European Commission issues draft TP Directive providing for an EU TP framework

On 12 September 2023, the European Commission published two separate legislative proposals for Directives: (i) the BEFIT Directive, which should establish a common framework (at least, for in-scope MNEs) for corporate taxation within the EU and (ii) the TP Directive, which in turn aims at ensuring that all Member States adopt coherent TP legislation and procedures for administering TP and resolving double-tax situations. We will focus in this alert on the legislative proposal for a Directive on Transfer Pricing (TP Directive). For more information on the BEFIT alert, we refer to our EY tax alert.

The TP Directive aims to harmonize transfer pricing rules within the EU, ensuring a common approach to transfer pricing problems. The TP Directive intends to codify the arm’s-length principle and the OECD Transfer Pricing Guidelines as a means of interpretation into EU law and introduces processes for relieving double taxation for multinational entities (MNEs). In particular, the Directive proposal affirms key elements of the analysis under the OECD Transfer Pricing Guidelines (delineation of the actual transaction undertaken, comparability analysis, the five recognized OECD TP methods) and clarifies how the mechanisms to perform adjustments should be performed within the EU to ensure that double taxation is prevented and relieved as effectively and efficiently as possible.

The draft TP Directive

Scope

The Directive applies to all taxpayers that are registered or subject to tax in one Member State, with the purpose to harmonize transfer pricing rules of Member States and to ensure a common application of the arm’s-length principle within the EU.

The Directive essentially ensures that the arm’s-length principle and its interpretation in the OECD Transfer Pricing Guidelines (2022) become part of the legislation of all EU Member States. Beyond this codification, the Directive aims to achieve more consistent application and interpretation of these rules within the EU, by providing:

• A common definition of associated enterprises (and therefore the transactions covered);
• A process for applying corresponding adjustments on cross-border transactions within the EU that aims at resolving, within 180 days, any double taxation that follows from TP adjustments made by an EU Member State;
• A framework through which year-end adjustments on associated transactions within the EU are recognized both by the Member State where the upward adjustment is made and the Member State where the downward adjustment is made (compensating adjustments).

Definition of associated enterprises

For the purposes of the Directive, “associated enterprise” means a person who is related to another person in any of the following ways:

a. Participates in the management of another person by being in a position to exercise a significant influence over the other person;
b. Participates in the control of another person through a holding that exceeds 25% of the voting rights;
c. Participates in the capital of another person through a right of ownership that, directly or indirectly, exceeds 25% of the capital;
d. Is entitled to 25% or more of the profits of another person.

Permanent establishments shall be considered associated enterprises of the enterprise of which they are a part.

The 25% threshold, in particular, establishes another criterion for defining a group from those contained in draft BEFIT Directive and Pillar Two, with coordination issues potentially arising.

Corresponding and compensating adjustments

When one Member State makes a primary adjustment, the counterparty’s Member State should ensure that a corresponding adjustment is performed (subject to identified circumstances) to prevent double taxation or, in any case, that double taxation can be relieved in application of a double tax convention, the Arbitration Convention or the Directive (EU) 2017/1852.

Compensating adjustments (i.e., adjustments performed by a taxpayer at year-end to correct the results of intercompany transactions) shall also be accepted if the following conditions are met:

a. Before recording the relevant transaction, or series of transactions, the taxpayer made reasonable efforts to achieve an arm's-length outcome;
b. The taxpayer makes the adjustment symmetrically in the accounts in all Member States involved;
c. The taxpayer applies the same approach consistently over time;
d. The taxpayer makes the adjustment before filing the tax return;
e. The taxpayer is able to explain why its forecast did not match the result achieved.

Determination of the arm’s-length range and TP adjustments by Member States

With respect to the arm’s-length range, the Directive adopts a stricter approach than the OECD Guidelines when the application of a TP methodology produces a range of values. In particular, it mandates the use of the interquartile range as a reference, whereas the OECD Guidelines (§3.57) refer to central tendency measures only when comparability defects remain in the set of comparable entities/transactions.

In addition, the TP Directive prescribes that Member States may only make adjustments if results fall outside the (interquartile) arm’s-length range, unless there it is proven that a different positioning within the range is justified by the facts and circumstances of the specific case. If an adjustment is made, it should be made to the median, unless it is proven that a different positioning in the range is justified by the facts and circumstances of the specific case.

Future work

The Directive also provides that the Commission shall be empowered to further supplement the rules of the Directive with regard to documentation, by laying down common templates, setting linguistic requirements and defining the type of taxpayer to complete these templates and the timeframes to be covered, further harmonizing the applicable TP rules throughout the EU.

In addition, the Directive establishes that the Commission may advance a future proposal on the application of the arm’s-length principle and other rules of the Directive, particularly with respect to certain transactions or dealings – specifically:

(a) transfers of intangible assets or rights in intangible assets between associated enterprises, including hard-to-value intangibles;
(b) the provision of services between associated enterprises, including the provision of marketing and distribution services;
(c) cost contribution arrangements between associated enterprises;
(d) transactions between associated enterprises in the context of business restructurings;
(e) financial transactions;
(f) dealings between the head office and its permanent establishments

Next steps

The draft Directive will now move to the negotiation phase among Member States, with the aim of reaching unanimous agreement1. Once unanimity is achieved, the next step would be the publication of the Directives in the Official Journal of the European Union.

The Commission proposes that the Member States transpose the TP Directive by 31 December 2025 and apply these provisions from 1 January 2026.

Implications

The TP Directive would benefit businesses in the internal market by adopting a common standard to address intercompany transactions, thus (i) reducing situations where peculiarities in Member States’ legislation could harm the functioning of the internal market and lead to double-tax situations and (ii) providing certainty on some important sources of disagreement between EU Member States. Codifying TP guidelines into EU law could eventually increase tax certainty, including through the case law of the European Court of Justice. On the other hand, in some respects the rules would be stricter than the OECD Transfer Pricing Guidelines and Member States would be required to depart from some of their existing practices, which may impact their support to this proposal.

Although it is not yet known whether Member States will embrace the Commission’s proposal, businesses should closely monitor the adoption process for any changes or clarifications to the proposal. As with previous Directives on direct taxation, changes likely will be made to the proposals during the negotiation process. Consequently, the final Directive, if adopted at all, could differ from the current proposal.

In case of any further questions with regard to these developments, please do not hesitate to reach out to your trusted EY person of contact.

1 Article 115 of the Treaty on the Functioning of the EU forms the legal basis for both draft Directive Proposals. Therefore, the proposals are subject to the Council’s unanimity for adoption, while the European Parliament only has an advisory role.