The Future of Transfer Pricing: A Practitioner’s View

How It Started

Niccolò Machiavelli once said, “I’m not interested in preserving the status quo; I want to overthrow it.” This approach to changing the status quo certainly seems to have similarities to current developments in the world of international taxation, particularly as it relates to transfer pricing and the arm’s length standard that governs the way multinational affiliates transact among themselves via financing, intangible property, product, and service flows.

To understand the future, it often helps to first understand the past. While transfer pricing regulations have been in place for nearly three decades in the U.S. and other countries within the OECD, and in broad statutes and case law dating over a century, the pace of regulatory change in the past decade has been dramatic. Starting with the release of the OECD/G20 BEPS 2015 Final Reports, commonly referred to as BEPS 1.0, tax administrations around the world have adopted and implemented new regulations which are intended to more efficiently tax the value creation as driven by 21st century business models.

However, as the digital economy became more prevalent in the years following BEPS 1.0, tax administrations, the OECD, and other bodies were of the view that further reform was needed. This sentiment was especially pervasive as companies in high-margin sectors amassed revenues, profits, and market values that the world had never seen, despite the global Covid-19 pandemic. Meanwhile, certain governmental bodies continued to compete for these profits by lowering corporate tax rates and offering special tax incentives in order to attract investment, also known as the race to the bottom.

How It’s Going

The current international tax-transfer pricing system is generally built upon the notion that taxation in a particular jurisdiction is triggered by traditional concepts of nexus—i.e., taxable presence. Therefore, BEPS 1.0 would not suffice, and new waves of legislation began to emerge from an OECD perspective.

Globally, BEPS 2.0 is in the process of development at the OECD, introducing new concepts of nexus for certain large multinationals—i.e., Pillar One—in which customer location can create a taxable presence. It’s a notion that has generally not existed since the dawn of international taxation and contradicts a robust international treaty system that has been in place for more than 100 years. Furthermore, BEPS 2.0 introduces a different set of rules for minimum taxation—i.e., Pillar Two—as compared to legislation within the U.S. Tax Cuts and Jobs Act of 2017, or TCJA, increasing the risk of double taxation particularly for U.S.-based multinational companies.

From a U.S. perspective, the TCJA introduced additional base erosion measures and incremental baskets of taxation on global profits of multinationals—i.e., minimum global taxes—among other new concepts, such as lowering the statutory corporate tax rate.

From a transfer pricing perspective, the above changes can be viewed as narrowing the sandbox of wider profits in which the arm’s length standard is applied, as competing legislative frameworks at a country and global level aim to tax more profits on non-arm’s length terms. While it is true that current draft rules from the OECD for Pillar Two stipulate that the starting point of the minimum tax calculation must be based on the arm’s length principle, pressure still remains on traditional concepts of transfer pricing, given the mechanics and baseline minimum tax thresholds that remain in the Pillar Two calculation.

While tax is only one of the many considerations affecting business investments, the influence of systems of taxation that are based on formulary approaches rather than the arm’s length standard can lead to the misallocation of factors of production and therefore impede economic growth. What might seem to be a cure for one ailment can often produce side effects of its own.

The Path Forward

So, how will traditional transfer pricing models be impacted by these changes? Complex questions never have straightforward answers, though there certainly will be pros and cons from a practitioner perspective. On the one hand, robust intercompany pricing, monitoring, and documentation becomes more important each year, as intercompany pricing arrangements under the arm’s length standard fall into the crosshairs of tax administrations, especially in the age of digital audits.

Additionally, more complex pricing issues will arise with business models that heavily rely on intangible property and those that interact with customers and business partners via digital mediums. Further, ESG initiatives bring a new wave of governmental benefits and subsidies that must be priced and integrated into existing transfer pricing models. The “case” for transfer pricing seems to grow exponentially when considering these fundamental changes, among others that deserve a more detailed conversation.

However, the notion of substantial tax benefits arising from the manner and location in which multinational affiliates implement transfer pricing via the arm’s length standard—i.e., traditional tax arbitrage—could be a distant memory given changes in tax legislation as of late. Further, combined with the ESG movement and in light of tax transparency, it is not in the interest of most C-suites to book profits in low tax jurisdictions with little operating activity, nor would this approach be likely to provide for material tax advantages given international tax reform.

In essence, the premium once placed on tax arbitrage opportunities of the past under the premise of the arm’s length standard may decrease to a degree, while tax authority microscopes—and certain public reporting of tax information—will provide an impetus for remaining arbitrage opportunities to require increased business purpose and enhanced documentation. This will require a bigger connection between the tax department and core operations of a business, as the substance over legal form doctrine is put into the crosshairs.

The name of the game in the future may be less so on tax differentials between affiliates, but rather other economic incentives that are above the line. Especially in economies that are dependent on foreign direct investment, we may see new forms of incentives beyond traditional corporate tax rate measures. For example, governments may employ local tax incentives in connection with ESG, property taxes, rental subsidies, research grants, or payroll tax breaks. Joint development initiatives between governments and multinationals may provide for foreign direct investment incentives. From a worker perspective, tax incentives may be enhanced for employees of the multinational as located in particular jurisdictions, providing an indirect but valuable incentive for the multinational to be located in a particular jurisdiction. Overall, governments will continue to compete for direct investments, although the way those incentives are provided will likely shift and face controversy in themselves.

To summarize, the status quo with respect to historical transfer pricing models will shift, and a new paradigm of incentives and increased controversy with respect to the arm’s length standard likely will arise. Transfer pricing operating models must adapt to this new paradigm.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Philip Borders is a tax director with a focus on cross-border taxation, specifically in the area of transfer pricing. As part of PwC’s Tax-Transfer Pricing practice, he advises companies on the implications of global tax regulations from a cross-border perspective.