Economic substance in Transfer Pricing
The following article was published on the Kreston Global website, authored by Jelena Mihić Munjić.
In today’s globalised economy, economic substance in transfer pricing plays a critical role in helping multinational companies align their tax strategies with business operations while ensuring compliance.. It enables companies to allocate income and expenses among subsidiaries in different jurisdictions, ensuring operational efficiency and supporting business objectives. At the same time, economic substance provides the necessary foundation for transfer pricing to function as a compliant and sustainable tax tool. These concepts work hand in hand to support sound tax and business practices.
The Transfer Pricing landscape
At its core, transfer pricing involves setting prices for transactions between related entities within a multinational group. These transactions can include goods, services, intellectual property, and financing. The arm’s length principle, which requires related-party transactions to be priced as if they were conducted between unrelated parties, is the international standard governing transfer pricing.
Chapter I of the OECD Transfer Pricing Guidelines provides the foundational principles for applying the arm’s length principle. It emphasizes the importance of analyzing the functions performed, risks assumed, and assets employed by the entities involved in intercompany transactions. This framework underscores alignment between pricing policies and the economic contributions of each entity.
The guidelines also highlight the need for consistency between a company’s operational reality and its transfer pricing practices, which means that economic substance is integral to demonstrating compliance with the arm’s length principle.
Economic substance principle
Economic substance is the principle that ensures the underlying reality of a transaction aligns with its legal and financial structure. Economic substance should strengthen transfer pricing by ensuring that intercompany arrangements are rooted in genuine business activity.
Chapter VI of the OECD guidelines, which addresses the treatment of intangibles, stresses the need to evaluate economic substance when allocating income from intellectual property. It specifies that entities claiming returns from intangible assets must actively contribute to their development, enhancement, maintenance, protection, and exploitation (the DEMPE functions). This ensures that profits are attributed to the jurisdictions where significant value-adding activities occur.
Indicators of economic substance include:
- Functions Performed – Are the parties involved contributing significant value through their roles and responsibilities?
- Risks Assumed – Does the entity receiving income bear meaningful risks, such as market or operational risks?
- Assets Used – Are critical assets, such as intellectual property or equipment, genuinely utilized in the jurisdictions where profits are reported?
By aligning transfer pricing policies with these indicators, companies can create a defensible position that satisfies tax authorities while reflecting real business dynamics.
Hybrid solutions
A complete shift to Formulary Apportionment (FA) which allocates profits using predefined factors like sales, assets, or payroll—could address these challenges but requires an unprecedented global consensus and a dismantling of existing tax treaties. Hybrid solutions, however, offer a practical middle ground, combining elements of both approaches to balance reform with stability.
One promising hybrid approach is Partial Formulary Apportionment, which applies FA selectively to certain types of profits or industries. For instance, residual profits, those exceeding routine returns, could be allocated using a formula, leaving routine profits under ALP. Similarly, sectors such as digital services or pharmaceuticals, where traditional ALP struggles due to the dominance of intangibles, could benefit from formula-based allocation.
Another pathway lies in Gradual Transitions, where hybrid rules are introduced incrementally to allow businesses and tax systems to adapt. This could involve sector-specific guidelines or residual profit splits based on simplified formulas, starting with industries most prone to profit shifting. These steps show that we can create a fairer and more efficient global tax system without completely dismantling the existing framework.
Strengthening international cooperation can reduce ALP disputes by providing clarity and efficiency. Advance Pricing Agreements (APAs) offer pre-agreed pricing methods for cross-border transactions, minimizing conflicts, while enhanced arbitration mechanisms, like binding arbitration or streamlined mutual agreement procedures, ensure fair and timely dispute resolution. These measures promote consistency and trust in global tax compliance.
OECD Guidelines and Regulatory Trends
The latest OECD Transfer Pricing Guidelines, updated in 2022, emphasize the critical role of economic substance in ensuring compliance and transparency. Key chapters of the guidelines provide a detailed roadmap for integrating economic substance into transfer pricing strategies:
- Chapter II focuses on traditional transaction methods and requires that pricing reflects actual contributions to value creation rather than artificial allocations.
- Chapter V advocates for robust documentation where transfer pricing reports must provide clear evidence of value creation and economic contributions.
- Chapter IX addresses business restructurings, requiring companies to evaluate the economic substance of changes to intercompany arrangements. It highlights the importance of ensuring that these restructurings align with business realities rather than being driven solely by tax considerations.
These principles are reinforced by measures such as country-by-country reporting (CbCR) under BEPS Action 13, which provides tax authorities with a comprehensive view of MNC’s operations and income allocation. Rather than viewing these measures as restrictive, companies can use them to strengthen their transfer pricing strategies and align operations with global best practices.
Practical strategies
To ensure that transfer pricing and economic substance work together effectively, companies can adopt the following strategies:
- Align Policies with OECD Guidelines – ensure that transfer pricing reflects the actual functions, risks, and assets of the entities involved.
- Maintain Comprehensive Documentation – provide clear, detailed documentation that explains the rationale for pricing decisions and demonstrates compliance with both the arm’s length principle and economic substance requirements.
- Focus on DEMPE Functions – evaluating intellectual property allocations considering Chapter VI’s DEMPE framework, ensuring profits align with value-adding activities.
- Stay Informed on Global Regulations – monitoring updates to OECD guidelines and evolving tax laws in jurisdictions where the company operates to stay ahead of compliance requirements.
- Expert Advice – when necessary, engage with transfer pricing specialists and legal advisors to navigate complex regulatory environments and optimize strategies.
- Promote Transparency – building trust with tax authorities by providing timely and accurate information during audits or inquiries.
Transfer pricing and economic substance are not opposing forces but interdependent concepts that, when aligned, form a robust foundation for multinational business operations. Specific chapters of the OECD’s guidelines highlight the importance of integrating economic substance into transfer pricing strategies to ensure compliance and transparency. By adopting these principles, companies can achieve compliance, optimize tax outcomes, and support sustainable growth. As global tax rules change, this approach will be key to confidently navigating the international business landscape.
