Is the Arm’s Length Standard Really the Problem?

The arm’s length principle has received a lot of criticism since the 2008 financial crisis. In this post, our chief economist, Mimi Song, and transfer pricing expert, Dr. Lorraine Eden discuss why  the arm’s length standard is not the problem, and that it still has a future as the foundation of transfer pricing.

Mimi Song: What was the purpose of the arm’s length standard?

Dr. Lorraine Eden: The corporate income tax was introduced in the United States in 1917 to raise revenue to help fund our involvement in World War I. Soon thereafter, many other countries followed suit. If you were a domestic firm in the United States, you simply paid a corporate income tax on your profits.

But even in the end of the 1800s there were multinational enterprises, such as the British tobacco company and Singer, a British multinational with subsidiaries the United States. Those multinationals had the opportunity to arbitrage the difference in the tax rates between the countries in which they operated, an advantage that domestic firms didn’t have.

And the way the arm’s length standard is written is to say you need to be on a level playing field. Multinationals should not be able to profit relative to domestic firms. The arm’s length standard elminates the arbitrage opportunities for multinationals.

Mimi Song: How many countries today subscribe to this idea of the arm’s length standard?

Dr. Lorraine Eden: Around 125 countries are on the inclusive framework. You know, the changes that are going on with the OECD on the digital economy has 135 members. So I’m not sure if the number really shouldn’t be 135 because I think all members of the inclusive framework have signed on in some way, shape or form any arm’s length standard, at least the minimum standards yet.

Mimi Song: Why is the arm’s length standard falling out of favor?

Dr. Lorraine Eden: After the financial crisis in 2008, so many things were thrown up in the air by firms going bankrupt. Governments needed more tax revenues and they started thinking that multinationals were not paying their fair share of tax. NGOs like Christian Aid and the Tax Justice Network started releasing reports detailing how MNCs like Amazon, Apple, and Starbucks were taking advantage of a variety of opportunities to avoid paying taxes.

They were engaged in these arbitrage opportunities. So, there was a real perception that the arm’s length standard wasn’t doing its job.

The arm’s length standard has become the scapegoat for governments having created a situation where firms can take advantage of these opportunities. The ongoing OECD Base Erosion and Profit Shifting (BEPS) Project has uncovered many examples of companies leveraging loopholes in tax laws to avoid paying taxes. It is not a transfer pricing problem, but rather an income tax design problem.

The term “transfer pricing” has become pejorative. But firms have to price transactions that move within them, and there’s nothing nefarious about that. But what’s evolved is a whole group of people whose purpose in life is to study tax rules and find those loopholes and exceptions, and then take advantage of them. And the larger you are and the more resources you have, the easier of course that is to do.

Mimi Song: How do we resolve this issue?

Dr. Lorraine Eden: There are three possible solutions.

One would be to revert to the system that was in place at the end of World War II and through the 50s, where most governments taxed on a worldwide basis. They taxed not only the domestic income of the multinational, but the foreign source income of the multinational, as well.

If a few large home countries, like the United States, China, England and Japan, agreed to move back to taxing worldwide income and eliminate deferrals that allow MNCs to just keep money off shore, they would create an umbrella under which everyone else would be able to set prices. That would solve most of the problem.

Those incentives to manipulate really go away with a worldwide system. Under the first crack principle, if the residence country of an MNC is willing to credit the MNC’s taxes, the MNC will set their tax rate right under that umbrella because they know they’re going to get a foreign tax credit for it.

The tax becomes the residence country’s tax. If five countries agree on a tax range within a couple of points and are willing to provide foreign tax credits up to that rate, that would eliminate most of the problems. Then the transfer price would just be a mechanism to level the playing field with domestic firms.

Unfortunately, the last major holdout on this was the United States. The Tax and Jobs Act passed in 2017 moved the U.S. to a territorial system of exempting foreign source income from tax. On the other hand, the FDII, BEAT and GILTI provisions are intended to actually claw back some of that foreign source income. A couple of those, including the FDII, are likely to be deemed illegal under WTO rules, however.

