Module 3

MODULE 3

THE PRACTICAL APPLICATION OF THE ARM’S LENGTH PRINCIPLE BY
WAY OF COMPARABILITY ANALYSIS

1.1 INTRODUCTION TO ARM’S LENGTH PRINCIPLE

The arm’s length principle means that:
‘Entities that are related via management, control or capital in their controlled transactions
should agree the same terms and conditions which would have been agreed between non-
related entities for comparable uncontrolled transactions’.
The primary source of the notion of arm length is Article 9 of the OECD Model Convention1,
which is enforced in most bilateral tax treaties. The OECD has incorporated the notion of arm
length as part of the transfer pricing regulations setting out the rules to be applied by MNEs
in determining controlled terms and conditions of transaction. For about 80 years, the ALP
has been acknowledged globally. Although, it was the subject of continuing debate,
consensus was crucial to prevent disputes and double taxation in cross-border transactions on
at least the basic features of the ALP. The OECD Transfer Pricing Guidelines and the
different domestic laws provide a structure for the implementation of the ALP. All MNEs are
required to provide comprehensive documentation of their transfer pricing that is regularly
reviewed by tax officials. Despite the broad regulatory framework, the bottom line of the
application of the ALP is that '..transfer pricing is not an accurate science, but requires that
the tax administration and taxpayer exercise their judgement '.2

1.2. ARGUMENT IN FAVOUR OF THE ALP PRINCIPLE

Probably the main argument for applying the ALP is that it is based on the specifics of each
transaction. It will inevitably be a challenging task to determine which terms would have
been agreed upon by independent undertakings, precisely because each MNE is characterized

1 http://www.oecd.org/tax/treaties/47213736.pdf.
2 Ibid.

by the prevailing circumstances.3 There is also no denying that the ALP's implementation
often relies heavily on working hypotheses generated in the framework of a comparability
evaluation. There is also no denying that the application of the ALP often relies strongly on
working hypotheses produced in the context of an assessment of comparability. The effect of
extreme or unsubstantiated assumptions is likely to be restricted by the need for MNEs to
substantiate and protect their corresponding assumptions i.e. in the context of transfer pricing
documentation.

1.3. THE NEED OF THE ARM’S LENGTH PRINCIPLE

Not long ago, the transfer pricing was subject to tax administrators and one or two other
specialists. Recently, however, politicians, economists and businesspeople, as well as NGOs,
have woken up to the importance of who pays tax on what in international business activities
between the same company's separate offices. The significance of transfer pricing becomes
apparent once you take into account the fact that more than 60 percent of world trade takes
place within multinational companies.4 Transfer pricing relates to the distribution of tax
revenues and other purposes between components of a multinational corporate group.
mConsider, a lucrative UK computer company that purchases microchips from its own
Korean subsidiary: how much the UK parent pays its subsidiary – the transfer price – will
determine how much earnings the Korean unit reports and how much local tax it pays.

If the parent pays below ordinary local market rates, even if the group as a whole
demonstrates a good profit margin when the finished computer is sold, the Korean unit may
appear to be in economic trouble.5 UK tax administrators may not grumble as the profit will
be recorded at its end, but their Korean counterparts will be disappointed that their side of the
procedure will not have much profit to tax. This issue occurs only within corporations with
subsidiaries in more than one country; if the UK firm purchased its microchips from an
autonomous Korean business, it would pay the market price, and the provider would
normally pay taxes on their own earnings. It is the fact that the different sections of the

3 Jen-Te Yao, The arm's length principle, transfer pricing, and location choices, Journal of
economics and Business, Vol. 65 (2013).

4 Keuschnigg, Christian & Devereux, Michael. (2013). The Arms Length Principle and Distortions to
Multinational Firm Organization. http://www.alexandria.unisg.ch/Publikationen/55253. 89.
10.1016/j.jinteco.2012.08.007..
5 Ibid.

organization are subject to some type of common control that is essential to the tax authority,
as this may imply that transfers are not subject to market forces complete play.

