Caroline recently took time out of her busy schedule to talk to The New European Economy about some of the current issues surrounding transfer pricing.

 

What are the mechanisms available to companies involved in cross-border disputes over taxation?

In the transfer pricing area, cross-border disputes over taxation can lead to economic double taxation where the same profits are taxed in the hands of two related parties located in two different jurisdictions. Suppose for instance that a company in Country A sells products to an associated enterprise in Country B at a price of 100. Suppose that the tax authorities in Country A adjust the transfer price of this transaction to 120 on the grounds that 120 is the “arm’s length” price, i.e. the price that would have been agreed between independent parties in comparable circumstances and which should be used for tax purposes. This may cause economic double taxation insofar as the company in Country A will be liable to tax on an amount of profit (20 in the example) which has already been taxed in the hands of its associated enterprise in Country B.

Article 9 (2) of the OECD Model Tax Convention, which is used as a model for over 2,500 bilateral tax treaties between OECD countries and between OECD and non-OECD countries, provides that in these circumstances, Country B shall make an appropriate adjustment so as to relieve the double taxation. Such an adjustment is not automatically to be made in Country B simply because the profits in Country A have been increased; the adjustment is due only if Country B considers that the figure of adjusted profits correctly reflects what the profits would have been if the transactions had been at arm's length.

In practice, these adjustments generally require the Competent Authorities of both Countries involved to consult with each other with a view to resolving the economic double taxation that arose from the transfer pricing adjustment. This consultation procedure is called the “mutual agreement procedure” or “MAP” and is provided for by Article 25 of the OECD Model Tax Convention, also found in most bilateral tax treaties. The MAP article in most bilateral treaties does not compel Competent Authorities actually to reach an agreement and resolve their tax disputes. They are obliged only to use their best endeavours to reach an agreement. Unfortunately, on occasion they are unable to come to an agreement.  Reasons for unresolved double taxation range from restrictions imposed by domestic law on the tax administration’s ability to compromise to stalemates on economic issues such as valuations.

Some bilateral treaties currently include arbitration clauses in their MAP articles. However since these procedures are new, there has been limited guidance and experience in their use

Some bilateral treaties currently include arbitration clauses in their MAP articles.  However since these procedures are new, there has been limited guidance and experience in their use.  For transfer pricing disputes between EU countries, the EU has a specific mechanism, the Arbitration Convention, which first entered into force in 1995.  Until now there have only been a few actual cases concluded, but the number of cases submitted is increasing. At the OECD level, an arbitration process will be added to the 2008 update of the Model Tax Convention, to deal with unresolved issues that prevent competent authorities from reaching a mutual agreement within two years. This is a major achievement towards more certainty and speedier resolution of cross-border tax disputes. Detailed information on the OECD dispute resolution work is available at www.oecd.org/ctp/dr.

 

 

As the European Union broadens its borders and moves ever eastwards, will this lead to more complex transfer pricing disputes?

Globalisation means that Eastern European countries are increasingly integrated in the world’s economy and involved in more significant and sophisticated cross-border transactions. This may in effect lead to more complex transfer pricing disputes with these countries, in particular when their tax authorities increasingly focus on these issues in their tax examinations. The solution is to have mechanisms in place to prevent and resolve double taxation that can arise from transfer pricing disputes. This requires countries to agree on a common set of principles.

This process is facilitated by the European Union broadening its borders, because new EU members are required to adhere to a number of EU instruments, including the EU Arbitration Convention which itself relies on the arm’s length principle – i.e. on the international consensus in the transfer pricing area, grounded in Article 9 of the OECD and UN Model Tax Conventions.

This may in effect lead to more complex transfer pricing disputes with these countries, in particular when their tax authorities increasingly focus on these issues in their tax examinations

Similarly, the OECD constantly devotes huge resources to its policy dialogue with non-OECD economies in order to encourage them to adopt the arm’s length principle and follow the guidance in the OECD Transfer Pricing Guidelines which describe how to apply the arm’s length principle in practice. In 2007 the OECD has started accession talks with five prospective new members (Chile, Estonia, Israel, Russia and Slovenia) and in parallel has announced plans to engage more closely with other significant economies, notably Brazil, China, India, Indonesia and South Africa. This should help broadening the international consensus and as a consequence facilitate the resolution of cross-border disputes.

 

 

Transfer pricing is often seen as a problem only for big multi-nationals. Should the tax departments of SME's (Small to Medium Sized Enterprises) be looking at this as a potential problem either now or in the future? 

In most countries transfer pricing legislation applies to SMEs in the same way as it applies to large MNEs, i.e. SMEs are in principle required to apply the arm’s length principle in their cross-border commercial or financial transactions between affiliates located in different tax jurisdictions. As part of a risk assessment process, some countries have set explicit or implicit administrative safe harbour rules whereby the compliance burden for SMEs is alleviated.

some countries transfer pricing documentation may not be required for small enterprises or small transactions

For instance, in some countries transfer pricing documentation may not be required for small enterprises or small transactions, or tax examiners may not focus on transfer pricing issues when auditing SMEs. In other countries however, transfer pricing audit activities which started approximately a decade ago by targeting large MNEs are progressively extended to include SMEs. The French Direction Générale des Impôts for instance released in November 2006 a transfer pricing handbook to the attention of SMEs, clearly indicating its intention to extend its transfer pricing audit activities to SMEs.

 

 

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Transfer Pricing