4.5.1 Examination of a controlled transaction ordinarily should be based on the transaction actually undertaken by the taxpayer insofar as these are consistent with the methods described in the Guidelines. However, when reviewing an agreement between associated persons, consideration is not only on the terms of the agreement but also the actual conduct of the parties.
Therefore, in determining an arm's length price, the IRBM may disregard and re-characterize a controlled transaction under the following circumstances:
- where the economic substance of a transaction differs from its form; or
- where the form and substance of a transaction are the same; the arrangements made in relation to the transaction, when viewed in their totality, differ from those which would have been adopted by independent persons behaving in commercially rational manner and this actual structure practically impedes the IRBM from determining an appropriate transfer price.
4.5.2 The need to re-characterize a transaction is based on the rationale that the character of the transaction is derived from the relationship between the parties and is not determined by normal commercial conditions. The controlled transaction may have been structured by the taxpayer to avoid or minimise tax. This is supported by the fact that -
- associated persons are able to enter into a greater variety of contracts and agreements compared to independent persons because the normal conflict of interest which exist between independent parties is often absent;
- associated persons often conclude arrangements of a specific nature that are not, or very rarely, encountered between independent persons; and
- contracts under a controlled transaction are quite easily altered, suspended, extended, or terminated according to the overall strategies of the multinational group as a whole and such alteration may even be made retroactively
4.5.3 The above principle can be demonstrated in the following examples extracted from the OECD Guidelines:
An investment in an associated enterprise in the form of interest-bearing debt would not be expected to be structured in the same way had it been conducted at arm's length, given the economic circumstances of the borrowing company. In this case, it might be appropriate for a tax administration to characterize the investment in accordance with its economic substance where the loan may be treated as subscription of capital
A sale under a long term contract, for a lump sum payment, gives unlimited entitlement to the intellectual property rights arising as a result of future research for the term of the contract. While it may be proper to respect the transaction as a transfer of commercial property it would nevertheless be appropriate for a tax administration to conform the terms of that transfer in its entirety to that which might reasonably have been expected between independent persons. Thus, in the case described above, it might be appropriate for the tax administration, for example, to adjust the conditions of the agreement in a commercially rational manner as a continuing research agreement.