OECD principle regarding transfer pricing

Introduction

2.1   A large share of world trade consists of transfer of goods, intangibles and services within enterprises, which are under the same or common control. Transactions between them may not be governed by open market considerations. Prices paid may be fixed, resulting in non-accrual of profit which would have accrued in a jurisdiction if the transactions had been at arm’s length. The principle of arm’s length has to be applied to such transactions as laid down in article 9(1) of the OECD and UN Model Tax Convention. It briefly provides that profits arising from the transactions between the associated enterprises may be adjusted to a level which reflects that would have been achieved had open market prices been used. That article also lays down qualification of “associated enterprises.” Two enterprises are associated if in their management, control, or capital there is participation (direct or indirect) by the same persons or there is such participation in such affairs of the one by the other enterprise. The enterprises are therefore, said to be associated if they are under the common or the same control.  The article only lays down the principle but does not provide for the methods for evaluation of the arm’s length price (i.e., the correct price) in respect of the transaction between the two associated enterprises. The OECD has issued guidelines on how the determination of the arm’s length price should be carried out. These are based upon the arm’s length approach under which the essential inquiry is what unrelated parties, not under the common control, would do in similar circumstances. In other words, the arm’s length approach involves an attempt to establish the price that would prevail in the market place.

OECD Guidelines 1995-Objects

2.2    The OECD (Organization for the Economic Co-operation and Development) is an organization of 29 Member Countries (Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Republic of Korea, Spain, Sweden, Switzerland, Turkey, United Kingdom, United States). Pursuant to Article 1 of the Convention signed in Paris on 14th December 1960, and which came into force on 30th September, 1961, the OECD shall promote policies designed:

Its mission is, therefore, to create an opportunity for Members to consult and co-operate with each other in order to achieve the greatest possible increases in economic growth and social well being for their population. It does not lay down rules and regulations to settle disputes like other international bodies. Instead it encourages the negotiation of agreements and the promotion of legal codes in certain sectors. Most importantly, the OECD gives advices and makes recommendations to its Members to aid them in defining their governmental policies. It is a forum for objective, skilled, and independent dialogue which allows the broad understanding and in depth comprehension required to deal with problems posed by an increasingly complex world.

The OECD addressed the question of the income tax treatment of the transaction between the related enterprises or different parts of the same enterprises located in different jurisdictions. Each country tax system operates under its normal domestic tax rules and treats the associated enterprises in its jurisdiction as an independent enterprise of the parent company. In order to apply separate entity approach to intra-group transactions, individual group members are taxed on the basis that they act at arm’s length in their dealings with each other. However, the relationship among the members of the multinational enterprises (MNE group) may permit the group members to establish social conditions in their intra group relations that differ from those that would have been established had the group members been acting as independent enterprises  operating in open markets. Arm’s length principle’s under which the effect of the special conditions on the level of profits is eliminated, ensures correct application of the separate entity approach. The OECD Council after considering the following, made recommendations  on the determination of transfer pricing between associated enterprises:-

“Considering that transactions between associated enterprises may take place under conditions differing from those taking place between independent enterprises.
Considering that the prices of such transactions between associated enterprises (usually referred to as transfer pricing) should, nevertheless, for taxing purposes be in conformity with those which would be charged between independent enterprises (usually referred to as arm’s length pricing) as provided in article 9 (paragraph 1) of the OECD Model Tax Convention on Income and on Capital;
Considering that problems with regard to transfer pricing in international transactions assume special importance in view of the substantial volume of such transactions;
Considering the need to achieve consistency in the approaches of tax administrators, on the one hand, and to associated enterprises, on the other hand, in the determination of the income and expenses of a company that is part of  Multinational Enterprises Group that should be taken into account within a jurisdiction”.

The OECD Council then recommended to the governments of the Members countries as follows:-
“that their tax administrators follow, when reviewing, and if necessary, adjusting transfer pricing between associated enterprises for the purposes of determining taxable income, the guidelines in the 1995 Report as amended –considering the integrity of the Report and the inter action of the different chapters- for arriving at arm’s length pricing fro transactions between associated enterprises;
1.2   that tax administrations should encourage taxpayers to follow the guidance in the 1995 Report, as amended and to that end that the they give the 1995 Report as amended publicity in their country and have it translated, where necessary, into their national language (s);
The Guidelines in the 1995 Report were intended to be a revision and compilation of the previous reports by the OECD Committee on Fiscal Affairs addressing transfer pricing. The principle report is Transfer Pricing and Multinational Enterprises (1979) the (1979 Report) which elaborated on the arm’s length principle as set out in Article 9 of the OECD Model Convention. Other reports addressed transferring pricing issues in the context of specific topics. The 1979 report was substantially revised and up-dated in 1995. Work continues on revising the Guidelines.

