A Change in Transfer Pricing Rules No One Can Ignore: Pillar One Amount B Is About to Come Online

On September 1, 2023, Kroll submitted to the Inclusive Framework (IF) and the Organization for Economic Cooperation and Development (OECD) comments concerning the Public Consultation (PC) draft published in July 2023. The PC draft reported to stakeholders the improvements made by the IF in designing Pillar One Amount B (Amount B) over its last version published in December 2022. In general, Pillar One Amount B seeks to simplify and streamline the application of the arm’s length principle (ALP) to so-called “baseline marketing and distribution” functions, increasing legal certainty and decreasing compliance costs, without diminishing the arm’s length nature of Amount B returns provided by the IF in a pricing matrix.

A very important aspect of Amount B is the scope of its application. It is currently envisioned that Amount B would apply to baseline distributors for whom a one-sided transfer pricing method (TPM) is appropriate. A one-sided transfer pricing method is appropriate for distributors operating businesses in a competitive market, with little to no barriers to entry. Distributors engaged in functions other than baseline marketing and distribution are likely to be out-of-scope Amount B unless their financial statements can be reliably segmented by functions and unless they do not contribute valuable intangible assets or functions in distributing their products. Baseline distributors include sale agents and commissionaires often used by multinational companies, particularly, in civil law countries.

In its comments, Kroll noted that the approach by the IF of specifying “in-scope” criteria should not be provided in the “methods” sections of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (TPG), which include Chapter II to Chapter X, and will “host” the Amount B “method,” but should rather be provided in Chapter I. The appropriateness of a one-sided TPM, which, according to the PC draft informs the Amount B in-scope nature of a distributor is controlled by guidance at Chapter II of the OECD TPG, which requires a full functional analysis and accurate delineation of the controlled transaction under Chapter I of the OECD TPG. Specifically, it is directly determined by (i) the competitiveness of the uncontrolled market wherein the controlled transaction would unfold at arm’s length and (ii) the information structure in that uncontrolled market (symmetrical or asymmetrical). Both (i) and (ii) are critical elements of the accurate delineation of a controlled transaction under Chapter I of the OECD TPG. Moreover, such guidance is applicable to any and all applications of the ALP to any and all controlled transactions (not just distributors).

Kroll notes that competitive markets are markets featuring symmetrical information and are markets wherein the Law of One Price (LoOP) holds. The LoOP states that the same item of property is exchanged, in a specific market, at one price and one price only. Such markets wherein the LoOP holds are such that the value of the best realistic alternative the controlled buyer has to transact with an alternative uncontrolled seller is equal to the value of the best realistic alternative the controlled seller has to transact with an alternative uncontrolled buyer. All transactions, including all realistic alternative transactions to a specific transaction, clear at the same unique price of the market. However, markets that are inefficient due to fragmentation, for example, are markets featuring asymmetrical information and are markets wherein the LoOP does not hold. The same item of property can go for different prices. Such markets wherein the LoOP does not hold are such that the value of the best realistic alternative the controlled buyer has to transact with an alternative uncontrolled seller is different with probability one from the value of the best realistic alternative the controlled seller has to transact with an alternative uncontrolled buyer.

An example of a competitive market is the market for certain undifferentiated commodities such as certain metals, grains or crops. These markets are not perfectly competitive, but they are competitive enough for the LoOP to approximately hold. An example of a fragmented market is the market for intellectual property rights to “further develop” intellectual property. This market comprises a large and constantly evolving number of temporary submarkets made by a potential buyer and a potential seller negotiating a deal. The price of the transaction is settled by negotiation of the parties, under their different information sets (asymmetrical information). Other market participants are often unaware of the existence of most of these submarkets because of the secrecy that typically surrounds the negotiation of intellectual property rights. What that means is that a potential buyer negotiating a deal with a potential seller does not know the prices at which the potential seller could realistically transact at with alternative buyers, neither does that potential buyer know the best price offer it could receive from any other potential sellers it has not yet negotiated with. Buyers and sellers use their private information sets strategically.

