Professional Documents
Culture Documents
ADIT
PAPER 3.03
Advanced International Taxation (Thematic)
2019 Sittings
June and December
145
PLEASE READ “HOW TO PASS” ON THE ACADEMY BEFORE
STARTING YOUR STUDIES.
Published by
This material contains general information only. Whilst every care has been taken
to ensure the accuracy of the contents of this work, no responsibility for loss
occasioned to any person acting or refraining from action as a result of any
statement in it can be accepted by the author or the publishers.
Parts of this manual have been prepared from original material supplied by
authors for the production of the Tolley publication: UK Transfer Pricing 2012/13.
CONTENTS
DETAILED CONTENTS
CHAPTER 1
FUNDAMENTAL SOURCES
1.1 Introduction
In this chapter we are going to begin by looking at the general concept of transfer
pricing, not just in a tax context. As you will see, transfer pricing is not just used for
tax purposes. We will then go on to look at transfer pricing in a tax context, looking
at the role of double tax conventions and the OECD Transfer Pricing Guidelines.
This chapter lays the foundations for this course - we will go on to look in detail at
the key concepts outlined here in later chapters.
The economic reason for charging transfer prices is to be able to evaluate the
performance of the relevant segments of the organisation. By charging
appropriate prices for goods and services transferred within a group, managers of
group entities are able to make the best possible decision as to whether to buy or
sell goods or services inside or outside the group and they are able to make a
realistic judgement about the relative contribution being made by each entity to
the overall profits from a particular product or service.
So it is not all about taxation; the illustration below demonstrates the importance of
setting the right transfer price for a business.
Illustration 1
Entity 1
← Production cost
(Loss)
Product
↓
Entity 2
Profit
↑
Sale
Revenue
Clearly, a transfer price is needed, so that the accounts of both entities better
reflect the economic contribution that they have made.
The above might seem obvious, but it bears repeating, because there has been a
tendency, particularly in recent years, for the term “transfer pricing” to be used (by
certain politicians, journalists and campaigners) in a pejorative sense, as if the term
has inherent connotations of deliberately charging inappropriate prices in order to
shift taxable income artificially from a company in a high tax country to a related
company in a country with a lower tax rate.
This is a misuse of the term. Transfer pricing is a process which every multinational
enterprise must necessarily carry out and it is inherently neither good nor bad. This
was a point made by the United Nations Secretariat in 2001. (“Transfer Pricing
History-State of the Art-Perspectives”, a paper by the United Nations Secretariat
dated 26 June 2001) It is certainly possible to set transfer prices that are blatantly
inappropriate, in an attempt to avoid tax, and no doubt there are some
organisations that do so. This is, however, certainly far less common than some
campaigners would claim, and highly unlikely to be successful.
We will look at the role transfer pricing has in respect of the internal operation of
multinational groups in a later chapter towards the end of this manual dealing with
the strategic and managerial aspects of transfer pricing.
As the taxable profits of the entities will normally be based upon the accounting
profits, which will necessarily reflect the transfer prices that have been used, the
transfer prices will affect the taxable profits in both countries. For this reason,
transfer pricing usually has important tax consequences, which has given rise to
specific tax legislation in relation to transfer pricing. This manual mainly relates to
transfer pricing in its tax context, rather than the wider management accounting
sense.
Illustration 2
Entity 1
Country 1
Product
↓
↓ 3rd Party Customer
Entity 2 ←
Country 2
↑
↑ Sales Product →
Revenue
To be specific, the main tax impact of transfer pricing is that although it would not
normally change the combined profit before tax made by the entities between
which the transfer price applies, transfer pricing does affect how that combined
profit is split between the entities. If those entities are taxpayers in different
countries, transfer pricing therefore affects the share of that combined profit that is
taxable by each country.
There is therefore potential scope for the two taxpayers to conspire to set the
transfer price in order to influence how the profits are split between them or for
other factors to lead the taxpayers to adopt transfer pricing that differs from what
they would have adopted if they were unrelated. Accordingly, transfer pricing
rules seek to ensure that transfer prices are set so that each country gets to tax its
fair share of the profit.
The term transfer pricing is inseparable from the concept of the arm's length
principle (we will look in detail at the arm’s length principle below).
Tax rules on transfer pricing generally authorise a tax authority to increase the
taxable profits of the taxpayer entity if the transfer pricing between it and another
related party is higher than or lower than the arm's length price, and, as a result,
the taxable profits of the taxpayer entity have been understated.
The arm's length price is the price that is paid in a comparable transaction
between unrelated parties.
The process of comparing the actual transfer price with the arm's length price is
referred to as the arm's length test.
The arm's length principle is the principle that transfer prices between related
parties should meet the arm's length test.
In some countries, the arm's length principle is used in a slightly different way, as
the standard by which it is determined whether a company has given a
constructive dividend or hidden profit distribution to its parent. The result is that the
company is denied a deduction for the relevant expenses for tax purposes and
may sometimes also suffer withholding tax on the deemed dividend.
Although the arm's length principle has been adopted extremely widely as the
appropriate standard by which it should be judged if a transfer price is
acceptable, there are some countries which refuse to accept the arm's length
principle. In recent years, countries such as India and China have adopted the
arm's length principle. In 2017 Italy further aligned its transfer pricing rules with the
OECD Standard by replacing their concept of “normal value” with specific
reference to the arm’s length principle. Perhaps the most notable country which
rejects the arm's length principle is Brazil, which currently sets its own rules about
acceptable levels of profits from intercompany transactions.
The arm's length principle appears in two main settings. First, it appears in domestic
tax transfer pricing legislation of many countries. Second, it appears in double
taxation treaties (also known as double tax agreements or conventions) and
related guidance. We will look at the arm’s length principle in the context of tax
treaties below.
Based on an OECD survey published in 2012, the arm's length principle was first
introduced in domestic legislation in 1911, by Norway. (“Multi-Country Analysis of
Existing Transfer Pricing Simplification Measures – 2012 Update”,
www.oecd.org/dataoecd/42/33/50517144.pdf). It was followed by the UK in 1915.
The USA, which is often seen as the birthplace of transfer pricing, did not introduce
this obligation until 1935, although this would still make it one of the earliest
adopters.
The aforementioned OECD survey provides the following chart showing the dates
reported by the 41 countries which provided information for the survey. (We note
however that some countries, such as France, interpreted the question as relating
to the introduction of the arm's length principle in its current legislative form.) As
can be seen, there has been a surge of countries introducing the arm's length
principle in their domestic tax legislation over the last two decades.
The chart only shows the OECD member countries, but the trend to introduce
transfer pricing rules has recently spread to many other countries and it is now
relatively rare for any countries not to have transfer pricing rules (which are
generally based around the arm's length principle). For instance, the 2015 edition
of the book International Transfer Pricing, published and written by
PricewaterhouseCoopers, contains reports on transfer pricing rules in more than 90
different countries. The main exceptions are tax havens, countries cut-off from
international trade, such as North Korea, and some of the least developed
countries in the world.
The arm's length principle was included in tax treaties concluded by France, the
UK and the USA as early as the 1920s. This led to the principle being incorporated in
Article 6 of the League of Nations draft Convention on the Allocation of Profits and
Property of International Enterprises in 1936. It was incorporated as Article VII in the
Mexico Draft of 1943 and in the London Draft of 1946. These articles are
substantially similar to Article 9 of the 1963 OECD Draft Convention and Article 9,
paragraph 1 of the present OECD and UN Model tax treaties. (“Transfer Pricing
History-State of the Art-Perspectives”.) Article 9 is described further on in this
chapter. These days, the arm's length principle is a ubiquitous feature of virtually
every fully fledged tax treaty.
The OECD Guidelines on Transfer Pricing are an important part of this course. We
will be making reference to them throughout the manual. You may find it useful to
have a copy to hand so that you can look at them as you are studying.
In the early 1990s, the OECD recognised the need to update, consolidate and
expand its 1979 and 1984 reports on transfer pricing and multinational enterprises
in response to huge growth in international trade and the spread of multinational
enterprises. Further impetus was given by the fact that the US was pushing ahead
with its own, wide-ranging, unilateral views on how the arm's length principle
should be applied and these views were not always congruent with the views of
other countries. The OECD took the view that it was important to bridge the
differences that were developing, as one of its main missions is to avoid double
taxation.
