The Sixth Sense (of Commodity Prices)

The world of international taxes and transfer pricing can focus so much on the tech world, valuable intellectual property and other mysterious intangibles that it can be tempting to think that commodities and other physical products are simple.

But, of course, in international taxes nothing is ever simple.

A recent draft "toolkit" from the Organization for Economic Cooperation and Development, meant to assist developing countries in tax enforcement of mining operations, lays out how pricing in this sector can be particularly challenging. Accounting for the costs of exploration, development (including financing), production and refining are just some of the concerns. There are also the complex value chains, with both subsidiaries and independent parties inserting themselves as intermediaries and middlemen. (Remember Enron?)

The publication also briefly touches on a controversial way that some countries are attempting to tackle this–the "sixth method." (Called that because there are five official sanctioned transfer pricing methods.) First created by Argentina in 2003, this has caught on as a way for countries to more easily price commodities in related-party transactions, reducing risks for base erosion and reducing administrative burden while ostensibly following the arm’s-length standard. At least, that’s what they’ve claimed.

The sixth method tries to take advantage of the public spot prices available for most commodities, that reflect what independent traders would use. At first glance, tagging internal transfers to that price would seem to follow the arm’s-length principle–the global benchmark that transactions between entities within a corporate group use rates that independent parties would agree to, based on comparable transactions. After all, it's the pricing that hundreds of buyers and sellers are using at that moment--what could be simpler?

The issue is that spot prices are only one data point about the transaction. True arm’s-length pricing should take into account all relevant conditions–the nature of the contract, the economic positions of the two parties, the amount being traded, and a plethora of other issues. To give a crude counter-example, what I’d pay for a pound of gold today might be different from what I’d pay to be guaranteed a pound of gold sometime in the next two years. (And since these are contracts drawn up by entities of the same ultimate taxpayer, they have leeway to choose whichever conditions are most advantageous.)

Argentina decided that the risk of tax avoidance on shipments of raw minerals was so great, it needed to disregard some of these potential adjustments. According to the OECD, Argentina’s law requires that on some commodities, the taxpayer must use the publicly quoted price on the day of shipment in internal transactions to offshore entities.

The sixth method isn’t exactly one method, but several approaches that countries have adopted using this basic idea–the spot price with minimal adjustment, from the date of shipment or a similar point in time. Many of the countries that have found the sixth method useful are in Latin America, which is heavily reliant on mining and other extractive industries. One of the countries to use the rule is Brazil, although it recently tweaked its commodity pricing law to better conform to OECD standards pending its entrance into the organization.

The OECD notes that it is not endorsing this approach, merely describing how some countries have used it. Nevertheless, several stakeholders pushed back against the passage in comments to the OECD, urging that it include more information about potential drawbacks to the method, or to drop it altogether.

“Generally, we find this particular section is not balanced in presenting the pros and cons of such an approach,” wrote the Australian Taxation Office, one of the few tax authorities to submit comments, adding that it should include “the consequences of and likely behavioral responses” of mining companies should also be added.

In other words, countries need to be warned that the sixth method could drive away potential investment.

“It is important that there is clarity for both businesses and tax authorities that alternative policy options (such as the ‘sixth method’ and administrative pricing) should only be used to support rather than override the OECD Guidelines,” Deloitte LLP wrote.

Interestingly, a mining consortium from one of the countries whose sixth method law was cited–Zambia–also provided its perspective, claiming that the law’s restriction on adjustments to copper prices don’t take into account the metal's different uses.

“The Practice Note currently feels like it is guiding users to consider a sixth method as a preferred method,” wrote the Zambia Chamber of Mines, which added that this is a “concern” as it can have “serious limitations” and violate the arm’s-length standard.

It’s interesting to compare the brief OECD passage to the United Nations Manual on Transfer Pricing’s more detailed chapter on the sixth method, which the OECD cites. While not claiming to answer whether it conforms to the arm’s-length principle or not, it notes that the method could be seen as an anti-abuse rule, or an “imperfect” way to arrive at a comparable uncontrolled price.

