Recent new Pillar I rules, an EU transfer pricing Directive, and Canadian and UK legislation revisions propose to reference and use the OECD Transfer Pricing Guidelines in often new and different ways. Rather than operating in their traditional role as the source for interpretation of the arm’s length principle, these new proposed uses appear more “law-like” to us. With Ruchelman PLLC‘s Michael Bennett, we take the first steps toward testing our theory from the U.S. perspective.
O.E.C.D. GUIDANCE AS AN ELEMENT OF FOREIGN TRANSFER PRICING TAX LAW – A VIEW FROM HERE
Multilateral transfer pricing guidance from the OECD was first released in 1979. A version of OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations[1] (the “OECD TP Guidelines”) has been in print since 1995, long enough that U.S. international tax practitioners are by now accustomed to hearing foreign colleagues talk sometimes interchangeably about country transfer pricing legislation and the OECD TP Guidelines.
U.S. transfer pricing regulations, the commensurate with income standard, and the economic substance doctrine are codified under Code §482, §7701(o) and Treas. Reg. §1.482. The only external references that guide the I.R.S. and taxpayers are applicable Revenue Procedures (such as Rev. Proc. 2007-13 concerning covered specified covered services referenced in the services regulations), and case law.
Foreign transfer pricing law, by contrast, frequently includes a provision that references the OECD TP Guidelines as the guidance that must be used to interpret other provisions of that law. OECD member and other national tax administrations publish their own interpretive guides to the OECD TP Guidelines and add to a body of administrative guidance over time with subject-specific bulletins or memoranda, often following a court decision or a trend in controversy. Like any other wide variation in standard practices some might consider to be alike, a tax administration’s deviation from the interpretation of the OECD TP Guidelines prevalent among its treaty partner group can change over time, and can also differ between treaty partners. Double tax controversy can result and lead companies and tax administrations into Competent Authority proceedings where the agreed common interpretation of the arm’s length principle is none other than the same OECD TP Guidelines.
The European Commission has recently proposed a Council Directive on transfer pricing released as part of the Business in Europe: Framework for Income Taxation or BEFIT. The Directive proposes to codify the arm’s length principle and elements of its interpretation from the OECD TP Guidelines, clarify the role of the OECD TP Guidelines in member state law, and homogenize the tax administration interpretation of the same guidelines.
Recent developments
In addition to the Directive itself, we are interested in how a new approach between E.U. members will influence the individual E.U. member state tax administration approach to interpreting the OECD TP Guidelines when examining transactions of E.U. resident companies with group companies resident in treaty partner countries outside the E.U., and how these same tax administrations will approach M.A.P. and A.P.A. matters through their respective Competent Authorities. Negotiating history is hard to ignore, and our guess is that the result will be non-uniform.
In addition, two major U.S. trading partners, the U.K. and Canada, are currently undergoing revisions to their transfer pricing legislation that contemplate references to the OECD TP Guidelines. Both developments are taking place as G20 countries and others move toward variously ceding and gaining taxation rights through the labyrinthine mechanical workings of Pillars I and II as part of another OECD digital economy project. For companies within the scope of the Pillar I rules, formulary apportionment (this time the equivalent of a complex differential equation in contrast to the simple three fractions approach used to apportion income between U.S. states) is intended in part to provide relief from the need to navigate through the fog and potential longer-term tax uncertainty of OECD TP Guidelines interpretation.
In what follows, we begin the task of understanding the possible future role or roles of the OECD TP Guidelines. The OECD TP Guidelines have been classified by others as “soft law”.[2] The document itself is after all written variously as a discussion of possible best practices, recommended approaches, and more definite guidance representing an incomplete consensus of OECD member state tax authorities, and not in the if/then form of rules governing transfer pricing positions for tax purposes. We examine recent developments to determine whether OECD “soft law” may be hardening over time and begin by looking for clues outside of the field of transfer pricing.
US law – Taisei Fire & Marine Insurance Co. v. Commr. 104 T.C. 535 (1995)
OECD “soft law” frequently serves as a tool for interpreting multi-jurisdictional agreements, including tax treaties. Courts often rely on the OECD Model Treaty and its commentaries to interpret provisions of bilateral income tax treaties between two countries. A notable example is found in the case of Taisei Fire and Marine Insurance v. Commr.,[3] where the tax court consulted the 1977 Commentary to the OECD Model Treaty to interpret the U.S.-Japan tax treaty.