The result was a report entitled “Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations”, which is almost universally referred to within
transfer pricing circles as the “OECD Guidelines”. As described below, the
Guidelines have evolved since they were created in 1995. In this manual we refer
to the OECD Guidelines as OECD TPG.
The original OECD TPG were issued in 1995. In fact, they were released in
instalments, starting with Chapters I to V in 1995, covering the Arm's Length
Principle (Chapter I), Traditional Transaction Methods (Chapter II), Other Methods
(Chapter III), Administrative Approaches to Avoiding and Resolving Transfer Pricing
Disputes (Chapter IV), and Documentation (Chapter V). These were
supplemented by Chapter VI, Special Considerations for Intellectual Property, and
Chapter VII, Special Considerations for Intra-Group Services, in 1996. A year later,
Chapter VIII, on Cost Contribution Arrangements, was published.
After a relatively quiet period in terms of new guidelines from the OECD, 2010 saw
the culmination of several years work on two projects. The first project led to
revisions of the first three chapters of the OECD TPG. Symbolic of the removal of
the preference for the traditional transaction-based methods, all methods are now
dealt with in a single chapter, Chapter II. Additional guidance was provided in
relation to comparability analysis. Arguably, the discussion of the Transactional Net
Margin Method is more accepting of the fact that often this method can only be
applied using the overall profitability of comparable companies, and therefore
moves closer to the US Comparable Profits Method.
The second project related to the Transfer Pricing Aspects of Business Restructurings
and this gave rise to Chapter IX, the first chapter to be added to the OECD TPG
since 1997. (Discussed further in a later chapter).
In April 2013 Chapter V was revised to reflect the new stance on safe harbours. We
will also look at this in a later chapter.
In May 2016 the OECD formally adopted the proposed changes to the 2010 OECD
TPG put forward in the final reports of October 2015 for Action Points 8 to 10 of the
Base Erosion and Profit Shifting (BEPS) project (see section on BEPS below). This
means that they are encouraging both members and non-members to follow the
guidance set down in the October 2015 BEPS reports. The OECD TPG were reissued
in July 2017.
The executive summary for Action Points 8 to 10 (as they were dealt with together)
states that the work under the BEPS Action Plan “will ensure that transfer pricing
outcomes better align with value creation of the MNE”.
The final report issued in October 2015 amends part of Chapter 1, adds additional
guidance to Chapter II and replaces in their entirety Chapters VI, VII and VIII.
Chapter I of the OECD TPG is where we find the guidance on the arm’s length
principle. The changes arising from the BEPS project will be looked at in detail as
you work through this manual, however at this point it is worth noting that the
changes focus on the accurate delineation of a transaction. That is to say,
ensuring that when we look at a controlled transaction we are looking at what is
really happening rather than what the paperwork might say. An important step in
this process will be an accurate functional analysis and the accurate assignment
of risk, as you will see as you work through this manual.
The impact of the recommendation to adopt the final report on Action Points 8 to
10 will vary from country to country; as mentioned below (see section on
Application of OECD TPG by States) countries take different approaches with
respect to whether and how they incorporate the OECD TPG into their domestic
tax systems. It may be that some countries will require formal administrative or
other action to incorporate a new version of the TPG into the domestic law, in
other cases it may be automatic. In addition, some countries may take the view
that the amendments to the TPG merely clarify pre-existing transfer pricing
principles, and consequently in practice could have retroactive effect.
The agreed amendments don’t just affect OECD members as they represent the
consensus of all the countries that were part of the OECD/G20 BEPS Action Plan.
These included all OECD Member States, plus Argentina, Brazil, the People’s
Republic of China, Colombia, India, Indonesia, Latvia, the Russian Federation,
Saudi Arabia and South Africa.
As mentioned above, the OECD TPG were reissued in July 2017. In addition to the
above changes, consequential amendments were made to other chapters, in
particular Chapter IX. In this manual, unless otherwise stated, all references are to
the 2017 Guidelines.
This is the agreement reached between Member States of the OECD that acts as
guidance when negotiating tax treaties. The convention consists of articles,
commentaries, position statements and special reports on evolving tax issues. Its
primary application is in guiding the negotiation of bilateral tax treaties between
countries. The OECD Model DTC has to be read in conjunction with the detailed
commentary on its interpretation. The Model and the Commentary are the work of
the Committee on Fiscal Affairs of the OECD, which is composed of senior
government officials drawn from the OECD members.
The aim of the OECD Model DTC is to provide certainty to international trade
transactions. The commentary is used to provide guidance on treaty interpretation
and to try to provide conformity in international tax.
It should also be noted that the UN has also produced a Model Tax Convention
(UN Model DTC) that is used by developing nations when negotiating tax treaties.
The UN Model DTC is designed to aid developing states to tax a larger part of the
overseas investor's income than other models.
In this section we are going to look at some of the articles from the OECD Model
DTC that are important to your studies. The current model treaty was issued in 2017
update; this will be referred to where relevant.
As already mentioned, the arm's length principle has been incorporated in double
taxation agreements since as early as the 1920s. This led to it becoming Article 9 of
the Model DTC originally issued by the OECD in 1963, based on earlier model tax
treaty wording created by the League of Nations. Article 9 of the United Nations
model treaty has similar wording. The arm's length principle also plays a role in
several other articles of the OECD Model DTC including Article 11, Interest, Article
12, Royalties, and Article 7, Business Profits. These are discussed below.
Article 9 is the article which permits countries that have signed a double tax treaty
(with wording based on the OECD Model DTC) to adjust inappropriate transfer
pricing. If it were not for this Article, it could be protested that making a transfer
pricing adjustment should not be allowed, because the treaty generally sets out to
eliminate double taxation.
Article 9
ASSOCIATED ENTERPRISES
1. Where
and in either case conditions are made or imposed between the two enterprises in
their commercial or financial relations which differ from those which would be
made between independent enterprises, then any profits which would, but for
those conditions, have accrued to one of the enterprises, but, by reason of those
conditions, have not so accrued, may be included in the profits of that enterprise
and taxed accordingly.
The wording is somewhat tortuous, but if it is read slowly the meaning is clear.
The Commentary makes it clear that if the two countries disagree about the
appropriate adjustment, the mutual agreement procedure provided for under
Article 25 should be implemented (we will look in detail at Article 25 in a later
chapter).
Article 9 does not contain any time limits. The Commentary makes it clear that this
is not because it necessarily feels there must be an open-ended commitment to
give a corresponding adjustment. The question of time limits is left for individual
countries to negotiate in their individual bilateral double taxation agreements,
based on the OECD Model DTC. If the relevant double taxation agreement is silent
on this matter, time limits will presumably follow domestic law.
Your syllabus includes knowledge of certain aspects of the UN Model DTC). The UN
Model DTC contains wording which mirrors Article 9 of the OECD Model DTC (also
at Article 9), but in 2001 a third paragraph was inserted, as follows:
This is an important difference between the OECD Model DTC and the UN Model
DTC that you should note.
The other main part of the OECD Model DTC in which the arm's length principle
plays a core role is Article 7.
Article 7 sets out the consequences of having a PE and defines the extent to which
the business profits of an enterprise are taxable in a Contracting State within which
it has a PE (sometimes referred to as the “source” state). The wording is as follows:
Article 7
BUSINESS PROFITS
2. For the purposes of this Article and Article [23A] [23B], the profits that are
attributable in each Contracting State to the permanent establishment referred to
in paragraph 1 are the profits it might be expected to make, in particular in its
dealings with other parts of the enterprise, if it were a separate and independent
enterprise engaged in the same or similar activities under the same or similar
conditions, taking into account the functions performed, assets used and risks
assumed by the enterprise through the permanent establishment and through the
other parts of the enterprise.
4. Where profits include items of income which are dealt with separately in other
Articles of this Convention, then the provisions of those Articles shall not be
affected by the provisions of this Article.
This wording is taken from the 2017 OECD Model DTC. We will look at the
background to this wording in detail in the chapter on attribution of profits to a PEs.
Paragraph 1 sets out the basic rule, which is that an enterprise of a Contracting
State is only taxable in the other Contracting State on the profits that are
attributable to its PE in that other State.
