BONUS CONTENT: The Sixth Method

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The fall of Enron Corp. was perhaps the biggest financial crime of the 21st century, until Bernie Madoff and the 2008 financial crisis made it seem comparatively small-time.

It’s still the largest bankruptcy due specifically to crime in U.S. history. The company was created through a series of mergers of traditional oil and gas companies, but it moved into trading of energy futures, swaps, and other complex financial transactions–acting more like a Wall Street firm than a Texas oil company. In fact, no one could really tell what they were doing, but it became one of the most well-respected companies in the country, with supposed profits of $100 billion in 2000. But its bankruptcy revealed it was all built on spin and lies–a lot of moving things from one entity to another, and puffing up the deals with accounting fraud. The scandal was so huge, it led to the dissolution of Arthur Andersen, then one of the U.S. “Big Five” accounting firms. (Now it's just the Big Four.)

I bring this up just to make the point that the journey a commodity like a barrel of oil goes from the ground to your car can be mind-bogglingly complex, both in terms of the physical processes of refinement and transportation and with the financial middlemen who can inevitably get involved on-paper.

This can be true even when it’s one company doing everything, or most of everything. That’s why many countries felt compelled to use a novel transfer pricing process, the “Sixth Method,” to peg the price of commodities to market prices on the date the commodity is shipped, in intercompany transactions. In most cases, this throws out the adjustments which companies can otherwise make when doing related-party transactions of commodities, to reflect the true “arm’s-length price,” or the price that independent parties would have paid.

True, the market price is, literally, the price that independent parties have paid for a given commodity. But it doesn’t necessarily reflect all of the different conditions buyers and sellers may use–the condition of the good, what is guaranteed through the sale, and the timeline involved, just for starters.

In theory, the arm’s-length standard should take all of that into account. But tax authorities, especially those in poorer countries with less resources available for staffing, found that this could be too complex to be administered fairly, leaving avenues open for tax abuse. Justifying a too-low or too-high price by referencing the byzantine transactions other unrelated parties might engage was too easy. This was especially a concern when the pricing applied to a critical mineral or good–the country’s cash crop.

(Why so many countries with valuable natural resources can’t seem to use them to better their citizens’ economic standing is a hot topic for economists, often called the “resource curse.” Many factors, including the history of colonialism, undoubtedly play a role, but tax avoidance by the companies that exploit these resources is certainly also part of it.)

So beginning with Argentina in 2003, these countries created a simpler standard to peg the price to a transparent, public benchmark. Whether this is in keeping with the arm’s-length standard, or a clear violation of it, is a matter of fiercely debated opinion.

A report from the left-leaning South Centre, a global nonprofit which has often been critical of the OECD transfer pricing regime, describes the history of how the Sixth Method came about–tracing it back to a legal case involving beef, of all things.

It’s called the Sixth Method because there are five recognized transfer pricing methods under the arm’s-length standard, according to the Organization for Economic Cooperation and Development. The OECD hasn’t sanctioned the sixth, but it has recognized that spot prices can be part of an arm’s-length calculation. A recent “toolkit” published by the organization on mineral pricing described the Sixth Method, and received pushback from some business associations who claimed it should have included more information about potential negative consequences. Deviating from the arm’s-length standard can potentially drive off investment and leads to unpredictability in prices, critics claim. And because most jurisdictions don’t recognize it as a valid method, it can also lead to double taxation.

Some of the countries that use the Sixth Method don’t concede that it violates the arm’s-length standard at all. In fact, to them it’s not even really a sixth method–it’s a refinement of the Comparable Unrelated Price method. The OECD itself notes that market prices can be used in a CUP analysis in its transfer pricing guidelines–although it also stressed that it should be used on a facts-and-circumstances basis, when the transactions are economically similar, and taking many factors and adjustments into account.

Mandating a formulaic outcome as being arm’s-length isn’t that uncommon in the developing world, where tax administrations can feel outmatched by the complex calculations that large multinationals will use to justify their pricing. Sometimes, the result will be based on annual revenue outright. This use of the sixth method, by comparison, more precisely follows true market prices.

After becoming popular in South America, the Sixth Method migrated to Africa, where many countries rely on mining to support their economies, and feel that they aren’t adequately benefiting from their own natural resources. Zambia and Malawi both enacted versions of the rule. It hasn’t been endorsed by the African Tax Administration Forum, although the organization has produced studies about its use.

Another interesting aspect of the sixth method is that many countries use it as more of a backstop to arm’s-length transfer pricing, than as the primary rule. Argentina, the first country to use it, only applies the method when the taxpayer cannot demonstrate economic substance in the transaction. Other countries use it for transactions involving designated tax havens. In these cases, the taxpayer at least has alternatives if they feel the spot prices are egregiously unfair.

I’ve written in the past about the shift towards more formulaic rules in international taxation, to replace principles-based rules that have proven to often be complex and subjective in practice. The Sixth Method is undoubtedly part of this transition, although the desire to mesh it with the approved transfer pricing methods indicates how strongly people want to retain the underlying foundations. Perhaps it even demonstrates areas where some kind of synthesis can be possible.

Contact the author at amparkerdc@gmail.com.