In Taisei Fire, several Japanese insurance companies authorized a U.S. company to serve as a reinsurance underwriting manager and enter into contracts on their behalf. The central issue was whether the Japanese insurance companies had a U.S. permanent establishment through the actions of the U.S. agent. The crucial determinant was whether the U.S. agent maintained an “independent status,” as the absence of such independence would lead to the Japanese companies being deemed to have a U.S. permanent establishment.
The U.S.-Japan tax treaty did not provide a definition for an “agent of an independent status.” However, the court recognized that the relevant provisions were not only based upon, but also duplicative of those found in the OECD Model Treaty. Consequently, the court turned to the commentary accompanying the OECD Model Treaty, which articulated that the test for independent status involves both legal and economic independence. The court ultimately held that given the lack of guidance in the U.S.-Japan tax treaty, the Japanese insurance companies did not have a permanent establishment based on the approach suggested by the OECD Model Treaty.
The role of OECD guidance in U.S. treaty interpretation has increased since the 1995 tax court decision. The U.S. explicitly embraced the OECD approach in its 2006 and 2016 Model Treaties. According to the OECD approach, a permanent establishment is treated as a functionally distinct entity for the purpose of attributing business profits. Furthermore, the OECD approach stipulates that business profits should be determined based on the arm’s length standard, applying transfer pricing principles to branch operations.
Taisei Fire serves as an illustration that a U.S. court can indeed draw upon OECD guidance to aid in resolving a contentious issue. Nevertheless, the extent to which a court will and should rely on such guidance remains a subject of uncertainty and debate.
Other OECD Guidance – OECD Guidelines for Multinational Companies
Before the introduction the OECD TP Guidelines, the OECD introduced the Guidelines for Multinational Enterprises (“MNE Guidelines”) in 1976, a thorough collection of government-recommended measures for MNEs to willingly embrace.[4] The purpose of the MNE Guidelines is to mitigate and address potential impacts stemming from activities in foreign locations, and promoting positive contributions to economic, social, and environmental advancement. These guidelines encompass various aspects, including human rights, environmental practices, labor standards, anti-bribery measures, corporate governance, disclosure practices, supply chain management, and taxation. Internationally, these guidelines enjoy widespread support and stand as the sole multilaterally agreed-upon and comprehensive set of principles for responsible business conduct, actively endorsed by governments.
Though widely accepted by countries throughout the world, observance of the MNE Guidelines by enterprises is voluntary and not legally enforceable. The MNE Guidelines do not supersede domestic law and are not designed to place enterprises in situations of conflicting requirements. Nevertheless, some matters covered by the MNE Guidelines may be regulated by national law or international commitments.
Despite the voluntary nature of the MNE Guidelines, signatory governments are required to establish a National Contact Point (“NCP”). Among their various responsibilities, NCPs play a crucial role in handling disputes, referred to as “specific instances.” This process serves as a non-judicial grievance mechanism, activated when a party raises allegations against the operations of a multinational enterprise.
The parameters defining the legal significance of the MNE Guidelines are explicitly outlined and commonly understood. This stands in contrast to the OECD TP Guidelines, where the line between general guidance and legal enforceability is blurred.
E.U. BEFIT Directive and the OECD TP Guidelines
Part of the larger BEFIT legislative package that aims to set out rules for large companies in the E.U., a recent Council Directive on Transfer Pricing[5] (“the Directive”) aims to use the OECD TP Guidelines to harmonize the interpretation of the arm’s length principle between E.U. Member States. Member States for the most part have legislated OECD TP Guidelines the task of interpretation of the arm’s length principle. The BEFIT transfer pricing proposal goes one step further to elevate the OECD TP Guidelines into E.U. law, and as more than the arm’s length principle interpretive standard.
The Directive requires that Member States adopt a common definition of associated enterprises as an initial condition to delineating a controlled transaction and proposes a new fast-track and joint audit approach to facilitate corresponding transfer pricing adjustments between companies resident in E.U. member states to minimize the risk of double taxation. One of the several positive intended effects of the Directive is to reduce or eliminate the need for transfer pricing rulings from E.U. Member State tax authorities that have historically caused significant State Aid and other controversy, especially when granted as a unilateral ruling. The remainder of the Directive concerns the identification and pricing of a controlled transaction, with the well-known “delineation of the actual transaction” OECD TP Guidelines language taken verbatim from paragraph 1.33 without including the plural “transactions.”
