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The primary purpose of an Agreement for the Avoidance of Double Taxation and of Tax Evasion with respect to Taxes on Income and Capital (double taxation agreement – hereinafter DTA) generally is to avoid double taxation by allocating taxing rights between the treaty partner jurisdictions. DTAs also usually provide a mechanism (by way of credit or exemption) to address cases where taxpayers are subject to double taxation. If a cross-border transaction takes place between associated enterprises whose countries of residence have concluded a DTA between themselves, and the relevant DTA contains an article based on Article 9 of the OECD Model Tax Convention on Income and on Capital³⁾ (hereinafter OECD-MTC) then the ALP must be considered for the allocation of taxation rights.

The Commentaries on the Articles of the Model Tax Convention (hereinafter OECD-Commentary) and the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereinafter TPG) are particularly relevant for interpreting the articles. DTAs, particularly with developing countries, are based on the United Nations Model Double Taxation Convention (hereinafter UN-Model). This also contains an article corresponding to Article 9 OECD-MTC. This means that the official United Nations Commentary and the United Nations Practical Manual on Transfer Pricing for Developing Countries (hereinafter TP-Manual) may have to be taken into account when interpreting articles, particularly in the case of more recent agreements with these countries. Since both model conventions basically follow the ALP, we refer primarily to the TPG.

Article 9 (1) of the OECD-Model forms the basis of the adjustment of profits of associated enterprises for tax purposes by applying the ALP as the underlying standard – dealing at arm’s length; the provision thus presupposes the allocation of the right of taxation under Article 7 OECD-Model.

By means of Article 9 OECD-MTC and the ALP as a legal fiction, taxation rights are therefore to be allocated according to a certain scale: profits should be taxed where they are generated economically. In the international context, the ALP is thus an expression of the territoriality principle and serves the principle of reason. It aims at an equitable allocation of taxation rights between states (inter-nation equity) and is intended to ensure that the same conditions of competition apply between independent and associated enterprises.

This is accompanied by the more secondary objective of avoiding economic double taxation. This is to be ensured in particular by the corresponding adjustment in Article 9 (2) OECD-MTC, provided that the other state shares the view of the state which made the primary adjustment in terms of the reason and amount; thus, the avoidance of double taxation is a combination of Article 9 (1) and (2) OECD-MTC.

At the same time, it follows from the objectives of avoiding double taxation, the fair allocation of taxing rights and the associated taxation at the place of economic activity that tax evasion or tax avoidance is undesirable. The prevention of tax avoidance is thus to be regarded merely as a reflex to the actual objective of regulating the allocation of taxation rights between the Contracting States and not as an independent objective in itself. Thus, the ALP is always to be applied in the same way, irrespective of any (low) tax rates, and is not aimed, among other things, at addressing arrangements which use preferential regimes or low-taxing states. As long as economic substance is available in these states (in the form of exercising functions, assuming risks and using assets), a corresponding share of the group’s profits is also allocated to these states.

The conditions for such an adjustment of profits are provided in Article 9 OECD-MTC and include the existence of associated enterprises in the Contracting States which are bound in their commercial or financial relations by agreed or imposed conditions which differ from those which independent enterprises would agree between themselves, whereby one of the two enterprises could have made higher profits without such agreements.

If a Contracting State makes an transfer pricing adjustment with regard to cross-border intra-group transactions (so-called primary adjustment), the function of Article 9 (1) OECD-MTC is to limit such adjustments to the level of profits which would have accrued under conditions made between independent parties.

The application of Article 9 (1) OECD-MTC requires a connection between the enterprises concerned:

i.	an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

ii.	the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State.

Article 9 (1) OECD-MTC distinguishes between the affiliation of two enterprises and the commercial or financial relations between them. It follows from this distinction that the shareholder relation that establishes or changes the relationship between the two enterprises must be excluded from the commercial and financial relationships. This does, however, not mean that the relations based on the shareholder relationship are excluded from Article 9 OECD-MTC. Shareholder relations may certainly qualify as financial relations unless they serve to establish or change the relationship between the two enterprises.