Therefore, in a competitive uncontrolled market, all market participants know that the price of the best realistic alternative transactions in that market with any alternative counterparty is the unique market clearing equilibrium price of that market. However, in a fragmented market wherein prices are settled by negotiation, the only price information a market participant has is the price it has negotiated with counterparties. Negotiating a deal is costly and shopping around for a better deal, in a fragmented market, is limited by the extent of the marginal cost of negotiation relative to its expected improvement in the deal received as an outcome of a marginal negotiation. Shopping around in a competitive market is useless as it is costly but does not yield a “better price” from the unique market price.

Therefore, in its comments, Kroll urged the IF to provide guidance at Chapter I of the OECD TPG that connects (i) the mandated application of the realistic alternatives principle (RAP) to controlled transactions in an application of the ALP, (ii) the informational structure of the uncontrolled market wherein the controlled transaction would unfold at arm’s length, (iii) the mechanism by which a price forms or prices form in that uncontrolled market, (iv) the accurate delineation of a transaction under Chapter I of the OECD TPG, and (v) the determination whether a one-sided TPM is appropriate informing the applicability of Amount B. Kroll noted that (i)-(v) applies to any and all controlled transactions, whether distribution or other, and is extremely important guidance currently lacking at Chapter I of the OECD TPG.

Based on Kroll’s discussions with clients, such additional guidance would prove extremely valuable, not only in the context of Amount B but also in the broader context of the application of the ALP to other controlled transactions. It is often the case that controlled transactions that would unfold in a fragmented market (negotiated prices) are treated, for transfer pricing purposes, as unfolding in a competitive market. This is particularly true for intellectual property transactions concerning rights to “further develop” intellectual property. None of the analyses typically performed in the transfer pricing analysis address the negotiated nature of the price and relate it to the different information sets of the buyer and the seller. This is often in contravention of paragraphs 9.12 and 9.30 of Chapter IX of the OECD TPG. Paragraph 9.12 mandates the application of the RAP “at the level of each of them,” (meaning separately for the buyer and for the seller because of potentially different values), and paragraph 9.30 mandates the consideration of the realistic alternative not to transact.

Another important aspect of Amount B is its asserted “safe harbor” nature. The OECD TPG provides a “blueprint” of what a safe harbor should look like, allowing taxpayers to elect such safe harbor if they so desire. The PC draft does not specify whether taxpayers will have a choice to elect Amount B if in its scope, or whether they will be mandated to elect the Amount B methodology if found in its scope. Making the “safe harbor” elective to taxpayers and elective to tax administrations is equivalent, as a practical matter, to making it mandatory. Kroll commented on the December 2022 PC draft that it is important to issue Amount B guidance that conforms with the OECD TPG’s own prescriptions about what a safe harbor should look like, which means making it elective to taxpayers only. Kroll maintained its position in its comments to the July 2022 PC draft. Input from our clients has been unanimous. Many clients with baseline distribution entities, often referred to as Limited Risk Distributors (LRD), have developed over the year a transfer pricing system that works, provides sufficient legal certainty, is cost effective, and has been in place for a long time. Such companies should have the right to maintain the status-quo and not be forced to incur the costs associated with a change in TPM. These costs are not limited to the development of transfer pricing reports under a new TPM; companies may have to access their ERP systems and re-code how invoices are issued, and at what price, which can be very expensive to do. Many clients noted that on a relative basis distribution entities are typically not causing their tax departments the most audit concerns and transfer pricing exposure. Baseline distribution activities by LRDs are typically handled by way of a Transactional Net Margin Method with comparable companies that are of reasonable to good quality for purposes of a reliable application of the ALP. Therefore, Kroll reiterated its request to the IF to make Amount B elective by taxpayer only.

