UN transfer pricing manual: what Brazil, India and China do differently

‘Country Practices’. The title of Chapter 10 of the new United Nations Practical Manual on Transfer Pricing [pdf] doesn’t exactly set the pulse racing. But as I noted in my blog on the manual as a whole, this document is politically very significant.

It’s probably the only detailed description of Brazil, China, India and South Africa’s approach to transfer pricing, both how they follow and how they differ from the OECD methods. Significantly, these contributions are expressed not just in terms of the legal and administrative realities, but also the policy objectives underlying them. Chapter 10 functions as a comprehensive critique of the OECD guidelines – almost a manifesto – endorsed and in most cases written by tax officials from some of the world’s most powerful economies.

So what’s in it? Here are some digested highlights – but you should read it all.

Brazil: fixed margins

Since the mid 1990s, Brazil has been the world’s transfer pricing maverick. It makes no claim to follow the OECD guidelines, although the core of its approach is analogous to some of the methods outlined in those guidelines. Brazil views its approach as consistent with the arm’s length approach, since it’s another way to approximate the price that would be paid between companies trading at arm’s length. Many others disagree with this view.

Under the OECD approach, the taxpayer (and tax authority, if it is challenging a taxpayer) needs to identify a ‘comparable’ company or transaction for each and every transfer price under assessment, subject to some adjustments. The simplest method is to find two independent companies that are trading a similar good or service, and use that price. Brazil adopts this method too.

If that can’t be done, some other OECD methods (Cost Plus and Resale Minus) use comparable profit margins, applying them to the price paid when the good or service under consideration is eventually bought from or sold to a third party. (There are other OECD methods that are even more complicated, but they’re not used in any form by Brazil). The Brazilian approach uses the same idea, but prescribes fixed profit margins.

In a simple example, imagine a Canadian mining company operating in Brazil. There are two subsidiaries, a mine in Brazil, and then an intermediary in Bermuda that buys the minerals and sells them on to third parties. To apply the OECD’s Resale Minus approach, you’d find a comparable commodity trader that buys minerals from third parties and sells them on to other third parties. You’d look at the profit margin it makes, then apply that same profit margin to the actual price at which the minerals from Brazil were sold on by the Bermudan company to a third party, to obtain the price at which the Bermudan company bought the minerals from its sister company in Brazil.

Brazil’s Resale Price Method is similar, except that rather than looking for a comparable, you apply a fixed margin of (usually) 20% to the actual price at which the minerals were sold on to third parties. In other words, the transfer price from Brazil to Bermuda would be 80% of the resale price from Bermuda to a third party. Last year Brazil made its method a bit more fine-grained, by setting out different margins for different sectors, based on data about each sector.

The Brazilian section of Chapter 10 argues that this method is easier to apply and provides more certainty than the OECD approach. It acknowledges that the approach may create double taxation because it’s not compatible with other countries that use the OECD methods, and that, “it is unavoidable that some Brazilian enterprises will be taxed at (higher or lower) profit margins not compatible with their profitability.”

China, India and South Africa

“As a developing country, China faces a number of difficult challenges, to many of which ready answers have not been found from the OECD guidelines,” notes the Chinese section of Chapter 10, written by two senior tax officials. South Africa’s submission concurs:

Whilst the OECD Guidelines have been particularly useful in providing a conceptual understanding of what is the nature of the arm’s length principle, there are instances when the Guidelines fail to address the more practical aspects of how to apply the principle

According to all three of these countries, the difficulty is with how to implement the arm’s length principle. And their sections of the manual set out many practical problems with implementation. But I think that there’s something more than that at stake here. These countries (or at least India and China) want to claw back a larger share of the tax base, which is about changing the apportionment between themselves and other countries. They may argue that their position is a more accurate implementation of the arm’s length principle, but to do so is to understate what they’re trying to achieve. Below are three examples.

Location specific advantages

The premise of the Location Specific Advantage (LSA) approach is that investments by multinational companies in these countries are more profitable than those in other countries, as a result of LSAs such as a cheap, comparatively skilled labour force, a large, relatively untapped consumer market, and more lax environmental legislation. This needs to be take into account when identifying and using comparables that do not have these same advantages.

To determine the transfer price by reference to a comparable transaction or company in another country, “China takes the view that there may be instances where the differences in geographical markets are so material that it warrants comparability adjustments to bridge the differences.” In other words, China revises up the profit made by Chinese subsidiaries, and hence the tax charge, when comparing them to other countries, because it thinks the LSAs it offers make investments in China more profitable than those in other countries.

