The persistent survival of the arm’s length standard: a different view on the FIAT and Starbucks decisions

By Cees Peters


For a long time, the arm’s length standard has been the undeniable foundation for the taxation of multinational companies. Critics have railed against this principle over and over again, but in a way or another it has always been able to persist. The current evaluation of new profit allocation mechanisms in the OECD BEPS 2.0. project does indeed attempt to find consensus on revolutionary formula-based transfer pricing rules (let’s call it command-and-control transfer pricing[1]), but this development does in no way mean that the arm’s length standard is being abandoned.

This blog discusses two factors that are able to explain the survival of the arm’s length standard in the longer run. It dwells upon the force of attraction of the OECD ‘gold standard’ on the interpretation of the arm’s length principle and on the possibilities for policymakers to camouflage the inherent weaknesses of this cornerstone of our corporate income tax systems. This perspective also makes it possible to shine a different light on the ongoing EU fiscal state aid developments (with the recent decisions of the General Court of the European Union in the Starbucks and FIAT cases) that have also put the arm’s length standard in the center of attention.

 International tax policy convergence in action: the force of attraction of the OECD ‘gold standard’

There should be no doubt that the endurance of the arm’s length principle is directly related to the gradual development of the OECD standard on transfer pricing. This ‘gold standard’ consists of article 9 of the OECD Model Convention in combination with the ever-expanding OECD Transfer Pricing Guidelines.

As a matter of fact, the continuous evolution of the OECD’s interpretation of the arm’s length standard is without a doubt an excellent example of successful international tax policy convergence in action. The political scientists Holzinger and Knill[2] identify several of such causal mechanisms that are able to explain the gradual convergence of policies of states. For example, they usefully distinguish several processes of transnational communication (such as transnational problem-solving and emulation), from regulatory competition and from harmonization of policies. Following their classification, it would seem that the force of attraction of the OECD ‘gold standard’ is mostly a success story of transnational communication.

Those states that were part of the OECD community resorted to transnational problem-solving to develop common solutions for problems that they were all facing. Even though their solutions are not legally binding, it is clear that this process has effectively limited the possibilities for this group of states to rely on its own domestic interpretation. The story is not very much different for those states that were not part of this OECD community. Many of these states were drawn to the OECD’s interpretation of the arm’s length standard in order to attune their policies to this generally accepted model. Consequently, there is, following the classification of Holzinger and Knill[3], a process of emulation at work towards the OECD gold standard.

This eagerness to follow the OECD standard on transfer pricing does obviously not disregard the fact that states such as Brazil, China and India have developed diverging views on the interpretation of the arm’s length standard in a list of situations. The United Nations Practical Manual on Transfer Pricing shows substantial deviations from the OECD Transfer Pricing Guidelines. It will however take another blog post to reflect on the question how long these states will be able to resist the lure of the OECD ‘gold standard’. For now it is sufficient to conclude that the persistent survival of the arm’s length standard is crucially dependent on the force of attraction of the OECD ‘gold standard’. There are various processes of transnational communication at work that draw states towards this standard and therefore to the arm’s length principle as the undeniable foundation for the taxation of multinational companies.

 Camouflage strategies that redress the arm’s length standard

This conclusion leads to the status of the OECD transfer pricing standard in the European Union. Ever since the European Commission reverted to EU fiscal state aid control to investigate APA’s there have been many doubts about the interpretation of the arm’s length standard in the EU. Do the hard law obligations of EU fiscal state aid law effectively result in tax harmonization along the lines of the OECD TP Guidelines? That would imply a break with the traditional processes of transnational communication and a transition towards tax policy convergence through harmonization with a legal obligation for the Member States to comply with the OECD gold standard.

The recent decisions of the EU General Court in the Starbucks and FIAT cases illustrate that this worry is unfounded. It is true that in both cases the Court refers to the OECD Transfer Pricing Guidelines as a reflection of the “international consensus achieved with regard to transfer pricing” which has “a real practical significance in the interpretation of issues relating to transfer pricing”. It does however not prescribe the application of this consensus in a compulsory way.

What is happening, instead, is that the European Commission, as currently supported by the General Court, is developing EU fiscal state aid control into a camouflage strategy that is able to correct an inherent flaw of the arm’s length standard. Consequently, it is actually contributing to the sustainability of this standard. In order to explain this better, it is important to illustrate how states have always been very creative at masking the weaknesses of the arm’s length principle with complementary policy measures.

