Thursday, May 24, 2012

The flawed, insensible, unworkable arm's length standard

TJN will host a conference on transfer pricing in Helsinki, June 13-15 2012, to analyse the OECD Transfer Pricing Guidelines and suggest alternatives.  Info here together with a new paper by David Spencer on the subject, "Transfer Pricing: Will the OECD Adjust to Reality?"  Spencer is understandably critical of the OECD arm's length standard:

[An] OECD Staff  Report [published on Oct. 20 2011] defended the OECD’s arm’s length principle described in the OECD’s Transfer  Pricing Guidelines for Multinational Enterprises and TaxAdministrations of July 2010 (“OECD Guidelines”), in particular for developing countries.  ... The OECD Staff Report ... begins by quoting the OECD Guidelines (paragraphs 1.14-15), that “the arm’s length principle is sound in theory .... The main weakness of the OECD Guidelines is that there is no such “sound theoretical basis.” According to Michael Durst, who from 1994 to 1997 served as Director of the U.S. Internal Revenue Service’s Advanced Pricing Agreement (APA) Program, there is “a gaping conceptual hole at the heart” of the OECD Guidelines....
...Michael Durst has in effect implied that the OECD’s arm’s-length standard exists precisely because it is unenforceable and that is why business lobbyists, in the United States and other countries, have supported it so energetically.
Spencer then documents a litany of criticisms of arm's length by such notables as Martin Sullivan ("The arm’s length method is seriously flawed in both theory and practice"), Reuven Avi-Yonah and Ilan Benshalom (arm's length's "central assumption defies reality, and it is not surprising that a system of
“arm’s length” pricing cannot yield sensible results"), David Rosenbloom ("the arm’s-length system as it operates today [is] fundamentally unworkable"), Stephen Shay ("there is evidence of substantial income shifting through transfer pricing"), and so on.  In conclusion, Spencer asks:

[W]hy should the OECD, a club of 34 rich countries, representing only 18  percent of the number UN member countries, and with a declining share of world trade and investment, be the arbiter, the rule maker, of such a “consistent global transfer  pricing system?” Why should the OECD try to impose its transfer pricing rules on major  developing countries such as Brazil, China and India, and other developing countries?

Professor Mike McIntyre, a vigilant observer of the follies of arm's length and a champion for the viable alternative of combined reporting with formulary apportionment, also responded to the OECD's Oct. 20 report, here, and will present at the TJN conference. He says:

[T]he arm’s-length system promoted by the OECD, after years of tinkering and major reforms has worked poorly or not at all for both developed and developing countries. The great sign of the general failure of the arm’s-length system is that it has permitted multinational enterprises to divert uncounted billions of dollars annually to tax havens.
Prof. McIntyre addresses the various critiques of CR/FA by those who support arm's length (such as the oft-made claim that CR requires a common tax base--no more true than for arm's length), and concludes:

If the goal is simply to eliminate double taxation, then the OECD can claim success. That goal, however, is rather unambitious. A far more worthy goal would be to make multinational enterprises report something close to the income they actually earn in each country in which they operate. The OECD’s arm’s-length approach does not come close to achieving that goal...In contrast, a combined reporting system with formulary apportionment is designed speci´Čücally to achieve that goal.
...The arm’s-length method simply is not working, and 50 years of tinkering and major revisions have revealed that it cannot be made to work.  ... Combined reporting remains the best hope of the world for moving past the failed system based on the arm’s-length principle to a system that actually apportions income exclusively to the countries where meaningful economic activity occurs.
It should be an interesting conference.

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