While thinking about BEPS (base erosion and profit shifting initiative of OECD and G-20 countries), it is helpful to remember that the focus of transfer pricing enforcement shifted from tangible property transactions to services, and then to intangibles over the last two decades, and is now moving onto the residual profits (i.e., profits over and above market benchmarks).
Let us also remember the progress made in transfer pricing. Since the 1990s, every tax and finance professional learned, sometimes through a contentious tax authority examination, that every manufacturing or sales subsidiary must report some level of taxable income in its local jurisdiction. Arm’s length profitability ranges, derived from the financials of independent comparable companies, have become common place. Who has not heard the question: “Are we in the range?”
The next were service fee charges and royalties. Both items appear as separate charges on general ledgers. As such tax administrations can challenge them or question their absence more easily. Another sign of progress is that most multinationals cleaned out their act in both regards. Very few, if any, asserts a free exchange of services or intangibles within their multinational group. Each piece of commercial intangible (i.e., an intangible that can potentially be subject to a sale or license in the marketplace) is identified and charged for. Most companies now have adopted policies for tracking intercompany services and charging for them.
While transfer pricing compliance was improving, potential mobility of intangible properties has been a constant concern for tax administrations. Now they are also concerned about the allocation of residual profits, which represent the amount of profits over and above returns attributable to routine business activities and commercial intangibles. In most cases, residual profits represent the competitive edge and efficiencies created by a multinational enterprise and thus a return on their invested capital. Tax administrations do not want to give taxpayers a free hand in the matter of allocating residual profits. They want to tie down the residual profits, ideally, to functions (i.e., employees), or at least to intangibles. They frown upon the concept of putting capital at risk, denying the separation of functions and risks, which has been the bedrock of finance since the time of medieval money dealers. All innovations that occurred in our financial system, from joint stock corporation, public corporation, securitized lending, re-packaging of securities and derivatives have all been about separating functions and risks. Reversing this trend appears to be the linchpin of the BEPS initiative.