Transfer pricing

The latest OECD transfer pricing guidelines

Ava Colocho and Srinidhi Tuppal examine the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022.

The Organisation for Economic Co-operation and Development (OECD) is an international organisation that – together with governments, policy makers and citizens – helps to shape policies and international standards. The goal of the OECD is to find solutions to a range of social, economic and environmental challenges. The OECD provides a unique forum and knowledge hub for data and analysis, exchange of experiences, best practice sharing and advice on public policies. Establishing international standards helps to improve economic performance, create job opportunities and fight international tax evasions.

The OECD/G20 Inclusive Framework on Base erosion and profit shifting (BEPS) implemented a 15 point action plan to tackle the tax planning st rategies used by multinational enterprises that exploit gaps and mismatches in tax rules to avoid paying tax. The action plan also aimed to improve the coherence of international tax rules and to ensure a more transparent tax environment.

The OECD Transfer Pricing Guidelines provide guidance on the application of the arm's length principle, which is the international consensus on the valuation of cross-border transactions between associated enterprises. Specifically, Actions 4, 8-10, and 13 of the BEPS Action Plan proposed certain changes to the transfer pricing guidelines. The 2017 edition of the OECD Transfer Pricing Guidelines reflected the majority of the clarifications and revisions contained in the 2015 BEPS Action Plan reports on Actions 8-10 (Aligning transfer pricing outcomes with value creation) and Action 13 (Transfer pricing documentation and country-by-country reporting).

After the 2017 edition of the OECD Transfer Pricing Guidelines, the OECD issued additional guidance reports:

● The application of transactional profit split method;

● Guidance for tax administrations on the application of the approach to hard-to-value intangibles; and

● Transfer pricing guidance on financial transactions.

The latest edition of the OECD Transfer Pricing Guidelines for multinational enterprises and tax administrations, published on 20 January 2022, reflects the revisions made to the 2017 edition of the OECD Transfer Pricing Guidelines based on these three additional guidance reports and also includes certain consistency changes.

The transactional profit split method

The revised guidance on the application of the transactional profit split method, published on 21 June 2018, responds to the mandate in the 2015 BEPS Action Plan reports on Actions 8-10 and specifically addresses Action 10 (Aligning transfer pricing outcomes with value creation: other high-risk transactions) of the BEPS Action Plan. This guidance is incorporated in the 2022 OECD Transfer Pricing Guidelines, replacing the previous text on the transactional profit split method in Chapter II, part III, section C.

The revised guidance retains the basic premise that the profit split method should be applied where it is found to be the most appropriate method to the case at hand, but it significantly expands the guidance available to help determine when that may be the case. It also contains more guidance on how to apply the method, as well as numerous examples.

This revised guidance, while not being prescriptive, clarifies and significantly expands the guidance on when a profit split method may be the most appropriate method. It describes the presence of one or more of the following indicators as being relevant:

● each party makes unique and valuable contributions;

● the business operations are highly integrated, such that the contributions of the parties cannot be reliably evaluated in isolation from each other; and

● the parties share the assumption of economically significant risks, or separately assume closely related risks.

The revised guidance makes clear that a lack of comparables is, by itself, insufficient to warrant the use of the profit split method; however, conversely, if reliable comparables are available it is unlikely that the profit split method will be the most appropriate. The revised text also expands the guidance on how the profit split method should be applied, including determining the relevant profits to be split, and appropriate profit splitting factors (see bit.ly/3xY31bT).

The revised guidance provides clarification regarding the distinction between profit split as a valuation method and profit split as a way to share in actual profits. The revised guidance provides that generally the relevant profits to be split are operating profits, but a different measure of profits such as gross profits may also be considered appropriate in certain cases. Regardless of the measurement of profits used, the account standards applicable should be selected in advance and should be consistently applied over the lifetime of the arrangement. The revised guidance has also included headcount to the list of potential profit split factors in addition to assets, capital or time spent. The guidance refers to the multinational enterprise’s Local Files and Master File as a potential source of information to determine economically valid splitting factors.

Hard to value intangibles

The guidance for tax administrations on the application of the approach to hard-to-value intangibles (HTVI), published on 21 June 2018, responds to the mandate in the 2015 BEPS Action Plan reports on Actions 8-10 and specifically address the Action 8 (Aligning transfer pricing outcomes with value creation: intangibles) of the BEPS Action Plan. This guidance document has been incorporated into the 2022 OECD Transfer Pricing Guidelines as an annex to Chapter VI.

