Do the OECD's recent proposals represent a step away form the arm's-length principle?
The OECD has said that all of the proposals under Pillar 1 would go beyond the arm’s-length principle, though many countries are hoping to limit any departure from what has been the foundation of transfer pricing for a very long time. Two of the proposals would introduce a residual profit split that aims to allocate more profits to market jurisdictions than would be allocated under existing transfer pricing rules, but returns to other functions would continue to be determined under the arm’s-length principle. The other proposal under Pillar 1 would be a more radical departure from the arm’s-length principle, and essentially would be a formulary apportionment of profits to market jurisdictions. None of the proposals have been worked out in full detail, though, so the exact impact on the arm’s-length principle is not clear.
What are some of the competing profit allocation models being proposed and how might they apply to different kinds of businesses?
One proposal is a residual profit split that would allocate part of the residual, or supernormal, profits to jurisdictions in which users of certain digital businesses are located. The proposal is explicitly limited to certain digital business models, such as social networks, search engines, and online marketplaces. Other businesses would not be subject to the proposal.
A second proposal is a residual profit split that would apply generally to all business models. Under this proposal, a portion of the residual profit would be allocated to jurisdictions in which sales revenue is sourced, based on a theory that the business is exploiting certain market intangibles in those jurisdictions. Certain exceptions are being contemplated, such as an exception for commodities businesses, on a theory that they don’t have marketing intangibles, but it’s unclear how much the proposal will try to be theoretically pure versus trying for simplicity and broad applicability.
The third proposal under Pillar 1 is the substantial economic presence proposal, which would find taxable nexus based on a certain threshold of sales plus other factors. Profits then would be allocated and apportioned on a formulary basis to the market jurisdictions.
More recently, there has been discussion of trying to take some of the elements of the third proposal and add them to the second proposals, the market intangible proposal. For example, businesses might be deemed to have profits in a jurisdiction equal to a percentage of sales, adjusted by certain factors such as global profitability. The allocation of profits to other functions would continue to be based on the arm’s-length principle.
How might the digital taxation proposals raise new dispute resolution issues?
The new proposals would allocate part of the global profits of the group to the market jurisdictions. That, by definition, would reduce the profits allocated to other jurisdictions. That suggests that subsequent transfer pricing adjustments in any jurisdiction could change the profits allocable to other jurisdictions, in which case every transfer pricing dispute could become a multilateral dispute. A large increase in the number of multilateral disputes would require the development of efficient ways to resolve those disputes. Mandatory binding arbitration would help, but more work would need to be done to adapt traditional arbitration procedures to the multilateral context.
More generally, both businesses and governments would need time to adjust how they deal with transfer pricing, if the global system is changed to move away from the arm’s-length principle, as such a fundamental change is likely to raise significant challenges.
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