KPMG report: The arm’s length standard after the pillars

Transfer pricing has been an important feature of the international tax system for about a century, but it has taken on an increasingly central role in recent times. The global expansion of multinationals, increased complexity of supply chains, and sustained divergence in countries’ tax rates have meant that questions about where groups should pay tax have become increasingly important and contentious.

Transfer pricing is in some respects an inherently subjective exercise, requiring that transactions between the different entities that make up a multinational group are priced at arm’s length. In recent years transfer pricing has become increasingly challenging as more countries have adopted transfer pricing rules, which now apply in almost every country, and as countries have adopted different approaches to applying the same arm’s length standard. Perhaps the most creative approaches to transfer pricing have been pioneered by China and India, which have used “market premium” and “location saving” arguments to claim very high returns for seemingly routine activities. These creative approaches have become increasingly common, in part because of the changes to the guidance provided in the OECD transfer pricing guidelines on control of risk and intangibles.

For transfer pricing practitioners globally, it has become difficult to navigate an ever-more uncertain world. In the United States, recent changes to the foreign tax credit regulations make identifying creditable taxes more difficult, while recent court cases show the IRS discarding transfer pricing settlements made in prior years, despite taxpayers’ reliance and settled expectations.

The first base erosion and profit-shifting project—BEPS 1.0—has already radically reshaped transfer pricing, and it may continue to do so as more countries interpret and implement its principles. It has placed more emphasis on functionality than contractual terms, the control rather than contractual allocation of risk, and the development rather than ownership of intangibles.

The OECD’s current work program—BEPS 2.0—has the potential to bring about even greater change. The two-pillar solution to address the tax challenges arising from the digitalization of the economy represents a paradigm shift. Pillar One, and specifically amount A, is designed to allocate taxing rights to market jurisdictions in a formulaic manner beyond that which they would be allocated under the arm’s length standard. Pillar Two would introduce minimum effective tax rules that give countries the right to tax low-taxed profits irrespective of where these profits are. Moreover, recent consultations by the OECD on the future of article 9 (associated enterprises) of the OECD model tax convention and dispute resolution mechanisms may lead to further changes in how the arm’s length standard is applied and administered.

Read a 2022 report* [PDF 561 KB] prepared KPMG LLP that explores how BEPS 2.0 and the OECD’s ongoing work on article 9 of the model tax convention and potential improvements to dispute resolution mechanisms may affect transfer pricing in the future

Read related reports on KPMG LLP’s webpage: Future of the Arm's Length Principle