The second possibility is a world where most governments are taxing on a territorial basis. In that scenario, you need some ways to protect the base. For example, not giving a credit if you know the income is not going to be taxed somewhere else. And there are some things developing countries particularly can do.

The third method is to throw the whole system out and move to formulary apportionment. We have a similar system here in the United States, where there’s a compact of about 40 states that share the corporate income tax.

Mimi Song: What is formulary apportionment?

Dr. Lorraine Eden: Under the current global system, multinational companies determine their profits separately in each jurisdiction in which they operate. Under formulary apportionment, a multinational corporation would allocate its profits across countries based on a calculation of its sales, payroll, and capital base in each jurisdiction. A company would pay U.S. corporate tax on the share of its worldwide income allocated to the United States.

But as we’ve seen, the U.S. state tax system is vulnerable to manipulation, even with strong federal oversight, so it would be difficult to effectively deploy and protect the integrity of a similar system on a global scale, with no real authority at the top to police it.

Mimi Song: What about BEPS?

Dr. Lorraine Eden: The tax rules, just with respect to related party transactions coming out of the tax cut and jobs act, are a thousand pages long. But someone will take the time to find the loopholes in those and engage in horse trading and setting up corporate income tax havens. Every legislator has to talk to their constituencies about tax rules. So, it’s not enough just to close the loopholes.

This is part of the aim of the Base Erosion and Profit Shifting (BEPS) action plan. As far back as 1998, the OECD was concerned about tax havens and preferential tax regimes.

They embarked on a campaign of identifying and spotlighting these tax havens, but the initiative was ineffective because it highlighted mainly small island nations and ignored problems in the largest economies.

In 2013, the OECD launched the BEPS action plan, made up of 15 action items, most of which were designed to plug the loopholes without going back to a worldwide system. We don’t know yet how successful they’ve been, because they only came into effect in 2018, but the reports coming out are showing that developing countries are now starting to garner more tax revenues. It really does look like maybe this is going to work if we just give it sufficient time.

Mimi Song: And are there any additional steps that you think need to be considered to make sure that this continues to work?

Dr. Lorraine Eden: Well, the U.S. kept the check-the-box regulations, which most European countries consider to be the most egregious arbitrage opportunity. Check-the-box regulations allow a U.S. MNC to classify business units differently based on where the unit is located. A U.S. MNC can take advantage of the rules of the subsidiary where the subsidiary is and take advantage of the rules of the branch where the branch is.

The big thing going on right now of course, is there were 15 action items, and the first one on the list was the last one to be dealt with and that’s taxing the digital economy.  If you’ve been reading the papers, you know about the tit-for-tat that is going on between the U.S. and France on the digital services tax.

Many countries are introducing digital tax, taking unilateral measures to try to deal with the digital economy tax. They’re just putting the cart before the horse because they don’t want to miss out on the tax receipts. Billions of dollars of revenue annually are received by Alphabet, Amazon, Facebook and Microsoft, all American companies. Other countries are looking at the U.S. and saying, “If you’re not going to tax them, then we want to.”

The third alternative here is formulary apportionment. This perception of multinationals making so much income and not paying tax could also work in favor of this model. Different countries are now gathering all this information in the form of country-by-country reporting and the quantitative data to be able to do the sort of analytics necessary to implement formulary apportionment.

The BEPS action items have led to country-by-country reporting. The way transfer pricing and taxes are paid is a duel. If the French tax authority is auditing MNCs, they will look at the related party transactions between the French entity and whatever the party is that’s trading. The taxing authority will not tend to ask for the MNC’s whole global value chain.

With country-by-country reporting, every multinational is now having to file a master file and local files. The master file is the global value chain for the whole entity, while the local file is the individual subsidiary level. Right now, that information is private and it is going government to government. But the advantage is it gives tax authorities a big window into the multinational enterprise. 

