A Report on Compensating Adjustments, issued by the EU Joint Transfer Pricing Forum in January 2014, provides a practical solution to address different approaches by EU Member States. The Glossary of the OECD Transfer Pricing Guidelines defines a “compensating adjustment” as “an adjustment in which the taxpayer reports a transfer price for tax purposes that is, in the taxpayer’s opinion, an arm’s length price for a controlled transaction, even though this price differs from the amount actually charged between the associated enterprises. This adjustment would be made before the tax return is filed.” In general, an adjustment is made at a later time to the transfer prices set at the time of a transaction.
A link to this report, and an excellent article by CGMA, are provided for reference:
Highlights of the Report:
- Compensating adjustments are enacted using one of two approaches, an ex-ante (arm’s length price setting approach), or ex-post (arm’s length outcome testing approach). The ex-post approach generally involves testing, and possible adjustment, of transfer prices at year-end, prior to closing the books or filing the tax return.
- When both Member States apply an ex-post approach and require compensating adjustments, a risk of double taxation, or double non-taxation, may arise.
- An ex-post approach by one Member State, with an ex-ante approach by a separate Member State, presents conflicts on making such adjustments.
- Guidance by the OECD is limited, with reference to the Mutual Agreement Procedure (MAP) to resolve disputes. Member States use their discretion re: application of compensating adjustments.
- A practical solution is described for transactions in which (i) profits are calculated symmetrically, and (ii) a compensating adjustment initiated by the taxpayer should be accepted if various conditions are met. However, if the Member States have less prescriptive rules for such adjustments, those rules are to apply.
- Upward as well as downward adjustments should be accepted.
- The practical solution provided should not limit a tax administration’s ability to make a subsequent adjustment and has no bearing in a MAP procedure.
- The adjustment should be made to the most appropriate point in an arm’s length range, with reference to OECD guidance.
The subject of compensating adjustments is an important topic in addressing potential double taxation, or double non-taxation. The Report is timely, offering practical guidance for Member States to achieve consistency, although only within the EU.
It will be interesting to follow this topic, and future guidance, by the OECD, as well as commentaries from EU Member States, UN, and other interested parties. The practical solution will be most effective if adopted in principle, or in legislation, by the EU Member States, with other countries referring to such guidance to resolve challenging transfer pricing issues fairly and effectively.