Economic substance has become established in international practice as a core element for the application of the arm’s length principle in transfer pricing. In an increasingly demanding regulatory environment—reinforced by the OECD Transfer Pricing Guidelines and the actions of the BEPS project—tax authorities and the technical teams of multinationals have shifted their focus from a purely formal assessment to an in-depth evaluation of the underlying economic reality of intra-group transactions.
This article examines with technical rigor what is meant by economic substance in transfer pricing, how it is integrated into functional analysis and the determination of tax results, and why it is a determining factor for the defensive sustainability of transfer pricing policies.
Technical definition of economic substance
In transfer pricing, economic substance refers to an entity’s actual ability to contribute to the generation of value within an intra-group transaction, based on the effective exercise of functions, the control of economically relevant risks, and the active use of assets necessary for the development of the business. This concept requires that the allocation of profits between related entities be consistent with the operational and decision-making reality, and not solely with the contractual structure or legal ownership of the assets.
From a technical perspective, economic substance is verified when the actual conduct of the parties confirms that key decisions and risk management are exercised in the entity that receives the corresponding economic returns. In this sense, the mere existence of contracts, internal policies, or formal agreements is insufficient if it is not supported by consistent functional, organizational, and financial evidence.
This concept has become established in international practice as a central criterion for assessing whether the allocation of profits between related entities effectively reflects the creation of value within the group. Consequently, economic substance operates as a technical element that connects functional characterization with the results obtained, making it possible to distinguish between structures based on real activity and those based solely on formal agreements.
Economic substance in the OECD Guidelines
The OECD Transfer Pricing Guidelines incorporate economic substance as a cross-cutting theme in the application of the arm’s length principle, particularly through the process of precisely defining the controlled transaction. This approach requires analyzing not only the contractual terms, but mainly the actual conduct of the parties, in order to identify how intra-group transactions actually take place.
In this context, the OECD establishes that, when there is a divergence between what is contractually agreed and how the parties act in practice, the latter should prevail for the purposes of characterizing the transaction and allocating results. This premise reinforces the importance of functional analysis as a tool for determining which entities exercise control over economically significant risks and which functions are decisive in generating value.
Likewise, in the area of intangible assets, the OECD deepens the analysis of economic substance through the DEMPE approach (development, enhancement, maintenance, protection, and exploitation), which seeks to ensure that the returns associated with these assets are allocated to the entities that effectively perform these functions, beyond legal ownership. In this way, economic substance becomes an operational criterion that conditions the allocation of profitability and limits structures that lack real functional support.
Technical components of economic substance
From a technical perspective, economic substance is not an abstract concept but rather a quantification and qualification of verifiable operational indicators. The main components include:
- Functions actually performed: decisions, execution of operational activities, active management of commercial relationships, and supervision of critical processes.
- Relevant assets used: not only the legal ownership of assets, but also their actual and direct use in generating income (including intangibles, specialized human capital, and technology).
- Risks assumed and controlled: entities claiming returns for specific risks are expected to demonstrate management capacity and actual economic exposure to those risks.
This approach requires that functions are not limited to contractual clauses, but translate into operational and financial decisions supported by documentary and quantitative evidence.
Economic substance and the arm’s length principle
The arm’s length principle requires that the terms of intra-group transactions be comparable to those that would occur between independent parties. Economic substance acts as the mechanism that links functional analysis to the transfer result, ensuring that the distribution of profits corresponds to the effective value contributions of each entity.
When economic substance is absent or insufficient, tax authorities may reconfigure transactions, reallocate income, or even question the deductibility of certain intra-group charges. Economic evidence thus becomes a decisive element in demonstrating that the returns obtained are aligned with the risks assumed and the functions performed.
Indicators of economic substance: assessment and evidence
The assessment of economic substance in transfer pricing is not limited to a formal review of the organizational structure, but requires the identification of objective indicators that make it possible to verify whether an entity plays a real and relevant economic role within the group. These indicators must be measurable, verifiable, and consistent with the actual conduct observed in the intragroup transaction.
From an audit perspective, the main technical indicators of economic substance include:
- Physical operational presence, understood not only as the existence of offices or facilities, but also as their effective capacity to support the performance of key functions. The authorities usually assess whether the available infrastructure is proportional to the economic relevance of the role attributed to the entity within the group.
- Specialization and qualification of personnel, particularly in relation to strategic decision-making and the control of economically significant risks. Substance is not demonstrated by administrative or support staff, but by teams with technical expertise, decision-making autonomy, and direct involvement in the management of the business.
- Real financial capacity to absorb the economic consequences of the risks assumed. This analysis considers, among other aspects, solvency, capital structure, and effective exposure to losses, avoiding assigning high returns to entities that lack the capacity to withstand adverse results.
- Contemporary documentary evidence, aimed at demonstrating that relevant decisions were made locally and at the appropriate time. Minutes, internal reports, approval flows, and operational documentation are essential to support that the observed conduct is consistent with the declared functional characterization.
Together, these indicators allow tax authorities—and internal technical teams—to distinguish between entities that operate as active economic centers, with a real contribution to value creation, and those whose function is limited to a merely legal or formal presence, lacking sufficient economic substance to justify the allocation of intragroup results.
Risks of failing to demonstrate economic substance
The absence of economic substance has very specific tax implications. Among the most significant risks are:
- Recaracterization of transactions: if the conduct is not aligned with the contractual structure, the authority may redefine the economic nature of the transaction.
- Redistribution of profits: profits allocated to entities without substance may be reattributed to jurisdictions where the economic value is actually realized.
- Tax adjustments and penalties: additional adjustments to the tax base and penalties for not reflecting transfer pricing planning economically.
These contingencies not only affect the tax burden, but can also trigger international disputes and double taxation if different jurisdictions adopt divergent interpretations of the substance principle.
Economic substance as a defense against modern taxation
Economic substance has become a central element in the application of the arm’s length principle and in transfer pricing risk assessment. Tax authorities no longer limit themselves to reviewing contractual structures or numerical results, but rather conduct a thorough analysis of whether the allocation of profits truly reflects where relevant decisions are made, how economically significant risks are managed, and which entities effectively contribute to value creation within the multinational group. In this scenario, demonstrating real economic substance becomes a determining factor for the technical soundness of tax compliance and defense.
In this context, TPC Group, as a company specializing in transfer pricing, assists multinational groups in the technical evaluation of the economic substance of their intra-group operations, aligning transfer pricing documentation and policies with the operational reality of the business and with the review criteria used by tax administrations. This approach not only mitigates tax contingencies but also strengthens the defensive position of organizations in the face of audits and disputes in multiple jurisdictions.
Source: OECD