Further use of terms from the OECD TP Guidelines appears throughout the Directive, which is largely a simplified paraphrasing of the OECD TP Guidelines. The 451 pages of the OECD TP Guidelines are not however able to be collapsed into 17 pages of draft Directive like 17 clowns into a Citroën Deux Chevaux. The distillation effort in drafting results in certain non-subtle departures from the OECD TP Guidelines and therefore potential causes of future controversy both among E.U. member states and between E.U. member states and non-E.U. treaty partners if the approach of the Directive comes to characterize standard members state tax administration practice.
The term “best evidence”, for example, is used in the Directive preamble to describe the utility of an intercompany contract for the purpose of identifying the transaction or transactions actually undertaken between two controlled corporations. Less weight is given to a written intercompany contract by the OECD TP Guidelines in accurately delineating the controlled transaction at issue. Paragraphs 1.36 and 1.43 of the OECD TP Guidelines indicate that a written contract is important but is not the only item of information used to understand the actual controlled transaction. In the OECD TP Guidelines, the “best evidence” term describes the utility of a written contract in determining the intention of the parties in relation to the assumption of risk.
The Directive’s explanation of the sufficient conditions for determining comparability are the OECD TP Guidelines conditions relevant to transactional methods only. More detailed interpretive guidance on the comparability standard relevant to the application of the transactional net margin method, or TNMM, the CPM’s OECD cousin, is absent from the draft Directive and must be taken from Chapter II of the OECD TP Guidelines. Absent an amendment, the OECD TP Guidelines will play their historical “soft law” interpretive role in this respect.
Finally, the interquartile range that is explained as an option for summarizing a group of uncontrolled pricing or profitability statistics under the OECD TP Guidelines (it is disliked by certain OECD member state tax administrations), defines the arm’s length range under the draft Directive. The E.U. and the U.S. may soon share both the leadership title of President and the interquartile range, portending a possible reduction in friction in U.S. double tax cases. Those OECD member state tax authorities, such as the Canada Revenue Agency, that are not proponents of the interquartile range, may experience different double tax case negotiations.
In summary, “soft law” in the form of the OECD TP Guidelines appears to harden under the directly adopted language of the Directive despite paragraph 15 of the Directive’s preamble that refers to the OECD Transfer Pricing Guidelines in an interpretive capacity, consistent with the legislation of many E.U. and OECD member states. The Directive defines the OECD TP Guidelines as the currently applicable 2022 publication date version and incorporates subsequent amendments to the guidelines by statute.
Legislative and administrative use of the OECD TP guidelines
Many non-E.U. member state tax administrations have a long-standing connection to the OECD TP Guidelines through their involvement with the OECD’s tax policy and administration development work. The outcome has been direct or indirect legislative reference to the OECD TP Guidelines and published administrative guidance that references or follows the OECD TP Guidelines.
The U.S. does not reference the OECD TP Guidelines in its transfer pricing regulations, or publish a companion interpretive document as is done by tax administrations both within and outside the E.U. As an OECD member state, the U.S. works with OECD member states through its treaty network to resolve double tax cases. The acknowledgement of the OECD TP Guidelines as an element of the lingua franca in these multilateral settings appears only in IRS Rev. Proc. 2015-41 and select IRS training materials.
In this sense, the U.S. follows an approach similar to Korea, China, Japan, and Israel (among other non-E.U. OECD member states) and does not specifically cite the OECD TP Guidelines in country legislation as a means of interpreting the relevant provision of law. The legislation of the foregoing countries resembles the Directive to the extent that a general claim (in these cases outside of a legislative preamble or administrative guidance document) is made concerning consistency, or incorporation of the basic aspects of the OECD TP Guidelines.
Country decrees and administrative guidance issued as supplements to enacted legislation may incorporate or reference the OECD TP Guidelines as a tax administration explains its approach to certain aspects of transfer pricing administration. Some tax administrations continue to roughly paraphrase the OECD TP Guidelines without citation in such a document. China’s Public Notice of the State Administration of Taxation [2017] No.6 is a good example of this, restricting the role of the OECD TP Guidelines strictly to “soft law”.