South Africa says it shares this concern:

There are many instances where unique dynamics exist within the South African market enabling South African subsidiaries to realise higher profits than their related party counterparts in other parts of the world, or than are evidenced by comparable data obtained from foreign databases…Building on the practice followed in India and China, the SARS is currently considering its approach to location savings, location specific advantages and market premiums etc. within certain industries and such factors will be addressed when conducting audits.

The Indian section also discusses location specific advantages. Its argument, however, relates to whether local comparables, as well as foreign ones, are valid. Although the chapter doesn’t say this, I think India’s argument is also that the arm’s length principle doesn’t work here, because there is no arm’s length scenario that captures the location specific advantages:

Hypothetically, if an unrelated third party had to compensate another party to the transaction in a low-cost jurisdiction by an amount that was equal to the cost savings and location rents attributable to the location, there would be no incentive for the unrelated third party to relocate business to a low-cost jurisdiction.

What makes the LSA concept interesting is not merely that these countries are laying claim to a larger share of MNCs’ tax base than the OECD guidelines attribute to it. They are saying, quite explicitly in China’s case, that under free market (“arm’s length”) conditions, they don’t receive a fair share of the profits from inward investment, because the LSAs aren’t fairly priced by the market. China is using the tax system to correct for what it sees as unfair conditions in the global economy.

Below is a presentation by another Chinese official at a Tax Justice Network conference last year. Scroll through to slide 20 for the part on LSAs.

Intangibles

Transfer pricing is supposed to start from a ‘functional analysis’ that takes into account functions, assets and risks to determine how profit should be allocated. But intangible assets (and risks, see below) can be more easily moved than functions and tangible assets. China and India are concerned that multinationals tend to characterise subsidiaries in their economies as exploiting foreign-owned intellectual property, on which they must pay royalties, in order to deflate the profits made there.

For example, China takes the view that the value of a marketing intangible (such as a brand name) is inextricably linked to the market in which it is sold. In a memorable example, Head & Shoulders is a popular shampoo in China, and a foreign brand. But when it first arrived on the Chinese market, most consumers didn’t know what the words “Head and Shoulders” meant. “Over time,” says the manual, “the local Chinese affiliates acquire the skill and experience from operations in China, and may even contribute to the improvement of the MNE’s original intangibles. The issue in this scenario is whether the local Chinese affiliates should be entitled to additional profit, and if so, what is the appropriate method to calculate the additional profit?”

The Indian approach is similar:

Indian subsidiaries/related parties (which are claimed as no risk and limited risk bearing distributors by the parent MNE in order to justify low cost plus return) have incurred and borne huge expenditure on development of marketing intangibles. These entities generally incur very large losses or disclose very nominal profit as evident from their return of income

Instead of a flow of royalty payments out of India, it argues, the parent company should be reimbursing its Indian subsidiary for the local marketing intangibles created, without which it couldn’t sell into India.

Risks, and the formulary apportionment bombshell

India is concerned that the OECD approach overvalues the role of risks in allocating profits. Risk plays an important role in the functional analysis that underpins transfer pricing, because the higher the risk taken by one part of a company, the higher the transfer price it can charge. The Indian section says risks are “a by-product of [a company’s] performance of functions and ownership and the exploitation or use of assets employed over a period of time.” It “does not agree with the notion that risk can be controlled remotely by the parent company” and says that if “important strategic decisions” are taken in India then “the allocation of risk to the parent MNE is not only questionable but is devoid of logical conclusion.” Ouch.

The Chinese section concurs, arguing that “a risk‐based approach may place insufficient regard for the fact that there are sizeable assets located in China (i.e. the work force and factory plants).” It goes as far as to conclude that, in the case of the electrical manufacturing sector, “In this case, the assets and the people should largely dictate where the group’s profits should stay, and a global formulary approach should be a realistic and appropriate option.”

This is quite a bombshell. The chapter effectively argues that, in order to reduce the distorting effect of risks and intangible assets in transfer pricing, there is a case for the limited use of the formulary system advocated by Tax Justice Network, distributing the profits based on only on the assets and people in each jurisdiction. Wow. That will no doubt get tax justice activists excited, but to me what’s more interesting is the open discussion about which factors to take into account in allocating profits, and which to disregard. That’s not just about refinements to the technical implementation of the arm’s length principle: it’s politics.

Advertisements

The United Nations Practical Manual on Transfer Pricing: a bluffer’s guide

Logo of the United Nations

Logo of the United Nations (Photo credit: Wikipedia)

Last week saw the official launch of a 495-page document by the United Nations tax committee, its new Practical Manual on Transfer Pricing for Developing Countries [pdf]. The final product has been four years in the making and is an impressive, introductory-level guide to transfer pricing. So definitely worth dipping in and out of if you’ve never quite got your head round exactly how international rules divide up the tax base of a multinational company.

