The Functional Fallacy

By Richard Collier (Oxford University Centre for Business Taxation) and Ian Dykes (PwC)

The Arm’s Length Principle (ALP) is globally the foundation for the rules for the allocation of corporate income and arguably the most consequential feature of the current international tax system. The theoretical approach of the ALP (and its practical application in the form of the transfer pricing rules) is based on the notion of “transactional comparability” – that is, an approach which involves two steps. The first step involves identifying the “controlled transaction” entered into by related parties (such as two subsidiaries in the same MNE group - technically, “associated enterprises”). The second step is to compare the pricing of the transaction identified in the first step to the pricing that independent parties, entering into a similar transaction, would have agreed - and adjusting the related party pricing in the event of any disparity.

The BEPS Project made some very significant changes that are relevant to the process of applying the two-step process referred to above: This new approach is largely delivered in what is now termed the “accurate delineation” process. This delineation process is at the heart of the BEPS changes to the OECD Transfer Pricing Guidelines. The new approach is intended to reverse the previous situation under which the nature of a “controlled transaction” would typically be arrived at by taking the legal or contractual arrangements at face value. The BEPS changes are therefore a response to the concern that a heavy reliance on the legal/ contractual arrangements had made it all too easy for MNEs to manipulate the transfer pricing rules, for example by legally booking assets such as IP into low-function tax haven entities (for example, simply as a result of providing for such a transfer in a legal agreement).

Under the new approach, the rights and obligations expressed in the relevant legal documentation (such as intercompany contracts) are now stipulated to be no more than the “starting point” in determining the transactional relationship between related parties. Critically, the BEPS changes are intended to ensure that the terms of that relationship are now subject to verification based on the actual conduct of the parties (i.e., taking account of the functions fulfilled by the parties including the decisions they actually take, etc). For example, the current version of the OECD Transfer Pricing Guidelines provides that: “If the characteristics of the [related party] transaction that are economically relevant are inconsistent with the written contract between the associated enterprises, the actual transaction should generally be delineated for purposes of the transfer pricing analysis in accordance with the characteristics of the transaction reflected in the conduct of the parties.” And again: “Where no written terms exist, the actual transaction would need to be deduced from the evidence of actual conduct provided by identifying the economically relevant characteristics of the transaction.” [emphasis added]

Critically, the new approach relies on the ready ability to apply the conduct-based approach so that the terms of “controlled transactions” can, where appropriate, be identified based on the relevant conduct. Determining the nature of the rights and obligations in a transaction or arrangement involving related parties is critical for the same reason that it is critical in a transaction or arrangement between independent parties: this is because it is impossible to tell what compensation one party owes to the other (or what returns are properly due to each of the parties) unless it is possible to specify the terms on which the parties transact. This means it is necessary to know which party (or parties) bears the financial consequences of risk associated with a transaction and which party is entitled to the profit (or is responsible for costs and other liabilities) associated with the relevant assets/rights/intangibles, etc. used in the transaction. In a transfer pricing context, establishing the core features of the transaction or arrangement under consideration is an essential part of the first step in the two-step approach outlined above. As the OECD Transfer Pricing Guidelines recognize, the second step (including the process of selecting valid third-party comparables) cannot be completed without first having made these determinations.

Our research explores the conduct-based approach, taking into account the historical development of the OECD’s reliance on the conduct of the parties, the detailed requirements of the rules introduced by the BEPS project and the experience of applying the conduct-based approach in practice. We find that the conceptual, technical and practical challenges posed by the new “conduct-based” approach have never been subject to any serious examination in the framing the relevant OECD guidance. The idea that legal/contractual arrangements can be modified – or constructed – based on the conduct of the parties is not new (and it is seen by many as a relatively uncontroversial idea). However, the approach is by no means straightforward or unproblematic. Though establishing the “accurately delineated” set of rights and obligations in a taxpayer transaction is an essential step in the transfer pricing process as explained above, it is far from obvious that it will always be easy, or even possible, to infer rights and obligations from the conduct of the parties.

An obvious area where difficulties might arise concerns situations where the conduct of a party does not convey any information that might assist with determining the legal capacity in which it acts (for example, whether as a principal in its own right or as an agent) yet that capacity may have a significant impact on the return that might be due. Similarly, questions about the ownership of legal rights (such as an exclusive right or licence to exploit IP in a specific market) may be very hard to divine based on conduct alone. A host of other matters that might affect the return due under an arrangement - such as the agreed term or duration of the arrangement - are similarly not answered merely by examining the conduct of the parties.

Further, it is striking that the OECD Transfer Pricing Guidelines rely on, yet do not clarify, the process by which actual conduct may be translated into or used to determine the existence of specific rights and obligations, and the examples provided in the OECD’s Transfer Pricing Guidelines (which are intended to illustrate the process) fail in that task and also raise several difficult and unresolved issues.

Under the current rules, the contractual modifications which may form part of the revised “accurate delineation” process arise where the conduct of the parties is misaligned with the legal arrangements in place between them. The Guidelines appear to suggest that contractual features can also be modified if they differ from those that “would have been” entered into between third parties, based on the options realistically available to them. The relationship between these two (and potentially contradictory) strands of the OECD guidance - namely based on (1) what can be inferred from the conduct of the parties and (2) what can be inferred from what third parties might or would have done in a corresponding situation - is unclear.

All these factors contribute to a very uncertain landscape in which the core principles being applied in the transfer pricing exercise have become contested, and in which the standards to which taxpayers and tax authorities should expect to be held can be difficult to discern. In the view of the authors, the issues go a long way to accounting for the rise in transfer pricing disputes which concern disagreements about the treatment and relative weighting of returns from functions (conduct) on the one hand and assets (such as IP assets and capital) on the other.

The Functional Fallacy

By Richard Collier (Oxford University Centre for Business Taxation) and Ian Dykes (PwC)

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