The arm's length principle is brought into play by paragraph 2 of the Article,
specifically the requirement that the profits that are attributable to the PE should
be the profits that the PE might be expected to make if it were a separate and
independent enterprise engaged in the same or similar activities under the same
or similar conditions. In other words, we are required to hypothesise that the PE is
an enterprise separate and independent from the enterprise of which it is in fact a
part. We then apply the arm's length principle in order to determine the
appropriate transfer pricing of any hypothetical transactions between the two
hypothetical entities. We will see in a later chapter that paragraph 3 provides for a
corresponding adjustment and that paragraph 4 gives precedence to other
articles in the treaty.
Article 11 Interest
Article 11 of the OECD Model DTC relates to interest arising in one Contracting
State and paid to a resident of the other Contracting State. The first five
paragraphs of the article apply regardless of whether the borrower and lender are
associated. However, paragraph 6 introduces a special rule which denies the
protection of the article to interest that does not meet the arm's length test.
It can be seen that the concept of the amount of interest that would have been
agreed upon between the borrower and lender in the absence of the special
relationship between them amounts to the arm's length test.
The general effect of Article 11 is to limit the amount of tax that can be applied by
the country where the interest is sourced. The OECD Model DTC limits the tax to
10% of the interest, although many double taxation agreements that are based on
the OECD Model DTC adopt different limits and in many cases source taxation is
prohibited altogether. This protection is removed for interest in excess of an arm's
length amount.
Article 12 Royalties
Article 12, the royalties article of the OECD Model DTC, includes a special
relationships paragraph (in this case paragraph 4) which has a similar effect to
paragraph 6 of Article 11. That is, there is no protection from source taxation of a
royalty that exceeds an arm's length royalty.
The OECD has no authority to bind member countries to its Guidelines. Few of
them have, like the UK, incorporated the TPG within their domestic legislation.
However, all member countries accept that the TPG are intended to represent the
international consensus and that if there is a divergence of practice, this heightens
the risk of double taxation, which could discourage international trade. In
practice, they are highly influential amongst all OECD member countries and
increasingly amongst countries that are not OECD members. They have become
the international norm for how transfer pricing analysis is conducted, except in the
relatively rare cases where governments explicitly reject the arm's length principle,
the most prominent example being Brazil. In February 2018, the OECD announced
that they had launched a joint project to examine the similarities and gaps
between the Brazilian and OECD approaches to valuing cross-border transactions
between associated firms for tax purposes. The project will also assess the potential
for Brazil to move closer to the OECD’s transfer pricing rules. A fifteen-month work
project has been set out.
Brazil has detailed rules on related entities and classes all entities in low tax
jurisdictions as related. The acceptable methodologies do not follow the OECD
TPG. For example, they do not include any profit based methodologies.
Brazil has an approach that sets out a maximum ceiling on the expenses that may
be deducted for tax purposes in respect of imports and lays down a minimum
level for the gross income in relation to exports, effectively using a set formula to
allocate income to Brazil. Taxpayers are allowed to use the method that gives the
lowest taxable income.
Part of the reason why most countries endeavour to abide by the OECD TPG is
that they can effectively be seen as forming part of the OECD Commentary on
how Article 9 of its Model DTC should be applied. The actual Commentary on
Article 9 cross-refers to the OECD TPG. The OECD TPG would therefore be a major
determinant of how any dispute between treaty partners is resolved under Mutual
Agreement Procedures (that is, negotiations to try to reach a common position
about the arm's length transfer price for the purposes of Article 9, so that any
transfer pricing adjustment made by one country is balanced by a corresponding
opposite adjustment in the other country, without which double taxation would
arise). We look at the Mutual Agreement Procedure (MAP) in detail in a later
chapter.
If a country adopts a transfer pricing position that is contrary to the OECD TPG, it
knows that it is likely to find itself trying to defend this position in the MAP and few
countries are willing to allow the MAP to fail by insisting on an interpretation of the
arm's length principle that is inconsistent with the OECD TPG. This tends to
encourage countries to abide by the OECD TPG at all stages of applying their
transfer pricing rules.
It should also be noted that the OECD TPG are just that: guidelines. They are not
worded in the same way as legislation, in a completely definitive, prescriptive
fashion. Rather, they make observations about what would generally be
preferable and they frequently leave room for alternative interpretations. They are
the result of discussions amongst many people representing many countries and
other organisations and it is not always possible to reach full consensus. As a result,
the OECD TPG sometimes deliberately do not address certain contentious issues
(or they explicitly state that no consensus has yet been reached). An example
would be the discussions about business restructuring before the 2010 update to
the OECD TPG, which frequently became bogged down by disagreements about
the treatment of intangible assets. In order not to hold up the Business
Restructuring chapter of the OECD TPG any longer, intangibles were taken out of
the scope of the business restructuring work. They were carved out into a separate
project.
At the time of writing the OECD member countries are: Australia, Austria, Belgium,
Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany,
Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea (South), Latvia,
Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal,
Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom
and the United States.
Generally speaking, these are highly developed countries, although some of the
more recent joiners, such as Turkey and Mexico, would generally be considered to
be developing countries, albeit at the richer end of the spectrum of development.
The OECD is accordingly seen by some as being a club that represents the
interests of rich countries.
The United Nations Model DTC is generally seen as being an alternative to the
OECD Model DTC which contains wording that is intended to be more favourable
to less developed countries. (However, the differences tend not to relate to
transfer pricing.) As noted earlier the UN Model DTC Article 9 (Associated
Enterprises) refers to the arm's length principle in a similar manner to the OECD
Model DTC.
The UN has not produced a set of guidelines of its own. Instead they have
published a Practical Manual on Transfer Pricing for Developing Countries. This
manual is designed for countries seeking to apply the arm’s length principle and
provides a practical approach to applying the OECD TPG. This manual is part of
your syllabus - again you should consider obtaining a copy to look at as you work
through this study manual. There is further detail on the UN Practical Manual on
Transfer Pricing below.
As mentioned above the OECD TPG are a guide to the member countries. The
OECD website includes country profiles at http://www.oecd.org/tax/transfer-
pricing/transfer-pricing-country-profiles.htm. If you go to this page you can click on
the various member countries and see how many diverge from certain aspects of
the guidelines, e.g. Mexico, Argentina or Germany.
Although the OECD TPG and the OECD Model DTC have now been updated for
the outcomes of the BEPS project, the project itself and some of the final reports
are still part of the syllabus. As a result, this section includes a recap on BEPS and a
summary of the final reports that are still included in the syllabus.
BEPS has wider implications than just transfer pricing. We will look briefly at some of
the wider aspects here and consider in detail the aspects relating to transfer
pricing throughout this manual whenever they are relevant.
The OECD published the BEPS Action Plan on 19 July 2013. OECD secretary general
Angel Gurría said that the Action Plan marks 'a turning point in the history of
international tax co-operation'. KPMG commentators noted that the scale of the
report and its ambitions for change represented 'a potential seismic shift in the
international tax landscape'. At the G20 meeting which followed the publication it
was commented that the effective taxation of 'mobile income' was a key
challenge.
As noted in the report, one of the key problems is that national tax laws have not
kept pace with the globalisation of corporations and the digital economy, leaving
'gaps that can be exploited by multinational corporations to artificially reduce
their taxes'. The digital economy offers 'a borderless world of products and services
that too often do not fall within the tax regime of any specific country, leaving
loopholes that allow profits to go untaxed'.
The Action Plan offers a 'global roadmap' to allow governments to collect the tax
revenue they need and give businesses the certainty they need to invest and
grow. Fifteen specific actions were identified in the report which would give
governments domestic and international instruments to prevent corporations from
paying little or no taxes.
The principle of coherence is highlighted in the plan with the intention that there
should be neither double taxation nor double non-taxation. From a business point
of view, coherence means all business income should be taxed once and all
business expenditure should be deducted once.
It is notable that the Action Plan clearly rejected the introduction of unitary
taxation or global formulary apportionment. This is because of 'the practical
difficulties associated with agreeing to and implementing the details of a new
system consistently across all countries'. However, within the existing transfer pricing
regime the plan did give consideration to measures which may 'go beyond the
arm's length principle' in dealing with intangibles, risk and capital allocation -
which is likely to mean a wider use of profit split methods in place of the reliance
on comparable transactions.
• review the application of existing international tax rules to the digital economy
(ie online businesses);
However, the Action Plan did not propose any radical change. Instead, the Action
Plan relied on amending and strengthening existing mechanisms such as transfer
pricing, controlled foreign company and permanent establishment rules.
