BEPS Actions 8-10: Transfer Pricing and Value Creation

One of the most crucial concepts in international taxation is Transfer Pricing (“TP”). TP requires that the pricing of transactions between related parties must align with comparable transactions between independent third parties. In other words, related-party pricing should match market prices to prevent multinational corporations from artificially shifting taxable profits from high-tax jurisdictions to low-tax jurisdictions. Let’s illustrate this with an example:

A company in Country A earns a pre-tax profit of $100, with a corporate tax rate of 30%, resulting in $30 of income tax. A related company in Country B, located in a tax haven with a 0% tax rate, provides services (e.g., management services) to the Country A company and charges $100. This reduces the pre-tax profit in Country A from $100 to $0, eliminating its income tax liability. Meanwhile, the Country B company’s pre-tax profit rises to $100, but because the tax rate is 0%, no income tax is paid. Before tax planning, the two companies collectively paid $30 in taxes; after tax planning, they pay nothing.

Under TP regulations, the service fee charged by the Country B company must reference the pricing of similar services between independent third parties. If the market value of the management service is only $10, the tax authority in Country A would only allow a deduction of $10 instead of $100. Consequently, the pre-tax profit in Country A would increase from $0 to $90, raising the tax liability from $0 to $27, thereby minimizing the impact of tax avoidance.

While tax authorities can use TP rules to combat tax avoidance, businesses often exploit loopholes through sophisticated arrangements. For example, the Country B company might artificially take on more functions (e.g., substantial management roles), allocate more assets (e.g., holding equity in the Country A company), and assume more risks (e.g., bearing the operational and financial risks of the Country A company). These changes could increase the market value of the services from $10 units to $100.

To counter such strategies, BEPS Actions 8-10 aim to accurately delineate corporate structures and transactions, identify the actual risks borne and economic activities performed by related entities, and ensure accurate pricing. Specific improvements in TP include:

• Arm’s Length Principle
• Transactional Profit Split Method
• Intangibles
• Low Value-Adding Intra-group Services
• Cost Contribution Arrangements

This article will analyze these five aspects in detail.

I. Arm’s Length Principle

1. How Companies Exploit the Arm’s Length Principle

TP rules prevent companies from artificially pricing transactions to shift taxable profits from high-tax jurisdictions to low-tax jurisdictions. The Arm’s Length Principle requires that related-party transactions be priced similarly to those between independent third parties. However, multinational corporations often manipulate transaction structures to comply with the principle while still achieving tax avoidance. Let’s look at two examples:

Case 1: Artificially Increasing Risk in a Tax Haven Entity

Company A operates in a high-tax jurisdiction with a 25% tax rate. Company B, a related entity, is located in a tax haven with a 0% tax rate. Company A sells goods directly to customers, earning a profit of $100, which results in $25 of tax. To reduce taxes, Company A arranges for Company B to act as an intermediary: Company A sells to Company B, which then sells to the end customer. After restructuring, $20 of profit remain with Company A, while $80 are shifted to Company B. Company A pays $5 in tax, and Company B pays nothing. The total tax liability drops from $25 to $5.

The tax authority in Country A may challenge this arrangement under the Arm’s Length Principle by examining whether the transfer price between Company A and Company B is reasonable. Upon investigation, if Company B is found to be a mere shell company, it may only retain $5 of profit under TP rules. The tax authority would then adjust Company A’s taxable profit from $20 to $95, increasing its tax liability from $5 to $23.75.

To counter this, Company A might use contractual arrangements to shift more operational risks to Company B, enabling Company B to retain more profit even under the Arm’s Length Principle. Examples of such risk-shifting arrangements include:

• Company B assumes responsibility for product warranties.
• Company B handles customer service.
• Company B bears the cost of product returns.
• Company B assumes the risk of customer non-payment.
• Company B manages marketing activities.

Case 2: Artificially Increasing Leverage in a Tax Haven Entity

Company C operates in a high-tax jurisdiction with a 25% tax rate, earning a pre-tax profit of $100 and paying $25 in tax. To reduce taxes, Company C arranges for Company D, located in a tax haven with a 0% tax rate, to lend it $1,000 at a 10% interest rate. The $100 interest payment eliminates Company C’s taxable profit, while Company D pays no tax on the interest income.

To combat this, the tax authority in Country C may challenge the reasonableness of the interest rate under the Arm’s Length Principle. If a market comparison shows that a 3% interest rate is appropriate, the deductible interest is reduced from $100 to $30. Company C’s pre-tax profit is adjusted from $0 to $70, resulting in a $21 tax liability.

In response, Company C might extend the loan term (e.g., from one year to five years), remove all collateral, or increase Company D’s debt-to-equity ratio. In open markets, longer loan terms, fewer guarantees, and higher borrower leverage typically result in higher interest rates. Under TP rules, this could artificially increase the deductible interest expense.

2. BEPS Actions 8-10 Recommendations

To address these tax avoidance strategies, BEPS Actions 8-10 propose aligning TP outcomes with value creation. Key measures include:

1）Value Creation Must Align with Genuine Risk

In the case of Company A, the risks assumed by Company B may be nominal rather than real. For example: If Company B cannot control risks, make decisions, or bear financial responsibilities, it has not created substantive value and should not retain significant profits.

• Can Company B lower prices to boost sales if product demand is weak?
• Does Company B have the freedom to choose its customers?
• Can Company B compensate customers for claims?

2）Value Creation Depends on Actual Conduct

Even if Company A legally transfers risks to Company B, if Company A assumes the risks in practice, Company A should be considered as controlling the risks. BEPS emphasizes accurately identifying the actual conduct of related entities and the economic substance of transactions.

3）Value Creation Relates to Functions and Substantiality

In the loan example, if Company D does not perform the functions of a lender or lacks economic substance, it should only earn a Risk-Free Return (e.g., government bond rates) rather than any interest rate above that.