China’s challenge to international tax rules and the implications for global economic governance

Hearson, M & W Prichard, 2018. China’s challenge to international tax rules and the implications for global economic governance, International Affairs 94(6): 1287–1307.

In scholarship on international economic governance – areas such as trade, the monetary system and development assistance – a lot of attention is now devoted to the rise of China. This literature appears to be settling on a consensus that China is a cautious reformist rather than a supporter of more dramatic change, and that it pursues outside options where existing institutions do not serve its interests. Meanwhile, work on the politics of the international tax regime is still largely preoccupied with the power that the US, as a ‘great power’, wields on the international tax regime. Our view is that this underestimates the influence a rising power can wield, and so we try to link the two literatures up. We focus on the Arm’s Length Principle, which underpins OECD-led international agreement on the distribution of multinational companies’ tax bases through transfer pricing. This international regime differs from areas such as trade and aid, which have fragmented in recent years, because it is a cooperation regime characterised by strong incentives for states to find and follow multilateral agreement.

Interests: Chinese exceptionalism

We begin with China’s interests. They align neither with developing countries, despite official rhetoric to that effect, nor with OECD countries. This is partly because China is undergoing an economic transition, summarised in table 1: its past, present and future interests differ from each other. In bilateral tax treaties, China has been able to manage this situation by adopting different negotiating stances with developing countries compared to developed countries. It faces more of a challenge in multilateral negotiations.

china1

China’s interests are also different because of what it calls its location specific advantages (LSAs). As a tax administration document states:

China has a huge population and a fast-growing middle class that form a great market capacity and huge consumer groups. This factor is unique in the world and inimitable by other small and medium-sized developing countries.

By arguing that the LSAs firms obtain from operating in the Chinese market (roughly divided into location savings for manufacturing, and market premiums for retail) are unique to it, China avoids the need to choose between its old and new interests. It has simply begun to claim a larger share of multinational firms’ taxable profits. We quote from an article written by some staff of the law firm Baker Mackenzie:

Most multinationals do not realize that their strategy of allocating ‘routine profits’ to China is under severe attack. To quote a Chinese tax director who has negotiated extensively with the Chinese tax authorities, ‘[i]t became clear that the State Administration of Taxation believes China has unique factors, including location savings and market premiums, that are not addressed by the OECD Transfer Pricing Guidelines […]’.

Capabilities: often underestimated

China has a particularly strong position in international tax negotiations because the same economic transition that is changing its preferences is also strengthening demand from multinationals to access its markets. Previous work by Lukas Hakelberg and Wouter Lips has focused on absolute market size, where China lags behind the US and EU, but we think three other variables also matter:

  1. Growth. China is undergoing huge economic and social shifts that make it a uniquely attractive place to do business, whether measured by the exploding size of its middle class, or its ascendency towards the top of the patent registration league tables. China’s attraction to investors is thus about future potential as well as present performance.
  2. Profitability. Its fairly new and rapidly growing consumer market is relatively untapped in many areas, has a taste for foreign goods and services, and is more willing to pay a premium for higher-quality products.
  3. Value-chain positioning. Chinese manufacturing has become indispensable to the production of a huge proportion of products consumed in the West, most iconically the iPhone, and this position is becoming increasingly institutionalized.

For these reasons, China can afford not to take too seriously any threats from multinational companies and foreign governments if it differs from international tax norms, giving it the kind of autonomy that only the US was thought to possess.

Strategies: Janus-faced

LSAs allow us to analyse how China has interacted with the established institutions of global tax governance. We conclude that its approach is neither conciliatory nor confrontational, but both, simultaneously. China adopts a rhetoric of common cause with developing countries, but pursues an agenda that is designed to maximize only its own share of the tax ‘pie’. It flirts with outside options such as the United Nations, while enjoying a privileged position within the G20-OECD complex at the heart of international tax rulemaking, and diverging from existing rules when it finds this to be in its interest. “China needs to strike a balance between conforming to international conventions and acknowledging its unique situation in transfer pricing legislation and practice,” wrote Chinese officials in a United Nations document in 2017. In practice, however, its actions have been more aggressive than this might imply.

In particular, China’s implementation of LSAs chips away at a core norm of the international tax regime, the Arm’ Length Principle (ALP). OECD rules require that the ALP be applied to each subsidiary of a multinational in isolation, in comparison to a locally owned independent enterprise. By contrast, the Chinese position is that:

With more and more companies poised to conduct business as groups, economic activities are more and more likely to take place in the inner circle of MNE groups. It is nearly impossible to take out one piece of a value chain of an MNE group and try to match it to comparable transactions/companies

This has ruffled some feathers, as can be seen in this quote from the United States’ former international tax negotiator, Robert Stack:

The OECD countries all ascribe [sic] to the arm’s-length standard and to what they call the basic OECD principles. Other countries have not signed on to the full implementation of the arm’s-length standard and the OECD guidelines, even countries that are in the G-20. And the reason this is very important is the question of market premium and intangibles that relate to markets and things like location-specific advantages that are specifically talked about in the OECD guidelines … [China should] not pick a rifle-shot issue that favors a large-market country and try to gerrymander the debate from that narrow issue.