The final reports from the Action Plan were delivered in October 2015. Their impact
on the OECD TPG and transfer pricing in general will be discussed throughout this
manual.
The final report on Action Points 8 to 10 used one report to cover the transfer
pricing aspects relating to the need to assure that transfer pricing outcomes are in
line with value creation in relation to intangibles, including hard-to-value ones, to
risks and capital, and to other high-risk transactions. The final report impacted on
many of the chapters in the OECD TPG beginning with Chapter I where
amendments were needed to the definition of risk and control of risk, the
guidance on comparability factors including synergies and market specific factors
and a new definition for when transactions can be set aside (non recognition).
Specific paragraphs were added to Chapter II to deal with commodities. Chapter
VI on IP was substantially amended. A section on low value-adding services was
added to Chapter VII on services. Chapter VIII on Cost Contribution Arrangements
(CCA) was rewritten. In addition, the final report set down the need for further work
to be done in relation to the profit split method. We will work through each of
these amendments as we progress through the manual.
The final report on Action Point 13 lead to one of the first BEPS outcomes, being the
revision of Chapter V on documentation and the implementation of the three-tier
approach including the now widely adopted country-by-country report (CbC).
The revised approach to documentation will be looked in detail in a later chapter.
The final report on Action Point 14 which concerned making dispute resolutions
more effective lead to changes in Article 25 of the OECD Model DTC and its
Commentary. It also included minimum standards and best practices – we will look
at these later when dispute resolution is covered in detail.
As with the first version there are chapters on country practices, which have been
revised and extended.
The aim of the UN Manual is to strengthen the application of the arm’s length
principle as set down in Article 9 of both the UN and OECD Model DTC and the
OECD TPG. The revision includes updates to reflect the outcomes of the OECD
BEPS project. The manual shows how the arm’s length principle can be applied by
developing nations who have particular problems trying to identify the market
price. These problems include a lack of comparables and local development of
intangibles not being taken fully into account.
The manual also includes areas of non consensus with the OECD approach. It
includes chapters outlining the rules of Brazil, China, India, Mexico and South
Africa. As noted above, these chapters were revised and extended in the 2017
version.
This section looks at the background and objectives of transfer pricing rules. It
includes a section on ‘value chain analysis’.
This is the main part of the manual which includes a detailed discussion of
comparability analysis and practical examples of the five OECD approved
methodologies, including selection and implementation of each. (We will look at
the methodologies in a later chapter). There is also a section on what is referred to
as the “sixth method” for commodity pricing. This “sixth method” is used in Brazil
and Argentina and there is also a mention of it in the revised OECD TPG. As noted
above, there are now chapters on services, intangible property, Cost Contribution
Arrangements and business restructuring.
This section includes practical guidance for implementing a transfer pricing regime
include practical advice for tax authorities trying to build capacity to deal with
transfer pricing issues. It also covers documentation, audit, risk assessment and
dispute avoidance.
D: Country example
As noted above the examples given are Brazil, China, India, Mexico and South
Africa. Each country is an example of a regime that does not conform to the
OECD approach and as a result may not always adhere to the arm’s length
principle. Mexico is the new addition in the revised version of the manual.
In the remainder of this section on the UN Manual we will look at some interesting
aspects of the 2017 UN Manual. It will make more sense when you have worked
through the entirety of this study manual. So, on your first read through, you should
note the points highlighted below but do not attempt to follow everything that is
covered. Highlight this section as one to come back to prior to starting your
revision phase.
The first version of the UN Manual adopted the approach to risk that the OECD in
its report on intangibles and previous reports on restructuring had taken i.e. that it is
not only the contractual obligation that determines allocation of risk but also
whether there is control over the contracted risk. Control is determined by
competence and ability to control risks.
The 2012 manual stated that in any transfer pricing study it is necessary to identify
risk and which party bears the risk. Tax authorities have to check that group
contracts allocation of risk also reflect the actual allocation of risk. This contractual
allocation should be arm’s length. The concept of control over risk is also
introduced to determine an arm’s length allocation of risk. Factors to consider in
determining control over risk are as follows:
• Core functions.
• Key decisions: strategic decisions which have greater potential to impact the
ability of an entity to generate profit and the amount of profits.
The revised version builds on this and includes a worked example of the six stage
process of risk assessment found in paragraph 1.60 of Chapter I of the OECD TPG.
You may find the worked example useful for your studies.
Location Savings
This chapter of the UN Manual (as with the earlier version) also has sections on
location savings (B2.3.2.51–B2.3.2.61) i.e. when an operation is transferred to a low
cost location, there is the question of which group company should benefit from
the cost reductions generated from the relocation. The savings can include:
labour costs, raw material costs, transportation costs, rent, training costs, subsidies,
incentives and infrastructure costs. There may also be location costs: poor
infrastructure, power supply deficiencies, transport costs, cost of quality control.
The difference is the net location saving.
There may also be location advantages: highly specialised skilled manpower and
knowledge, proximity to growing local/regional market, large customer base with
increased spending capacity, advanced infrastructure (e.g. information/
communication networks, distribution system) or market premium. The manual
refers to the savings and advantages as location specific-advantages (LSAs).
A further term is used in the manual. This is location rent which is defined as the
incremental profit derived from LSAs. Even if LSAs exist there may be no location
rent e.g. where the market is competitive and LSAs have to be passed to third
party customers through lower prices. In other cases the whole of the location rent
may pass to the group in the short term until competition erodes the profit.
The allocation of rent depends on the competitive factors in the market. Some
examples are given:
• The group low cost producer may be the first to operate in the low cost
jurisdiction and there are no comparable low cost producers in its or other
jurisdictions. Therefore the low cost producer can take advantage of the
location rents.
The question is then how to split these profits. The guidance is fairly limited but does
refer to the relative bargaining position of the group as one solution to how to do
this split.
China has also contributed a section - location specific advantages together with
examples.
It defines location savings as the net cost savings derived by a MNE when it sets up
its operations in a low cost jurisdiction. Net cost savings are commonly realised
through lower expenditure on items such as raw materials, labour, rent,
transportation and infrastructure even though additional expenses (“dis‐savings”)
may be incurred due to the relocation, such as increased training costs in return
for hiring less skilled labour.
India has also contributed to the UN Manual on location savings. The Indian
transfer pricing administration states that the concept of “location savings” is one
of the major items to be reviewed when carrying out comparability analysis during
transfer pricing audits. Location savings is interpreted as any cost advantage. The
manual states that India provides operational advantages to groups such as
labour or skill employee cost, raw material cost, transaction costs, rent, training
cost, infrastructure cost, tax incentives.
Again the incremental profit from LSAs is known as “location rents”. The main issue
in transfer pricing is the quantification and allocation of location savings and
location rents among a group.
The Indian transfer pricing administration believes it is possible to use the profit split
method to determine arm’s length allocation of location savings and rents in
cases where comparable uncontrolled transactions are not available taking into
account the bargaining power of the parties.
The Indian tax authorities also point to the problems that may arise with payments
of brand and trade mark royalties where the Indian distributor has incurred costs of
promotion. In fact in many cases no royalty should be paid and in fact the Indian
distributor is entitled to a reward for developing the marketing intangible in India.
This issue has been examined in the recent case of LG Electronics India Pvt. Limited
v ACIT. On the facts of the case an adjustment made by the tax authorities for
creating a brand was upheld by the Delhi tribunal.
The marketing intangible issue has historically been raised by the IRS in its dispute
with Glaxo. Initially the IRS denied Glaxo US a deduction for the payment of trade
mark royalties because it was the economic owner of the marketing intangibles. It
appears that the Indian tax authorities have taken this point and more tax cases
may be expected on this topic.
Chapter B3 of the revised manual covers the selection and application of the five
OECD approved methodologies. It also includes guidance on the “sixth method”.
This is described as a method used by developing nations when they lack sufficient
documentation from the controlled transaction to determine if it is comparable
with uncontrolled transactions. The tax authorities in these cases will rely on the
quoted prices of the commodities market to price commodity transactions
between associated enterprises. This is what the UN Manual calls the “sixth
method”; it is also sometimes referred to as the “commodity rule”.
To date, practical experience with the rule exists in mainly in Argentina, Brazil,
Ecuador and Uruguay. However, the method is not applied unequivocally the
same in all these countries.