To avoid such problems, the current international guidelines of the OECD are based on the
principle of arm length – that a transfer price should be the same as if the two companies
involved were indeed two independents, not part of the same corporate structure.6 The OECD
Transfer Pricing Guidelines provide a framework for solving these issues by providing
considerable detail on how to apply the principle of arm length. In the hypothetical case of
French-Dutch bicycles, the French MNE could ask the two tax authorities to try to agree on
what the bicycle's length transfer price is and avoid double taxation. The initial transfer cost
set by the MNE was probably incorrect because it left all the profit with the manufacturer,
while on the other hand the Dutch proposition erred by wanting to transfer all the profit to the
distributor.

But, all of this assumes the best possible world where tax authorities and MNEs work
together in good faith. Transfer pricing, however, has gained wider attention among
governments and NGOs because of another risk: that it could be used to transfer income to
low tax jurisdictions even if the MNE does little business in that jurisdiction. This adds to
trade distortions and distortions of taxes. No nation — poor, emerging, or rich — likes to
suffer as a consequence of its tax base from transfer pricing. That is why the OECD has been
working so hard to create its Transfer Pricing Guidelines. While helping corporations prevent
double taxation, they also assist tax authorities get a fair share of multinational corporate tax
base.

Applying transfer pricing legislation based on the notion of arm length is not easy, even with
the help of the OECD rules. It is not always feasible–and certainly needs valuable time–to
find comparable market activities to set a suitable transfer price. A computer chip subsidiary
in a developing country could be the only one of its kind locally.

1.4. HISTORICAL BACKGROUND OF ARTICLE 9 OF OECD
For tax reasons, many jurisdictions at the start of the last century regarded subsidiaries as
permanent establishment of their parent business. There was no need, according to this
strategy, to have a provision comparable to Article 9 concerning the distribution of company

6 John Neighbour, Transfer pricing: Keeping it at arm’s length,
http://oecdobserver.org/news/archivestory.php/aid/670/Transfer_pricing:_Keeping_it_at_arms_length.html.

revenue between related companies. But, it was altered when affiliated firms were excluded
from a permanent establishment's definition in 1928. Because of the absence of a fresh clause
relating to the distribution of company revenue between associated companies, they were at
risk of double taxation as mentioned. The first tax treaty was signed in 1932, which included
an allocation standard for company revenue between related companies in the form of the
principle of length of arm.

In addition, the Caroll Report was released in 1933, which referred to the concept of arm
length as an appropriate allocation standard as states (Carrol, 1933). Furthermore, in 1933,
the League of Nations Draft Convention introduced the principle of arm length in
international tax legislation. Until the first OECD Model Convention (1963), the
classification of the article dealing with the principle of arm length was changed several
times, but it was incorporated as Art. 9(1) based on the London Model (1946) into the first
OECD Model Convention. What is important to mention there, that the wording of article
9(1) has remained unchanged since that time. However, there was no provision for
corresponding adjustment in related company’s instances. Corresponding adjustment was
applied only to the transactional distribution of company revenue between head office and
permanent establishment, not between related undertakings.

1.5. THE PRACTICAL APPLICATION OF ARTICLE 9 BY THE CZECH
MINISTRY OF FINANCE

In 1997, the Czech Republic joined a reservation on Art. 9(2) OECD Model Convention,
which obtains the right not to insert paragraph 2 into the double tax treaties, but to be ready to
acknowledge this paragraph by adding a third paragraph which limits the possibility of
associated adjustment to bona fide cases. During the last revision of the 2010 OECD Model
Convention, the Czech Republic did not withdraw this reservation. In the event of a tax
conflict concerning compliance with the principle of arm length and the consistency of profit
modifications, a concept of Article 9 in the double tax treaty concluded is essential. Four
situations can be identified in this regard. The first situation: if a double tax treaty includes
Article 9(2) and financial double taxation is incurred owing to a main adjustment made by
another contracting state, a taxpayer shall fill in his extra tax return and return it to the Czech
tax authority. The Czech tax authority subsequently chooses whether it agrees that the main

adjustment made by another contracting state is both justified in principle and in terms of the
quantity. Once the Czech tax authority agrees with a main adjustment, the Czech tax
authority also states that the principle of arm length from the Czech side has not been
followed. A matching adjustment is therefore required. By inserting Article 9(1) of the
OECD Model Convention into the double tax treaty, the contracting states undertook to
follow the principle of length of arm and thus, avoid economic double taxation. If the Czech
tax authority fails to create a corresponding adjustment, a taxpayer may open a procedure for
mutual arrangement established under the Model Convention of Art. 25 OECD.

