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Innovate, innovate, says Schumpeter and his prophets, because innovation is associated with cost reduction and increased profits. However, many controlled (within group) corporate reorganizations lack economic substance because they violate this basic principle of innovation. Ergo, an objective of innovation is to reduce average costs and therefore to increase profits.  We provide a theorem and include an arithmetic proof that cost-reducing innovations (holding the product or service price constant) increase profits.

Transfer pricing audit of a controlled corporate reorganization ("reorg") has two phases. First, a corporate reorg between related parties must pass an economic substance test. Second, after economic substance is ascertained, the controlled transactions resulting from the reorg must pass an arm’s length test based on comparable uncontrolled transactions. This arm's length test can be measured per transaction or in aggregate. In a prior post, we provided a test to determine if a controlled corporate reorganization shows economic substance. Here, we further illustrate economic substance.  

Corporate reorganizations among related parties are vulnerable to challenges by tax authorities for lacking “economic substance”.  E.g., the U.S. Treasury Regulations § 1.482-1(d)(3)(ii)(B) provides that written contractual terms and the reallocation of risks will be respected if they are “consistent with the economic substance of the underlying transactions.” 

Likewise, the OECD Transfer Pricing Guidelines provides on ¶ 1.65: “There are two particular circumstances in which it may, exceptionally, be both appropriate and legitimate for a tax administration to consider disregarding the structure adopted by a taxpayer in entering into a controlled transaction. The first circumstance arises where the economic substance of a transaction differs from its form. In such a case the tax administration may disregard the parties’ characterization of the transaction and re-characterize it in accordance with its substance. … The second circumstance arises where, while the form and substance of the transaction are the same, the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price.”