated in Union law and the legislation would clarify the role and status of the OECD Transfer Pricing Guidelines, but these would also be complemented with a mechanism for coordinating their interpretation and application at Union level. Additionally, this includes several provisions laying down the core rules of transfer pricing. This option would further establish specific anti-abuse rules in transfer pricing. It would also call for setting up of an expert group to discuss and agree on the interpretation of the arm’s length principle ensure a coordinated interpretation and approach to practical problems that emerge from transfer pricing practices in the Union.
The two options were compared against the following criteria: effectiveness, efficiency, coherence and proportionality. In the impact assessment it was concluded that option 2 was the preferred option.
This proposal reflects this option 2 albeit with minor amendments. Firstly, the proposal does not include any specific anti-abuse rule. Yet, the proposal addresses the issue of downwards adjustments as a systematic rule in line with OECD Model Tax Convention approach. Secondly, binding rules regarding certain transactions are now envisaged to be issued in the form of Council implementing acts following a proposal by the Commission.
The Commission considers that a positive economic impact will materialise due to lower compliance costs both at the level of the tax administrations and the taxpayer due to more tax certainty and thus less tax disputes. The social and environmental impact is expected to be rather limited.
Fundamental rights
Fundamental rights, in particular the requirements concerning the protection of personal data under the General Data Protection Regulation (‘GDPR’)24, are safeguarded. The personal data will only be processed to the extent and only as long as it is strictly necessary for their competent authorities to ensure compliance with their national tax legislation and mitigation of the risk of tax fraud, evasion or avoidance in Member States, in particular by verifying the correct application of the transfer pricing rules enshrined in this Directive.
4. BUDGETARY IMPLICATIONS
The main budgetary implications of the initiative for the Commission include additional human resources to cover the new tasks and the creation of an expert group. This expert group will be composed of experts in the area of transfer pricing and will provide the Commission with knowledge and expertise to consider which elements should be covered in the implementing acts that it will propose to the Council. The legislative financial statement provides details regarding the human and administrative resources required.
5. OTHER ELEMENTS
• Implementation plans and monitoring, evaluation and reporting arrangements
The Commission shall evaluate the Directive five years after national rules transposing the Directive come into effect and every five years thereafter.
For the purpose of monitoring and evaluating the implementation of the Directive, Member States shall provide the Commission with data on an annual basis reflecting relevant information on the functioning of the Directive. The relevant information is to be defined via an implementing act in line with the procedure stated in Article 17 of the proposal.
• Detailed explanation of the specific provisions of the proposal
The proposal can be divided into three parts: (1) the first part covers the arm’s length principle and possible consequences of applying this principle; (2) the second part lays down core elements which are relevant for applying the arm’s length principle; and (3) the third part includes a mechanism for establishing further common rules covering a limited set of subjects that will provide further simplification and tax certainty for taxpayers on the interpretation and application of the arm’s length principle.
(i) The arm’s length principle
The principle
Article 4 specifies that when the terms and conditions of cross-border intragroup transactions are not at arm’s length, they must be adjusted to reflect the terms and conditions that would have been established between independent parties and the profits taxed accordingly.
For the purpose of this Directive, a permanent establishment should be treated as an associated enterprise and thus the general rule contained in article 4 is also relevant for the attribution of profit to permanent establishment. As a consequence, the internal dealings between head office and permanent establishment should be determined in accordance with the arm’s length principle.
Under the arm’s length principle, price of transactions between associated enterprises (“transfer prices”) are tested and may be adjusted to reflect prices of comparable uncontrolled transactions.
For a transaction to be in scope of the general rule provided by article 4, it must take place between two associated entities. Thus, it is imperative to have a common definition of associated enterprise within the Union. Article 5 includes the definition of associated enterprise that Member States must implement for the purpose of applying the transfer pricing rules laid down in this proposal for a Directive.
Adjustments
Transfer pricing adjustments can be classified into two main categories: (i) those made by a tax administration after the company's tax return is filed, which can comprise primary adjustments and corresponding adjustments and (ii) those voluntarily made by the taxpayer before the company's tax return is filed, which are known as compensating adjustments.