CFC-legislation is without a doubt the most widely accepted camouflage strategy in this regard. It serves as a ‘backstop’ that covers up the weaknesses of the arm’s length standard. This camouflage technique is currently being taken to the next level in the discussions about the taxation of the digital economy in the BEPS 2.0. project. The likely support of a significant group of states for the minimum tax (i.e. the global anti-base erosion proposal) will guarantee the future of the arm’s length standard. In other words, a firm stance on harmful tax competition (i.e. pillar 2) is able to camouflage the weaknesses of the arm’s length standard as the foundation to tax multinational companies.

The development of EU fiscal state aid control into a camouflage mechanism

It is this very same mechanism that is currently at work in the domain of EU fiscal state aid control. The European Commission is successfully reverting to an instrument to tackle harmful tax competition to camouflage a fundamental weakness of the arm’s length standard. This weakness concerns the fact that the standard relies to a great extent on self-regulation by the taxpayer[4].

The OECD Transfer Pricing Guidelines lay down procedures in the form of a step-plan (i.e. para 3.4 of the current Guidelines), but eventually it is up to the taxpayer to set the arm’s length price. This very character of the arm’s length standard implies that the multinational taxpayer enjoys a certain freedom to allocate profits amongst states. It also implies that the tax authorities are always one step behind in comparison to the starting point of the taxpayer. States in the European Union could potentially take advantage of their disadvantaged position when taxpayers, such as FIAT or Starbucks, apply for a tax ruling. Such states could attract investments at the expense of other EU Member States when they would accept the (favorable) transfer pricing positions of the taxpayer without much further ado.

The European Commission, as currently supported by the General Court, is trying to prevent this kind of behaviour of EU Member States. It wants to ensure that states exercise sufficient control on the process of allocation of the tax base. It is therefore not the eventual allocation of taxing rights that matters, but the fact that every Member State should exercise sufficient control on the process of allocating the tax base. Unfortunately, the current decisions of the General Court are not providing sufficient guidance on the criteria that should supervise this allocation process. The relationship between the relevant “tool”, i.e. the arm’s length principle that is indeed an intrinsic part of article 107 TFEU, and the actual application of that “tool” is still insufficiently clear and coherent. We should therefore hope that the ECJ will be able to draw a more precise line between the acceptable and unacceptable behaviour of Member States. The goal should be, as I have written[5] before, to target only those states that have been actively and intentionally involved in strategic rent-shifting. Such a ruling is very much needed in order to take away the concerns about the legitimacy of EU fiscal state aid control[6].

Nevertheless, there is little doubt to me that EU fiscal state aid control is gradually evolving into a mechanism that is able to camouflage a significant weakness of the ALP standard. In this way, it is not very much different from CFC-legislation and the proposed minimum tax. The only truly revolutionary aspect is that in this case it is not the states themselves, but a supra-national institution (i.e. EU fiscal state aid control) that is supporting the sustainability of the arm’s length nature. Given the particular nature of the problem at hand that is however a logical step in the institutional development of EU tax governance. Those who were afraid that the European Commission was trying to force a breakthrough towards C(C)CTB should therefore not worry. The current state aid developments are enforcing the hegemony of the arm’s length standard and as such they are making the transition towards truly different allocation mechanisms only more difficult!

[1] Peters, C. (2019). Transfer pricing en winstbepaling: van zelfregulering naar ‘command and control’-regulering. Fiscaal ondernemingsrecht, (163.2), 92-98.

[2] Katharina Holzinger & Christoph Knill (2005) Causes and conditions of cross-national policy convergence, Journal of European Public Policy, 12:5, 775-796, DOI: 10.1080/13501760500161357

[3] Katharina Holzinger & Christoph Knill (2005) Causes and conditions of cross-national policy convergence, Journal of European Public Policy, 12:5, 775-796, DOI: 10.1080/13501760500161357

[4] Peters, C. (2019). Transfer pricing en winstbepaling: van zelfregulering naar ‘command and control’-regulering. Fiscaal ondernemingsrecht, (163.2), 92-98.

[5] Peters, C. (2019). Tax policy convergence and EU fiscal state aid control: In search of rationality. EC Tax Review, 28(1), 6-17

[6] Peters, C. (2019). The legitimacy of EU fiscal state aid control: What is your legitimation narrative? In C. De Pietro (Ed.), New perspectives on fiscal state aid: Legitimacy and effectiveness of fiscal state aid control (pp. 5-30). (EUCOTAX Series on European Taxation). Alphen aan den Rijn: Kluwer Law International BV.


 

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