Economic Substance Over Legal Form: Key Transfer Pricing Challenges and Case Insights

This article is part of a series that builds on my previous article: Lessons on the Arm’s Length Principle, Economic Substance, Documentation, and Comparability Challenges – For proper context, read that article first.

The following articles are also related:

In transfer pricing, the principle of economic substance over legal form has become a cornerstone of tax authority scrutiny and judicial interpretation. This principle emphasizes that the true economic reality of a transaction—its substance—should take precedence over the written agreements or legal forms that describe it.

The disputes in Refinitiv (Thomson Reuters Group), Glencore Energy UK Ltd, and GE Canada demonstrate how the alignment of intercompany arrangements with actual economic activities and risks is central to adhering to the Arm’s Length Principle (ALP). This article explores the significance of economic substance in transfer pricing and the challenges it presents to multinational enterprises (MNEs).

Understanding Economic Substance in Transfer Pricing

Economic substance refers to the real-world activities, risks, and benefits that underpin a transaction. In transfer pricing, tax authorities assess whether intercompany arrangements reflect these economic realities, rather than relying solely on the contractual terms between related parties. This focus ensures that profits are allocated to the jurisdictions where value is genuinely created, safeguarding equitable tax distribution.

The shift toward economic substance is driven by global efforts to combat profit shifting and tax base erosion. Initiatives such as the OECD’s Base Erosion and Profit Shifting (BEPS) project have heightened scrutiny of transactions that appear artificial or misaligned with economic contributions. Consequently, businesses must not only ensure that their legal agreements are arm’s length but also demonstrate that these agreements align with the substance of their operations.

Economic Substance in the Refinitiv Case

The Refinitiv case provides a compelling example of how economic substance influences transfer pricing disputes. Refinitiv’s UK entities played a pivotal role in developing and enhancing intangible assets, yet the intercompany arrangements compensated these entities based on a cost-plus methodology agreed upon in an Advance Pricing Agreement (APA). This method failed to adequately reflect the value generated by the UK entities’ contributions.

HMRC argued that the economic reality of these contributions necessitated a profit-split methodology to allocate a greater share of profits to the UK entities. The mismatch between the legal agreements and the underlying economic substance of the transaction was central to HMRC’s challenge. This case highlights the risk of relying on static agreements that do not evolve with the business or adequately reflect economic realities.

Economic Substance in the Glencore Case

In the Glencore dispute, economic substance took center stage in evaluating the pricing mechanisms for commodity transactions. Glencore’s contractual terms outlined risk allocation between related entities, but HMRC contended that these terms did not reflect the actual risks borne by each party.

For instance, the pricing mechanism used by Glencore was designed to mitigate market volatility. However, HMRC argued that the mechanism disproportionately allocated profits without adequately compensating the entities assuming market risks. This discrepancy between the contractual risk allocation and the economic substance of the transactions formed the basis of HMRC’s challenge.

The case underscores the importance of ensuring that contractual terms not only appear arm’s length on paper but also align with the economic substance of the activities and risks undertaken.

Economic Substance in the GE Canada Case

The GE Canada case revolved around the pricing of guarantee fees paid by the Canadian subsidiary to its US parent company. The contractual terms provided for explicit guarantee fees, but the Canadian Revenue Agency (CRA) questioned whether these fees were justified given the implicit support already inherent in the parent-subsidiary relationship.

The court examined whether the economic substance of the guarantee provided any real value beyond what was already implied by the relationship between the entities. This analysis went beyond the contractual terms to assess whether the fees reflected an arm’s length arrangement. The focus on economic substance highlighted the need to evaluate the actual benefits derived from intercompany agreements, rather than relying solely on the legal form.

Challenges of Demonstrating Economic Substance

Aligning transfer pricing arrangements with economic substance presents several challenges for MNEs:

Complex Value Chains: As businesses operate across multiple jurisdictions, demonstrating the economic substance of intercompany transactions becomes increasingly complex. For example, intangible asset contributions or shared risks may not be easily quantifiable, as seen in Refinitiv.
Industry-Specific Nuances: Different industries pose unique challenges in proving economic substance. In Glencore’s case, commodity pricing required adjustments for market volatility, while GE Canada’s financial transactions demanded specialized analysis of implicit and explicit support.
Documentation Requirements: Proving economic substance requires detailed and contemporaneous documentation. MNEs must maintain comprehensive records of the roles, risks, and contributions of each entity, ensuring that these align with the terms of intercompany agreements.
Dynamic Business Models: Static agreements often fail to capture changes in business models or operations, as evidenced in the Refinitiv case. Businesses must regularly review and update their transfer pricing policies to reflect evolving realities.

The Growing Importance of Economic Substance

Tax authorities are increasingly sophisticated in their analyses, relying on functional and risk analyses to uncover discrepancies between legal form and economic substance. This trend is part of a broader shift toward substance-based taxation, exemplified by the BEPS initiative and the introduction of measures such as Pillar Two’s global minimum tax.

For MNEs, aligning with economic substance is not merely about avoiding disputes—it’s about ensuring long-term compliance and sustainability. By aligning legal agreements with the true economic activities of their operations, businesses can build resilient transfer pricing policies that withstand scrutiny.