Article 6 provides rules on how Member States should deal with primary and corresponding adjustments. Primary adjustments concern the increase of the taxable profits of a company, as a result of cross-border transactions with an associated enterprise not having been carried out at arm's length. Corresponding adjustments are made in response to a primary adjustment and aim at eliminating any double taxation which may occur as a result of a primary adjustment. In fact, when a tax administration increases a company's taxable profits in one tax jurisdiction (by means of a primary adjustment), a corresponding adjustment may be necessary in order to lower the tax liability of that company in the second tax jurisdiction involved.
The primary objective of paragraph 1 of Article 6 is to ensure that Member States have in place an adequate mechanism to enable them to make a corresponding adjustment when a primary adjustment is made in another jurisdiction. Where there is no corresponding adjustment taxpayers operating cross-border are likely to suffer double taxation, a situation that should be avoided. In this regards, Member States should have the possibility to perform corresponding adjustments and should consider not limiting the granting of such an adjustment in the context of mutual agreement procedures but also, for example, as results of a “fast-track” procedure when there is no doubt that the primary adjustment is well founded or joint audits.
In some cases, there may be legitimate reasons why a corresponding adjustment is not granted. Member States should not grant corresponding adjustments if: (i) the primary adjustment is not considered to be consistent with the arm’s length principle; (ii) the primary adjustment does not result in the taxation of an amount of profits in another jurisdiction on which the associated enterprise in the relevant Member State has already been subjected to tax; (iii) when a third country jurisdiction is involved, if there is no double tax treaty in place. In the absence of a primary adjustment, Member State can perform a downward adjustment only if (i) the downward adjustment is consistent with the arm’s length principle; (ii) an amount equal to the downward adjustment is included in the profit of the associated enterprise in the other jurisdiction; (iii) a communication on the intention to perform the downward adjustment has been sent to the relevant jurisdictions. This is aimed at ensuring that Member States can preserve their national tax sovereignty and the right to assess whether the primary adjustment is at arm’s length and that there is neither double taxation nor double non-taxation.
A “compensating adjustment” is defined in the Glossary of the OECD Transfer Pricing Guidelines as “an adjustment in which the taxpayer reports a transfer price for tax purposes that is, in the taxpayer's opinion, an arm's length price for a controlled transaction, even though this price differs from the amount actually charged between the associated enterprises”. However, compensating adjustments are a cause of double taxation as they tend not to be recognised in all jurisdictions on the grounds that the tax return should reflect the actual transactions. To avoid litigation and establish a common approach to compensating adjustment within the Union, Article 7 provides the conditions under which Member States should recognise a compensating adjustment. This provision is inspired and should be interpreted in conjunction with the report JTPF/009/FINAL/2013/EN25 on compensating adjustments approved by the Joint Transfer Pricing Forum in 2013.
(ii) Common core elements
Accurate delineation of the commercial and financial relations
Article 8 of the Directive provides that transfer pricing outcomes must be determined in accordance with the actual conduct of related parties in the context of the contractual terms of the transaction. To achieve this objective, the provision requires careful delineation of the actual transaction between the associated enterprises by analysing the contractual relations between the parties in combination with the conduct of the parties. In this regard, the critical first step of the transfer pricing analysis must be to accurately define the intercompany transactions by analysing their economically relevant characteristics, as reflected not only in the contracts between the parties, but also their conduct and any other relevant facts. The contractual terms should be the starting point for the analysis and to the extent that the conduct or other facts are inconsistent with the written contract, the parties’ conduct (rather than the terms of the written contract) should be taken as the best evidence of the transaction(s) actually undertaken.
Transfer Pricing Methods
In line with chapter III of the OECD Transfer Pricing Guidelines, article 9 of the proposal for a Directive refers to the following main transfer pricing methods,
The “Comparable Uncontrolled Price Method” compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. If there is any difference between the two prices, this may indicate that the conditions of the commercial and financial relations of the associated enterprises are not arm’s length, and that the price of the controlled transaction may need to be substituted by the price of the uncontrolled transaction. The comparable uncontrolled price method can be applied on the basis of the taxpayer’s transactions with independent enterprises (internal comparables), or on the basis of transactions between other independent enterprises (external comparables). Although this method is potentially available for all types of transactions, the product comparability requirement to be able to apply it in a reasonably reliable manner is especially high, because any product difference may materially affect the price of the transaction while it is often not practicable to determine reasonably accurate comparability adjustments for such product differences.
