The OECD transfer pricing methods are dead: Long Live the Alternatives

In its second article about TJN's world-leading seminar on transfer pricing (the previous article has been blogged here), Transfer Pricing Week (TPW) opens with a simple yet devastating statement about the global tax regime promoted and enforced by the OECD:

"A conference organised by the Tax Justice Network in Helsinki heard how the arm's length principle (ALP) is failing developing countries and that it must be redeemed or replaced . . . That was the overwhelming feeling among delegates and speakers at last week's event . . . despite the OECD's insistence that it can be made to work for developing countries."

The so-called "Arm's Length" method was adopted by the OECD over fifty years ago, when the world was very different from today. It was clear by the 1970s, however, that multinational companies were restructuring themselves to take advantage of the method's inherent weaknesses. This was a time of rapid growth of complex corporate structures spanning multiplicity of offshore jurisdictions as MNC adapted to a set of rules that encourage profits shifting to tax havens.

In a vain attempt to tackle the method's failings the OECD has added layer upon layer of complexity to the "Arm's Length" method, but the situation has simply deteriorated as MNCs have become more imaginative in the way they shift intangible services and intellectual property rights around the globe, as a way to shift their profits into convenient (usually low-tax) jurisdictions. Basically, their arms are as long or as short as their accountants say they are, and length becomes an elastic concept.

This blogger's favourite bit of nonsense was the creation of a new intangible, called "management foresight", used by US telecoms giant WorldCom, to shift truckloads of profits offshore to a Cayman Island based subsidiary. All the "management foresight" in the world didn't prevent WorldCom from collapsing up shortly afterwards in a gigantic fraud scandal.

The "Arm's Length" method has become almost inoperable in many circumstances. In 2007 the Guardian published a fascinating case study of banana trade to demonstrate how easy it is for MNCs to shift profits to tax haven subsidiaries even in the case of a simple commodity such as bananas. Subsequent revelations about Apple and Google demonstrate the ease with which major companies can drive a coach and horses through the OECD's method. As David McNair commented in Helsinki:

"The QWERTY keyboard was originally designed to slow down typists because their keys were getting stuck, but now everyone uses it though it is a sub-optimal model. Should we be tying everyone into the OECD's sub-optimal model?"

Well the answer is clearly no. And the solution lies with following the general trend (which the OECD itself endorses through its transaction net margin method, which is formula based) towards a profit split arrangement using a formula approach to tax profit on the basis of the economic substance of an MNC's activities. Kerrie Sadiq, professor at Queensland University of Technology, proposed using multinational financial institutions, which are generally highly integrated in their global operations, as an ideal test case for moving towards alternative approaches, namely unitary taxation (which is explained here):

"Unitary taxation stops pretending multinational enterprises can be divided into different parts: they are one entity."

Brazil already has an alternative method that does not depend on alleged "arm's-length comparables," and other countries have or are exploring alternative approaches, as Tatiana Falcão recently wrote for us.

As TPW concludes, however, despite the enormous weight of evidence that the "Arm's Length" method is flawed in both theory and practical application, TJN has a long way to go before we convince the rest of the world that a better system of taxing multinational companies is possible: such is the inertia in the system, and the embedded interests.

This is the challenge we must take on in the coming months.

You can read the full TPW article here.