Commercial or financial relations between the associated enterprises are to be bound by made or imposed conditions. The requirement of commercial or financial relations is to be understood on the basis of the interconnectedness of two enterprises. Commercial or financial relations are not a constituent element of the relationship between the two enterprises. The terms commercial and financial relations are not defined in Article 9 OECD-MTC. Therefore, they cannot be clearly defined and distinguished from each other. The broad terms were intended to cover all possible constellations.

Participation in management, control and/or capital alone does not justify a profit adjustment. In addition, made or imposed conditions that do not comply with the ALP and therefore have an impact on the profits of the two enterprises must occur. Consequently, the participation must give the opportunity to have an impact on these conditions. The term conditions again, is subject to a broad interpretation. By way of example the TPG refer to „the price of goods transferred or services provided and the conditions of the transfer or provision” (see para. 1.2 TPG) and „including prices, but not only prices” (see para. 1.7 TPG). These conditions do not have to be agreed in writing, they can also be agreed orally and can be reflected in the behaviour of the parties involved. The conditions are normally negotiated by the associated companies. In this context, the assumption of conditions agreed does not prevent one of the two associated enterprises from exercising its dominant influence when the agreement is concluded. In the utmost cases, this can result in conditions being imposed by the dominant party. However, the conditions must be within the companies’ sphere of influence. If the conditions are external circumstances which cannot be influenced by the parties involved, then they are not accessible to the ALP (see also section 1.3). These include effects due to membership of the group, such as group support (implicit support), or circumstances which the law links to MNE groups (for example, the subordinated debt service of loans).

The ALP follows the approach of treating each MNE group member as if they were independent entities (separate entity approach). Hence, attention is focused on the nature of the transaction between the MNE group members and on whether the conditions differ from conditions which would have obtained between independent enterprises in comparable transactions and comparable circumstances, so-called comparable uncontrolled transactions. Given this, the analysis of controlled and uncontrolled transactions – the so-called comparability analysis which is further explained in Chapter 4 of this book – is „at the heart of the application of the ALP” (para. 1.6 TPG).

Any conditions that deviate from the ALP and are agreed or imposed between the associated companies must result in a reduction in profit for one entity. The term reduction in profit refers to the profit shown in the accounts of one of the two associated companies.

As for any other provision of the OECD-MTC, Article 9 is based on the principle that the provision does not oblige the Contracting States to adjust profits. An adjustment is allowed according to the relevant domestic law. Thus, the existence of relevant domestic regulations is a necessary condition for making the profit adjustment. If the domestic law of the Contracting States provide for the possibility of an adjustment, it is likely to be based on the ALP. In this respect, Article 9 (1) basically also defines the scope of the ALP. Article 9 (1) OECD-MTC however, does not provide a method of the profit adjustment, this is subject to the domestic law of the relevant Contracting State.

Article 9 (1) OECD-MTC is designed in such a way that a profit adjustment must first be made at the entity whose profit was reduced in deviation from the ALP. The term profit also includes losses which, contrary to the ALP, are shown too high. The relevant profit is always to be determined in accordance with the domestic law of the Contracting States. The amount of the reduction in the differential amount that has occurred and thus the amount of the profit adjustment to be made is also determined by domestic law.

Whereas Article 9 (1) OECD MTC forms the primary adjustment, Article 9 (2) OECD-MTC provides the basis for the so-called corresponding adjustment. The aim of Article 9 (2) OECD-MTC is to compensate the adjustment of income made by one Contracting State by an appropriate corresponding adjustment of income by the other Contracting State in order to avoid economic double taxation. This mechanism is intended to ensure that income should be taxed as if the controlled transaction had been undertaken at arm’s length conditions in the first place (para. 4.32 TPG). A corresponding adjustment is only made by a state to the extent that it shares the opinion of the state making the primary adjustment in terms of both reason and amount. However, the corresponding adjustment is not mandatory (OECD-Commentary, Article 9 para. 6.).

In order to make the actual profit allocation consistent with the primary adjustment, some countries assert a so-called constructive transaction under their domestic law. The constructive transaction will take the form of constructive dividends, constructive private equity contributions (or repatriations) or constructive loans (para. 4.68 et seq. TPG; see also EU-JTPF, https://ec.europa.eu/taxation_customs/sites/taxation/files/docs/body/jtpf_015add_2010_en.pdf).