It also notes that while the OECD hasn’t endorsed the method, its rules (kind of) allow for it. As updated by the organization’s 2015 Base Erosion and Profit Shifting project, the OECD guidelines note that transfer pricing can take public commodity prices into account–and, in some situations, can also “impute” a transaction date. (That’s essentially what the sixth method is doing–mandating that the date of shipment also be considered the date of sale, regardless of what the contract says.)

But, the guidelines stress, this should only be used when appropriate to arrive at the correct arm’s-length price.

Given the current tension between the OECD and the UN, it’s interesting that the former would delve into this territory. But the OECD has been trying to give the developing world more assurance that its concerns are being taken into account, including by giving them input into the global minimum tax through the Inclusive Framework, however limited.

And whether or not the sixth method is more widely adopted, it’s yet another sign of how formulaic, back-of-envelope-style rules meant to simplify international tax enforcement are becoming a greater and greater part of the overall global tax system. These kinds of rules are pivotal to both of the OECD's Two Pillars, aspects of which could be described as outright formulary apportionment. And you’re also seeing it in “soft law” regimes, like safe harbors and risk assessments. If the rules aren’t required, but heavily encouraged as an administrative matter, that (in theory) gets around the question of whether they violate the arm’s-length standard.

Whatever other pros and cons apply to the arm's-length principle, its greatest virtue is that it's the rule which virtually all of the world's nations have agreed to. Would any other system reach that level of unanimity? But as more and more countries begin to question the standard's logic, and look for ways to either support it or work around it, that pillar of consensus begins to look more shaky.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• Congress is now in recess, but if you thought that Republicans wouldn't keep up their white-hot criticism of the OECD's global minimum tax agreement, you'd be sorely mistaken. And, apparently Treasury official Michael Plowgian's recent testimony before the House Ways and Means Committee did little to assuage their concerns. Thirteen Republican committee members penned a letter to Secretary of the Treasury Janet Yellen on July 31, excoriating the Biden Administration for making "unprecedented and anti-America concessions" in the OECD negotiations and neglecting its "constitutional duty" to keep Congress informed and defer to its prerogative to set tax policy. Most of the criticisms are familiar, but the letter especially focuses on Treasury's refusal to release its own revenue and economic impact assessments. One issue the letter touches on, which hasn't received much attention previously, is how the Pillar One agreement would affect franchise and split-ownership structures. They claim a proposed marketing and distribution safe harbor would leave them out. This letter comes as Ways and Means members plan a Congressional delegation to the OECD later this year. (I hear Paris is lovely in the fall.)
• While conservatives and business groups are keeping the heat on the OECD, it's also beginning to receive pushback from the other side as well. Responding to the organization's July announcement of progress on Pillar One, the South Centre--a think tank established by 55 developing countries--issued a statement urging countries to approach the agreement with caution. West African Tax Administration Forum followed with a similar statement urging caution and review before signing on. While hardly as strident as statements from nonprofit advocacy groups like Oxfam and the Tax Justice Network, this is a sign that the OECD may still need to win over some skepticism in the developing world.
• It's not all discord and disharmony these days. As a bipartisan measure to boost trade with Taiwan awaits President Biden's signature, Senate Finance Committee Chairman Ron Wyden, D-Ore., and ranking Republican member Mike Crapo, R-Idaho, issued a statement promising to consider legislation to prevent double taxation with Taiwan in September. This is sort of a tax treaty-without-the-treaty, given the island's disputed status.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Jetman, premiering in 1945, had a suit, a rocketpack, his own series and even a female sidekick. But what he didn't have were any actual stories. He just appeared on the covers to sell reprints of other comics. (Apparently, this is something they'd do back then.) So his backstory is up to your imagination.

Contact the author at amparkerdc@gmail.com.