The OECD Council instructed the Committee of Fiscal Affairs:-

The OECD Council then decided to repeal the Recommendations of the determination of Transfer Pricing between associated enterprises issued in 1979. In April 1997, new chapters were published looking at intangibles and services. In August 1997, a new chapter on cost contribution arrangements (CCAs) was issued. In February 1998, Annexes were published containing practical examples and the procedures for monitoring the implementation of the guidelines. In October 1999 an Annex was published which covered the Guidelines for conducting advance pricing arrangements under the mutual agreement procedure (“MAP APAs”). The matter is discussed later.

OECD Guidelines- US Regulations of 1968 setting the trend

2.3   The principle of arm’s length determination of the transactions between enterprises under the same or common control was enshrined in article 9 of the 1963 OECD Model Tax Convention and the tax treaties based on such Model and also in the treaties entered prior to 1963. But there were no guidelines as to how tax administration should go about ascertaining arm’s length prices in order to arrive at arm’s length profit. No efforts were either made for many years in that direction. In consequence of non-arm’s length transfer pricing, there could, therefore, be the possibility of losses of tax. The US Treasury published in 1968 regulations under section 482 of the Internal Revenue Code, setting out in some detail various approved methods by which taxpayers could calculate for themselves the arm’s length prices to be used, for tax purposes, for intra-group transactions. The methods are classic four. The arm’s length price is to be calculated by

Other countries also became concerned the transfer pricing of multinationals and consequently loss to their revenue. Adjustment to the transfer pricing was, therefore, sough to be made. Tax determined in respect of such adjustments might not have been given relief by the residence state, under 1963 OECD Model Tax Convention in the absence of a provision. Consequently, the taxpayer would have suffered unrelieved relief on mutual consultation). There was, therefore, a felt need of guidelines which are internationally acceptable. With such consideration in mind the Committee on Fiscal Affairs of the OECD set up in 1973 a working party to look into the possibility of having an internationally accepted guideline. The working party produced a series of reports focusing on transfer pricing in respect of intra-group transactions relating to sale of goods and services, transfer of technology, and loans. These reports were brought together and published in 1979 under the title “Transfer Pricing and Multinational Enterprises”.

OECD Guidelines-1979 Report

2.4   The “Transfer Pricing and Multinational Enterprises” Report (1979 Report) reaffirmed and elaborated the arm’s length principle as set out in Article 9(1) of the 1977 OECD Model Tax Convention and explored in some detail the use of the classic methods mentioned in the proceeding paragraph. It only outlined the principles, without laying down precisely rules to be followed in determining the transfer price for tax purposes. It, therefore, recommended a line of approach which was found acceptable to both the taxpayers and the tax administrations. The 1979 Report represented the basic guidelines for the individual countries to follow while seeking to develop their own rules or guidelines for the tax treatment of transfer prices.

OECD Guideline-1984 Report

2.5    The 1979 Report was supplemented in a report entitled “Transfer Pricing and Multinational Enterprises: Three Taxation Issues” published in 1984 (the 19894 Report). The Report considered:-