Because of its length, few people outside those who follow the UN committee in depth have really understood what the manual is about, and its implications for the international politics of taxation. So here’s a crib sheet on some of its more controversial aspects.

1. The manual is hardly the product of a group of tax mavericks

The subgroup responsible for drafting the manual includes two members of the OECD’s Working Party 6, the technical group responsible for its transfer pricing guidelines – indeed the subgroup’s Norwegian chair is also a bureau member of WP6 – as well as the head of the transfer pricing unit of the OECD secretariat. The subgroup had several private sector representatives, including people from Ernst & Young and Baker & Mackenzie, who did large amounts of drafting, and Shell’s global transfer pricing manager.

This was balanced by government and private sector representatives from developing countries (many of whose countries also have the status of observing participants over at WP6). I understand that there were some quite heated exchanges at times, and the group certainly did include some considerations unlikely to have been given much airtime at the OECD.

2. The main body of the manual is consistent with the OECD guidelines

To set the context, we need to understand the UN committee’s position on the OECD transfer pricing guidelines. The 2001 edition of the UN model convention explicitly endorsed the arm’s length principle, and recommended that countries implement it using the methods set out in the OECD guidelines:

the Contracting States will follow the OECD principles which are set out in the OECD Transfer Pricing Guidelines. These conclusions represent internationally agreed principles and the Group of Experts recommend[s] that the Guidelines should be followed for the application of the arm’s-length principle which underlies the article.

The Manual defines the arm’s length principle as, “an international standard that compares the transfer prices charged between related entities with the price of similar transactions carried out between independent entities at arm’s length.”

The 2012 update to the UN model convention also endorses the arm’s length principle, but it is more circumspect about the OECD guidelines. This is because in 2011, when the updated model convention was agreed, the Brazilian, Indian and Chinese committee members recorded a reservation to the paragraph of the 2001 model quoted above. (The model conventions are the views of the individual members of the committee at the time they are agreed). Rather than attempting to find a consensus statement for the new model convention, the committee agreed to quote what their predecessors had said in 2001, and then add the following text:

The views expressed by the former Group of Experts have not yet been considered fully by the Committee of Experts, as indicated in the records of its annual sessions.

So we can see that the UN committee’s position on the role of the OECD’s transfer pricing guidelines has changed over the course of this session (though it continues to endorse the arm’s length principle). Depending on how this evolution continues under the new committee membership, future versions of the transfer pricing manual might have the scope to carve out a more distinctive methodology for developing countries. But that was ruled out early on for this manual. The subcommittee concluded, as its chair reported back to the full committee in 2010, that its mandate required that the Manual maintain “consistency” with the OECD guidelines, which the UN model at that time – the old version – recommended that countries follow.

3. Consistent, but not identical

The transfer pricing subcommittee’s mandate, from 2009, embodies the balancing act that anyone working on transfer pricing in developing countries faced. The subcommittee must ensure:

a) That it reflects the operation of Article 9 of the United Nations Model Convention, and the Arms Length Principle embodied in it, and is consistent with relevant Commentaries of the U.N. Model.

b) That it reflects the realities for developing countries, at their relevant stages of capacity development.

c) That special attention should be paid to the experience of other developing countries.

An earlier proposed outline for the manual had included among subheadings on transfer pricing methods ‘current’ and ‘alternatives’. Under the latter, a single bullet point says. “Global Formulary Apportionment – an introduction (alternative method for applying the ALS or alternative to the ALS?).” This was effectively ruled out by the mandate, but there was still a question about how to balance “consistency” with the OECD guidelines on the one hand with “reflecting the realities for developing countries” on the other.

The UN committee continued to discuss ‘simplifications’ to the methods included in the OECD’s transfer pricing guidelines. For example, in 2010:

The discussions of the group of experts, however, included an exchange of views at some length regarding the use of presumptive arm’s length margins, safe harbours and formulas when applying arm’s length pricing profit methods….[Monique van Herksen of Ernst & Young] explained the potential benefit to developing country tax administrations in making use of presumptive margins and safe harbours in relevant circumstances. Additionally, she mentioned as an idea to be considered that the United Nations, in an appropriate form, might issue temporary industry margins based on research and statistics to be used by taxpayers and tax administrations as arm’s length presumptive benchmarks.