The second situation: if a double tax treaty also includes Article 9(1), Article 9(2) and Article
9(3) restricting the future adjustment to bona fide instances. If a primary adjustment is agreed
by the Czech tax authority, but the case cannot be deemed a bona fide case, then there is no
duty to make a corresponding adjustment.

The third situation: If a double tax treaty does not contain article 9(2) and only includes
article 9(1) regarding a primary adjustment, accordingly to the Czech Ministry of Finance-
there is no obligation to make a corresponding adjustment. However, in view of the
fundamental spirit of the double tax treaty, namely the elimination of double taxation, this
position could be challenged. In addition, with regard to (OECD, 2010a)11, the mere fact that
Article 9(1) of the double tax treaty was inserted by the Contacting States shows that the
intention was to include financial double taxation under the tax treaty.

Thus, the implementation of a procedure for mutual agreement under Article 25 of the OECD
Model Convention is evident from the wording of Article 9(2) of the double tax treaty
provided that Article 9(2) is contained in the double tax treaty. However, if Article 9(2) is not
included in a double tax treaty, it is apparent from Commentary on Art. 25 that a mutual
agreement procedure is implemented. Consequently, as a country (OECD, 2010), taxpayers
have the chance to open a shared agreement procedure on the content of the principle of the
length of the arm in the absence of Article 9(2) of double tax treaties.

However, it is essential to emphasize that a mutual agreement method is open in all Czech
double tax treaties as the Czech Ministry of Finance has not included a fresh Article 25(5) of
the OECD Model Convention in its double tax treaties, so there is no time limit for achieving
an agreement and a tax conflict can be long-lasting and burdensome without any remedy.
Thus, if a taxpayer does not wish to open a procedure for mutual agreement under Article 25
of the OECD Model Convention for the above reasons, he may use an alternative to the

procedure for mutual agreement in the form of a procedure under the EU Arbitration
Convention, where the time limit for achieving a mutual agreement is set and, consequently,
the taxpayer receives more rapidly as a consequence of his tax conflict.

1.6. ARM’S LENGTH PRINCIPLE: CRITICISM

There are a number of difficulties in applying this principle in a number of situations. One
particular problem is the need to find comparable transactions between independent parties.

MNEs may carry out transactions in a different way from independents, for example in terms
of the allocation of risks, or may structure transactions to achieve the benefits of economies
of scale or synergies within a MNE group. In some industries there are no independent
enterprises performing particular activities due to vertical integration within certain
industries.

Further, the reductionist approach of splitting an MNE group into its component parts before
evaluating transfer pricing may mean that the benefits of economies of scale or integration
between the parts are not appropriately allocated between the members of the MNE group or
may escape taxation all together. The application of the ALP also imposes a burden on
business as it may require the MNE to do things that it would otherwise not do, for example
in searching for comparable transactions, documenting transactions in detail. Further,
although the track record of reaching mutual agreement is good in terms of producing results
that eliminate double taxation (there are very few cases where some kind of agreement is not
reached), the time taken to reach the agreement can be frustratingly long.

Some argue that the arm’s length principle is inherently flawed. This is mainly due to the fact
that the arm’s length principle does not account for the economies of scale related to
integrated systems when compared to independent parties. MNEs are known to have great
cost savings through centralised management structures and cost centres (as discussed
previously in ‘The reason for the existence of MNEs’). These savings are, however, not
considered in the determination of the arm’s length range.