OECD Guidelines-1987 Report

2.6       In 1987 the OECD published a study of “Thin Capitalization” (the “1987 Report”). Thin or hidden equity capitalization is viewed as providing opportunities for a tax minimization leading to avoidance of payment of tax where it is due. Since there is no easy guide to what proportion of a company’s capital should properly take the form of debt rather than as equity. Equity capital is kept very thin, whereas the debt capital very heavy. The tax advantage is obvious when it equity capital is in the form of dividend paid out of the profit on which tax had already been charged, and return paid on loan capital is in the form of interest (a deductible expenses) that is met before profits are calculated on which tax has to be charged. This differential tax treatment may make it more advantages for the associated companies to arrange financing amongst themselves in the form of loan rather than equity. The tax administrations are, therefore, concerned about the tax advantages of loan capital and the fact that these may induce the parties to introduce equity capital in the form of loan. This phenomenon is referred to “Thin Capitalization”. It is also called “Hidden Capitalization” as it represents a low equity/debt ration. The Report on “Thing Capitalization” is, certainly, concerned to an extent with the possibilities of evasion and avoidance but is more concerned with the ways in which the domestic provisions designed to counter evasion and avoidance various effort have been made by tax administrations to counter possible abuse in this area. Expedients of this kind are discussed in the 1987 Report together with the ways in which they may interact with the provisions in the tax treaties. The discussion on thin capitalization in this Report has been taken into account in the 1992 OECD Commentary on Articles 9, 10, 11, 23, 24 and 25 of the OECD Model Tax Convention.

OECD Guidelines-“International Tax Avoidance and Evasion-Four Related Studies” 1987
2.7     The OECD publication “International Tax Avoidance and Evasion-Four Related Issues” in 1987 analysis in some depth various aspects of the general phenomenon of international tax evasion and tax avoidance. In particular, it discusses the use, for this purpose, of low or no tax countries (tax haven) and especially the use therein of the “base company” as a shelter. It also analyses the possible modes of “treaty shopping” and the methods of countering them. Though transfer pricing is not explicitly one of the four issues, it is treated throughout of the publication as a very relevant matter.

OECD Guidelines- Tax Treatment of Transfer Pricing in US, changes in 1986 and 1994
2.8     The two innovations in the US in the tax treatment of transfer pricing, one is 1986 and the other in 1994, promoted the OECD to review and undertake revision of the existing Guidelines and thus provided the base for 1995 guidelines. In 1986, section 482 of the International Revenue Code was changed to provide new rules for adjustment of transfer prices for intangibles, such a patent, copyright, trademark etc. In 1994, the US authorities produced new Regulations under that section to make more precise for determining arm’s length price.
The transfer in respect of the intangible property may involve outright sale for a capital sum or license to a user for a royalty or license fee. The price on which such transfer takes place is the transfer price. The new rules of 1986 provided that, for the purposes of section 482, the price for an intangible must be commensurate with the income derived from the use of intangible. Income derived from the use of the intangible is the basis. At the time of transfer the income yielding capacity of the intangible is only estimated. But the actual derived income may be substantially more than the expected. The new method, therefore, provides for periodic evaluation of capital payments as well as royalties and similar payments. Price once accepted as arm’s length price cannot be said final. It is subject to revision if in the course of time income turns out to be unexpectedly high. Periodic adjustments require that changes be made to payments to reflect changes in he income stream attributable to an intangible. Such a periodically adjusted royalty is sometimes known as “super royalty”.
The 1994 Regulations remain committed to the arm’s length standard as a mean of arriving at arm’s length profit as against formulary determination, and still recognize the classic methods viz.

Determination of the arm’s length price is the purpose of the above methods. Under the new Regulations what is determined is the arm’s length profit. Instead of arm’s length price, it is the arm’s length profit. Profit rather than the price determines the arm’s length result. The methods are comparable profits method (corresponding to 1 above) and the transactional profit split method and the transactional met margin method (a modified version of cost plus/resale price method), and the residual profit split method. These are not the methods of arriving at an arm’s length price but are the methods which directly determine an arm’s length profit. All these look to the profit; the one made in similar transaction between the uncontrolled parties (comparable profits method), how total profit on a series of transactions between uncontrolled parties would be split between the parties (comparable profit split would be received for comparable functions and risks in transactions between related parties (residual profit split method). The comparable profit method requires a comparison of operating income that results from the consideration actually charged in a controlled transfer with the operating incomes of similar taxpayers that are uncontrolled. Thus, it looks to the profits made in similar transactions between uncontrolled parties. The concept of periodic adjustments introduced in the US law in 1986 has been incorporated as a part of the general principle which permits the IRS to consider all facts relevant to the year under examination and also in the rules governing transfer of intangibles for more than one taxable year. Under these rules, if an intangible in transferred under an agreement with a term covering  more than one taxable year, periodic adjustment would be made in subsequent year even through the consideration for the intangible was determined to be arm’s length in a prior year. There are, however, three exceptions when the periodic adjustments are not required to be made:-

When the above regulations were purposed as contained in the USA’s consultation documents, the OECD undertook discussion in a report “Tax Aspects of Transfer Pricing within Multinational Enterprises: The United States Proposed Regulations (1993). “That Report specifically addressed the United States proposed Regulations. Its scope was, therefore, limited.

