The other directive proposal concerns “Business in Europe: Framework for Income Taxation” (“BEFIT”). This proposal aims to improve efficiency for both corporate income taxpayers and tax authorities by introducing a new, single set of rules to determine the tax base of (European) groups of companies. This proposal will be further elaborated upon in a separate blog.
1. At arm’s length principle
The TP Directive acknowledges the at arm’s length principle as the international standard prescribing that associated enterprises must transact with each other as if they were independent third parties. This recognition is in line with the current OECD standards for TP.
According to the proposal, cross-border intragroup transactions that deviate from the at arm’s length principle must be adjusted. Since cross-border intragroup transactions influence the profit level of the involved entities, this should better enable Member States to receiving their “fair share” of the overall tax base.
2. Associated enterprises
Currently, Member States apply different rules on whether an enterprise is associated or not. The Directive however seeks to harmonize the definition of an associated enterprise as a person (or company) who is related to another person because:
1. a person participates in the management of another person by being in a position to exercise a significant influence over ethe other person;
2. a person participates in the control of another person through a holding that exceeds 25 % of the voting rights;
3. a person participates in the capital of another person through a right of ownership that, directly or indirectly, exceeds 25 % of the capital;
4. a person is entitled to 25 % or more of the profits of another person.
Additionally, a permanent establishment shall be considered an associated enterprise of the enterprise of which it is a part.
3. Transfer pricing methods
The TP Directive prescribes that in principle one of the OECD transfer pricing methods should be used. These methods are a) the comparable uncontrolled price method, b) the resale price method, c) the cost-plus method, d) the transactional net margin method or e) the profit split method. An alternative method may be used if none of these methods are appropriate, as long as it aligns with the arm's length principle. The TP Directive also outlines rules for selecting the most appropriate method.
4. Various transfer pricing methods and determining the transfer pricing methods
The TP Directive acknowledges that TP adjustments can be classified in two categories:
a. those made by a relevant Tax Authority; or
b. those made by a taxpayer.
4.1 category a
With category a, there is first the primary adjustment. This adjustment of an incorrect transfer price, made by a Member State, increases the taxable profit in that Member State. A corresponding adjustment in the other Member State may be required to avoid double taxation. This can be illustrated by the following example.
Company A in state A sells a machine to an associated enterprise, company B, in State B for 100. The fair market value of the machine is 30. State B therefore corrects the price to 30 (the primary adjustment). Without a corresponding adjustment, this would possible lead to double taxation on 70. In state A an income of 100 is reported, while in State B only 30 costs are deductible. A corresponding adjustment therefore lowers the income in State A to 30.
When there is no doubt that the primary adjustment is well founded or in case of joint audits, a fast-track procedure should result in a corresponding adjustment within 180 days. A corresponding adjustment can also be made based on a double tax treaty or mutual agreement procedure (MAP).
When applying the most appropriate method (as referred to in paragraph 3) produces a range of figures, the arm’s length range must be determined using the interquartile range. The interquartile range is the range from the 25th to the 75th percentile of the results derived from the uncontrolled comparables. A Member State is in principle not authorized to make a correction if the at arm’s length range falls within the interquartile range (from the 25th to the 75th percentile of the results derived from the uncontrolled comparable), unless the Member State can prove that a specific different positioning in the range is justified by the facts and circumstances of the specific case. This can also be applied by the taxpayer.
Additionally, under strict conditions, a Member State can make a downward adjustment in absence of a primary adjustment.
4.2 category b
If taxpayers make a voluntary adjustment prior to filing its corporate income tax return and subject to other requirements, the Directive obligates a Member State to make a compensating adjustment.
5. Documentation requirement
Further guidance on the documentation requirements will be provided in a later stage. However, the TP Directive already obligates Member States to ensure that taxpayers will have sufficient administration in respect of their intercompany transactions and the at arm’s length nature of these transactions.
6. Common rules
The European Commission should also provide for further common rules according to the Directive. How these rules are determined and to which extent Member States will have influence on this (voting with unanimity) is unclear.
• The European Commission acknowledges that transfer pricing mismatches exist within the European Union.
• This proposal may reduce the complexity of procedures to avoid double taxation as a result of these mismatches. However, we expect that there will still be room for a significant amount of views on the appropriate transfer pricing method and ultimately applied price and therefore we conclude that issues around double taxation as a result of transfer pricing mismatches will not completely disappear.
• The European Commission continues its focus on tax and transfer pricing and seems to want to have more control over how Member States apply transfer pricing rules.