Subsequent to a transfer pricing adjustment, it is not uncommon to have funds in the hands of one associated enterprise when, if in line with that adjustment, they should be in the possession of another associated enterprise. To make the actual allocation of funds consistent with that primary adjustment, some countries deem there to be a constructive transaction – that is, a secondary transaction – whereby the ‘excess’ funds are deemed to have been transferred in some way and are taxed accordingly.
This article, as a starting point, analyses the most typical constructive transactions that countries may consider as secondary transactions (i.e., constructive dividends, constructive capital contributions, and constructive loans). It analyses, in general terms, whether the constructive transaction is viable under a given fact pattern (e.g., whether a dividend analysis is appropriate where the deemed payer is not a (direct) subsidiary of the deemed recipient). To the extent that the policy on secondary adjustments (i.e., whether and how those adjustments are applied) is determined country by country based on domestic law, an outline of the rules and practices adopted by certain Organization for Economic Cooperation and Development (OECD) Member States is provided for illustrative purposes.
Following this introduction, the discussion moves towards whether and, if so, how secondary adjustments are effectively affected (i.e., restricted) by relevant treaty provisions. Secondary adjustments are not dealt with Article 9 of the OECD Model Convention (‘OECD MC’), which applies the arm’s length principle for taxation of profits of associated enterprises. Nevertheless, other treaty provisions may affect the application of secondary adjustments. This article considers in particular the interaction of secondary adjustments with the distributive rules contained in Articles 10, 11, and 21 of the OECD MC to determine whether the source state has its taxing rights restricted by the convention.
In addition, this article analyses how the constructive transaction (and the taxation imposed on such a transaction) are regarded by the other Contracting State for the purposes of applying double taxation relief in accordance with Article 23 of the OECD MC. Different scenarios may arise depending on whether the residence state also considers there to be a constructive transaction. A brief analysis of the applicability of the mutual agreement procedure and arbitration to secondary adjustments under Article 25 of the OECD MC 2008 is also provided. The research findings are summarized in the conclusion.Intertax