OECD Guidelines- 1995 Guidelines-Background

2.9    As aforesaid, the OECD set out internationally accepted guidelines in 1979, which emphasized arm’s length principle as embodied in Article 9 of the OECD Model Tax Convention. It only set out the principle, but not the rules for its application to evaluate the transfer pricing of associated enterprises. Those guidelines were much influenced by the US Treasury regulations under section 482 of the Internal Revenue Code, published in 1968, setting out in some details various approved methods by which taxpayers could calculate for themselves the arm’s length price for tax purposes, for intra-group transactions. The US changed section 482 in 1986, and produced new regulations in 1994, to provide new rules and methods for determining arm’s length price in respect of intangibles. In 1994, the OECD began a very detailed review of the transfer pricing guidelines outlined in 1979 Report, in the light of developments since 1979, especially the changes in section 482 of the IRC and the regulations made hereunder.
The project to revise the 1979 transfer pricing report was promoted by a number of factors, not the least of which were the increase in number of and complexity of cross-border transactions, the proliferation of MNC, and the difficulties in finding comparable market transactions to price controlled transfer involving  non-routine intangible property. It was argued that the arm’s length principle was unworkable and should therefore be discarded in favor a system of worldwide income apportionment according to a predetermined multi factor formula a system referred  to as global formulary apportionment (“GFA”). This system was seen by most administrators as likely to produce an arbitrary allocation of the tax base, and there was little chance of obtaining an advance global agreement on the formula to be used. Without such an agreement, GFA would result  in serious double taxation.
In the meantime, new methods were introduced in an effort to handle more complex cases including those with intangible property. The United States introduced its comparable profits method (“CPM”) based on a comparison on net profit margin) and along with other countries began to experiment with various profit split approaches. The traditional method of comparable uncontrolled price (“CUP”) cost-plus or resale price (the latter two based upon gross profits margins) were said to be insufficient to handle all cases, because they relied heavily on assessing relevant data about comparable transactions between independent parties.
The profit methods were heavily criticized as not being within the ambit of the arm’s length principle. Opponents claimed that countries using these methods would be able to claim excessive share of tax base from cross-border transactions. So the arm’s length principle has two sides, opposite to each other. One favors its discard in favor of GFA; and the other, favors its retention and its three traditional methods, a narrow interpretation that threatened to make the principle itself obsolete.

2.9-1 OECD Guidelines 1995-Salient features- The OECD consensus solution to the conflict  between rejection of the arm’s length principle in favor of the GFA and its retention, was a balance one. It is to preserve the arm’s length principle as the most effective means to dealing with transfer pricing but to interpret it broadly enough as to permit non-traditional methods in the last resort case.  The idea of using non-traditional method is not new and has its origin in the discussion of the fourth or “any other method” approach described in Chapter I of the 1979 OECD Transfer Pricing Report. The non-traditional methods would have to be applied in a manner to safeguard the arm’s length principle. As a result thereof, the Committee on Fiscal Affairs of the OECD issued new Guidelines in 1995. The 1995 Report is the final version of the two discussion drafts published by the OECD’s said Committee. Part I of the draft report reaffirms the OECD’s support for the arm’s length principle. Part II discusses a wide range of topics including the treatment of production and marketing intangibles, intra-group services, cost-contribution arrangements, the burden of proof, penalties, corresponding adjustments, the mutual agreement procedure, simultaneous tax examination, safe harbors, advance pricing agreements, arbitration and documentation.
The 1995 Report is the “revision and compilation of previous reports by the OECD Committee on Fiscal Affairs addressing transfer pricing and other related tax issues with respect to multinational enterprises. The Principal Report is Transfer Pricing and Multinational Enterprises (1979) (the “1979”) which elaborated on the arm’s length principle as set out in Article 9. Other reports are Transfer Pricing and Multinational Enterprises- Three Taxation Issues (1984) the (1984 Report), and Thin Capitalization (the “1987 Report) (“Paragraph 13 of the Preface of the 1995 Report)
The OECD has not devised any new method. The following is the approach:-

The above salient features are discussed under the following headings as the 1995 Guidelines: -

2.9-2 OECD Guidelines 1995-Reaffirming 1979 Report- Reaffirming the conclusions of 1979 Report, the 1995 Report:-

“….The Chapter discusses the arm’s length principle, reaffirms its status as the international standard, and sets forth guidelines for its application.”