The “Resale Price Method” begins with the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. This price (the “resale price”) is then reduced by an appropriate gross margin (the “resale price margin”), determined by reference to gross margins in comparable uncontrolled transactions, representing the amount out of which the reseller would seek to cover its selling and other operating expenses and, in light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit. What is left after subtracting the gross margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g. customs duties), as an arm’s length price for the original transfer of property between the associated enterprises.
The “Cost-Plus Method” begins with the costs incurred by the supplier of property or services in a controlled transaction for property transferred or services provided to an associated enterprise. An appropriate mark up, determined by reference to the mark up earned by suppliers in comparable uncontrolled transactions, is then added to these costs, to make an appropriate profit in light of the functions performed and the market conditions. Such arm’s length mark-up may be determined by reference to the mark up that the same supplier earns in comparable uncontrolled transactions (an internal comparable), or by reference to the mark up that would have been earned in comparable transactions by an independent enterprise (external comparable). In general, the cost-plus method will use margins computed after direct and indirect costs of production or supply, but before the operating expenses of the enterprise (e.g. overhead expenses).
The “Transactional Net Margin Method” compares the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realises from a controlled transaction (or from transactions that are appropriate to aggregate and consider together) with the net profit margin earned in comparable uncontrolled transactions. The arm’s length net margin of the taxpayer from the controlled transaction(s) may be determined by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions (internal comparables), or by reference to the net margin earned in comparable transactions by an independent enterprise (external comparables). In cases where the net profit margin is weighed against costs or sales, the transactional net margin method operates in a manner similar to the cost plus and resale price methods respectively, except that it compares the net profit margins arising from controlled and uncontrolled transactions (after relevant operating expenses have been deducted) instead of comparing a gross margin on resale or gross mark up on costs. Functional comparability is generally of greater importance than product comparability in applying the transactional net margin method.
The “Profit Split Method” identifies the combined profit from the controlled transactions in which the associated enterprises are engaged and then splits that profit between the associated enterprises on an economically valid basis with the aim to approximate the division of profits that would have been agreed at arm’s length between independent enterprises. This economically valid basis may be supported by independent market data (e.g. uncontrolled joint-venture agreements) or by internal data. The types of such internal data that are relevant to split the combined profit between the associated enterprises (“splitting factor/s”) will depend on the facts and circumstances of the case and may include, for example, allocation keys relating to the respective sales, research and development expenses, operating expenses, assets or headcounts of the associated enterprises. The splitting factor/s should reflect the respective contributions of the parties to the creation of income from the controlled transaction and be reasonably independent from transfer pricing formulation (i.e. it should be based on objective data (such as sales to unrelated parties), not on data relating to the remuneration of controlled transactions (such as sales to associated enterprises).
The combined profit may be divided between the associated enterprises based upon a residual or a contribution analysis.
In the residual analysis, in a first step the routine profits attributable to contributions which can be reliably benchmarked, i.e. typically less complex contributions for which reliable comparables can be found, are identified and attributed to the associated enterprises. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method to identify the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by a second category of contributions which may be unique and valuable, and/or are attributable to a high level of integration or the shared assumption of economically significant risks. In a second step, any residual profit (or loss) remaining after allowing for the profits attributable to the first category of contributions would be based on an analysis of the relative value of the second category of contributions by the parties.
In the contribution analysis, differently than in the residual analysis, the combined profit is divided between the associated enterprises all at once based upon the relative value of the contributions made by each of the associated enterprises participating in the controlled transaction.
This proposal does not advocate any preference for any of the above listed recognised transfer pricing method. The rule provided for in Article 10 must be applied and thus the most appropriate method must be chosen taking into consideration the facts and circumstances of the specific case.
Paragraph two of Article 9 further provides that a transfer pricing method other than the approved methods provided in paragraph 1 can be applied only where it can be demonstrated that (i) none of the approved methods can be reasonably applied to determine arm’s length conditions for the controlled transaction, and (ii) such other method produces a result consistent with that which would be achieved by independent enterprises engaging in comparable uncontrolled transactions under comparable circumstances. The taxpayer or the tax administration asserting the use of a method other than the approved methods contained in paragraph 1 shall bear the burden of demonstrating that the requirements of paragraph 2 of Article 9 have been satisfied.
