Profit Allocation - ‘Formular Approach Versus Traditional Transfer Pricing’

; posted on
August 30th, 2018

To determine the proper level of profits in tax jurisdictions is extremely essential for the tax revenues of the hosting countries. The most widely-accepted principle for tax purposes by MNE groups and tax administrations is the arm’s length principle. In the OECD 2017 Transfer Pricing Guidelines, the OECD reaffirms the status of the arm’s length principle as the international standard. Both the traditional transaction methods and the transactional profit methods are designed as methods to establish whether the conditions imposed in the commercial or financial relations between associated enterprises are consistent with this principle.

Formular approach

As an alternative to the arm’s length principle, the formular approach has sometimes been suggested, but has not been applied between countries until now. In general, the formular approach would allocate the global profits of an MNE group on a consolidated basis among the associated enterprises in different countries on the basis of a pre-determined and mechanistic formula. To apply this approach, there are three essential components: determining the subject to be taxed, accurately determining the consolidated profits and establishing the formula to be used to allocate the consolidated profits of the unit. The formula would most likely be based on some combination of costs, assets, payroll, and sales.

Formular approach vs. transactional profit methods

Many people might confuse the formular approach with the transactional profit methods based on the arm’s length principle. In the formular approach, the formula is pre-determined for all taxpayers to allocate profits which leads to the pre-determined and mechanistic nature of this approach. In comparison, the transactional profit methods compare, on a case-by-case basis, the profits of one or more associated enterprises with the profit experience that comparable independent enterprises would have sought to achieve in comparable circumstances. Also, the formular approach is different from the selected application of a formula developed by both tax administrations in cooperation with a specific taxpayer or MNE group, such a formula might be used in an advance pricing agreement since such a formula is derived after a careful analysis of the particular facts and circumstances.

Comparative disadvantages

No matter whether using the traditional transfer pricing methods or the formular approach, it is of vital importance to implement it in a manner that both protect against double taxation and ensures single taxation. Advocates for the formular approach claim that it would provide greater administrative convenience and certainty for taxpayers than the traditional transfer pricing methods. However, the formular approach requires a more substantial international coordination and consensus on the pre-determined formulae to be used, such as common agreement to adopt the approach in the first instance, followed by common measurement of the global tax base, on the use of a common accounting system, on the factors to be used to apportion the tax base among different jurisdictions and on how to measure and weigh those factors.

Unless the approach includes every member of a MNE group, it must retain the traditional transfer pricing methods for the interface between that part of the group subjected to global formulary apportionment and the rest of the MNE group. Thus, a clear disadvantage with the formular approach is that it does not provide a complete solution to the allocation of profits of an MNE group unless this approach is applied on the basis of the whole MNE group.

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