“Traditional transaction methods are the most direct means of establishing whether conditions in the commercial and financial relations between the associated enterprises are arm’s length. As a result, traditional transaction methods are preferable to other method.”

“There are, however cases, where traditional transaction methods cannot be applied alone or exceptionally cannot be applied at all. These would be considered cases of lost resort….”

“For the foregoing reasons, OECD Member countries reiterate their support for the consensus on the use of the arm’s length principle that has emerged over the years among Member and non-Member countries and agree that the theoretical alternative to the arm’s length principle represented by global formulary apportionment should be rejected.”

“It is not possible to provide specific rules that will cover every case. In general, the parties should attempt to reach a reasonable accommodation keeping in mind the imprecision of the various methods and the preference for higher degrees of comparability and a more direct and closer relationship to the transaction. It should not be the case that useful information, such as might be drawn from uncontrolled transactions that are not identical to the controlled transactions, should be dismissed simply because some rigid standard of comparability is not fully met. Similarly, evidence from enterprises engaged in controlled transactions with associated enterprises may be useful in understanding the transaction under review or a pointer to further investigation, further, any method should be permitted where its application is agreeable to the members of the MNE group involved with the transactions or transactions to which the methodology applies and also a tax administration in the jurisdictions of all those members.”

“The methods set forth in Chapter II and III establish whether the conditions imposed in the commercial and financial relations between associated enterprises are consistent with the arm’s length principle. No one method is suitable in every possible situation and the applicability of any particular method need not be disproved. Tax administrators should hesitate from making minor or marginal adjustments…”

“The foregoing analysis suggests that while safe harbors could accomplish a number of objectives relating to the compliance with the administration of the transfer pricing provisions, they raise fundamental problems. They could potentially have perverse effects on the pricing decisions of enterprises engaged in controlled transactions. They may also have negative impact on the tax revenues of the country implementing the safe harbor as well as on the countries whose associated enterprises engage in controlled transactions with taxpayers electing a safe harbor. More importantly, safe harbors are generally not compatible with the enforcement of transfer prices consistent with the arm’s length principle. These drawbacks must be measured against the expected benefits of safe harbors, certainly, and compliance simplicity on the taxpayers side and relief from administrative burden on the tax administration’s side.”

2.9-3 OECD Guidelines 1995- Details and Systematic- The Report gives much more detailed and systematic, and other more positive, guidance, making many specific recommendations and providing many illustrative examples and,

2.9-4    OECD Guidelines 1995- Supplement 1979 and other Reports: The 1995 Report supplements the earlier Reports by dealing in detail with a number of topics, which were considered cursorily or not considered at all such Reports. The 1995 Guidelines provide:-

“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 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 be also be many occasions when the application of the most appropriate method or methods produces a range of figures all of which are relatively 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 parties. It is also possible that the different points in a range represent the fact that the 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 necessarily requires exercising good judgment….”
A range of figures may also result when more than one method is applied to evaluate a controlled transaction.

“In order to obtain a complete understanding of the facts and circumstances surrounding the controlled transactions, it generally might be useful to examine data from both the year under examination and prior years. The analysis of such information might disclose facts that may have influenced (or should have influence) the determination of the transfer price. For example, the use of the data from past years will show whether a taxpayer’s reported loss on a transaction is part of a history of losses on similar transactions, the result of particular economic conditions in a prior year that increased costs in the subsequent year, or a reflection of the fact that the product is at the end of its life cycle. Such an analysis may be useful where as a last resort a transactional profit method is applied.”
Multiple year data will also be useful in providing information about the relevant business and product life cycles of the comparables. Differences in business or product life cycles may have a material effect on transfer pricing conditions may have a material effect on transfer pricing conditions that needs to be assessed in determining comparability. The data from the earlier years may show whether the independent enterprise engaged in a comparable transaction was affected by comparable economic conditions in a comparable manner, or whether different conditions in an earlier year materially affected its price or profit so that it should not be used as a comparable.

