European Commission proposes transfer pricing directive

On 12 September 2023, the European Commission (the “Commission”) published a Proposal for a council directive on transfer pricing to harmonise rules within the EU as part of its Business in Europe: Framework for Income Taxation (BEFIT) package.

Even though many EU member states already apply OECD rules on transfer pricing, the proposals are for a common and uniform application of the arm’s length principle and key transfer pricing rules by all member states.

Background

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD guidelines”) have been developed over many decades to provide guidance to businesses and tax authorities on the meaning and application of the arm’s length principle. In the EU, most member states commit to applying the OECD guidelines, but their status and the way they are interpreted and applied is not consistent. The Commission’s proposal seeks to create more certainty for businesses by ensuring a common application of some core transfer pricing principles across the EU. It is intended that these will be supplemented, at a later stage, with the development of common transfer pricing approaches to certain transactions.

The proposed directive would apply to all taxpayers that are registered for, or subject to, tax in one or more member states, including through permanent establishments.

Overview of the proposed directive

The proposed directive contains 22 Articles including:

1. Subject matter
2. Scope
3. Definitions
4. General rule on the application of the arm’s length principle
5. Associated enterprises
6. Corresponding adjustments
7. Compensating adjustment
8. Identifying the commercial or financial relations
9. Transfer pricing methods
10. The most appropriate method rule
11. Comparability analysis
12. Determination of the arm’s length range
13. Transfer pricing documentation
14. Application of the arm’s length principle
20. Transposition.

Associated enterprises

Domestic laws of member states have different definitions of ‘associated enterprises’ for the purpose of determining when entities are connected such that transfer pricing rules apply. The Commission suggests that this can create uncertainty for businesses and may lead to tax disputes. The proposal defines associated enterprises with reference to a 25% threshold for voting rights, capital participation or entitlement to profits. It also clarifies that a permanent establishment is to be considered an associated enterprise of the head office.

Arm’s length principle

The proposed directive requires member states to apply the arm’s length principle to determining taxable profits from cross-border commercial or financial transactions between associated enterprises. Under this principle, if such a transaction does not result in the same outcome that it would if it were between independent parties, any profits that have not accrued to an enterprise due to the non-arm’s length condition, should be included in its taxable results.

Adjustments

Rules are proposed on how member states should deal with corresponding adjustments to alleviate double taxation where there has been a primary adjustment made in another member state or a non-EU treaty country. The proposal is that corresponding adjustments should not be limited to cases when a treaty mutual agreement procedure (‘MAP’) has been initiated, but should also be available, for example, at the business’s request or following a joint audit. Where a business requests (with supporting information and evidence) for a corresponding adjustment to be made, the proposal sets out timeframes for communicating with the business and, if double taxation arises from the primary adjustment, requires the procedure to be concluded within 180 days.

Member states may perform a downward transfer pricing adjustment in the absence of a primary adjustment but only if:

• the adjustment amount is consistent with the arm’s length principle;
• the adjustment amount is included in the profit of the associated enterprise in the other country;
• the profits are, absent the adjustment, subject to double taxation; and
• the member state performing the downward adjustment has communicated the adjustment to the other country including all relevant factual and legal circumstances.

Finally, the proposal sets out conditions under which a compensating year-end adjustment initiated by a business is to be accepted. (A compensating adjustment, sometimes called a ‘year-end adjustment’, is one that a business makes in its tax return to produce an arm’s length result but where this differs from the amount actually charged).

Selection of transfer pricing method

The proposal states that the arm’s length price to be charged between associated enterprises is to be determined under one of the five common transfer pricing methods set out in the OECD guidelines:

• comparable uncontrolled price method;
• resale price method;
• cost plus method;
• transactional net margin method; and
• profit split method.

However, if it can be demonstrated in a satisfactory manner that none of these methods is appropriate in the circumstances, member states are required to allow any other valuation method if it produces a more reliable estimate of the arm’s length price.

The proposed directive requires that the most appropriate transfer pricing method for a particular case should always be used and sets out the criteria to be considered in the selection.

Under the proposal, application of the arm’s length principle should start with accurate delineation of the actual transaction between the associated enterprises by analysing the contractual relations between the parties in combination with their actual conduct. To the extent that the conduct or other facts are inconsistent with the written contract, the parties’ conduct should be taken as the best evidence of the transaction(s) actually undertaken. In order to test whether an arm’s length result is produced, the conditions and economically relevant circumstances of transactions between associated enterprises should be compared with those of comparable transactions in independent circumstances. The proposed directive also lists factors to be considered to determine whether transactions are comparable.

Arm’s length range

Where the application of the most appropriate method produces a range of results, the proposal sets out that the arm’s length range is to be determined using the ‘interquartile range’ (the range between the 25^th and 75^th percentile of the results derived from comparable independent data). A business using a price within this range should not be subject to adjustments unless the business or the tax authority can prove that a different point in the interquartile range is more appropriate. If the results are outside the interquartile range, an adjustment must be made to the median (i.e. 50^th percentile of the results of the comparable transactions) unless it can be proved that a different point is more appropriate.

Documentation

The proposed directive requires that businesses have ‘sufficient information and analysis’ to verify application of the arm’s length principle, at the minimum covering:

• identification of commercial or financial relations between associated enterprises (delineation of the transactions);
• application of transfer pricing methods;
• selection of the most appropriate transfer pricing method;
• comparability analysis; and
• determination of the arm’s length range.

The Commission will have powers to adopt further rules specifying transfer pricing documentation, including common templates, language requirements and timelines.

Further common rules

The proposed Directive also gives powers to the Commission to develop further common binding rules for certain transactions between associated enterprises. These rules are intended to give businesses a clear view of what EU tax authorities would consider acceptable for specified transactions and provide ‘safe harbours’. The Commission expects these to reduce the compliance burden for businesses as well as the number of disputes. The specified transactions are:

• transfer of intangibles, including hard-to-value intangibles;
• provision of services, including marketing and distribution;
• cost contribution arrangements;
• transactions in the context of business restructurings;
• financial transactions; and
• dealings between a head office and its permanent establishments.

Link to the OECD guidelines

The proposed directive requires member states to ensure that their national law on transfer pricing is consistent with the OECD guidelines. The proposed directive refers to the January 2022 version of the OECD guidelines. Any future amendments to the OECD guidelines are to be incorporated into the EU legislative framework, subject to EU approval.

Next steps

There will be a public consultation on the proposed directive (the deadline for responding will depend on how soon the proposal can be translated into all EU languages). As a tax measure, the proposed directive requires unanimous approval by all member states. If adopted by the Council the proposal is that the directive would apply from 1 January 2026.