The OECD Guidelines (2001) acknowledge that the arm’s length principle may not always be
simple to use in practice, but it is sound in theory and gives the closest approximation to a
fair price between related parties. The arm’s length principle usually allocates appropriate

levels of income between off-shore related parties and is therefore accepted by tax
administrations. There may be instances when the arm’s length principle is flawed but it is
the closest method of establishing a fair principle for each tax administration. There are no
other acceptable principles or methods to determine values for cross-border related party
transactions that are fair and sound in theory. The arm’s length principle has been accepted
internationally by the major corporations and tax administrations and the experience with the
arm’s length principle has become “sufficiently broad and sophisticated to establish a
substantial body of common understanding among [them]” (OECD, 2001:I-6). This
understanding ensures that each tax administration receives its fair share of taxes and in
addition, the corporation does not suffer double taxation.

1.7. ALTERNATIVE TO ARM’S LENGTH PRINCIPLE

The most frequently advocated alternative is some kind of formulary apportionment method.
At its simplest, global formulary apportionment would split the entire profits of an MNE
group amongst all the subsidiaries in the various locations in which it operates. This would be
done without any reference or comparison to profits that would be earned by independent
enterprises performing similar activities in those locations. Instead, the profits are allocated to
locations by a pre-set formula. The formula uses a number of factors, such as sales, payroll
and assets and the factors may, or may not, be weighted. An example of weighting would be
to have a three factor formula that allocated 50% of the profits to sales and 25% to payroll
and 25% to assets, thereby double weighting the sales factor. Profits are allocated to a
subsidiary in a particular location by determining the relative contribution of that location to
each factor in the formula. Suppose the profits of the MNE group are 200, the weighted
formula described above is applied and the subsidiary in location A has 10% of sales, 5% of
payroll and 10% of assets. The profits of the subsidiary in location A under the formula will
be 17.5 (sales (50% of 200 x 10% = 10) + payroll (25% of 200 x 5% = 2.5) + assets (25% of
200 x 10% =5). There are a number of variations on the above approach. Some proposals
recognise the problems in coming up with a single formula covering very different activities
and so would develop different formulas for particular business sectors, e.g. for financial
services and for manufacturing. If an MNE group carried on more than once activity, the
profits would have to be split between the different activities, so that the relevant formula

could be applied. Other variations use different factors, for example the recent approach in
the Tax Notes International article by Brian E. Lebowitz proposes using factors based on
economic principles, such as the social costs imposed by an enterprise in a particular location.
The recent proposal by the Stockholm group to use a formula to allocate profits between
groups of MNEs operating in the European Union, has suggested using the relative VAT base
as the allocation factor.

The global formulary apportionment has been suggested as an alternative to the arm’s length
principle to compare a cross-border related transaction and its related profits for each
participating tax administration. The OECD (2001) expresses the opinion that some tax
administrations have tried to use the method without success. The global formulary
apportionment method is not seen as a suitable method to determine the arm’s length price
and the OECD Guidelines do not recommend the use of the global formulary apportionment
(Please note- some still believe that the global formulary apportionment is the way forward
and will take over the arm’s length principle in the future).

The global formulary apportionment method is not accepted by OECD member or observer
countries and therefore, is not a realistic alternative for the arm’s length principle. The reason
given by the OECD Guidelines (2001) is that the global formulary apportionment does not
achieve the protection against double taxation or ensure taxation of the profit by a single
fiscal authority. In order to achieve this, it would require extensive international coordination
and consensus on the global formulary apportionment method. The difficulty in this is that
every single tax administration must agree to the method and its predetermined formula. A
common accounting system would have to be chosen and adopted within all the tax
jurisdictions, even the non-member countries. To achieve this, it may be very time
consuming, extremely difficult and there is no guarantee of no double taxation, because if one
tax administration does not apply the method in its jurisdiction there would be a problem.