• Burden of proof: The Report discusses the incidence of burden of proof. It provides that regardless of whether the tax administration or the taxpayer bears the burden of proof, an assessment of the fairness of the allocation of the burden of proof would have to be made in view of the other features of the jurisdiction’s tax system that have a beating on the over all administration of transfer pricing rules, including the resolution of disputes. These features include penalties, examination practices, administrative appeals processes, rules regarding payment of interest with respect to tax assessment and refunds, whether proposed tax deficiencies must be paid before postponing an adjustment, the statute of limitations, and the extent to which rules are made known in advance.

• Paragraph 4.16 of the Report reads as under:-
“In practice, neither country not taxpayers should misuse the burden of proof in the manner described above. Because of the difficulties with transfer pricing analysis, it would be appropriate for both taxpayers and tax administrations to take special care and to use restraint in relying on the burden of proof in the course of the examination of a transfer pricing case. More particularly, as a matter of good practice, the burden of proof should not be misused by tax administrations or taxpayers as a justification for making groundless or unverifiable assertions about transfer pricing. A tax administration should be prepared to make good faith showing that its determination of transfer pricing a consistent with the arm’s length principle even where the burden of proof is one the taxpayer, and the taxpayers similarly should be prepared to make good faith showing that their transfer pricing is consistent with the arm’s length principle regardless of where the burden of proof lies.”

“It is generally regarded by the OECD Member countries that the fairness of the penalty system should be considered by reference to whether the penalties are proportionate to the offence. This would mean, for example, that the severity of a penalty would be balanced against conditions under which it would be imposed, and that the harsher the penalty the more limited the conditions in which it would apply.”

“To eliminate double taxation for transfer price cases, tax administrations may consider requests for corresponding adjustments  as described in paragraph 2 of Article 9 (of the OECD Model Tax Convention). A corresponding adjustment, which in practice may be under taken as part of the mutual agreement procedure, can mitigate or eliminate double taxation in cases where one tax administration increases a company’s  taxable profits (i.e., makes a primary adjustment) as a result of applying the arm’s length principle to transactions involving an associated enterprise in a second tax jurisdiction. The corresponding adjustment in such a case is a downward adjustment to the tax liability of that associated enterprise, made by the tax administration of the second jurisdiction, so that the allocation of profits between the two jurisdictions is consistent with the primary adjustment and no double taxation occurs. It is also possible that the first tax administration will agree to decrease (or eliminate) the primary adjustment as part of the consultative process with the second administration, in which case corresponding adjustment would be smaller (or perhaps unnecessary). It should be noted that a corresponding adjustment is not intended to provide a benefit to the MNE group greater than would have been the case if the controlled transactions had been undertaken at arm’s length conditions in the first instance”
Under paragraph 2 of Article 9, a corresponding adjustment may be made by a contracting state either by recalculating the profits subject to tax for the associated enterprises relief against its own tax paid in that State for additional tax charged to the associated enterprise by the adjusting state as a consequence of the revised transfer price. The former method is more common.
Paragraph 4.37 of the Report further says:-
“Corresponding adjustments can be a very effective means of obtaining relief from double taxation resulting from transfer pricing adjustments. OECD Member countries generally strive in good faith to reach agreement whenever the mutual agreement procedure is invoked. Through the mutual agreement procedure, tax administrations can address issues in a non-adversarial proceeding, often achieving a negotiated settlement in the interests of all parties. It also allows tax administrations to take into account other taxing rights issues, such as withholding taxes.”