It is recognised that the workings of the sixth method may resemble the
Comparable Uncontrolled Price (CUP) method, however no attempt is made to
reconcile them or state the impact of the sixth method for the arm’s length
principle.
The sixth method has the benefit of relative certainty and relative ease of
application for the tax authorities and its tax collection efficiency. However it also
has the disadvantage that it is not one of the OECD approved methods and thus
may not be recognised by the country of the associated enterprise at the other
end of the transaction; this could lead to double taxation. There are also other
disadvantages outlined in this section.
The OECD position on the sixth method is outlined as it was looked at as part of
Action Point 10 of the BEPS project; as a result Chapter 2 of the OECD TPG was
amended to include a section on the application of the CUP methodology to
commodity transactions. We will look at this in a later chapter when we look at the
OECD Methodologies.
Services
In the minor expense safe harbour option, a tax authority agrees to refrain from
making a transfer pricing adjustment if the total cost of either receiving or
providing intra-group services by an associated enterprise is below a fixed
threshold based on cost and a fixed profit mark margin is used. The rationale for
this safe harbour is that the cost of a tax authority making adjustments is not
commensurate with the tax revenue at stake and therefore the taxpayer cannot
be expected to incur compliance costs to determine more precise arm’s length
prices.
The description of the low value-adding services safe harbour is in line with the
OECD approach although no indication of the % mark-up is given or a reduced
benefits test. The rationale for this safe harbour is that there may be difficulties in
finding comparable transactions for low value-adding services; and the
administrative costs and compliance costs may be disproportionate to the tax at
stake. In addition, the safe harbour provides taxpayers and tax authorities with
certainty.
The chapter finishes with a list of low value-adding services based on the list of
intra-group services set out in Annex I ‘List of intra-group services commonly
provided that may or may not be within the scope of this paper’ of the European
Commission, ‘Guidelines on low value-adding intra-group services’ (Brussels,
25.1.2011 COM(2011) 16 final.)
Intangibles
The chapter on intangibles, in line with the OECD approach, points out that group
synergies are not an intangible although they do need to be taken into account
when looking at intangibles.
Business Restructuring
This chapter is surprisingly short given that it begins by noting that business
restructuring increasingly affects developing countries. In recent years a number of
large MNEs have either (i) transferred their manufacturing facilities into low-cost
countries, e.g. where the cost of labour of a skilled workforce is lower and/or (ii)
similarly moved certain distribution functions and/or (iii) similarly moved valuable
intangible property out of the jurisdiction where they were acquired, developed or
exploited.
The chapter sets down a process for setting or testing the arm’s length principle in
business restructuring operations and gives a worked example.
The arm’s length principle has always had its detractors. The original report by the
OECD in 1979, “Transfer Pricing and Multinational Enterprises”, devoted space to
discussing the alternatives to the arm's length principle as a way to allocate taxing
rights in relation to the profits made by multinational enterprises.
The main alternative is global formulary apportionment, (as noted earlier this is
sometimes called unitary taxation) under which the total consolidated worldwide
profits of a group are allocated between the various jurisdictions where the group
carries out business activities. The allocation is based on a formula, usually
consisting of certain allocation keys, such as turnover, payroll and the value of
assets in each country. Variations on this approach are used within federal states,
such as the USA and Switzerland, in order to determine what portion of the profits
of individual entities in those countries are taxable in each State/Canton.
The OECD came to the firm conclusion that such methods should not be
endorsed, on the grounds that they are arbitrary, disregard market conditions,
ignore management’s own allocation of resources, do not bear a sound
relationship to the economic facts, and carry significant risk of double taxation.
This conclusion is reiterated in the OECD TPG.
The tide has long been in favour of the arm's length principle and it has been
adopted by almost all major economies, whether or not OECD members, with a
particular surge of adoption since 1995. Even Brazil, which rejects the arm's length
principle, does not use formulary apportionment. It uses instead a modified version
under which it insists on the right to specify acceptable profit margins for Brazilian
entities in relation to transactions with non-Brazilian related parties.
In recent years, particularly since the global financial crash that began in 2007,
voices opposing the arm's length principle and championing formulary
apportionment have grown louder, fuelled by a growing perception (correct or
not) that transfer pricing is being widely abused by multinational companies to
avoid paying their fair share of taxes in the countries where they have significant
operations. A form of formulary apportionment is being considered by the
European Union if it moves to a common tax base for member countries (or a
subset thereof).
Now would be a good time to have a look at a copy of the OECD TPG. If you turn
to Chapter 1 you will see that it begins with an explanation of the arm’s length
principle. Reading through this will reiterate what we have discussed so far in this
manual. The next section of Chapter 1 looks at Article 9 and sets down the OECD’s
views on the arm’s length principle. You can see in paragraph 1.15, as mentioned
above, the OECD do not think a move away from the arm’s length principle would
be a good idea despite the recent debate in this area. Paragraph 1.15 states that
experience to date with the arm’s length principle should be used to elaborate
and refine its operation. You will also note that in paragraph 1.15 the OECD do not
see that there is a viable alternative to the arm’s length principle.
Finally Section C gives the OECD view on global formulary apportionment. As part
of the work on Action Points 8 to 10 of the BEPS Action Plan, the OECD considered
whether special measures needed to be introduced either within or beyond the
arm’s length principle. The final report concluded that “the goals set by the BEPS
Action Plan in relation to developing transfer pricing rules have been achieved
without the need to develop special measures outside the arm’s length principle”.
We will look at other aspects of Chapter 1 of the OECD TPG later in the manual.
In 2003 they adopted a documentation package that was voluntary and did not
exceed the requirements of local laws. The member countries are all currently in
the process of adopting domestic law to comply with and implement the OECD
three-tier documentation package that includes country-by-country reporting (we
will look at this in more detail in a later chapter). The PATA members include
Australia, Canada, Japan and the United States.
The ATAF is a forum to promote and facilitate cooperation between African tax
administrators and other interested parties. The ATAF has been working with the
OECD to promote awareness of the need for transfer pricing rules in Africa. A
working group has been set up to look at transfer pricing issues including review of
the OECD TPG.
There has been a lot of concern with the implications of transfer pricing for
developing countries. It has been recognised that developing nations are not just
in danger of losing tax revenue through the use of tax havens but also via transfer
pricing if the arm’s length principle is not observed.
We have seen that the UN has developed a Practical Manual on Transfer Pricing
for Developing Countries. The World Bank has produced a handbook to help
developing economies (Transfer Pricing and Developing Economies: A Handbook
for Policy Makers and Practitioners you can access it at
https://openknowledge.worldbank.org/handle/10986/25095. The World Bank has
developed as a social institution since its inception in 1944. The handbook seeks to
provide an overview of transfer pricing and act as a framework for identifying and
addressing issues that arise when implementing and applying a transfer pricing
regime in a particular country. The handbook is not an alternative to the OECD
TPG or the UN Practical Manual. It includes guidance on drafting transfer pricing
legislation, applying the arm’s length principle, and developing a transfer pricing
audit system.
The importance of the investment environment is stressed. It is noted that this can
be protected and damage limited by ensuring that double taxation is avoided
and that the compliance regime is not burdensome, along with an efficient and
equitable dispute resolution mechanism and well trained staff. The World Bank
supports the use of the Mutual Agreement Procedure (MAP) found in double tax
treaties (a subject we will look at in detail in a later chapter). The compliance
burden can be reduced by the use of safe harbours; however the World Bank
notes that if these are unilateral then they may result in problems of double
taxation and offer little solution. The handbook gives guidance on the use of
Advance Pricing Arrangements (again a subject we will look at in detail in a later
chapter). The handbook also includes illustrative examples from actual country
domestic law and guidance. The overall aim is to provide technical guidance, as
a result it can be useful to both tax administrations and multinational enterprises.
respect of transfer pricing. In June 2017 the Platform published the toolkit:
"Addressing Difficulties in Accessing Comparables Data for Transfer Pricing
Analyses"; it specifically addresses the ways developing countries can overcome a
lack of data on "comparables," or the market prices for goods and services
transferred between members of multinational corporations. The toolkit also
includes a supplementary report on “Addressing the Information Gaps on Prices of
Minerals Sold in an Intermediate Form”. The toolkit can be found at
http://www.oecd.org/tax/toolkit-on-comparability-and-mineral-pricing.pdf.