1.8. MULTINATIONAL FIRM ORGANIZATIONS

With the increasing importance of multinational enterprises (MNEs), collecting corporate
taxes has become a challenging task. One important problem is that by shifting profits from
high tax to low tax countries, MNEs can reduce their overall tax liability. One method of
doing so is to manipulate the transfer prices at which goods and services are exchanged

between elements of the MNE that are resident in different countries. To protect the tax base,
authorities have adopted arm's length (AL) pricing as the central principle in taxing MNEs.
The principle is set out in Article 9 of the OECD Model Tax Convention and governs the
prices at which intracompany transfers are set for tax purposes. Such transfers can be of
intermediate goods, produced by one Affiliate Company and sold to another, or they can
include a licence or royaltyfee paid for the right to use intellectual property owned by another
part of the group. The AL price is the price at which the transaction would take place between
independent firms. In many cases, it is difficult, in practice, to identify a price for the same
product actually transferred between two independent agents. This paper, however, is not
concerned with the practical difficulties of implementing the AL principle, but rather with the
underlying rationale. This rationale is based on the implicit assumption that AL prices
observed in trade between independent firms are the ‘correct’ ones for assessing the value of
intracompany trade. The key point is that the AL principle might be an inappropriate
benchmark and thus, may introduce new distortions in the taxation of multinational firms.

The paper analyses the AL principle in a model with offshoring of component production for
the assembly of final goods in a high tax country (the ‘North’).Final goods producers in the
North can offshore to the ‘South’, either by entering an outsourcing relationship with an
independent firm, or establishing a wholly owned subsidiary via foreign direct investment
(FDI). The model endogenously explains AL prices paid in outsourcing to independent firms,
and also the transfer prices set by MNEs when importing the same components from foreign
affiliates. These prices are different from each other, even in the absence of taxation.
Imposing AL prices for tax purposes in the case of FDI distorts investment decisions and
creates a welfare loss, at least in the South, and possibly globally. The key element of the
model is a financing constraint due to capital market frictions, along the lines of Tirole (2001,
2006) and Holmstrom and Tirole (1997). All firms – including the parent company in the
North – are endowed with limited own resources and hence, need to raise funds on the
external capital market. The more funds that each firm can raise externally, the greater the
investment that can be undertaken, and the higher is profit. But, external funds are limited by
the amount of income that can be pledged to the lender. Pledgeable income differs between
the two cases considered. In the case of outsourcing, the parent company must extract profit
generated by the outsourcing firm in the South through a royalty payment. The requirement to
make the royalty payment reduces pledgeable income in the outsourcing firm, and hence
reduces its borrowing and investment. In the case of direct investment, however, the parent

has the opportunity to extract profit in the form of a dividend, which does not reduce
pledgeable income. In this case, the parent can increase pledgeable income in its Southern
subsidiary by foregoing a royalty, and also by increasing the price it pays for the purchase of
an intermediate component from the subsidiary. This increased pledgeable income leads to
higher borrowing, higher investment and higher surplus in the subsidiary, compared to the
case of the outsourcing firm. As a result, and even in the absence of tax, optimal contracts
specify higher component prices and lower royalty fees for intracompany trade compared to
AL relationships. Profit shifting occurs for economic reasons, allowing MNEs to overcome
financing problems and invest on a larger, and more efficient scale. In this situation, the
Arm’s Length principle is a flawed benchmark in the taxation of MNEs. It imposes a tax
penalty on MNEs by forcing them, for tax purposes, to assess the value of imports at lower
AL prices and to declare fictitious royalty income as observed in outsourcing relationships.
The results of imposing the AL principle are: (i) the tax penalty leads to lower transfer prices
and less profit shifting; (ii) it reduces debt capacity and subsidiary investment; (iii) it
strengthens tax revenue and raises national welfare in the North; (iv) it strongly reduces tax
revenue and welfare in the South;(v) it can lead to a loss of world welfare. The last result is
due to the fact that tax authorities, when observing AL prices, misinterpret high transfer
prices and low royalties as a result of tax induced profit shifting while, in fact, these choices
are an efficient way to cope with financial frictions.

