How to separate fact from fiction in transfer pricing

This article appears in the May issue of our International Corporate Structures Newsletter.

The diagram above is adapted from the teachings of Werner Erhard, the American personal development thinker. The circle on the left represents the realm of “reality” or “facts”; what actually happened. The circle on the right represents our stories about what happened.

As non-stop “meaning-making-machines”, our minds are programmed to create stories, or “meanings” around facts (“he or she didn’t call because…” or “I didn’t get that promotion because… .”). We become emotionally attached to those meanings. Our stories and the underlying facts merge into a single mass of perceived facts, judgements, accusations and excuses. It feels like there is not much space for freedom of action.

It seems that we can’t switch off our “meaning making machines”, but we can become more aware of how they work. It can be very liberating to de-clutter our thinking about particular situations, by separating out the facts from the “meanings”, deciding which “meanings” are helpful to us, and choosing which of them to adopt. Does not driving the right car, not living in the right house or not sending our children to a certain school mean that we have failed? No, this is just a disempowering interpretation we have created for ourselves.

There is a similar opportunity for clarity in the world of corporate structuring and transfer pricing. There is a tendency to regard a corporate group as an undistinguished “blob”. The world inside that blob is a mass of economic theory, mixed with “do’s and don’ts” for dealing with particular tax authorities. It is said that legal documents are all very well, but they are ‘trumped’ by functional analysis, and the internal workings of an enterprise can be whatever you say they are. A transfer pricing strategy becomes a statement of what might have been, if it had actually been created.

One helpful distinction here can be that of “legal reality” vs “fiction”. (Of course, this is not the only distinction.) The legal relationship between the members of a corporate group is a matter of legal reality. Corporations are creatures of law – and they only exist as legal persons (with the benefit of limited liability for shareholders) to the extent that they satisfy the requirements of the laws under which they are established. Where services or goods or financial support are provided by one group company to another, legal rights and duties arise, whether or not a contract is reduced to writing. The officers of legal entities are subject to personal duties, for which they can be held personally accountable. This legal reality becomes decisive whenever a matter involves third parties. If trade marks need to be enforced, it’s not the “group” that brings a claim. It’s the registered proprietor and/or licensee of the mark in the relevant countries. If a health and safety incident occurs, the potential criminal prosecution is not against the “group”, it is against the relevant legal entity … and its directors.

Without an understanding of the actual legal relationship between group companies, including the ownership of assets, any statement as to the allocation of risk between the parties is fiction. It is a story which may or may not be supported by the facts. A proper legal analysis is part of functional analysis, and is fundamental to the concept of comparability. Intercompany agreements and corporate structuring are two of the tools available to shape the legal reality, and to create a firm foundation for good governance, regulatory compliance and transfer pricing compliance.