The final manual outlines these kinds of simplifications (although not van Herksen’s final proposal quoted above) but it doesn’t propose them as alternatives to the OECD guidelines – instead it notes that the latter are currently being updated to endorse the use of safe harbours. In the future, as both the OECD and UN consider how developing countries can simplify the implementation of the arm’s length principle, it will be interesting to watch the interplay between their respective documents.

4. The manual sets out the contours of current transfer pricing debates, and business is not happy

As I blogged at the time, the US Council for International Business wrote a rather angry letter [pdf] to the committee ahead of its final discussion of the manual last year. One section that it was unhappy about was 9.4.2, which according to USCIB, “ought to be deleted in its entirety. In our view, the only purpose of this section is to undercut the value of the OECD [transfer pricing guidelines] as the global standard in the area of transfer pricing.”

That section is still in the final version, and it still notes that, “the interpretation provided by the OECD Transfer Pricing Guidelines may not be fully consistent with the policy positions of all developing countries.” It is summed up as follows:

developing countries may wish to consider the relevance of the OECD Transfer Pricing Guidelines, along with the growing body of UN guidance and other available sources, when establishing their own domestic and cross-border policies on transfer pricing.

It’s hard to view this as a dramatic policy statement by the Committee. Rather, it’s an accurate description of the current state of affairs, and the concluding recommendation is made in the context of dispute avoidance, for which developing countries need to consider the actual practices of countries with which they may get into a dispute.

5. Chapter 10 is probably the manual’s biggest contribution

During 2011, as the manual developed, its outline started to include a chapter 6, on ‘The [Possible] Use of Fixed Margins’, otherwise known as ‘the Brazil chapter’. Although it existed in draft form, this chapter – a description of the Brazilian approach to transfer pricing, which is not consistent with the OECD guidelines – was never published on the UN website. By 2012, it had disappeared from the manual, replaced instead by a chapter 10, which unlike the rest of the manual “does not reflect a consistent or consensus view of the Subcommittee.”

I’ve heard that the proposed ‘Brazilian chapter’ was the subject of a lot of controversy, as well as variously that it was opposed by OECD members, lobbied against by the OECD secretariat, and even fought by other large developing countries, who didn’t see why Brazil should get a chapter all of its own. Certainly it seems inconsistent with the way the subgroup interpreted its mandate (see 2 above).

Whoever opposed the Brazilian chapter may instead have created a monster in chapter 10. It’s probably the only detailed description of Brazil, China, India and South Africa’s approach to transfer pricing, both how they follow and how they differ from the OECD methods. Significantly, these contributions are expressed not just in terms of the legal and administrative realities, but also the policy objectives underlying them.

It seems unlikely that smaller developing countries will read this chapter and try to adopt the methodologies it outlines. Rather, chapter 10 functions as a comprehensive critique of the OECD guidelines – almost a manifesto – endorsed and in most cases written by tax officials from some of the world’s most powerful economies. As a focal point in transfer pricing discussions, it is politically very significant.

The nature of this critique is the subject of a separate blog.

6. The political significance of the manual depends on what happens next

The UN manual contains a lot of very useful text that, on a technical level, will be very useful for developing countries. The current committee wants the manual to develop in the future, and it seems clear that the UN’s arrival on the transfer pricing scene is a fundamental change in international tax governance.

The UN Manual is not an alternative to the OECD Guidelines. Yet. It could evolve in that direction, creating a counterweight in the same mould as its model treaty, but that depends on what the new committee decides to do with it.

It also depends on two more things. First, on the unresolved discussion concerning the UN model convention’s position towards the OECD guidelines. Further work on the UN manual will inevitably be framed in terms of the model convention, which is the committee’s signature document, so the tension between OECD members and larger developing countries on this point is significant.

Second, it depends on the OECD, which has been working hard to reach out to developing countries [pdf]. Institutionally, it has brought many of them into its new Global Forum on Transfer Pricing, several are observers on its standards-setting committees, and there’s of course its Tax and Development Task Force. In terms of content, its project on transfer pricing ‘simplification’ has already incorporate some of the measures mentioned in the UN manual, and may even go further. So the OECD may succeed in creating a broad enough tent to regain its UN endorsement. It’s hard to see, though, how Chinese and Indian measures, which place them at odds with OECD countries, could be incorporated by the OECD itself.

On the BRICS’ choice of diplomatic language at the OECD

I’ve just been reading through the 2010 update to the OECD model tax treaty [pdf] and in particular the different positions set out by non-OECD countries. This is where countries can put on record their objections to the model treaty, so that potential treaty partners know what they’re getting themselves into. I think the difference of language used by Brazil, China and India is quite illustrative of their approach to diplomacy in international tax.

Continue reading