1.9. ISSUES IN APPLICATION OF THE ARM’S LENGTH PRINCIPLE

A frequent situation occurs when the vertically integrated enterprise achieves economies in
transaction costs, logistics, brand development, risk management, and other functions or risks
as a consequence of integration measures that cannot be duplicated in the context of arm's-
length, independent transactions. Two non-integrated businesses performing the same or
similar functions and selling the same or similar products would have either higher total
costs, and therefore, higher gross margins with the same profitability as the integrated
business, or the same gross margins with lower profitability. Applying the observed gross
margins of the independent reseller to determine the arm's-length distribution margins of the
integrated, controlled reselier produces a range of ambiguity depending on the magnitude of
the vertical integration economies and the relative profitability of the parties.

Moreover, if the economies of integration are significant relative to the additional costs of
administration and stewardship in the integrated enterprise, and the non-integrated business
competes with the integrated business, then the non-integrated business may not be viable
over an extended period of time. The relative scarcity of independent wholesale distribution
comparable in most industries attests, indeed, to the relatively transitory nature of
independent distribution arrangements in many competitive situations. Where competition
favours the integrated model, competitive equilibrium is established at the point where price
competition between integrated firms eliminates any excess profits attributable to integration,
so that in the end each integrated firm earns only a market return on investment, or its cost of
capital. Here, application of the observed gross margins for 'comparable' independent
resellers, assuming any exist, as arm's-length benchmarks for the controlled reseller or
distributor overstates the required gross margin of the controlled reseller unless specific
adjustments are made to account for the integration economies. Because of the difficulty in
making these adjustments, the next best alternative may be to identify comparable operating
profitability as a function of operating expenses or capital employed. These ratios can be
observed for independent resellers in a variety of industry contexts, and they are comparable
to the controlled situation provided that overall product and factor markets are competitive,
independent of the presence or absence of economies of integration. Accordingly, situations
where economies of integration are present and closely similar resale price comparable are
therefore, absent provide compelling justification for seeking alternative benchmarks of
arm's-length profitability such as the Comparable Profits iMetho3 (TPM') or the
Transactional Net Margin Method ('TNMM'), both of which focus on profitability and
profitability drivers as opposed to gross margins. Depending on the circumstances, their use
may be indicated, based on their greater reliability relative to the other methods and available
data.

Fundamental differences in the way that arm's-length transactions are structured vis-a-vis
similar related- party transactions comprise a formidable challenge in determining an arm's-
length result in many situations. On the one hand, principal-agent problems associated with
incentive formation and moral hazard constrain the arm's-length transaction to make it a poor
template for how related parties may choose to structure their division of functions and risks.
On the other hand, even with appropriate adjustments to account for these differences in
functional responsibilities and account- abilities, differences in the fundamental bargaining
situation can have an important influence on the results negotiated by arm's-length parties,

and further adjustments may be necessary to approximate the related-party arm's-length
result.

An alternative viewpoint maintained by some tax authorities is that the arm's-length principle
mandates consideration of the transfer pricing that would have occurred between hypothetical
independent enterprises without regard to changes in the commercial circumstances of the
transaction as a result of the common controlling interest. Under this reading of Art. 9 of the
OECD Model Tax Convention (quoted above), arm's-length pricing would be determined
based on gross margin comparisons with independent transactions without the need to adjust
for integration economies because these economies are not actually present in the
independent situation. We believe this interpretation to be incorrect, however, for two
reasons. First, as discussed above, a standard for determining transfer pricing without regard
to fundamental differences in costs would lead to economic distortions, which is inconsistent
with general tax principles. Secondly, both the OECD Guidelines and the US s. 482
regulations take care to recognize the need for comparable circumstances and reliable
adjustments thereto as a criterion for comparability:

Application of the arm's-length principle is generally based on a comparison of the conditions
in a controlled transaction with the conditions in transactions between independent
enterprises. In order for such comparisons to be useful, the economically relevance
characteristics of the situations being compared must be sufficiently comparable. To be
comparable means that none of the differences (if any) between the situations being
compared could materially affect the condition being examined in the methodology (e.g.,
price or margin), or that reason- ably accurate adjustments can be made to eliminate the effect
of any such differences.