2.9-5   Administrative procedure and approaches to resolving transfer pricing disputes: The 1995 Report examines various administrative procedures that could be applied to minimize transfer pricing disputes and recommends several administrative approaches to help resolve them when they do arise between tax payers and the tax administrations. The dispute could be on account of differing determinations of the arm’s length conditions for the controlled transactions under examinations given the complexity of some transfer pricing issues and the difficulties in interpreting and evaluating the circumstances of individual cases. The disputes are broadly of two kinds; causes by transfer pricing adjustments, and, for avoiding double taxation. For minimizing the transfer pricing disputes, the Report made suggestions about

2.9-5a  TRANSFER PRICING COMPLIANCE AND EXAMINATION PRACTICE: The following are the three aspects of transfer pricing that help tax jurisdictions administer their transfer pricing rules in a manner that is fair to taxpayers and other jurisdictions:-

Examination practices: Examination practices of transfer pricing cases are to be different from other examinations. Those cases present special challenges to the normal audit or examination practices. They are fact intensive and may involve difficult evaluations of comparability, markets and financial or other industry information. It requires specialized and expert knowledge, follows as different procedure and takes longer than other examinations. In paragraph 4.9, the 1995 Report suggests how the tax administrations should proceed with the examination:-
“In a difficult transfer case, because of the complexity of the facts to be evaluated, even the best intentioned taxpayer can make an honest mistake. Moreover, even the best-intentioned tax examiner may draw the wrong conclusions from the facts. Tax administrations are encouraged to take this observation into account in conducting their transfer pricing examinations. This involves two implications. First, tax examiners are encouraged to be flexible in their approached and not demand from taxpayers in their transfer pricing a precision that is unrealistic under all the facts and circumstances. Second, tax examiners are encouraged to take into account the taxpayer’s commercial judgment about the application of the arm’s length principle, so that the analysis is tied to business realities. Therefore, tax examiners should undertake to begin their analysis of transfer pricing from the perspective of the method that the taxpayer had chosen in setting its prices…”

Burden of proof: Transfer pricing should be consistent with the arm’s length principle. There should be good faith showing of such consistency by the taxpayer in respect of his transfer pricing and by the tax administration in respect of its determination. This has to be done regardless of where the burden of proof lies (see paragraph 4.16 of the 1995 Report)

Penalty system: The Report recommends that penalties for procedural non-compliance and for no fault tax understatement should be fair and not unduly onerous. Penalties are directed towards procedural compliance, such as timely submission of filling of returns and information reporting; and, for tax understatement inadvertently (no fault), or deliberately because of negligence or willful intent to evade. Penalties for procedural non-compliance are normally small. For understatement, they are imposed only by showing a high degreed of taxpayer culpability. No fault penalties tend to be lower. The 1995 Report suggests in paragraph 4.25 that, “However, owing to the nature of transfer pricing problems, care should be taken to ensure that administration of a penalty system as applied in such cases is fair and not unduly onerous for taxpayers.” Paragraph 4.28 of the Report further states: -
“Since penalties are only one of many administrative and procedural aspects of a tax system, it is difficult to conclude whether a particular penalty is fair or not without considering the other aspects of the tax system. Nevertheless, OECD Member countries agree that the following conclusions can be drawn regardless of the other aspects of the tax system in place in a particular country. First, imposition of a sizeable “no-fault” penalty based on the mere existence of an understatement of a certain amount would be unduly harsh when it is attributable to good faith error rather than negligence or an actual intent to avoid tax. Secondly, it would be unfair to impose sizable penalties on taxpayers that made a reasonable effort in good faith to set the terms of their transactions with related parties in a manner consistent with arm’s length principle penalty on a tax payer for failing to consider data to which it did not have access, or for failure to apply transfer pricing method that would have required data was not available to the tax payer. Tax administrations are encouraged to take these observations into account in the implementation of their penalty provisions.”

2.9-5b  SIMULTANEOUS TAX EXAMINATIONS: Simultaneous tax examination is a form of mutual assistance, used in a wide range of international issues, which allow two or more countries to co-operate in tax investigations. It is defined in Part A of the OECD Model Agreement for the Undertaking of Simultaneous Tax Examinations (“OECD Model Agreement”) to mean:
“An arrangement between two or more parties to examine simultaneously and independent, each on its own territory, the tax affairs of (a) taxpayer(s) in which they have a common or related interest with a view to exchanging any relevant information which they so obtain.”
Simultaneous tax examinations can be particularly useful where information based in a third country is a key to tax investigation, since they generally lead to more timely and more effective exchanges of information. Historically, simultaneous tax examinations of transfer pricing issues have focused on cases where the true nature of transactions was obscured by the interposition of tax havens. In complex transfer pricing cases, simultaneous examinations could serve a broader role since they may improve the adequacy of data available to the participating tax administrations for transfer pricing analysis. It could also reduce the possibilities for economic double taxation, reduce the compliance cost to taxpayers, and speed up the resolutions of issues. Paragraph 4.93 of the Report reads as under: -
“While the increasing internationalization of trade and business and the complexity of transactions of the MNC, transfer pricing issues have become more and more important. Simultaneous tax examinations can alleviate the difficulties experienced by both tax payers and tax administrations connected with transfer pricing of MNC. A great use of simultaneous tax examinations is therefore recommended in the examination of transfer pricing cases and to facilitate exchange of information and the operation of mutual agreement procedures. In a simultaneous examination, if a reassessment is made, both countries involved should Endeavour to a reach a result that avoids double taxation for the MNE group.”

