Tax Treaty Series

ITQ T-

040

April 24, 2020

Question

ACo (a company resident in A) and BCo (a company resident in B) are sister subsidiaries in the global XYZ group.

ACo carries on a mining business in A. It sells (and exports) minerals to BCo for prices which the XYZ group believes comply with the arm's length principle ("ALP").

A's tax law includes transfer pricing provisions which deem the price of exported minerals according to a schedule. The scheduled prices for ACo's mineral exports exceed the price which would be determined under the ALP.

The A tax authorities increase ACo's taxable profits to reflect the scheduled prices for mineral exports.

Q1: The A/B treaty is identical to the 2014 OECD model treaty. Does the A/B treaty prevent A from applying the scheduled prices to ACo's mineral exports?

Q2: Would your answer change if the A/B treaty were identical to the 2017 OECD model treaty?

Answer

Q1:

Threshold issue: what is the effect of Art. 9(1) on cross-border transactions between associated enterprises? Is it:

“permissive” only – i.e., it permits Contracting States (CS) to apply domestic law to adjust taxable profits to satisfy the ALP; or
“restrictive” only – i.e., it prohibits CS from applying domestic law to adjust taxable profits to an amount which exceeds the arm’s length profit; or
both “permissive” and “restrictive”?

This is a controversial issue. However, the majority support (case law, academic articles, tax administrations, and the OECD Commentary) is for either (ii) or (iii). That majority support is catalogued in a recent article: Georg Kofler & Isabel Verlinden, “Unlimited Adjustments: Some Reflections on Transfer Pricing, General Anti-Avoidance and Controlled Foreign Company Rules, and the ‘Saving Clause’ ”, Bulletin for International Taxation, IBFD, 2020 (Volume 74), No. 4/5.

Adopting that majority view: Art. 9(1) would prevent A from adjusting ACo’s taxable profits to an amount which exceeds the arm’s length profit.

Q2:

Another controversial issue: what is the interaction between Art. 9(1) and Art. 1(3), in view of the fact that Art. 9(1) is not listed in the exceptions to Art. 1(3)?

Arguably, Art. 1(3) prevents the “restrictive” operation of Art. 9(1) in regard to residents. This point is discussed in the above-mentioned article by Kofler & Verlinden.

If that view is correct, Art. 9(1) would not prevent A from adjusting ACo’s taxable profits to an amount which exceeds the arm’s length profit.

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