A similar need to adjust to the actual commercial arrangements established between related
parties, as opposed to the transaction structure actually or ordinarily undertaken between
independent enterprises, is discussed below.

1.10. ALLOCATION OF FUNCTIONS AND RISKS

In competitive markets, the organization of production and distribution is determined by
considerations of efficiency and risk management, subject to the constraints of the available

resources and technology. Vertically and horizontally integrated business enterprises are
established in part, because the expense of negotiating complete contracts between
independent agents outweighs any inefficiencies associated with organizing resources in a
'command and control' format within a corporate structure. Accordingly, the division of
functional accountabilities and risk-management responsibilities between the members of an
integrated group may differ in important ways from how these functions and risks are divided
in an arm's-length contractual relationship between unrelated parties performing the same or
similar combined functions as in the integrated value chain. These differences in the division
of functions and risks occur for two reasons. First, and most importantly, the contractual
relationship between independent parties is constrained by the needs of both parties to
address imperfections in incentive systems and their ability to monitor and enforce
contractual provisions effectively in the face of uncertainty. This 'principal- agent' problem,
as it is called in the economics literature, affects both the contractual relationship agreed upon
by the independent parties and their respective divisions of functions and risks. Because
contractual provisions cannot, generally, avoid all of the distortions in incentive formation or
the moral hazards inherent in any arms-length relationship, the optimal division of functions
and risks between the parties is also affected. For example, marketing expenses may be
shared in the arm's-length situation, or at least managed differently through cooperative
advertising support or rebate agreements and similar mechanisms, whereas in the integrated
business these decisions, expenditures, and accountabilities might rest more exclusively with
the distribution division. Similarly, it would be unusual in an arm's-length situation to find
independent distributors bearing the full cost and risk of warranty expense, because it is
typically the manufacturer that controls the quality of production and benefits from the
incentive to maintain and manage quality. In certain related-party situations, on the other
hand, integrated organizations have found it productive to place the burden of warranty
expense on the distributor, providing distribution management with the incentive to control
administration and claims expenses as well as to support customer service and marketing
objectives. Allocations of this function to an independent distributor would likely not be
possible in an arm's-length situation. Another relevant example is the celebrated double
marginalization problem. In an independent distribution arrangement, the transfer price of the
producer becomes the marginal cost of the distributor, which will generally be substantially
greater than the marginal cost of the producer. The independent distributor, in turn, is
incentivized to determine final sales prices at the level that restricts volumes to the point
where marginal revenue equals the distributor's marginal cost, i.e. the transfer price, and not

the marginal costs of the producer, which would be the profit maximizing result for the
integrated enterprise. To ameliorate this fundamental problem, the producer will typically
establish various volume incentive mechanisms to align the distributor's perception of
marginal cost with that of the producer and, in addition, the producer may participate in
certain functions like marketing and advertising to better approximate the optimal result. The
second reason that the integrated firm may choose to shift functions and risks from what they
otherwise might be in the arm's-length situation is because the choice is fundamentally driven
by considerations other than the need to establish a viable transaction structure. Thus, in some
industries and markets a high level of downstream autonomy is desirable to improve
customer service and achieve marketing goals, and accordingly, in these cases, firms may
choose to grant substantial decision-making autonomy and functional accountability to their
downstream subsidiaries. In other situations, there may be long-run tax or financial security
advantages to domiciling key functions or risks in specific locations, to justify a greater level
of profit at that location. Accordingly, establishing comparability with available independent
transactions becomes difficult at best without detailed consideration of and adjustments for,
these functional or risk differences. Even in instances where the allocation of functions and
risks is largely (or even exclusively) motivated by tax considerations, the integrated
enterprise's choices are normally respected by tax authorities. Thus, the OECD Guidelines
state:

“In other than exceptional cases, the tax administration should not disregard the actual
transactions or substitute other transactions for them. Restructuring of legitimate business
transactions would be a wholly arbitrary exercise the inequity of which could be compounded
by double taxation created where the other tax administration does not share the same views
as to how the transaction should be structured.”

