Rethinking the source of the arm's-length transfer pricing problem

Almost everyone agrees that the arm s-length standard is inapt for sourcing a multinational enterprise s (MNE) income. At the same time, all consider it unlikely that tax authorities will explicitly depart from it any time soon. This essay tries to overcome the policy deadlock by inquiring whether the arm s-length standard could be applied in a more accurate, consistent, and difficult-to-manipulate way. Traditional transfer-pricing scholarship identifies intra-group intangibles transactions and debt-related transactions as the root of the current regime s vulnerability. This essay focuses on financial transactions and takes a new approach by noting that equity (rather than affiliated-debt) investments are the core of the sourcing problem. These equity transactions provide the parent corporation with control, which is antithetical to the arm s length standard. Control implies relatedness; dividend policy of private subsidiaries that is designed to meet the needs of the parent corporation is, therefore, inherently related and cannot be at arm s length. To overcome this problem, the author proposes maintaining the arm slength standard but applying it more rigidly--that is, to re-characterize intra-group equity investments as long-term subordinated debt (with imputed interest rates). This essay then explains how tax authorities can use this re-characterization to reduce income-shifting manipulation and to simplify many existing international tax arrangements. The proposal offers a relatively cheap, consistent, and accurate way to allocate MNE income, which is the building block in each of the various international tax policies that different countries employ. It should not be seen as associated with any specific agenda with respect to how MNEs foreign income should be taxed. Instead, the essay offers policymakers a tool that could help them incrementally improve all existing regimes and suggested reforms with respect to the taxation of foreign income.