The development of transfer pricing rules or special measures for transfers of HTVI are aimed at preventing base erosion and profit shifting by moving intangibles among group members.

The 2022 OECD Transfer Pricing Guidelines, Chapter VI, section D4 contains the approach to HTVI. The HTVI approach protects tax administrations from the negative effects of information asymmetry by ensuring that tax administrations can consider ex-post outcomes as presumptive evidence about the appropriateness of the ex-ante pricing arrangements. At the same time, the taxpayer has the possibility to rebut such presumptive evidence by demonstrating the reliability of the information supporting the pricing methodology adopted at the time the controlled transaction took place.

The guidance for tax administrations on the application of the approach to HTVI aims at reaching a common understanding and practice among tax administrations on how to apply adjustments resulting from the application of the

HTVI approach (see bit.ly/3MyoADM). It aims to improve consistency and reduce the risk of economic double taxation. In particular, the new guidance:

● presents the principles that should underlie the application of the HTVI approach by tax administrations;

● provides a number of examples clarifying the application of the HTVI approach indifferent scenarios; and

● addresses the interaction between the HTVI approach and the access to the mutual agreement procedure under the applicable tax treaty.

The guidance for tax administrations on the application of the approach to HTVI prevents the application of the HTVI approach when the transfer of the HTVI is covered by a bilateral or multilateral advance pricing agreement in effect for the period in question between the jurisdictions of the transferee and the transferor. In the event that the application of the HTVI leads to double taxation, it is important to permit resolution of such cases through access to the mutual agreement procedure under an applicable treaty.

Guidance on financial transactions

The transfer pricing guidance on financial transactions, published on 11 February 2020, responds to the mandate in the 2015 BEPS Action Plan reports on Action 4 and Actions 8-10 and specifically addresses Action 4 (Limiting base erosion involving interest deductions and other financial payments) of the BEPS Action Plan. Sections A to E of this guidance has been included in the 2022 OECD Transfer Pricing Guidelines as Chapter X. Section F of the guidance has been added to section D.1.2.1 in Chapter I of the 2022 OECD Transfer Pricing Guidelines, immediately following paragraph 1.106.

In particular, section B.1 of the transfer pricing guidance on financial transactions elaborates on how the accurate delineation analysis under Chapter I applies to the capital structure of a multinational enterprise within a multinational enterprise group. It also clarifies that the guidance included in that section does not prevent countries from implementing approaches to address capital structure and interest deductibility under their domestic legislation.

Section B.2 outlines the economically relevant characteristics that inform the analysis of the terms and conditions of financial transactions. Sections C, D and E of the guidance address specific issues related to the pricing of financial transactions (e.g. treasury functions, intra-group loans, cash pooling, hedging, guarantees and captive insurance). This analysis elaborates on both the accurate delineation and the pricing of the controlled financial transactions. Finally, Section F provides guidance on how to determine a risk-free rate of return and a risk-adjusted rate of return (see bit.ly/37QfS52).

The guidance on financial transactions elaborates on the concept of accurate delineation of the actual transaction with regards to the conditions and economically relevant circumstances that may relate to the balance of debt and equity funding of an entity within a multinational enterprise group. In other words, the tax authorities normally should not disregard the actual transaction undertaken by the taxpayer or substitute other transactions for them unless the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances (see bit.ly/3vrrRiF).

The purpose of the functional analysis is highlighted in the guidance on financial transactions to explain the activities and liabilities of related entities when determining the appropriate distribution of interest income based on inherent risk. A company’s financial capacity and control functions are taken into consideration when evaluating the level of risk in regard to justifying the interest income allocable to the related party lender.

The guidance on financial transactions’ endorsement of the comparable uncontrolled price method solidifies the approach as an appropriate method to benchmark comparable data to support the specific interest rate range selected by a company when implementing an intercompany loan transaction. Also, the guidance reiterates the necessity of considering comparability adjustments to ‘eliminate the material effects of differences between the controlled intra-group loan and the selected alternative in terms of, for instance, liquidity, maturity, existence of collateral or currency’.

In conclusion

Global business in general and specifically those that are involved in highly integrated activities and intra-group financial transactions should assess their transfer pricing policies in light of this latest 2022 OECD Transfer Pricing Guidelines. Careful consideration should be taken when determining the unique and valuable contributions provided by the parties and during the selection of an appropriate method. Multinational enterprises should consider the use of a mutual agreement procedure if there is a potential risk of double taxation as a result of adjustment related to HTVI.