The common thread in each of these examples, which helps to define the essential concept of
'economic substance', is that a risk is being taken or - asserted without adequate
compensation. Thus, in the debt example it is not possible to determine a reasonable interest
rate because the loan would not be undertaken in the first place. In the brand name promotion
example, a market and cost risk has been undertaken by the distributor, and therefore an
adequate compensation opportunity must be per- mitted, so as to respect the implicit
contractual terms of the relationship with the parent company. In the future research example,
no reliable valuation can be placed on research that has not even been undertaken. Thus,
instead of re-characterization according to a hypothetical arm's-length bargaining situation,

the 'economic substance' of the terms and conditions of a controlled transaction is determined
by whether the underlying assignment of functions and risks is capable of objective valuation
and whether it respects prior agreements or understandings between the parties. Frequently,
the key principle is that the financial consequences of the underlying risks be assigned
explicitly in advance of the realization of events. The OECD Guidelines provide a clear-cut
example:

Suppose that a manufacturer sells goods to a controlled distributor located in another country
and the distributor accepts all currency risk associated with these transactions. Suppose
further that similar transactions between independent manufacturers and distributors are
structured differently in that the manufacturer, and not the distributor, bears all currency
risks. In such a case, the tax administration should not disregard the controlled taxpayer's
purported assignment of risk unless there is good reason to doubt the economic substance of
the controlled distributor's assumption of currency risk. The fact that independent enterprises
do not structure their transactions in a particular fashion might be a reason to examine the
economic logic of the structure more closely, but it would not be determinative. However, the
uncontrolled transactions involving a differently structured allocation of currency risk could
be useful in pricing the controlled transaction, perhaps employing the comparable
uncontrolled price method if sufficiently accurate adjustments to their prices could be made
to reflect the difference in the structure of the transaction.

1.11. CONCLUSION

The ALP has a long history, for example it is found in the League of Nations Model Tax
Conventions that formed the international consensus in the first half of this century.
Formulary apportionment has been around just as long-it was one of the three methods used
for attributing profit to a permanent establishment under Article 5 of the League of Nations
Model Tax Conventions. One reason for this longevity is that, although the principle has
remained the same, the ways of applying that principle in practice, have continually evolved
to take into account changing economic circumstances and business practices. One positive
outcome of the political debate in the United States in the early 1990s as to whether the ALP
should be replaced by formulary apportionment, was the recognition that the last published
guidance on applying the ALP in practice, the 1979 OECD Report on Transfer Pricing,

needed updating. Consequently, the revised OECD Transfer Pricing Guidelines published in
1995 tried to deal with many of the problems identified by the proponents of formulary
apportionment. Three developments are worth particular attention as they demonstrate the
flexibility of the ALP.

The ALP has proved itself sufficiently flexible to cope with the enormous changes in the
global economy that took place in the twentieth century. The question is whether the ALP
will remain flexible enough to deal with the challenges likely to be faced in the early part of
the twenty first Century.

This will require constant monitoring of the application of the ALP as described in the OECD
Transfer Pricing Guidelines. The OECD has set up procedures to do this (see 1998 update to
the Guidelines) which explicitly acknowledge the need for input from the business
community. The authors take the opportunity given by this article to encourage the business
community to become actively involved in the monitoring process. Another challenge to be
met is to ensure that the ALP and the OECD Transfer Pricing Guidelines are recognised as
the international standard by all countries, regardless of whether or not they are members of
the OECD. The signs are encouraging. A number of non-member countries have recently
adopted transfer pricing legalisation and these have been based on the ALP and have
followed, to varying extents, the approach in the OECD Guidelines. However, new ways will
have to be found to ensure that non-OECD members can play a more active role in
developing the application of the ALP to suit the economic circumstances in the next century
and to take into account any special requirements of non-members.

In conclusion, the ALP has proved itself capable of adapting to the dramatic changes of the
20th Century. There is no reason to believe it will not prove equally adaptable to deal with
whatever changes occur in the first part of the next Century. It is premature to publish its
obituary notice at the end of this millennium.