CHAPTER 2
ASSOCIATED ENTERPRISES
In this chapter we are going to look at Associated Enterprises, an important but somewhat
ill-defined concept, in particular looking at:
– The OECD and UN Model DTC and the definition of Associated Enterprises
– State practices and the Associated Enterprise definition
2.1 Introduction
As we saw in the previous chapter, Article 9 of the OECD Model DTC permits
Contracting States to apply domestic law transfer pricing legislation only in respect
of transactions between “associated enterprises”. As such, defining the scope of
what is, and is not, an associated enterprise is of considerable practical
importance. There are definitional difficulties with this term as it appears in the
OECD and UN Model DTC. Moreover, there is very extensive variation between the
scope of different countries’ domestic associated enterprises rules which may give
rise to the possibility of double taxation even in cases where tax treaties apply.
2.2 The OECD and UN Model DTC and the Definition of Associated
Enterprises
“Two enterprises are associated enterprises with respect to each other if one of the
enterprises meets the conditions of Article 9, sub-paragraphs 1a) or 1b) of the
OECD Model tax Convention with respect to the other enterprise”.
However, the above “definition” is not illuminating. Article 9 of the 2014 OECD
Model DTC is titled Associated Enterprises, but the text of the article does not
explicitly use the word associated. You will recall that Article 9(1) reads as follows:
Where
and in either case conditions are made or imposed between the two enterprises in
their commercial or financial relations which differ from those which would be
made between independent enterprises, then any profits which would, but for
those conditions, have accrued to one of the enterprises, but, by reason of those
conditions, have not so accrued, may be included in the profits of that enterprise
and taxed accordingly.
There are many circumstances where there will be no doubt that two enterprises
are associated with each other. The two most obvious cases are two companies in
a parent/100% subsidiary relationship or two companies under 100% control by a
third common parent company.
Illustration 1
A Inc
State A
B Limited
State B
Illustration 2
As Illustration 1, except A Inc also holds 100% of the voting shares of C SA resident
in State C and no person other than A Inc has an interest in the management,
control or capital of C SA.
A Inc
State A
B Limited C SA
State B State C
All states which have domestic transfer pricing legislation include such blatant
control relationships within the scope of that legislation, so that if conditions are
made or imposed between the above which deviate from arm’s length terms,
then such domestic legislation that may exist in States A, B or C would be
supported by a double tax convention which included wording based on Article
9(1) of the OECD Model DTC.
Enterprises
“This Article deals with adjustments to profits that may be made for tax
purposes where transactions have been entered into between associated
enterprises (parent and subsidiary companies and companies under common
control) on other than arm's length terms”.
It might be thought that the word “enterprise” was deliberately used instead of the
word “company” in order to ensure that the article was not restricted to
companies, despite the suggestion quoted in the Commentary above. It is clearly
possible that taxable entities other than companies (such as partnerships and
individuals) could be sufficiently associated with other taxable entities that they
might not be dealing on an arm’s length basis.
Overview
It is not clear from the OECD Model DTC or its Commentary what constitutes
participation in management, control or capital. It is left to individual states to
define (usually in their domestic legislation) exactly how much participation in “the
management, control or capital of an enterprise” is sufficient to bring transfer
pricing rules into effect.
There is an enormous variation in state practice. At one extreme are countries such
as Denmark which apply a relatively narrow de jure requirement of at least 50% of
share capital or voting rights. As an example of the other extreme, Australia’s
legislation is engaged in a wide variety of de facto circumstances including both
parties having common directors or being members of a cartel.
It is instructive to examine the required relationship threshold for two countries, the
UK and India, in a little more depth.
United Kingdom
The term “person” includes a body of persons. So, for example, a partnership can
control a company even if, individually, none of the partners control the
partnership or company.
In the first instance, TIOPA 2010 s217 determines that control is defined by
reference to CTA 2010 s1124 which considers matters such as voting power, power
given by the Articles of Association and the actual ability of a person to direct the
affairs of the company in the absence of the visible signs of such rights.
We can see from the above that it is very important to underline that control does
not only manifest itself where one enterprise is the majority shareholder in the
other. Control exists whenever one enterprise has the power to ensure that the
business of another enterprise is managed to achieve the other enterprise's goals.
There are detailed rules setting down when voting rights and control should be
attributed to a person. However, the attribution rules need to be considered in
relatively few cases.
While the legislation prevents abuse where trusts are interposed in a control chain,
it does not reproduce ITA 2007 s993(4), with the result that persons are not
connected simply by virtue of being members of the same partnership.
The control rules in TIOPA 2010 s160 contain an important feature. This is the
inclusion of a provision deeming a 40% participant in a joint venture to control that
joint venture where there is one other participant who owns at least 40% of the
venture. Hence, the transfer pricing rules also apply to joint ventures; however, the
rules only apply to transactions between at least one of the joint venture parties
and the joint venture itself, not between the two joint venture parties themselves.
Nevertheless, if the transaction meets the conditions of TIOPA 2010 s157 transfer
pricing rules still apply.
UK transfer pricing rules, in relation to financing transactions only, also apply where
persons have “acted together” in relation to the financing arrangements of a
company or partnership. This concept of “acting together” is much more widely
drawn than the above condition; it connotes a “community of interests”.
Illustration 3
The ordinary shares in D Limited are owned respectively 45% by A Inc, 38% by B
GmbH and 17% by C SA in a contractual joint venture. D Limited is a UK resident
company. D’s shareholders are otherwise unconnected by virtue of legal control.
D Limited enters into the following separate transactions with its shareholders:
i. A Inc sells trading stock to D Limited in the normal course of its trade.
The sale of trading stock to D Limited is unlikely to be within the scope of the UK
participation condition. Although A Inc owns more than 40% of D Limited, there is
no other participant that also owns at least 40% of D Limited.
However, the provision of financing facilities will fall within the extended “acting
together” definition and the tax return of D Limited must reflect arm’s length terms
in relation to that transaction.
There are a number of cases where associated enterprises are exempt from the
transfer pricing rules, including certain small- and medium-sized enterprises (SMEs)
transacting with states that have a comprehensive double tax convention with the
UK.
India
In India the transfer pricing law is found in Income Taxes Act 1961 s92 onwards. An
associated enterprise is “defined” analogously to Article 9(1) of the OECD Model
DTC. However, an extensive list is then provided of situations in which two
enterprises shall be regarded as associated. These include:
• A loan advanced from one enterprise constituting at least 51% of the book
value of the assets of the borrower.
• One enterprise guarantees at least 10% of the total borrowings of the other
enterprise.
Thus a very broad view of direct or indirect control is taken by the Indian
legislation.
Indian tax law does not have exceptions for SMEs as in the UK rules outlined above.
There are certain simplifications for small transactions where the aggregate value
of the international transaction does not exceed 10 million INR – the simplification
relates to documentation requirements.
Illustration 4
Fledgling Enterprises Pvt Limited, an Indian company, is owned 30% by Big Farm
Danmark A/S a Danish manufacturer of specialised agricultural machinery. The
other 70% of the Indian company is owned by a number of individual members of
a wealthy family. The Indian company is in the business of importing and
distributing agricultural machinery into India. Over 90% of its stock is procured from
Big Farm Danmark A/S which has a dominant market position and superior
bargaining power to the Indian company. The Indian tax authorities succeed in
asserting that the prices paid for inventory by Fledgling Enterprises are in excess of
an arm’s length amount and an increase in Indian tax is imposed accordingly.
The two companies are associated enterprises within the meaning of the Indian
transfer pricing rules because there is greater than 26% voting power and the
Indian company is dependent on the Danish company for nearly all its inventory.
However, the two companies are not associated within the meaning of the Danish
rules because there is less than 50% control by share capital or voting rights.
The India/Denmark DTC includes an Article based on Article 9(2) of the OECD
Model DTC.
2.4 Conclusion
CHAPTER 3
3.1 Introduction
The purpose of this chapter is to explore the arm’s length principle, and to
understand how it should be applied by taxpayers and tax authorities (namely,
through comparability analysis). The arm’s length principle itself is very simple:
pricing between related parties for any transaction should reflect pricing that
would be agreed between independent parties (ie. Parties operating at “arm’s
length” from each other). However, the complexity of applying this in practice is at
the heart of all uncertainty and controversy within transfer pricing.
