By Guy Sanschagrin
In his blog post: BEPS - What It All Means, my esteemed colleague Kash Mansori explained that a key to a defensible transfer pricing policy is to align the allocation of taxable income among entities in multinational supply chains with “value creation”. And while this concept introduced under BEPS seems sensible in theory, merely focusing on value creation as the main driver to allocate profit creates tension with the arm’s length standard. After all, it is easy to observe countless instances in the free market where some value creators earn significantly lower returns than others.
As a case in point, companies routinely pay employees wages that are significantly below the value they create. If an employee develops a new blockbuster product, the company owns the technology and enjoys its returns. This is reinforced through non-compete agreements where the employee is barred from competing with the company. Such employment contracts violate the BEPS directive that income should be earned by entities in proportion to their value creation, yet they are frequently observed arm’s length arrangements.
Employers put their capital at risk to provide employees with wages who in turn provide the company with value that may be well beyond a routine return. And while employees who create high value may be able to obtain higher than normal compensation relative to their peers, the equity holders of the company are often the main beneficiaries of value creation; they typically reap most of the fruits of the efforts of employees.
So what is BEPS missing? While value creation should be an important consideration in determining arm’s length pricing, I would argue that other factors such as access to capital, risk management objectives and bargaining power should also be prominent factors in determining the arm's length allocation of profits within an enterprise’s global supply chain. Myopically focusing on value creation is missing a significant component of the arm’s length standard. Unless we want to abandon the arm’s length standard – which many postulate is where BEPS is going - multinationals, transfer pricing practitioners and the OECD BEPS team should develop additional frameworks that enable us to include other relevant factors in conjunction with value creation as we develop, implement and evaluate arm’s length pricing arrangements.