Another piece of that is big data, so the French tax authority will see that France has 5% of the labor force and 10% of the capital stock, but 50% of the sales, and conclude that the MNC should be paying more taxes.

Mimi Song: What are some reasons formulary apportionment wouldn’t work?

Dr. Lorraine Eden: One of the justifications for taxing labor was the perception that it wasn’t mobile. If you tax something mobile, it leaves. People have tended to stay where they were, where their jobs were. The problem with a digitalization of the economy is there are fewer and fewer people – laborers – involved. Most of the U.S. states have moved away from taxing labor.

They don’t tax capital, all they tax is sales. If labor were to be a factor in the calculation of the tax, as soon as you add five employees, you have to pay that much more tax. So, corporations operating in multiple U.S. states will just add more people in a low-tax state, even if all the value is created by workers in a high-tax state. There are too many loopholes with taxing labor.

While the international tax system needs an overhaul, the arm’s length principle is still valid and relevant. If the original BEPS works to take care of the most egregious loopholes in the system, then the arm’s length standard is an essential lynch pin to make the whole thing work.

You need a set of rules at the top of the game and then you need a referee. The arm’s length standard says that you need to price according to what similar parties would have done under the same set of facts and circumstances. If we moved to a formulary apportionment system, that’s a very blunt instrument. All those facts and circumstances are thrown out.

The window says 50% of your sales are here, you owe me 50% of the tax base. It doesn’t take into account how business or the competitive landscape changes. The arm’s length concept is simpler. It looks at what you would charge under related situations and under similar circumstances if you’re unrelated parties. And that’s really the fundamental premise of the arm’s length principle.

Mimi Song: Is a global minimum tax a potential solution?

Dr. Lorraine Eden: We’ve been seeing letters going back and forth between the U.S. Treasury and the OECD Secretariat with respect to a global minimum tax. One of the things that may come out of this is the opportunity to set a floor for taxes.

With the U.S. moving to a territorial approach, it’s not going to happen. But we could take a crack at raising the bottom from zero to 10%, as an alternative to setting a ceiling at the resident’s rate.

If you talk about setting a minimum floor, countries will just cluster under the floor. If you set the floor at 10%, they’ll cluster under 10%. If you set the floor at eight, they’ll cluster under eight. Why not cluster under it and then take that money in a developing country and use it to fund schools, put people back to work or renew infrastructure?

There is some opportunity there and it is possible that the U.S. may be able to lead that way. We dropped the corporate tax rate from 35 to 21%, so a huge cut in the corporate income tax did away with the umbrella, but we’re shoring up under the bottom with some of these other things. Some of the way they were structured affects exports and imports, which means they may be seen as an export subsidy in the United States, contravening the WTO.

Those will probably have to be taken out. But the others do offer some opportunity. And the letters that are going back and forth, along with the BEPS initiatives, do suggest some plugging of these things at the bottom for developing countries in particular.

Mimi Song: Of those major jurisdictions that don’t adhere to the arm’s length standard, like Brazil, do you ever see them coming into the fold?

Dr. Lorraine Eden: Brazil thinks that they’re playing the arm’s length. They’re moving closer to the existing approach of the OECD. In all of the latest developments like digitalization and taxing the digital economy, a group of 124 developing countries is playing a leading role. China, Brazil and India are all in that group. Brazil is one of the lead actors in the group of 124.

Mimi Song: What’s the biggest mistake you see multinationals make in terms of transfer pricing?

Dr. Lorraine Eden: Failure to document. A compulsory documentation has to be done and has to be prepared even if you don’t have to give it out. But if you don’t document, you leave yourself open to the tax authority coming after you.

To hear more of Mimi and Dr. Eden’s conversation about the arm’s length standard, listen to this episode of The Fiona Show.