draining development.pdf - Khazar University

238 Draining Development?What Is the Arm’s-Length Principle?A simple theoretical constructIn a world of multijurisdictional taxation and multinational enterprises(MNEs) operating across borders, intercompany transactions haveimportant tax implications, primarily because the associated transferprices determine the distribution of profits and tax liabilities by jurisdiction.3 Crucially, however, such transactions are not open-market transactions,which leaves unresolved the issue of the appropriate pricingmechanism (see box 8.1). 4For these cases, the pricing mechanism used most often is the ALPinitially adopted by the OECD in 1979. The appeal of the ALP resides inits theoretical simplicity: simulate the market mechanism and set thetransfer prices as if the transactions had been carried out between unrelatedparties, each acting in its own best interest. This simple constructprovides a legal framework that easily accommodates the two overridingobjectives of an internationally consistent system: governments shouldcollect their fair share of taxes, and enterprises should avoid double taxa-Box 8.1. A Trading Intermediary: A Case of Management Foresight?Background: A large natural resource company has vertically integrated operations in an industrycomprised of a relatively few similarly structured firms and with sales agreements primarily in theform of long-term supply contracts.Business arrangement: An intermediary subsidiary in a low-tax jurisdiction buys 100 percent ofthe company’s production under a long-term contract and resells the product under a mix oflong-term arrangements and spot contracts. The intermediary receives financing from the company,legally holds inventory, and assumes the business risks associated with the negotiating andreselling function.Market developments: Because of unforeseen circumstances, the market changes (in what amountsanalytically to an outward shift of the supply curve), and prices drop. It is during this time that theintermediary is set up. As the reasons for the original supply shift abate and as stronger economicgrowth boosts demand, the market changes again, and prices rise to historical highs.Financial results: With long-term purchase contracts in place, the intermediary’s financial resultsbenefit significantly from the positive developments in the spot market, and, as some of the longtermsales contracts come up for renewal, its financial results improve additionally.Bottom line: Should this outcome be attributed to management foresight (or perhaps fortune)?Should it be considered, ex post, as an example of abusive transfer pricing?