Part 1 - AL-Tax

International Taxation Handbooktest model (i.e. price or margin test, value chain analysis, budget-actual analysis).The OECD Guidelines (OECD, 1995b) on transfer pricing and income allocation aswell as national provisions and/or tax authority-internal guidelines for documentation– as, for instance, in the USA, Germany, UK, or France – deem the economicnature and activity decisive for the type and model of arm’s length analysis. Forexample, in the prevailing transfer pricing language, whether a function is characterizedas ‘routine’ or ‘nonroutine’ determines the use of the most suitable transferpricing method, which itself may have impacts on the arm’s length nature, and size,of a given transfer price to be tested. 1In this chapter we offer an economic model which structures the arm’s lengthanalysis subject to the economic features of the transfer pricing case. Though weillustrate the model in its theoretical dimensions, in practice the model can supporttransfer pricing decision-makers on questions of what type of transfer pricing caserequires what type of arm’s length analysis. For characterizing the entrepreneurialunits involved in the business process of multinational companies, we distinguishbetween two dimensions – ‘functional type’ and ‘functional density’. In our model,the attribute ‘functional type’ measures functional features along the dimensioncontractible risk versus entrepreneurial uncertainty. The attribute ‘functional density’measures along the dimension comparability versus uniqueness. Normatively,we believe – from our own experience – that assessing these two dimensions allowsthe transfer pricing expert to make substantial and economically sound decisions onsuitable arm’s length analysis.The relevance of the question addressed in this article is considerable (cf. Eden,1998; Owens, 1998; European Commission, 2001; The Economist, 2001; OECD,2001, 2005). Cross-border trade in the OECD region is about US$ 15 trillion.Estimates indicate that, depending upon the two countries considered, up to 80% ofsuch trade between two countries takes place within the boundaries of multinationalgroups, i.e. between related-party taxpayers. Transfer pricing ranks numberone among the tax challenges of multinational taxpayers (Ernst & Young, 2005). Toaudit the income allocation assessment of such related-party taxpayers, the USapproach of using database-driven margin analysis is widespread in the transferpricing community. On the other hand, litigation has significantly increased in thelast decade (Walpole, 1999) and litigation periods of 15 years or more are possibleeven in well-functioning legal jurisdictions. 2 Besides the tax risk of income adjustmentimposed by the tax authorities involved in transfer pricing cases, it is the compliancecosts that matter for related parties of a multinational player, especially inthe case of mid-sized group companies. Compliance costs increase significantly ifforeign affiliated operations are involved (Erard, 2001). For the USA, it was reported150