Consider a company manufacturing and selling products in its local market. If that
company becomes successful, it will likely seek to grow its market, and at some
point that will involve seeking to sell its products overseas. To achieve this, the
company would have the choice of either using third party distribution channels in
other countries, or selling directly to customers itself. Using third parties may have
the short-term advantage of selling to companies with an existing customer basis
and local market knowledge, however it would require sharing some of the value
chain profit with another party. Therefore, the manufacturer may choose to sell
directly. With small scale sales, this may be achievable whilst maintaining only a
sales force in the home country. Nevertheless, at some point it would most likely
seek to establish a sales force overseas.
Once this happens, for a raft of administrative reasons, the company is likely to
seek to establish a subsidiary overseas to employ the sales force (the same effect
could be achieved through establishing a branch, but this would basically have
the same outcome for transfer pricing purposes). When this company begins to
purchase products from the local country manufacturer to sell to its local
customers, we have created the need for a transfer price – a price that is
reflected in the sales ledger of the local manufacturer and in the cost base of the
accounts for the overseas sales company. Thus, the transfer price exists for
accounting purposes rather than explicitly for tax purposes.
In the absence of any tax constraints, the company is in theory free to choose any
price for the products. If the sales company were located in a country where the
corporate tax rate is currently say 40%, the company would be incentivised to set
a relatively high transfer price. For a given cost of production and end sales price,
this would allow the bulk of the profit to be earned in the home country, where a
corporate tax rate of say 23% would be applied. With a high transfer price, little
profit would be earned in the overseas country and thus little tax would be paid at
the higher rate, minimising the group’s overall tax liability.
Conversely, if the sales company were located in a country with a corporate tax
rate of say 12.5%, the company would be incentivised to set a low transfer price.
This would allow more of the profits to be earned and taxed in the overseas
country, and less in the home country, reducing the overall tax liability.
Illustration 1
In each case the total profit is 300. However where Country A has the lower tax
rate, more of the profit has been left there to be taxed at 23%. Where the tax rate
is lower in Country C most of the profits have been moved there.
Let us focus on sales in Country B. With a transfer price of 400 to Country B the total
tax payable by the group is 46+40 = 86 leaving after tax profits of 214.
If we amend the transfer price from 400 to 300 as used for Country C the total tax
bill would become 23+80 = 103 giving after tax profits of 197. We can see how the
lower transfer price has resulted in a larger tax bill overall on the sales in Country B.
This setting of the transfer price based on tax rates is sometimes referred to as tax
arbitrage.
This inherent ability of multinationals to set transfer prices based on tax rate
arbitrage is what drives the need for transfer pricing rules. In the example above, a
Country A manufacturer selling to third party distributors in Country B and Country
C would not have flexibility to choose any price, but rather would have to
negotiate. Furthermore, it would not care about the tax liability of the
counterparties, and instead would only be interested in setting a price that
maximised its long term profits.
To protect against this, tax authorities need a basis for determining an appropriate
transfer price that is independent of the tax rate of counterparties. From a short-
term tax yield perspective, tax authorities may be inclined to use an approach
that maximises the taxable profit in their territory, irrespective of the fact pattern.
The problem with this approach is that it would be highly unlikely to be accepted
by the tax authority in the territory of the counterparty. This would lead to two
different transfer prices used in the calculation of taxable profits in each country
and the double taxation of group profits.
Under this principle, prices are to be set on an objective basis to reflect the price
that would have been agreed if the two parties couldn’t collude to produce a
better post tax outcome. In short, it says the price should be fair to both parties,
and by inference, to both tax authorities.
As you will have noted when you studied Chapter 1 of this manual, the OECD TPG
recognise the limitations of the arm's length principle as “the separate entity
approach may not always account for the economies of scale and interrelation of
diverse activities created by integrated businesses. There are, however, no widely
accepted objective criteria for allocating the economies of scale or benefits of
integration between associated enterprises.” (See OECD TPG Chapter I, B, 1.10).
However imperfect, the arm's length principle has been adopted by most tax
jurisdictions and no other alternative has yet been recognised; hence, the
comparability analysis is key in ensuring that the transfer pricing can be supported
in case of a tax audit. The OECD TPG state at Paragraph 1.15:
“A move away from the arm's length principle would abandon the sound
theoretical basis described above and threaten the international consensus,
thereby substantially increasing the risk of double taxation. Experience under
the arm's length principle has become sufficiently broad and sophisticated to
establish a substantial body of common understanding among the business
community and tax administrations. This shared understanding is of great
practical value in achieving the objectives of securing the appropriate tax
base in each jurisdiction and avoiding double taxation. This experience should
be drawn on to elaborate the arm's length principle further, to refine its
operation, and to improve its administration by providing clearer guidance to
taxpayers and more timely examinations. In sum, OECD member countries
continue to support strongly the arm's length principle. In fact, no legitimate or
realistic alternative to the arm's length principle has emerged.”
Although taxpayers cannot rely upon the defence that prices have been
negotiated for compliance purposes, it may still very well be the case that such
prices are in fact arm’s length. Prices within a business are often set by commercial
rather than tax departments, with performance incentives for both counterparties
meaning that there will be a natural tension tending towards an arm’s length
outcome (we will look at this in a later chapter). Furthermore, commercial teams
will generally have a good understanding of their own industry and a reasonable
idea of what constitutes arm’s length arrangements.
A further complication is that taxpayers will often enter into transactions and
arrangements that simply do not exist between unrelated parties.
It has long been established by economists that large firms tend to exist to take
advantage of economies of scale and scope not available to smaller firms. The
concept of comparability analysis can sometimes be difficult to apply as
businesses part of a larger multinational enterprise (MNE) often exchange services
and products, which are often not the “finished article”.
The natural point that follows from this is to note that the arm’s length principle
does not require taxpayers to behave in an arm’s length manner.
It is simply the case that pricing for transactions should be consistent with an arm’s
length consideration. For example, companies are not required to negotiate as
independent parties would, or limit access to commercial information.
The OECD suggest that features of the parties, such as capabilities and actual
contributions, can affect the options realistically available to the parties. Therefore,
the process of identifying the economic circumstances of the commercial and
financial relations should include consideration of the capabilities of the parties,
how under the arm’s length hypothesis such characteristics affect options
realistically available, and whether similar capability is reflected in potentially
comparable arm’s length arrangements.
Where there are written contractual agreements, those agreements provide the
starting point for identifying the commercial and financial relations between the
associated enterprises. The OECD states that where no written terms of a
transaction exist, or where the conduct of the parties indicates that the
contractual terms are ambiguous, incorrect or incomplete, the delineation of the
transaction should be deduced, clarified, or supplemented through the analysis of
the commercial or financial relations as deduced from the actual conduct of the
parties.
Section D (paragraph 1.33) states that there are two steps to a comparability
analysis:
The first step is dealt with in Chapter I of the OECD TPG, while Chapters II and III
focus on the second aspect.
This is the first time we are going to look at the five comparability factors; however
we will look at them again in more detail in a later chapter.
• Contractual terms;
• Functional analysis;
• Business strategies.
These factors are fundamental to choosing the right comparables, however their
relative importance varies depending on the transfer pricing method chosen to
price the transaction under review.
To best understand the role of these factors, and the reason they impact on the
arm’s length price, it is helpful to consider them in the context of a simple example.
Consider a Japanese-owned multinational company, manufacturing televisions in
Japan and selling them into the UK market through a related party distributor.
Connected Distributor
UK sales
The sole transaction under review is the sale of televisions, and the transfer price
that we therefore need to establish is the price per unit of the televisions. The five
comparability factors will tell us what we need to consider when evaluating
objective data that may be available.
Contractual Terms
The contractual terms define how the parties to a transaction are going to divide
the risk and responsibilities between them. This may be done explicitly or implicitly.
In some cases there may not be a formal contract as we are dealing with
associated enterprises. Here it will be necessary to look at correspondence and
other communications to determine the contractual terms.
Another complication with associated enterprises is that they may not hold each
other to the terms of a contract. In a third party situation we would normally
expect to see each party wanting to maximise their benefits and reducing their risk
- this can be achieved by imposing the strict terms of the contract. This may not
happen where the companies are associated.