2.9-5c  ADVANCE PRICING AGREEMENT: An advance pricing agreement (“APA”) is an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria  (e.g., method, comparables and appropriate adjustments thereto, critical assumptions as of future events) for the determination of the transfer pricing for those transactions over a fixed period of time. An APA is formally initiated by a taxpayer and requires negotiations between the taxpayer, one or more associated enterprises, and one or more tax administrations. APAs are intended to supplement to traditional administrative, judicial and treaty mechanisms for resolving transfer pricing issues. They may be most useful when traditional mechanisms fail or difficult to apply. The success of the APA programs depend on the care taken in determining the proper degree of specificity for the arrangement based on critical assumptions, the proper administration of the program, and the presence of the adequate safeguards to avoid the pitfalls described in the Report, in addition to the flexibility and openness with which all parties approach the process. Paragraph 4.161 of the Report states:-
“There are some continuing issues regarding the form and scope of APAs that require greater experience for full resolution and agreement among Member countries such as the question of unilateral APAs While it is too early to make a final recommendation whether the expansion of such programs should be encouraged, it seems likely that in certain circumstances they will aid in resolving transfer pricing disputes. The Committee on Fiscal Affairs intends to monitor carefully and expanded use of APAs and to promote greater consistency in practice among those countries that chose to use them.”

2.9-5d  ARBITRATION: About the arbitration, paragraph 4.170 of the Report makes the following observations:-
“The possibility of the use of arbitration in tax disputes has been recognized for sometimes in the work on the OECD Model Tax Convention. In 1977, the Commentary on Article 25 mentioned the possibility of “independent arbitrators” who could be asked to give “advisory options.” The current version of the Commentary on Article 25 also refers to the possible “solution” of arbitration and the Arbitration Convention as well as the development in bilateral conventions concerning arbitration.”
The Committee on Fiscal Affairs has agreed to undertake a study whether the introduction of a tax arbitration procedure would be appropriate addition to international tax relations and to supplement the Guidelines with the conclusions of that study when it is completed.

2.9-5e DOCUMENTATION WHICH CAN BE REASONABLY DEMANDED FROM ENTERPRISES: Generally the initial burden is on the tax administration to make a prima facie showing that the pricing is inconsistent with arm’s length principle. For the purpose tax administration might reasonably oblige the taxpayer to produce documentation about its transfer pricing. The burden then shifts to the taxpayer for showing for showing that his determination is consistent. The burden has to be discharged on the basis of documents.
The 1995 report assists taxpayers in identifying documentation that would be most helpful in showing that his controlled transactions satisfy the arm’s length principle and hence resolving transfer pricing issues and facilitating tax examinations. Paragraph 5.28 of the Report provides as follows:
“Taxpayers should make reasonable efforts at the time transfer pricing is established to determine whether the transfer pricing is appropriate for tax purposes in accordance with the arm’s length principle. Tax administrations should have the right to obtain the documentation prepared or referred to in this process as a means of verifying compliance with a arm’s length principle. However, the extensiveness of this process should be determined in accordance with the same prudent business management principles that would govern the process of evaluating a business decision of a similar level of complexity and importance. Moreover, the need for the documents should be balanced by the costs and the administrative burdens, particularly where this process suggests the creation of documents that would not otherwise be prepared or referred to in the absence of tax considerations. Documentation requirements should not impose on taxpayers’ costs and burdens disproportionate to the circumstances. Taxpayers should nonetheless recognize that adequate record-keeping practices and voluntary production of documents facilitate examinations and the resolution of transfer issues that issue.”