At one level, the focus on the location of decision making as a factor in determining whether a business arrangement is arm’s length is odd. While the requirement that the decisions made by the local entity have to be selfish ones that are consistent with the self-interest of the local entity rather than the self-interest of the MNE as a whole is logical, given the separate legal entity standard, it is the decision itself and not the location of the decision makers that determines whether the local entity behaves in an arm’s length manner. The decision to pay a price of $100 per barrel for oil by an entity that is legally entitled to oil for $50.00 per barrel is inconsistent a reasonable alternatives analysis regardless of whether that decision is made by a local employee or by the tax department of the parent company. As long as the decisions that are made are in the economic interest of the local entity, it is not at all clear as (at least to me) why the arm’s length nature of transfer prices should vary depending upon where the decision is made.
At another level, it is relatively easy to understand the rationale for the OECD’s guidance. The funding of at-risk investments is highly mobile, and it is therefore relatively straightforward for MNEs to arrange to fund such investments from low tax or no tax jurisdictions, and to therefore ultimately realize the profits from such investments in such low tax or no tax jurisdictions. By linking at risk funding with the control exercised by the legal entity making the funding, the OECD hopes to make it more difficult to fund such investments from legal entities on sandy beaches with few if any employees. The OECD also appears to believe that at least certain types of decision making are an integral part of the value-creation process, and therefore cannot be either ignored or treated as a routine activity that can be subcontracted out. (In this regard, the OECD has indicated that an intangible owner is entitled to all profits from intangibles only if it carries out DEMPE –Develop, Enhance, Maintain, Protect and Exploit – functions).
However, the establishment of an administrable linkage between decision making and risk will be complicated by the fact that there is no clear relationship between the magnitude of the risk control effort (either in terms of the amount of effort expended or the technical expertise of the decision makers) and the magnitude of the risk that it being managed. For example, a relatively limited amount of expertise may be needed to decide to fund a billion-dollar decision to undertake a clinical trial for a new drug – all that is needed is a report by competent experts that there is a 20% chance that the drug will be approved, and that if it is the net present value of resulting profits will be well in excess of five billion. The actual management of the clinical trials may require a much larger amount of effort and may require more substantial technical expertise. But the key decision is the decision to invest; all of the rest is risk mitigation. Given that this billion-dollar investment decision may be made a small number of very senior executives in the MNE, all of whom are employed by the Parent Company, does this imply that only the Parent Company can be treated as the true risk taker? If so, this represents a very significant change in the nature of the arm’s length standard.
The nature of the expertise required is also unclear — e.g., can marketing executives be viewed as key decision makers in determining what types of R&D will be funded? The rationale for this may be simple — the likelihood that the R&D will be successful in generating future profits may be much more dependent upon whether or not the bet is made on the right product than the technical challenges presented by the R&D itself. (As a simple example, the decision of whether or not to invest in the R&D needed to produce hybrid cars may be much more dependent upon whether consumers are willing to buy such cars than the technical challenges with the R&D itself.)
In this regard, most large corporate bets are the result of shared decision making, in that expectations regarding market demand, expectations regarding manufacturing challenges and locations, and expectations regarding the technical challenges that will have to be overcome in developing new technologies and products are all taken into account in determining what to invest in and where to make the investment. Key inputs into the decision making process therefore may come from a collection of people employed in multiple different legal entities. Under such circumstances, does the OECD’s new guidance imply that each source of decision making is entitled to a slice of profits coming out of that decision, or can MNE’s structure their operations such that any legal entity that has a key role in the decision-making process can assume the role of principal and key risk-taker? (The current OECD guidance notes that there may be cases where multiple different legal entities exercise control over risk, that risk can be allocated to any one or these entities and that this business arrangement should be respected.) (1.94).
Finally, the timing of decisions and changes in the location of decision makers may raise issues. Almost by definition, the decision to make an at-risk investment occurs before the outcome of that decision is known, and before the realization of any profits resulting from that decision. In some cases, the critical decision to invest in a particular venture may take place years before the outcome is known – the decision to start Phase I clinical trials on a pharmaceutical compound typically occurs a number of years before regulatory approval is obtained. Moreover, there may be a number of other specific derivative decisions that are made along the way, not just whether or not to fund Phase II and Phase III trials, but decisions as to how to set up the trials, what indications to seek, what dosage levels should be tried, and how to price the product once regulatory approvals have been obtained. These decision may made by employee located in different legal entities. However, the key business arrangements are often set up at the outset of this process – will such arrangements be respected? Similarly, what happens when key decision makers located in Germany are replaced by ones located in Spain? This shift may occur simply because of the availability of the best person for the job, and may not be associated with any change in business arrangements, funding or tax planning. Does this imply a shift in profits from Germany to Spain?
As can be seen, while it is possible to understand why the arm’s length standard has evolved to incorporate profit-based methods, reasonable alternatives, and the location of decision makers, each of these changes has added its own level of complexity, and has also added more room for varying interpretations by different tax authorities.
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