Formula Fights

When my first-born child was 3 months old, my wife and I flew to Germany to introduce our daughter to my parents and family. As any new parent knows, the amount of luggage increases exponentially when you travel with a baby, especially internationally.?While I was wondering how to get everything into the allocated luggage weight maximum, my wife presented me with something I hadn't accounted for: the liquid baby formula our daughter was drinking for our two week trip. Two weeks supply (plus safety stock) of liquid formula is no trivial amount. I tried to push back but she insisted we needed it. When I suggested we take more space/weight-saving powder instead she agreed that was an excellent idea - IN ADDITION!

Anyway, as every new father will know, this wasn't a very long debate and I was left wondering how much excess luggage weight fee I might be charged.

Ensuring that your baby has access to its formula is obviously of paramount importance for parents. This has become abundantly clear in the US where the baby formula shortage triggered the White House to invoke the National Defense Production act and use the US Air Force to fly in baby formula from overseas. The baby formula shortage is yet another tale in the string of stories about pandemic supply chain disruptions.?While the common narrative around supply chain disruption has been that the pandemic is accelerating the end of globalization, the formula shortage highlights the contrary - the supply chain disruption was caused because of a lack of globalization in this particular market.

The shortage was triggered most immediately by the closure of a major manufacturing plant in the US.?However, the problem was exacerbated because the US market for baby formula is highly protected and regulated.?Instead of protecting consumers, the rules and regulations, by limiting trade,?created rigidity and weakened our national resilience.

Globalization is an important topic for transfer pricing practitioners.?Our business is built on globalization. One reason I work in transfer pricing is because I believe in the positive power of free trade.?Call me a globalist!?But if globalization is coming to an end, does that mean the death of transfer pricing??After all, multinational companies, my clients, account for 2/3 of all global trade.

As the famous saying goes, any reports of the death of globalization or transfer pricing are greatly exaggerated. In fact, after freezing up initially at the start of the pandemic, global trade reached new record growth in 2021.?And arguably the official trade statistics don't capture all the growth in global trade, especially in intangibles.?Imagine a multi-national with a cost-sharing agreement between the US and a European entity.?The trade statistics will only show the cost payments made between the participants.?But it won't reflect the value of the intangibles created and traded as a result of the activities.??

Free trade has transformed our world.?Free trade has lifted billions out of poverty.?Free trade has enabled people and cultures to connect and enrich each other.?Free trade has been a force for good.

But free trade isn't free. It would be foolish not to acknowledge that it has its downsides and can be abused by bad actors.?We need rules and regulations to get the best out of free trade. The world of international trade is full of rules and rule setters.?Institutions like the WTO and global and regional trade institutions and agreements have facilitated the global growth of free trade.?

One such set of rules are the transfer pricing rules that have developed around the arm's length standard.?For a while now, the arm's length standard and associated rules have come under heavy criticism.?It is said they are too difficult and complex to administer and are easily gamed by multi-nationals and their advisors.?As one of these advisors, I have a very different perspective.?Obviously, there are complexities with the arm's length standard.?After all, if it was simple, I wouldn't have my job.?But any criticism has to be weighed against the alternative. And what is the alternative to the arm's length standard: formulas!??

Formulary apportionment has long been discussed as a potential alternative to the arm's length standard. But for the first time, formulary apportionment is being seriously considered - not in its full-blown glory - but as a partial solution to tricky and not so tricky transfer pricing problems.?Proposed amounts A & B under Pillar 1 are nothing but formulas that apportion profits to jurisdictions.?And as we are quickly learning through the debates at the OECD and elsewhere, formulary apportionment is anything but simple, fair, and easy.

The US baby formula experience shows how bad rules can quickly choke off markets when the environment changes.?Rules that are ostensibly put in place to protect the consumers or strengthen national resilience are suddenly found to do the opposite.?Replacing the arm's length standard with formulary apportionment may end up throwing the baby out with the bathwater.??

Free trade isn't dying.?In fact, I suspect we will see an acceleration of free trade as we move more and more of our activities into a virtual world or "Metaverse."? That trade may be less visible, measurable and tangible compared to the trade in widgets. But it is trade, nonetheless. This trade, like all trade needs to be regulated to be of the greatest benefit to us all.

The original rationale of Pillar 1 was to address concerns with the digital economy. The digital economy supposedly drives monopoly profits that escape taxation. There were always two problems with this argument. For one, in a world with indirect taxes, transactions, if properly recorded, don't escape taxation. And second, the real issue are monopoly profits. Would there even be a Pillar 1 discussion if some digital companes weren't so profitable? Complex rules around the taxation of such profits do nothing to reduce them. On the contrary, the complexity only creates additional barriers to entry, which limits competition further.

Just like I had to pay for the extra weight of our daughter's baby formula, the extra weight of the Pillar 1 formulas will extract a price on our global prosperity. But I doubt the Pillar 1 formulas will give jurisdictions and companies the same peace of mind my wife got from knowing we had the formula in our luggage.