OECD Must Not Allow Pillar One to Erode the Arm’s-Length Standard

To preserve tax fairness that underlies voluntary tax compliance, the OECD should leave room for facts-and-circumstances exceptions to part of its global tax treaty.

Part of Pillar One of the global tax treaty, known as Amount B, intends to simplify transfer pricing compliance and reduce controversy by establishing profit targets for “baseline marketing and distribution activities” of tangible goods.

Unlike the limited set of taxpayers affected by Amount A, which seeks to reallocate profits from the world’s largest multinationals to the jurisdictions they’re in, the scope of Amount B includes nearly all companies that engage in routine wholesale distribution of tangible goods.

Core distribution functions within Amount B’s scope include buying goods for resale; identification of new customers and managing customers’ relationships; certain after-sales services; implementing promotional advertising or marketing activities; warehousing goods; processing orders; or performing logistics, invoicing, and collection. There is no minimum revenue level required for application of Amount B.

Excluded from Amount B are situations where a distributor owns valuable, non-routine intangibles, conducts significant manufacturing activities, or where services in connection with the sale of products are material. Also excluded from the scope of Amount B are retail sales to consumers above a minimum amount (20% of revenues) and sales of commodities.

Amount B is designed to respond to income tax administration concerns, namely that many of the approximately 140 countries that have participated in the expanded OECD inclusive framework of Pillar One and Pillar Two projects lack the resources or expertise to enforce the existing facts-and-circumstances-based transfer pricing rules.

In addition, many Organization for Economic Cooperation and Development member countries may believe the existing facts-and-circumstances-based transfer pricing rules lead to excessive controversy for taxpayers engaged in routine distribution activities, in which controversy could be avoided through a set of objective transfer pricing targets for such routine activities.

In contrast to Amount A, which will require participating countries to adopt a multilateral treaty, no new legislation or treaties are required to implement Amount B.

Rather, the Amount B guidance will be incorporated into the OECD transfer pricing guidelines. As currently drafted, Amount B profit targets can be either mandatory or safe-harbor based at the option of the country adopting Amount B.

Amount B applies through a multi-step process that is incorporated into a matrix with limited profit target ranges (plus or minus 0.5%) based on the industry in which the distributor operates, such as food, consumer product, and software distributions; the distributor’s ratio of operating assets to sales revenues; and its ratio of operating expenses to sales revenues.

Amount B, like Amount A, will be determined without regard to the actual local country taxable profit or loss of the entity being taxed. In substance, Amount B is a formulary amount based on a non- “facts and circumstances” application of the transactional net margin method, or comparable profits method in the US. Because Amount B applies without business activity scope, net revenue, or pre-tax profit limitations, it will have wide application.

Annual reports published each year by the IRS’s advanced pricing agreement program show about 85% of the US advanced pricing cases have involved controlled distribution, manufacturing, or service transactions that are resolved using the transactional net margin method or comparable profits method.

These methods don’t apply to transactions involving exploitation of non-routine intangibles, such as ownership of valuable trademarks or brand names. If Amount B reflects a reasonable solution to tax administration concerns, the scope of Amount B could be extended to include routine manufacturing and service transactions, eroding the base of controlled party transactions subject to normal arm’s-length principles and analysis.

A fundamental principle underlying the arm’s-length principle is tax fairness, namely that controlled party transactions should be taxed as if the transactions were entered into by unrelated parties dealing with each other at arm’s length. Unrelated parties don’t always earn minimum levels of profit and can incur losses in arm’s-length transactions.

However, profits below the mandated minimum or losses are banned under Amount B. Under such circumstances, the question becomes whether the expected gains in simplifying tax administration by eliminating facts-and-circumstances-based transfer pricing enforcement and reducing tax controversies are worth the erosion of tax fairness.

Before proposing Amount B, the OECD’s answer to the last question was no. In its transfer pricing guidelines, it said that “member countries consider that an appropriate adjustment is achieved by establishing the conditions of the commercial and financial relations that they would expect to find between independent enterprises in comparable transactions under comparable circumstances.”

The OECD must not allow the arm’s-length standard to erode. It must allow exemptions to Amount B through advanced pricing agreements or similar administrative measures.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Mike Patton is senior counsel at DLA Piper and helped negotiate the first bilateral APA.

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