INTM576030 - Thin capitalisation: working a case - knowledge and negotiation: Formulating an arm's length position - comparables and OECD guidance

The arm’s length range

As discussed in INTM576020, there is no single, correct answer to the question of what constitutes the arm’s length position in a particular case. More usually there is a range of values, all of which may be regarded as approximating to the arm’s length standard. After all, even businesses that appear to be identical may be subjected to circumstances and events throughout the trading year that result in differing profits.

In the UK, the OECD ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’ (‘the OECD Transfer Pricing Guidelines’) have been adopted through ICTA88/SCH28AA/PARA2 as guiding principles for the transfer pricing legislation and they address these practical difficulties.

For example, when dealing with a potential range of values, the OECD Transfer Pricing Guidelines indicate, at section 1.45:

In some cases it will be possible to apply the arm’s length principle to arrive at a single figure (e.g. price or margin) that is the most reliable to establish whether the conditions of a transaction are at arm’s length. However, because transfer pricing is not an exact science, there will also be many occasions when the application of the most appropriate method or methods produces a range of figures, all of which are equally reliable. In these cases, differences in the figures that comprise the range may be caused by the fact that in general the application of the arm’s length principle only produces an approximation of the conditions that would have been established between independent enterprises. It is also possible that the different points in a range represent the fact that independent enterprises engaged in comparable transactions under comparable circumstances may not establish exactly the same price for the transaction. However, in some cases, not all comparable transactions examined will have a relatively equal degree of comparability. Therefore, the actual determination of the arm’s length price requires exercising good judgement.

In thin capitalisation cases it is particularly difficult to establish an arm’s length price by the use of comparables, since there is scope for many variations, and it may be difficult to agree on the relative weight of any differences. A wide range of values may indicate little more than that there has been a less than rigorous selection process. Nevertheless, where comparables of reasonable accuracy do exist, they may be used as a starting point for discussing the position in a particular case. They may, for example, narrow down the range of possible values to one within which useful discussion can take place. It is necessary to bear in mind, however, what the OECD Transfer Pricing Guidelines say at section 1.48:

If the relevant conditions of the controlled transactions (e.g. price or margin) are within the arm’s length range, no adjustment should be made. If the relevant conditions of the controlled transaction (e.g. price or margin) fall outside the arm’s length range asserted by the tax administration, the taxpayer should have the opportunity to present arguments that the conditions of the transaction satisfy the arm’s length principle, and that the arm’s length range includes their results. If the taxpayer is unable to establish this fact, the tax administration must determine how to adjust the conditions of the controlled transaction taking into account the arm’s length range. It could be argued that any point in the range nevertheless satisfies the arm’s length principle. In general, and to the extent that it is possible to distinguish among the various points within the range, such adjustments should be made to the point within the range that best reflects the facts and circumstances of the particular controlled transaction.

Careful choice of comparables therefore narrows down the range of possible answers, but only close analysis of the transaction(s) in question can lead to an acceptably accurate conclusion.

Would a transaction between connected parties have taken place at all?

The legislation at ICTA88/SCH28AA/PARA1A (2) invites consideration of the question whether at arm’s length a transaction would have taken place at all, reflecting the position taken in the OECD Transfer Pricing Guidelines.

Section 1.37 recognises two particular circumstances in which it may be appropriate to disregard the structure of a controlled transaction. The first circumstance arises where the economic substance of a transaction differs from its form:

‘An example of this circumstance would be an investment in an associated enterprise in the form of interest-bearing debt when, at arm’s length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. In this case it might be appropriate for a tax administration to characterise the investment in accordance with its economic substance with the result that the loan may be treated as a subscription of capital.’

The second circumstance is where, although the form and substance of the transaction are the same, the arrangements made with regard to the transaction, viewed in their totality, are different from those that would have been made by independent entities behaving in a commercially rational manner.

The example in this instance is a transfer pricing arrangement concerning a long-term contract for the sale of entitlement to intangible assets, involving a lump sum payment for the fruits of future research.

The point here is that while it might be correct to accept the form and substance are the same (i.e. a sale of intellectual property has taken place), the terms of the transaction in its entirety - the way in which all present and future fruits of the research have been sold for a single sum - is open to question. It would be reasonable to expect that if the parties were independent, the pricing would reflect ongoing research and that intellectual property would be sold when it arose. The conclusion drawn in the Guidelines on this second example is that while the transfer of the commercial property might be respected, the terms might not be accepted by tax authorities as “commercially rational”.

In formulating an arm’s length position in a thin capitalisation case it may therefore be appropriate to consider whether a transaction would have taken place at all, with the possible consequence that all finance costs associated with the transaction will be disallowable as non-arm’s length.

1.39 makes the very important point that associated enterprises are able to make a greater variety of arrangements between them than independent parties can, because there is no conflict of interests. The task of tax administrations is to determine, where necessary, the “underlying reality”.

By getting to know the circumstances of a particular case in some detail (see INTM575050 and INTM576010), it is usually possible to arrive at a range of values for the arm’s length position that is acceptable to all parties involved, and settle on values that will allow agreement on the way forward.

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