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 units, with a corporate tax rate of 30%, resulting in 30 units 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 units. This reduces the pre-tax profit in Country A from 100 units to 0, eliminating its income tax liability. Meanwhile, the Country B company’s pre-tax profit rises to 100 units, but because the tax rate is 0%, no income tax is paid. Before tax planning, the two companies collectively paid 30 units 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 units, the tax authority in Country A would only allow a deduction of 10 units instead of 100. Consequently, the pre-tax profit in Country A would increase from 0 to 90 units, raising the tax liability from 0 to 27 units, 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 units.

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.