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Transfer Pricing: Types of transactions: difference between accurate delineation and disregard

The 2017 OECD Transfer Pricing Guidelines make a clear distinction between:

a)鈥渁ccurate delineation of the actual transaction鈥�, and

b) disregarding of that accurately delineated transaction

As per the first sentence of Paragraph 1.122 of those Guidelines:

鈥淭his section sets out circumstances in which the transaction between the parties as accurately delineated can be disregarded for transfer pricing purposes.鈥�

which makes it clear that it is necessary to accurately delineate the transaction prior to considering whether it can be disregarded; a message which is reinforced by other statements such as in the penultimate sentence of that same paragraph:

鈥淭he transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where鈥︹��

Accurate delineation of the actual transaction (see INTM485021-485024)

In introducing the issue of possible non-recognition or disregard of the transaction, Paragraph 1.120 gives a succinct summary of the meaning of 鈥渁ccurate delineation鈥� when it states that:

鈥淲here the characteristics of the transaction that are economically significant are inconsistent with the written contract, then the actual transaction will have been delineated in accordance with the characteristics of the transaction reflected in the conduct of the parties.鈥�

Although the term 鈥渁ccurate delineation鈥� is one that does not appear in previous versions of the Guidelines, it is not a new concept. It is, in essence, recognition of the actual transaction based on:

1. conduct or substanceover
2. contractual form.

which is referred to in, for example, paragraphs 1.48, 1.53, 9.13 and 9.14 of the 2010 Guidelines.

The 2017 Guidelines go into far greater detail upon the issue than the 2010 Guidelines and, in particular, place great emphasis on the subject of allocation of risk based upon the relevant control functions carried out in respect of the risk in question (in essence presented as a rebuttable presumption 鈥搕hat - unless a closely comparable uncontrolled transaction can be identified in which it is not the case - the party which exercises control over the risk and has the financial capacity to assume it would be the party which bears the upside or downside consequences of that risk at arm鈥檚 length. See paragraph 1.97 of the 2017 Guidelines). However, the conduct over form concept remains at the centre of the process of determining the actual characteristics of (i.e. 鈥渁ccurately delineating鈥�) the actual transaction that is to be transfer priced.

Disregard (non-recognition)

Both of these terms are used in Paragraph 1.122 of the 2017 Guidelines.

Paragraph 1.122 of the 2017 Guidelines sets out the circumstances in which the actual transaction as accurately delineated may be disregarded:

鈥淭he transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction.鈥�

Expressed differently, this sentence says that the actual transaction may be disregarded where a 鈥榮trike鈥� price 鈥� that is a price which would be acceptable to both of the parties taking into account their particular economic circumstances and characteristics and the options realistically available to them given those circumstances and characteristics 鈥� cannot be determined.

Disregard (non-recognition) under the 2010 & 1995 TP Guidelines

Earlier versions of the TP Guidelines (paragraph 1.65 of the 2010 Guidelines and paragraph 1.37 of the 1995 Guidelines) refer to two particular circumstances in which it 鈥渕ight be both appropriate and legitimate for a tax administration to consider disregarding the structure adopted by a taxpayer in entering into a controlled transaction.鈥� :

1. 鈥渨here the economic substance of a transaction differs from its form.鈥�
2. 鈥渨here, while the form and substance of the transaction are the same, the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price.鈥�

The reference to identifying the economic substance of the transaction as opposed to its form at both paragraphs 1.48 and 1.49 of the 2010 guidelines (1.26 and 1.27 of the 1995 Guidelines) and also as being the first circumstance under which the actual transaction could be disregarded reflects the fact that some OECD members consider that, in the absence of an explicit over-ride within the Guidelines, their domestic law binds them to transfer pricing of a transaction based upon its contractual form rather than economic substance. The 2017 amendments create greater internal consistency within the Guidelines by expanding upon the concept of establishment of the economic substance of a transaction 鈥� now termed 鈥渁ccurate delineation of the actual transaction鈥� 鈥� to provide those OECD members who have such concerns regarding their domestic law to use the substance of the transaction as the basis for a transfer pricing analysis without this being considered to be a disregard of the actual transaction.

The second circumstance, as expressed in the 1995 and 2010 Guidelines, could be interpreted as requiring two separate criteria to be met:

1. That the arrangements 鈥渄iffer from those which would have been adopted by independent enterprises behaving in a commercially rational manner鈥� and
2. That 鈥渢he actual structure practically impedes the tax administration from determining an appropriate transfer price鈥�

However, the more logical interpretation, as clarified by the 2017 Guidelines, is that the second element is an inevitable consequence of the first (or, put differently, if a price acceptable to both parties - taking into account their particular economic characteristics and circumstances and options realistically available to them - can be determined, the transaction isn鈥檛 commercially irrational).