When the conditions provided for in paragraph 2 are fulfilled and an economic valuation technique is applied to identify an arm's length price, the content and recommendations of report JTPF/003/2017/FINAL/EN26 on the use of use of economic valuation techniques in transfer pricing approved by Joint Transfer Pricing Forum in 2017 shall be taken in due consideration. The report provides a comprehensive description of valuation techniques and the specific elements that should be taken into consideration when using those for transfer pricing purposes.
Selection of the most appropriate Method
Article 10 of the Directive provides that the selection of a transfer pricing method must always aim at finding the most appropriate method for a particular case.
For this purpose, the selection process should take account of the respective strengths and weaknesses of the transfer pricing methods; the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method and/or other methods; and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them. No one method is suitable in every possible situation, nor is it necessary to prove that a particular method is not suitable under the circumstances.
In general, the Comparable Uncontrolled Price method is an appropriate method for establishing an arm’s length price for a) sales of commodities traded on a market, subject to the controlled transaction and comparable uncontrolled transaction(s) taking place in comparable circumstances, including at the same level of the commercial chain (e.g. sale to a secondary manufacturer, to a distributor, to a retailer, etc.), and b) some common financial transactions, such as the lending of money. Market prices (such as commodity prices or rates of interest) may be publicly available for these types of transactions.
The Resale Price method is most useful where it is applied to sales and marketing operations such as those typically carried out by a distributor. In some circumstances, the resale price margin of the reseller in the controlled transaction may be determined by reference to the resale price margin that the same reseller earns on items purchased and sold in comparable uncontrolled transactions (an internal comparable). In other circumstances the resale price margin may be determined by reference to the resale price margin earned by independent enterprises in comparable uncontrolled transactions (external comparables).
The Cost-plus method is most useful where a) goods are sold by a manufacturer that does not contribute valuable unique intangible assets or assume unusual risks in the controlled transaction, such as may be the case under a contract or toll manufacturing arrangement; or b) where the controlled transaction is the provision of services for which the provider does not contribute any valuable unique intangible assets or assume unusual risks.
The transactional net margin method operates in a manner similar to the cost plus and resale price methods respectively, except that it compares the net profit margins and it is useful where there is no or limited publicly available reliable gross margin information on third parties and as a consequence, the former traditional transaction methods are difficult to apply. In general, it is observed that cost-based net profit margin indicators are used for manufacturing and service activities; sales-based indicators are used for sales activities; and asset-based indicators are used for asset-intensive activities. In any case, the selected financial indicator should be one that: (i) reflects the value of the functions performed by the tested party (i.e. the party to the controlled transaction for which a financial indicator is tested), taking account of its assets and risks; (ii) is reasonably independent from transfer pricing formulation, i.e. it should be based on objective data (such as sales to unrelated parties), not on data relating to the remuneration of controlled transactions (such as sales to associated enterprises); and (iii) is capable of being measured in a reasonably reliable and consistent manner at the level of the controlled transaction and of the comparable uncontrolled transaction(s).
One-sided methods (Resale Price, Cost Plus, Transactional Net Margin Method) are not reliable if each party to a transaction makes unique and valuable contributions in relation to the controlled transaction, or where the parties engage in highly integrated activities. In such a case, the profit split method is the most appropriate method, since independent parties might effectively price the transaction in proportion to their respective contributions, making a two-sided method more appropriate. Furthermore, since those contributions are unique and valuable there will be no reliable comparables information which could be used to price the transaction in a more reliable way, through the application of another method.
One-sided methods are appropriate in cases where one of the parties makes all of the unique and valuable contributions involved in the controlled transaction, while the other party does not make any unique and valuable contribution. In such a case, the tested party should be the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found. The party that does not make any unique and valuable contributions in relation to the transaction will most often be the one to which a one-sided transfer pricing method can be applied most reliably.
Comparability Analysis
The comparability analysis is the cornerstone for application of the arm’s length principle.
In order to apply the arm's length principle, it is necessary to carry out a comparability analysis, which broadly consists of two key aspects: (i) identifying the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attaching to those relations; and (ii) comparing the conditions and economically relevant circumstances of transactions between associated enterprises (controlled transactions) with those of comparable transactions between independent enterprises (comparable uncontrolled transactions).