Many taxpayers are likely to have distributors that perform baseline distribution functions but also perform other routine-type functions (e.g., provision of services). The IF requested input from stakeholders concerning a scoping criterion that would only allow distributors that incur operating expenses in total costs less than a certain percentage (tentatively set at 30%) to be deemed in-scope Amount B. Kroll disagreed with the approach. Kroll noted that the notion that it would be unreliable to segment an income statement between a distribution function and another function solely because of the size of the operating expenses subject to an allocation to each function is flawed. To illustrate that point, Kroll developed a simple numerical example of two distributors similar to each other in every possible way, other than the value of the product they each distribute. The number of units of products distributed is the same, and the operating expenses required per unit distributed is the same. The only difference is in the per unit sale price of each unit also reflected in the per unit cost of goods sold of each unit. Both distributor is assumed to earn the same operating margin on their distribution function. In addition to distribution functions, each is assumed to perform routine services (or some other routine function) and incur the same costs and the same income for these services. If it is reliable to segment the income statement of one of these distributors, it is reliable to segment the income statement of the other. Because the one distributing the more valuable product will have cost of goods sold well in excess of the other distributor; it will also have a much smaller ratio of operating expenses to total cost. In the example developed by Kroll, the distributor of the more valuable product (saffron) has a ratio of operating expenses to total cost below 30%, but the other distributor (widgets) has a ratio in excess of 30%. This inclusion in Amount B of one distributor but not of the other is a “false negative” that is problematic. The IF conflated reliability of segmentation with the size of the quantum being allocated; one is not necessarily a proxy for the other. The reliability of a segmentation should, instead, be examined in the context of a full functional analysis and accurate delineation of the transaction. It should be a determination that is facts and circumstances driven by an application of Chapter I of the OECD TPG and not left to a quantitative financial criterion (financial ratio) that, in and of itself, has little to do with the reliability of a segmentation.

Finally, Kroll commented on the inclusion in the Amount B pricing matrix of risk-premia for geopolitical and other geographic risk factors related to doing business in certain higher-risk jurisdictions. Kroll refrained from taking any specific position but warned the IF that while it may be true that carrying out business in certain countries may be riskier, it is also often the case that these riskier countries have much less developed and competitive markets, resulting in higher costs of doing business and “leakage” of value caused by market inefficiencies. First, this observation, when placed in the context of our previous discussion concerning “market structure,” means that an uncontrolled market may be sufficiently competitive in a low-risk country to support the appropriateness of a one-sided TPM, but the same uncontrolled market, in a higher-risk jurisdiction, may not. Countries wherein bribes, kickbacks and other forms of non-market fees must be paid to conduct business are more inefficient. Moreover, transparency often lacks in these higher risk countries, resulting in different market participants having different information sets. Thus, the same distributor operating in a low-risk country in-scope Amount B may not be in-scope Amount B in a higher-risk country when the Amount B scoping criteria are applied. Geopolitical differences not only cause potentially different returns to the same function but also, they could cause different conclusions as to the in-scope nature of a distributor. Kroll also noted that the IF should think hard about the incentives given to high-risk countries if allowed to require a greater return in their jurisdiction than otherwise allowed in low-risk countries. These greater returns yield greater tax revenue for these countries, which is the exact opposite incentive from incentivizing these countries to lower corruption, increase market transparency, and decrease inefficiencies and fragmentations.

The OECD and IF are aiming to finalize Amount B by the end of the 2023 calendar year. Significant progress has been made in the July 2023 PC draft relative to its December 2022 version. A few specific technical issues need to be resolved but the general notions of (i) determining the in-scope nature of a distributor and (ii) assigning a return to an in-scope distributor based on a few financial ratios (asset to sales and operating expense to sales) by way of a pricing matrix (the idea of econometric regressions has been abandoned), appear to have been decided. Stakeholders have a very short window left to influence the final Amount B guidance expected to be incorporated in the OECD TPG.

Kroll has been monitoring the evolution of the IF progress concerning Amount B since the beginning of the work by the IF and Working Party 6 (transfer pricing) at the OECD. Kroll has provided input to the IF and to U.S. delegates at the OECD. Our managing directors are available upon request for further discussions concerning Amount B, its consequences and its implementation.