Part 1 - AL-Tax

Chapter 7AbstractGiven the arm’s length principle as proposed by the OECD Model Tax Convention, the typeand structure of arm’s length analysis on transfer pricing between related parties of a multinationalgroup depends upon the economic nature of the related-party transactions considered.Many documentation projects for the tax purpose of cross-border income allocation aresolely based on a database-driven margin analysis to estimate arm’s length transfer prices.However, this type of analysis often does not reflect the economics in the functional patternof related-party transactions, especially if the functions considered along the value chains ofthe multinational group of corporate taxpayers vary in complexity, integration, and density.In order to account for the functional complexity, integration, and density in different typesof transfer pricing situations, we propose to measure two dimensions of functional scope.The feature ‘functional type’ makes reference to the economic difference between (a) riskinsurable (or insured) and (b) uncertainty managed by the entrepreneur. The feature ‘functionaldensity’ measures the degree of comparability of a given functional pattern of relatedparties with an arm’s length dealings situation. The chapter shows that a model to characterizethe ‘function’ can improve our approaches on valuation, which is an incremental partof transfer pricing documentation and the arm’s length analysis.7.1 IntroductionSeveral countries have introduced transfer pricing documentation provisions in thelast decade as an enforcement mechanism on the tax jurisdictional level so that taxauthorities can audit the taxable income of related-party taxpayers. The internationalprinciple underlying such audits is the so-called ‘arm’s length principle’ asproposed in Article 9 of the OECD Model Tax Convention (OECD 1995a, b; Feldsteinet al., 1995). A key feature of documentation requirements is the arm’s length analysisfor transactions between related-party taxpayers of multinational corporategroups. Related-party taxpayers are requested to deploy the arm’s length analysis inorder to establish a traceable reasoning on the nature, appropriateness, and pecuniaryvalue of transfer prices for such related-party transactions. While the factualcase documentation is often referred to as ‘paperwork’, with the notion of providingthe tax auditor with relevant documents and descriptions, the arm’s length analysisis analytical. However, in practice, the arm’s length analysis is often reduced to asimplified model of margin comparisons. Subject to the economic conditions andfactual case pattern, however, alternative important features of an arm’s length testcan be the so-called value chain analysis and/or the budget-actual assessment.In order to achieve the arm’s length analysis, the first step is the characterizationof the multinational’s functional units regarding their economic nature and activity.The characterization is necessary for the choice of the most appropriate arm’s length149