Countries intentionally misinterpret transfer pricing guidelines on risk to increase tax revenue, US official asserts

by Julie Martin

The US is concerned that some countries aim to increase their share of tax revenue from multinational firms by incorrectly applying OECD transfer pricing guidelines on the allocation of risk, a Treasury official said at a National Association for Business Economics (NABE) conference held July 18–20 in Washington.

Michael McDonald, a financial economist in the Business and International Tax Division of Treasury’s Office of Tax Analysis, warned that countries have a “fundamental interpretive disagreement” concerning the OECD/G20 base erosion profit shifting (BEPS) plan final reports on the allocation of risk in transfer pricing. These BEPS revisions have since been incorporated into Chapter 1 of the 2017 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.

Contractual allocation of risk

The dispute relates to the interaction of paragraphs 1.194 and 1.105 in Chapter I of the OECD transfer pricing guidelines, McDonald said.

Specifically, countries disagree on how to proceed when it is determined under the guidelines that a contractual allocation of risk should be respected but an entity other than the entity contractually assuming risk also exercises some control over that risk.

McDonald said that paragraph 1.194 of Chapter I, part of the general discussion of risk, states that the contract should be respected as the accurate delineation of the transaction when the entity contractually allocated risk passes the control test and has financial capacity to assume risk.

“At that point, paragraph 1.87 says ‘ok, you’re done, now just price the deal. There is no more analysis required,'” he said.

Paragraph 1.94 states that this conclusion does not change merely because there may be other entities contributing to the control of risk, which might often be the case, he said.

“Paragraph 1.94 is important,” McDonald said, “because it prevents the possibility of a contractual arrangement being routinely recast because of some subjective determination that other entities are contributing to control, notwithstanding that the contractual allocation passes muster.”

In fact, McDonald said the US agreed to the BEPS six-step process to analyze transfer pricing risk only because it starts with and “stress tests” the MNE’s contractual arrangement and thus avoids “subjective mumbo jumbo.”

Nonetheless, McDonald said that some countries are arguing that paragraph 1.105 in Chapter I of the transfer pricing guidelines is, in essence, a “trumping rule,” providing that when an entity other than the entity contractually assuming risk exercises some control over that risk, that entity should share in the upside and downside. These countries argue that the risk becomes a shared risk, McDonald said.

McDonald called those advocating the alternative interpretation “maddeningly opportunistic” and “completely galling.”

The US believes that paragraph 1.105 merely states that it may be appropriate to remunerate such control of risk if this is consistent with the accurate delineation of the transaction. He said that once it is determined that the taxpayer’s allocation of risk in the contract is the ‘real deal,’ one must look only to the contract to see what the contract says about appropriate remuneration.

The dispute affects, for example, the analysis of ‘risky services’ provided by a group member, which are contractual arrangements in which payment is made to a contract service provider that are contingent on successfully performing the services, he said.

“There are plenty of countries looking to ignore contracts and look quite subjectively for who exercises control and then profit split their way to the bank,” he said.

McDonald also said that example 4 in the 2016 profit attribution paper “was a convoluted as it was” because Working Party 6 of the OECD Committee on Fiscal Affairs (WP6) was attempting to ‘”work around” this interpretive disagreement.

General vs. detailed OECD guidance

McDonald also said that WP6’s latest draft guidance on the attribution of profits to PEs is much more general and high level than the previous draft, as mandated by the BEPS inclusive framework. The BEPS inclusive framework said the earlier draft was overly complex and did not reflect the fact that the authorized OECD approach for attribution of profits to PEs has not been adopted in all countries, he said.

McDonald said he prefers the earlier, lengthy, draft because that best explains WP6’s views on profit attribution. He said that it would be helpful if practitioners commented on whether the new format actually provides useful guidance.

“This may be the wave of the future,” he warned.

Regarding the latest profit split draft, McDonald suggested that practitioners consider commenting on whether they approve of the fact that some items in the former draft have not been included in the new draft. He said sometimes commentators don’t mention if it they are happy that something has been deleted; this would be a good time to say so since others may comment that they want the old provisions added back in, he said.

BEPS inclusive framework

McDonald said that he is “not cynical” about the future of the BEPS inclusive framework, which now numbers over 100 members.

He said it is difficult to draft guidance with so many countries at the table, but he said the BEPS work reveals the benefit of mutual agreement and inclusiveness to the workings of the international tax system.

He said the inclusive framework reflects a commitment to transparency which is important to countries that believe they are systematically disadvantaged by international tax norms.

McDonald was somewhat critical of the current set up, though, because it allows BEPS inclusive framework members to receive the fruits of compromise on international tax guidance even though they don’t ultimately agree to be bound by the OECD transfer pricing guidelines.

Julie Martin

Julie Martin

Founder & Editor at MNE Tax

Julie Martin is the founder of MNE Tax. She edits the publication and regularly contributes articles on new developments in cross-border business taxation.

Martin has worked as a tax journalist and editor for more than 13 years. Prior to that, she worked as an in-house tax attorney in New York. She also holds an LLM in taxation from New York University School of Law.

Julie Martin


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