The destabilising effect of China’s actions could lead to one of two outcomes, we suggest. In the first scenario, China would behave very much like the United States, throwing its lot in with the G20-OECD complex. Its growing influence would allow it to use a combination of incremental changes at global level and selective unilateralism to adapt as its place in the global economy evolves. In the second, by design or by accident, China’s approach could destabilise the core norms of the international tax regime. By opening cracks in the existing system, LSAs may induce other countries—perhaps led by other large emerging markets—to seek their own accommodations, thus placing increasing strain on the multilateral foundations of the international tax system. It remains to be seen whether China’s successful challenge to the ALP will similarly prompt subsequent challenges from elsewhere.

Some political questions for Unitary Taxation

It sometimes feels like, when discussing unitary taxation [pdf], one is expected to self-identify as either a UT advocate, interested in how it could be made a reality, or a sceptic, determined to defend the status quo. I’m neither. As a political scientist, I want to understand (among other things) how our international tax instruments came about, how they affect what individual countries do, and how different actors influence national and international policymaking. These are empirical questions that I think are relevant to the UT debate.

Unitary tax is certainly a case in point for each of these questions. If it really is a better system than transfer pricing, then a political economist would want to explain the persistence of the latter. It seems clear enough that developing countries, when they decide to get serious about taxing multinational companies, head almost automatically down the transfer pricing route. Yet the people making these decisions are often, in my experience, very sharp, with a healthy scepticism of the international tax institutions from which transfer pricing standards have emerged. So have they considered other options? Are their decisions based on legal or economic preference, political calculation, or the hegemonic power of the OECD guidelines? I’d like to know.

There is a tremendous body of legal literature arguing that unitary taxation would be a more effective way to administer corporation tax than transfer pricing. I find this more convincing than the argument for the status quo, as made for example in the OECD guidelines. This seems to boil down a political impossibility theorem: to prevent double taxation there would need to be global agreement on a formula, but this would be impossible, so we should stick to the status quo.

What I find odd about it is that the same surely applies to transfer pricing, and yet there has never been a global agreement on those standards: just an agreement between OECD countries. Everyone should do what the OECD countries do, it seems, not because of its technical merits, but because it would be too difficult to do anything else.

I’ve argued elsewhere that moves in some of the BRICS countries are specifically undermining any notion that there’s an international consensus on the arm’s length principle. What India and China are doing is not, like Brazil, just based on the idea that they have found a better way to approximate the arm’s length price: they seem to argue instead that they are entitled to a larger-than-arm’s length share of taxing rights, because that’s what they consider fair.

If there has been a breakdown in the transfer pricing consensus, and one that leads to double taxation, that substantially lowers the bar for UT: it no longer needs a tight global consensus in order to match transfer pricing. Furthermore, if a debate is opening up over the fair distribution of taxing rights, that’s comfortable territory for unitary taxation, where the debate is articulated clearly over the choice of formula.

In making a judgement about which international tax system is best, we need to ask ‘best in what way?’ I think we can look at it through the classic three-way lens of tax policy valuation:

  • Equity: does it produce a fair (we might say ‘progressive’) result?
  • Efficiency: does it minimise the role of tax factors in shaping economic decisions?
  • Administrability: can it be administered and enforced effectively without imposing too large a burden on taxpayers and revenue authorities?

Looking at one of Sol Picciotto’s recent papers, it seems that his main argument in favour of unitary taxation is an administrability one: under UT there would be less avoidance and evasion than under transfer pricing. (He also touches on the impact of tax planning on economic efficiency, and we could discuss how it affects equity as well). Efficiency is interesting, but I am certainly not able to do the kind of economic modelling that we’d need to predict behaviour change under UT.

But what if we start from equity? There is the question of equity between taxpayers, and in particular how the tax treatment of multinationals compares to domestic firms – a matter of vertical equity. But I am interested in ‘inter-nation equity’. How would (or indeed could) unitary taxation affect the distribution of taxing rights between countries, and in particular between developed and developing countries? Sol’s paper ends on this point:

Some might also wish to see even more ambitious projects for global taxes, which might be used for international redistribution to assist development. Those, however, are topics for another occasion.

To me, this is a political question. Considering how different formulae would change the distribution of taxing rights is the starting point, but you can’t end there: you have to ask what a politically viable settlement would look like. If global consensus is needed, is it possible to imagine one in which developing countries have a bigger share of taxing rights than under transfer pricing? If global consensus is not needed, how are developing countries likely to act? One hypothesis might be that larger, more powerful economies would adopt formulae that maximise their tax revenues, just as they are doing with their transfer pricing standards, while the choice of formula could become a matter of tax competition for smaller countries.

Of course it may not be a zero sum game. If avoidance and evasion are reduced under UT, the overall cake to be divided up would be bigger. In that case, it may just be a question of working out how to divide up the spoils.

My view is that these questions can’t be asked through only thinking about unitary taxation in the hypothetical. Key to determining if unitary taxation produces a more equitable outcome is developing a model of how countries behave in international tax. To do this, we need to study how countries act under the current international tax system – both unilaterally and in international negotiations. Coincidentally, that is what I am trying to do!