As regards the first aspect, Article 11 provides the comparability factors that Member States should take into account when identifying the circumstances of a controlled transaction. These factors are the contractual terms of the transaction, the functional analysis (the functions that each enterprise performs, taking into account assets used and risks assumed), the characteristics of the product or service object of a transaction, the economic circumstances, and the business strategies. Once the circumstances of the controlled transaction have been established, the actual comparison and assessment of whether the transaction is at arm's length has to take place. For that, it is necessary to identify which magnitude will be the object of comparison (i.e. a transfer pricing method has to be selected); and with what it will be compared (i.e. a potential comparable uncontrolled transaction has to be identified).
A controlled and an uncontrolled transaction are regarded as comparable if the economically relevant characteristics of the two transactions and the circumstances surrounding them are sufficiently similar to provide a reliable measure of an arm’s length result.
The two transactions do not necessarily have to be identical to be comparable. Instead, none of the differences between them should materially affect the arm’s length price or profit; where such material differences exist, reasonably accurate adjustments should be made to eliminate their effect.
These adjustments (which are referred to as “comparability adjustments”) are to be made only if the effect of the material differences on price or profits can be ascertained with sufficient accuracy to improve the reliability of the results.
Article 11 further specifies that Member States should ensure that the search for comparable uncontrolled transactions is based on a principle of transparency. This means that taxpayers should justify and document the steps of the searches vis-à-vis the tax administration, and, symmetrically, that the tax administration should provide the relevant information for these steps to the taxpayer, when preparing or challenging such searches.
In the search for comparables uncontrolled transactions, the recommendations contained in the report JTPF/007/2016/FINAL/EN27 on the use of comparables within the EU approved by the Joint Transfer Pricing Forum in 2016 should be taken in due consideration.
Establishing the arm’s length range
In some cases, application of a pricing method will produce a single result that is the most reliable measure of an arm’s length result. In other cases, application of a method may produce a number of results from which a range of reliable results may be derived. In line with the best international practices, Article 12 prescribes that where the application of the most appropriate method produces a range of figures, the arm’s length range must be determined using the interquartile range. The interquartile range is the range from the 25th to the 75th percentile of the results derived from the uncontrolled comparables.
In order to minimize disputes and ensure a common approach across the Union, the provision further prescribes that (i) a taxpayer should not be subjected to adjustment when its results fall within the interquartile range unless the tax administration or the taxpayer prove that a specific different positioning in the range is justified by the facts and circumstances of the specific case; (ii) when the results of a controlled transaction fall outside the arm's length range, tax administrations must make an adjustment to the median of all the results unless the taxpayer or the tax administration prove that any other point of the range determines a more reliable arm’s length price in the specific case at hand.
Transfer Pricing Documentation
A major element of compliance for transfer pricing is the documentation to show that the relevant transactions are priced in line with the arms’ length principle. Annex 2 shows the basic elements for rules on the documentation and will be further specified by the Commission later on, in compliance with the provisions set out in Article 13, to possibly add elements like standard templates setting the type and content of transfer pricing information, timeframes to be covered, linguistic requirements and taxpayers in scope of the documentation obligation.
(iii) Application of the arm’s length principle and future common rules on specific subjects
To ensure a common application of the arm’s length principle the latest version of the OECD Transfer Pricing Guidelines will be binding when applying the arm’s length principle in the Member States. As the OECD Transfer Pricing Guidelines will be amended from time to time these new guidelines should be the new binding reference framework. In order to ensure adherence to these new guidelines in the Member States the procedure pursuant to article 218 paragraph 9 of the Treaty on the Functioning of the European Union should be applicable. The Commission may in addition also propose an amendment to this Directive in order to reflect an amendment of the OECD Transfer Pricing Guidelines
In order to achieve the objective to create more certainty for taxpayers it is proposed to establish further common binding rules in the area of transfer pricing by way of implementing acts. These implementing acts will provide taxpayers with a clear view of what tax authorities in the Union would consider acceptable to be used for specified transactions and also provide so-called safe harbours that will bring down the compliance burden and the amount of disputes.
In view of the sensitive nature of such measures which touch on national executive and enforcement powers regarding direct taxation, the exercising of taxing rights allocated under bilateral or multilateral tax conventions that prevent double taxation or double non-taxation and given the potential financial ramifications on Member States’ tax bases, implementing powers to adopt decisions under this Directive should be conferred on the Council, acting on a proposal from the Commission.