BEPS: OECD proposes “special measures” to shore up the arm’s length principle

Ofsted can make a school subject to “special measures” if it considers that the school is failing to give pupils an acceptable standard of education. I was reminded of this when an OECD paper published on 19 December proposed “special measures” to shore up the “arm’s length” principle underpinning the current, outdated international tax system. More on that below.

The OECD now has nine open consultations on proposed reforms to tackle base erosion and profit shifting (BEPS), following publication of six discussion papers in the week before Christmas.

The content is highly technical and will be virtually inaccessible to all but those with a professional interest in international tax. But the OECD’s action plan published in July 2013 and the earlier publication “Addressing Base Erosion and Profit Shifting” provide some useful context. The OECD said in February 2013:

“Base erosion constitutes a serious risk to tax revenues, tax sovereignty and tax fairness for many countries. While there are many ways in which domestic tax bases can be eroded, a significant source of base erosion is profit shifting … [Current] rules provide opportunities to associate more profits with legal constructs and intangible rights and obligations, and to legally shift risk intra-group, with the result of reducing the share of profits associated with substantive operations.”

As the BEPS project has progressed the discussions have become more technical, and inevitably the media coverage has been largely confined to trade journals and financial press. But as Sol Picciotto, co-ordinator of the BEPS Monitoring Group, has told Tax Analysts, these issues are “too important to be left simply to tax advisers”.

‘Information asymmetries’

The discussion paper published on 19 December, dealing with the application of the arm’s length principle notes that BEPS actions 8, 9 and 10 are intended to “assure that transfer pricing outcomes are in line with value creation”. The paper runs to 45 pages, and part I (34 pages) proposes changes to section D of chapter I of the OECD’s transfer pricing guidelines.

Part II begins with an admission that Part I does not go far enough. It says (emphasis added):

“The proposed revisions set out in Part I … will go far in aligning where profits are reported and where value is created. However, in preparing the revised guidance in response to the mandate of the BEPS action plan, it has been recognised that even if these changes to the transfer pricing guidance are introduced, certain BEPS risks may remain. These residual risks mainly relate to information asymmetries between taxpayers and tax administrations and the relative ease with which MNE groups can allocate capital to lowly taxed minimal functional entities (MFEs). This capital can then be invested in assets used within the MNE group, creating base eroding payments to these MFEs. Therefore, special measures have been considered to address these risks.”

Part II goes on to outline “broadly” options for potential special measures. Significant design work will be needed, it says, as the measures are “further considered”.

The OECD has been consulting on transfer pricing issues – and proposed changes to the guidelines published in 2010 – since 2012. According to Ajay Gupta, editor of Tax Notes International, even the OECD’s 130-page report published last September on transfer pricing and intangibles “doesn’t amount to much”. Gupta wrote (paywall):

“The OECD’s single-minded devotion to the arm’s-length standard, however, stultifies thought and ossifies action. The result is an incomplete exposition and many ill-suited prescriptions.”

A “lack of finality”, he added, “only accentuates the report’s lack of clarity”.

Gupta argued that the arm’s-length standard “has long outlived whatever utility it may once have had” for inter-company pricing of intangibles:

“Positing a market within an MNE flies in the face of the enterprise’s reason for existing as an integrated firm: minimising transaction costs by eliminating the pricing mechanism in favour of command and control.”


Those who defend the arm’s length principle appear to base their arguments on criticism of the alternative approach advocated by the Tax Justice Network and others.

This is unitary taxation, with formulary apportionment of profits. The International Centre for Tax and Development (ICTD), based in Brighton, has published three working papers on unitary taxation in the last month or so.

Alex Cobham, co-author of the paper titled “International Distribution of the Corporate Tax Base: Implications of Different Apportionment Factors under Unitary Taxation”, has suggested that under the current system:

“Lower-income countries in general suffer the greatest shrinkage of the tax base as a result of corporate profit-shifting … Achieving alignment [of economic activity and tax base] could more than double the associated tax base of some lower-income countries.”

Cobham argues that:

“the revealed scale of misalignment suggests that the current approach – based as it is on tightening specific, identified areas of international tax rules – may not suffice to make substantial progress.”


However, there is no sign that the OECD is going to consider the unitary taxation approach. The transfer pricing guidelines themselves appear to rule this out. Section C of chapter I discusses “a non-arm’s-length approach: global formulary apportionment”.

I have not seen any indication that this assessment is to be revised. The OECD said:

“Global formulary apportionment (GFA) would allocate the global profits of a [multinational] group on a consolidated basis under the associated enterprises in different countries on the basis of a predetermined and mechanistic formula. There would be three essential components to applying GFA: determining the unit to be taxed, i.e. which of the subsidiaries and branches of a multinational group should comprise the global taxable entity; accurately determining the global profits; and establishing the formula to be used to allocate the global profits of the unit. The formula would most likely be based on some combination of costs, assets, payroll and sales.”

In summary, the OECD went on to argue that:

GFA should not be confused with the “transactional profit methods” used under the current system, nor should it be confused with the selected application of a formula developed by tax administrations for the purpose of an advance pricing agreement or as part of a “mutual agreement” procedure. Such a formula is “derived from the particular facts and circumstances” and avoids the “mechanistic nature of GFA”.

The “most significant concern” with GFA is the difficulty of implementing the system in a manner that protects against double taxation and ensures single taxation: “To achieve this would require substantial international coordination and consensus on the predetermined formulae to be used and on the composition of the group in question.”

There would have to be “agreement to adopt the approach in the first instance, followed by agreement on the measurement of the global tax base, [agreement] on the use of a common accounting system [and] on the factors that should be used to apportion the tax base among different jurisdictions and on how to measure and weight those factors”. Reaching such agreement would be “time-consuming and extremely difficult”, the OECD said, and it is “far from clear that countries would be willing to agree to a universal formula”.

The OECD set out other concerns, including the potential for tax avoidance and a concern that predetermined formula are arbitrary and “disregard market conditions”.

What are we to make of all that? While last month’s discussion paper might read as an advertisement for unitary taxation, moving towards that goal may be impractical and, if you believe the OECD, undesirable. The ICTD research (which I haven’t read yet) will be useful. In the meantime, the profit-shifting intra-group transactions remain largely absent from a group’s consolidated accounts and beyond public scrutiny.