Intercompany transactions and the market value trap

The most important obligation of taxpayers under transfer pricing regulations is to demonstrate that the transactions were conducted in accordance with the “arm’s length” principle, which is based on Article 9 of the Model Tax Convention of the Organization for Economic Cooperation and Development (OECD), as follows:

“If conditions are established or imposed between the two associated enterprises in their commercial or financial relations that differ from those that would be established between independent enterprises, then any profit that would have been obtained by one of the enterprises, but which, due to those conditions, has not been obtained, may be included in the profits of that enterprise and taxed accordingly.”

In Mexico, the arm’s length principle is established in Article 179 of the Income Tax Law, in its first paragraph, which states:

“Taxpayers subject to Titles II and IV of this Law who enter into transactions with related parties are required, for the purposes of this Law, to determine their taxable income and authorized deductions, considering for these transactions the prices, amounts of consideration, or profit margins that would have been used or obtained with or between independent parties in comparable transactions.”

Unfortunately, the Mexican provision is not equivalent to Article 9 of the OECD Model Tax Convention. The Mexican regulation seeks that, through the analysis of a condition evaluated through a transfer pricing method (price, amount, margin), the taxpayer demonstrates that the transaction was agreed upon on an arm’s length basis.

This difference in the approach to the arm’s length principle has led to a simplistic interpretation of the regulation. Often, instead of analyzing whether taxpayers replicated the negotiation dynamics that independent third parties would have observed, it seems sufficient to demonstrate a “market price” through a transfer pricing method. And nothing could be further from the truth. Under this perspective, Mexican taxpayers could engage in transactions that, even if not in their best interests, simply by being at market value would comply with the transfer pricing regime, and of course, this premise is false.

This becomes evident in current open transfer pricing audits, where the disputed aspects go far beyond the mere establishment of price. For example, the transfer of risks during the negotiation between related parties (risks that end up being rejected as deductions for not being those that an independent third party would have accepted in a comparable transaction).

In summary, in any intercompany transaction, if the conditions imposed between the parties differ from those that would have been negotiated by an independent third party, the transaction is NOT at arm’s length, regardless of whether the transaction price is at market value.