Tax Analysts Blog

Renouncing the Dogma of Surrey’s Infallibility

Posted on Sep 19, 2014
Stanley Surrey was a remarkable policy wonk. He served as Treasury assistant secretary for tax policy under two presidents, Kennedy and Johnson. He formulated the concept of tax expenditures. And in adopting the arm’s-length standard for transfer pricing in the section 482 regulations of 1968, he not only stymied Congress but also carried the rest of the developed world with him.

A provision in a 1962 House bill would have explicitly authorized Treasury to explore the use of formulary apportionment for reallocating under section 482 income arising from transactions between a U.S. corporation and its related foreign entities. That provision was, however, dropped from the Senate bill and never became law. But the conference report recorded the conferees’ belief that the provision’s intent could be satisfied by amending the existing section 482 regulations.

Nonetheless, Treasury’s ensuing regulatory project, which culminated in 1968, steered clear of a formulary approach. Instead, the final regulations endorsed the arm’s-length standard as the touchstone for income reallocation. Even before the regulations became final, Surrey went on a worldwide speech-making spree explaining why a unilateral approach could never work. The objective, he asserted, was “an internationally acceptable set of rational rules to govern the allocation of international income.”

Surrey both charged the OECD with coming up with those rules and ensured that it would converge upon the arm’s-length standard. In a 1966 speech to the Tax Institute of America, he reiterated his belief “that the OECD Fiscal Committee is the proper body to undertake the task of establishing the allocation standards to guide countries in reaching accommodations with each other.” To guide the OECD Fiscal Committee, Surrey undertook “to lay before it our proposed section 482 regulations as they are developed.” The OECD took Surrey’s mandate to heart, and the rest, as they say, is history. Arm’s length became the polestar of the OECD’s transfer pricing guidance.

The problem that Surrey sought to remedy with his global approach was one of double taxation—where the same dollar of income is taxed by more than one jurisdiction. He warned that “if our unilateral rules do not mesh with those of other countries, the result will be double taxation, the tax burden of which will be borne either by one government through the foreign tax credit or by the taxpayer, with the other government obtaining an unwarranted benefit.” He dismissed the “undertaxation of the taxpayer” as an outcome “far less likely.”

Today, of course, the OECD is under a mandate to confront and solve that very outcome of undertaxation. The base erosion and profit-shifting initiative addresses the problem not of double taxation but of double nontaxation—where a dollar of income becomes “stateless” and ends up not being taxed by any jurisdiction.

Yet the OECD persists with the same solution handed it by Surrey to solve the converse problem of double taxation. In a report released this week on BEPS action 8, “Guidance on Transfer Pricing Aspects of Intangibles,” the OECD doubles down on the arm’s-length standard, declaring its mission to be the issuance of guidance “tailored to determining arm’s length conditions for transactions that involve the use or transfer of intangibles.”

The arm’s-length standard assumes that related entities are unrelated and seeks to find the price at which they would have bought and sold in the marketplace. A multinational enterprise, however, exists as an integrated firm precisely to avoid marketplace transactions. Disregarding that irreconcilable conflict may not have mattered in avoiding double taxation a half-century ago. But today the fiction of unrelated parties and market transactions not just obfuscates reality but can also compound the double nontaxation problem.

This is especially true of intangibles that by definition have no physical situs and can therefore be deemed to have been created almost anywhere. Increasingly, an MNE’s profits are derived from intangibles and reinvested in research that develops and refines these virtual assets. As long as the OECD retains the blinkers of the arm’s-length standard, it is unlikely to see most cross-border research endeavors for what they truly are—cynical attempts at gaming the international tax regime.

Treasury’s export of Surrey’s arm’s-length standard was perhaps the most successful case of ideological conversion in the arena of international tax policy. But the United States itself has been inching away from that construct. In 1986 Congress amended section 482 to require a "commensurate with income” standard for transfers of intangibles. Treasury proposed the profit-split method in 1988 and more recently finalized the cost-sharing regulations. Each of those attempts at reform rejects the simple-minded notion of market transactions between unrelated parties.

The OECD, however, clings to the gospel of the arm’s-length standard with a zeal befitting a convert. It seems that Treasury will have to renounce the dogma of Surrey’s infallibility before a true reformation in transfer pricing can finally get underway.

A related article will appear in next week’s Tax Notes International.

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