PS: on the technical side, I’m also watching the International Centre for Tax and Development’s unitary tax workstream and the unitary taxation project on Andrew Jackson’s blog with interest

 

Double tax treaties: a poisoned chalice for developing countries?

It’s been an interesting couple of days here at Strathmore University Business School in Nairobi. I’m at a conference to launch the School’s new Tax Research Centre, which has brought together tax officials, tax practitioners and academics to address some critical issues for Kenya, including anti-avoidance, taxing multinationals and tax treaties. The quality of discussion is very high, and certainly banishes the notion that there is no technical expertise in developing countries.

I was asked to speak on the title above, and my presentation is below. There was a fascinating exchange when I put up the slide showing Kenya’s current treaties. Not one person, including the tax advisers in the room, thought Kenya should ratify the treaties it has signed with Mauritius and the UAE.And nobody was even aware that a treaty had been signed with Iran! Interestingly, in contrast to the academic literature, the participants here took it as self-evident that tax treaties have no impact on the levels of inward investment into a country. But now Kenyan companies are starting to expand abroad, some people did advocate treaties to encourage this outward investment.

Link to presentation on slideshare.net

BEPS Part 2: international politics and developing countries

sluto | beps

This graffiti is definitely about Base Erosion and Profit Shifting (Photo credit: feck_aRt_post)

I wrote earlier this week with some questions about UK tax policy and the OECD’s Action Plan on Base Erosion and Profit Shifting. A lot of the areas that it’s looking at are probably not going to affect smaller developing countries very much, but there are a few things worth highlighting. I also recommend Chris Lenon’s comments on the action plan, to which I’ll refer below.

Beyond the arm’s length principle

I thought it very interesting that the action plan concedes that some of the current problem with tax planning derives from the transfer pricing rules themselves:

multinationals have been able to use and/or misapply those rules to separate income from the economic activities that produce that income and to shift it into low-tax environments.

But the more significant rhetorical shift from the OECD is that it now appears to believe that solutions within the arm’s length principle (ALP) may not be enough. The ALP’s self-sufficiency has seemed to me to be an article of faith for the OECD secretariat every since I began working on tax. The action plan says:

special measures, either within or beyond the arm’s length principle, may be required with respect to intangible assets, risk and over-capitalisation to address these flaws.

Some academics are fond of arguing that the OECD abandoned the ALP in all bit name some time ago. So I wonder whether this is really a substantive change or just a rhetorical shift designed to underline that BEPS is a ‘radical rethink’.

Chris thinks that “[t]his is a clear indication that apportionment may be considered as the way to deal with high value intangibles.” It does seem to imply that the OECD may come more into line with the Chinese approach.

Tax reporting

Noting that “timely, comprehensive and relevant information on tax planning strategies is often unavailable to tax administrations”, the action plan proposes to:

Develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business. The rules to be developed will include a requirement that MNE’s provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template.

Chris thinks that this is “very significant”, and that “business needs to develop a strategic response to the issue of transparency”. I think that it is worth considering in the context of the report to the OECD task force on tax and development last year [pdf], which outlined the information challenges faced by developing country tax authorities. The main value of a global report as proposed would be to give tax authority in country A some readily available information on a multinational’s operations in country B, if neither country is the head office. At the moment this is difficult to obtain, because the subsidiary in country A can’t be required to provide information on a sister company in country B, despite them being under common control. Tackling this problem through global documentation seems sensible.

A multilateral treaty and mandatory arbitration

I said when the original BEPS report came out that a multilateral treaty designed to update current treaties in one fell swoop has potential dangers for developing countries. They’re mostly excluded form the BEPS process, but a multilateral treaty could gain such momentum that it becomes obligatory for them to sign up, despite the difference of interests acknowledged by the existence of separate UN and OECD model bilateral treaties. The new UN tax committee‘s response to any multilateral treaty will surely be very significant.

As an example, the Action Plan implies that one area for change is in the area of mutual agreement procedures (MAPs) and arbitration:

Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under MAP, including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.

Alison Christians has written about her concerns about this in the past. Experience with investment treaties shows that developing countries should be wary of mandatory arbitration, yet they may find themselves with little choice if this makes it into a multilateral treaty.

G20 versus OECD

The new model of G20-OECD cooperation is intriguing. The Action Plan explains it as follows:

interested G20 countries that are not members of the OECD will be invited to be part of the project as Associates, i.e. on an equal footing with OECD members (including at the level of the subsidiary bodies involved in the work on BEPS), and will be expected to associate themselves with the outcome of the BEPS Project.

The equal footing part is new and unusual, but that last clause means that countries who have got used to stating their difference of opinion with the OECD will presumably want to think carefully. I will be very interested to see which of the non-OECD G20 members take up this invitation.

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.

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.

Do the BRICS present a challenge to the governance of international tax?

For campaigners, journalists and academics, the more interesting answer to the title question of this post would clearly be “yes”. It’s fascinating to think that we might be living through a paradigm shift in the politics of international tax, with the OECD struggling to maintain its relevance in the face of a more and more divergent position from its most powerful non-members. But is that just wishful thinking?

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