U.K. and Canadian consultations
In mid-2023, both the U.K. and Canada began consultations on amendments to specific aspects of their transfer pricing legislation. U.K. legislation incorporated the OECD TP Guidelines (and subsequent amendments) for the purpose of interpreting the arm’s length principle in 2004, while Canada’s legislation has not. Both countries have issued administrative guidance that cites the OECD TP Guidelines before the respective consultations commenced, though in different ways and with different points of emphasis.
The U.K. consultation question relevant to the OECD TP Guidelines was relatively narrow in scope and contemplated the replacement of the term “provision” used in U.K. transfer pricing legislation to indicate the series of conditions comprising a controlled transaction with the term “conditions” for the purpose of greater consistency with the language of Article 9(1) of the OECD Model Tax Convention.
Article 9(1) uses the term conditions in the phrase “conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises”, which is a critical part of the Article 9 text that is interpreted by the OECD TP Guidelines. One purpose of the U.K. consultation was to solicit input on the practical implication of the proposed change in terminology for the operation of domestic legislation. The U.K. tax administration’s practical concern was the over-broad scope of the term “conditions” in comparison to the term “provision” used elsewhere in legislation.
The Canada Revenue Agency (“CRA”) began its legislative consultation after the Federal Court of Appeal found for the taxpayer in The Queen v Cameco Corporation, 2020 FCA 112 and the Supreme Court of Canada refused leave to appeal, thwarting a tax administration attempt to recharacterize a controlled transaction based on proposed series of alternate transaction circumstances. The CRA consultation asked for input on the question of the codification of the term “economically relevant characteristics” used to further describe a controlled transaction.
Article 9(1) of the Model Convention, with which the U.K. seeks to harmonize its legislative language, refers to the actions (“conditions made or imposed”) of two related parties resulting in the establishment of a series of “conditions” that define the controlled transaction. The OECD TP Guidelines make it clear that contractual terms are only one of the economically relevant characteristics or comparability factors that describe or delineate a controlled transaction.[6] CRA proposes to codify the term “economically relevant characteristics” to mean something different than the OECD TP Guidelines definition, and to define the term “conditions” broadly.
The proposed U.K. amendment retains the OECD TP Guidelines as “soft law” and reduces a possible conflict between domestic law and the U.K.’s double tax treaties. The proposed Canadian amendment generally incorporates the OECD TP Guidelines conditionally and proposes inexact codification of one element (“economically relevant characteristics”) of the same guidelines. Whether the result is hard law on the outside and soft in the middle, or something else entirely remains to be seen in draft legislation and the litigation that will follow.
Conclusion
Distinct from the status of the OECD Model Treaty and MNE Guidance as non-binding guidance with well-defined parameters of legal significance, the OECD TP Guidelines may be set to step out of their historical role as “soft law” and into a role as either a stronger authority on the interpretation of the arm’s length principle or the source of legislative language itself. From a U.S. perspective, this signals a growing heterogeneity in transfer pricing approaches among treaty partners, and a potential hardening of treaty partner positions in double tax cases as OECD TP Guidelines guidance is enacted as law in one form or another.
If we accept the proposition that the OECD TP Guidelines are “soft law” and effective to the greatest extent in their current form, are the E.U. and Canada asking too much of these guidelines by proposing codification of one type or another? The positive role played by other legally non-binding OECD guidance in fostering international cooperation and harmonized approaches suggests this may become a future concern. The current OECD-led efforts to reform the taxation of digital commerce with the legislation of Pillar I and II by multilateral instrument may provide relief for large multinational groups but leave controversy for all others to resolve.
[1] OECD (2022), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, OECD Publishing, Paris, https://doi.org/10.1787/0e655865-en
[2] Alberto Vega, International Governance through Soft Law: The Case of the OECD Transfer Pricing Guidelines, Max Planck Institute for Tax Law and Public Finance Working Paper 2012 – 05, July 2012
[3] Taisei Fire & Marine Ins. Co. v. Commr, 104 T.C. 535 (1995).
[4] OECD (2023), OECD Guidelines for Multinational Enterprises on Responsible Business Conduct, OECD Publishing, Paris, https://doi.org/10.1787/81f92357-en.
[5] Proposal for a Council Directive on Transfer Pricing, SWD(2023) 308-309, (European Commission, September 9, 2023)
[6] OECD TP Guidelines, para. 1.36