There may be practical difficulties in obtaining the details of contractual terms for
third parties. The impact of this will vary according to the type of transaction we
are looking at.
Contractual terms and conditions should always be reviewed when using the CUP
method (see later in this chapter) as differences between the third party and the
related party contracts could result in different pricing (e.g. transfer of stock and
forex risk from one distributor to another). At one level, the contractual terms may
simply consider the size of and nature of the transaction. A transaction where the
distributor is seeking to import 50,000 units of a product will likely attract a very
different price to a contract for 500 units, even if the products are identical.
Section D states that the starting point will be any written agreement between the
parties. It goes on to emphasise that the conduct of the parties and the other four
comparability factors will also be important in establishing if the economic reality
matches the written agreement. The conduct of the parties will be important as
will the options that would have been available in terms of how (or whether) to
conduct the transaction. There is more emphasis on economic reality than legal
form.
The OECD TPG (see paragraphs 1.42 to 1.45) now explicitly authorise the recasting
of contractual terms to reflect the commercial or financial relations that actually
exist between the parties based on their conduct and the economically relevant
characteristics of the transaction, including options realistically available to the
parties to the transaction.
Functional Analysis
Functions are the most easily identifiable of the three areas, and this area requires
an assessment of the relative activities of both counterparties, specifically in
relation to the transaction under review. In the case of our example, there may be
a range of activities undertaken by the UK entity. At one end of the spectrum, it
may have very limited functions. There may be only a handful of employees
engaged in account relationship management. Orders by the customers may be
shipped directly to them by the manufacturer with the distributor taking legal title
for only a split second.
At the other end of the spectrum, the distributor may have a full range of activities.
It may operate a warehouse and engage in a full suite of logistics services, or it
may have an extensive marketing team developing, advertising and producing
marketing materials to promote the products directly to customers. Other things
being equal, it would be expected that a distributor undertaking more of the
value chain activities would purchase goods at a lower price in order to be able
to fund those activities, and would typically expect to earn more profits.
Comparability analysis needs to consider whether the counterparts in the third
party data have a similar functional profile.
In relation to risks, it is noted that a party bearing more risk would typically expect
to earn more profit (albeit that the actual level of profit earned may fluctuate
depending on whether those risks are realised). In the case of our distributor, it
would be expected that the distributor would earn a higher margin if it bore
inventory risk, warranty risk and customer credit risk, than if those risks were passed
on to the manufacturer. It should be noted that consideration needs to be given
to the behaviour of the parties and not just the contractual relationships. Under
OECD principles, risk (and the reward associated with it) should be attributed to
the party that manages that risk, not just the party that contractually bears it.
Assets are important too, and in particular, intangible assets can be a critical
determinant of transfer prices. If the Japanese manufacturer owns a globally
recognised brand, and attaches that brand to the televisions, that will result in a
very different transfer price to the case where the manufacturer simply produces
unbranded products. In the latter case, the UK distributor may have developed its
own brand through marketing activities, and therefore would expect to pay less
for the products, even if the technical capabilities were the same.
We will look at functional analysis in more detail in a later chapter. For now we will
note that Section D contains guidance on risk. It stresses the importance of control
over risk and financial capacity to assume risk and gives a six step process for
analysing risk. Further, it sets down a two stage test for assumption of risk; the first is
the financial capacity to take on the risk; the second is the actual control of
decision making in respect of the risk. This ensures that “cash box” companies
within a MNE (ie capital rich entities without any other relevant economic
activities) cannot be allocated high returns unless they have control of risk as
defined (see subsection D1.2.1.6 OECD TPG).
You will see more detail on what a functional analysis looks like in a later chapter.
• the duration and degree of protection, and the anticipated benefits from the
use of the property.
If we are able to identify market data for the wholesale price of televisions, we
may be able to use a CUP method. In this case the specification of the products in
question would be very important. Factors such as screen size, 4K resolution,
internet access and others would all impact the price. In order to use the third
party data to set or test the transfer price, the third party products would need to
be almost identical. If the third party data in question related to televisions that
had 4K resolution and the tested party products did not, one would expect the
third party products to be materially more expensive. As such they could not be
used as comparable data to apply the CUP.
Economic Circumstances
Another factor may be the degree of competition amongst customers. For the
connected distributor, there may be a large number of significant customers and
a high degree of competition at the retail level in its home country. This would
enable the distributor to earn a higher margin. In other territories, there may be
much less competition, with one or two retailers accounting for the vast majority of
sales. Those customers would have much more buying power, driving down the
profit potential for the connected distributor.
Business Strategies
The OECD TPG acknowledge that business strategies will play an important role in
determining the arm’s length price. In practice, this is most commonly considered
in the context of market penetration. The Japanese group and its products may
be new to the UK. It may therefore be the case that it incurs abnormally high set-
up costs and additional marketing and promotional costs to make consumers
aware of the new product, whilst at the same time being unable to command the
same market premium as more established market participants. Under such
circumstances, it may therefore be acceptable for the UK distributor to earn lower
profits (or even losses) than comparable companies whilst still paying an arm’s
length price.
The OECD TPG recognise the fact that associated enterprises may have the ability
to enter into a much wider variety of arrangements than their unrelated
For non-recognition, the key question is whether the actual transaction possesses
the fundamental economic attributes of arrangements between unrelated
parties, not whether the same transaction can be observed between
independent parties. The non-recognition of a transaction that possesses the
fundamental attributes of an arm’s length arrangement is not an appropriate
application of the arm’s length principle. An arrangement should be considered
to include these fundamental economic attributes if it offers each of the parties a
reasonable expectation to enhance or protect their commercial or financial
positions on a risk-adjusted basis, compared to other opportunities realistically
available to them (including the alternative of not entering into the transaction) at
the time of entering into the arrangement. It is also relevant to consider whether
the multinational group as a whole is left worse off on a pre-tax basis (see
paragraph 1.123).
Section D2 finishes with a couple of illustrative examples which are worth reading
through as part of your studies. We will look again at Section D2 in a later chapter
when we look at non-recognition recharacterisation.
3.5 Losses
It is recognised that in the short term losses can be justified as a way to break into
a new market or launch a new product but in the long term such an approach
would not be maintained by an independent enterprise.
In the case of an MNE it may be that there are business reasons why some non
profit making products are kept; it may be that the MNE wants to be able to say it
supplies the full range of products. THE OECD TPG point out that in this case if the
associated company making the non profit making product was an independent
enterprise it would only produce the product if it was compensated in the form of
a service fee so that in the end it did make a profit. The OECD TPG suggest that
this may be the approach that needs to be taken within an MNE - a service fee to
the associated enterprise that would otherwise be loss making.
In some jurisdictions we see government interventions into the market in the form
of price controls, subsidies, interest rate controls, exchange controls, anti dumping
policies etc (see paragraph 1.132). The question then arises as to how these
interventions should be taken account of in price setting between associated
enterprises and as a consequence their impact for the arm’s length principle.
The OECD TPG paragraphs 1.134 - 1.136 devote some time to considering the
impact for the arm’s length principle of blocked payments. What will happen if the
government intervention means that payment cannot be received (for example if
there are exchange controls that prevent the funds leaving the country)? Would
an independent enterprise enter into a transaction where there was a real risk that
they would not receive payment? As always we have to look at all the terms of
the transaction; an independent enterprise may seek a higher profit level to
compensate for such risk or they may seek some kind of service fee.
If the policy only affects associated enterprises it follows that it is harder to establish
what independent enterprises would do in the same circumstances. The OECD
TPG suggest that where independent enterprises would not enter into such
transactions then the party who cannot receive the payment should be treated as
performing a service for the MNE. In addition the OECD TPG put forward an
alternative of preventing the party that cannot receive the payment from being
able to deduct related expenses until the payment is received. The concern will
be with protection of the tax base and in the final analysis an enterprise should not
be able to treat a blocked payment from an associated enterprise any differently
than when from an independent enterprise (see OECD TPG paragraph 1.136).
Section D contains some guidance on location savings and local market features.
It begins by explaining that the points made on the subject in Chapter IX on
Business Restructuring also apply in a wider context (we look at Chapter IX in a
later chapter).
To the extent that location savings exist and are not passed on to customers or
suppliers it is necessary to determine how they would be allocated in an arm’s
length situation. This can be done by searching for a reliable local comparable. In
the absence of a local market comparable, the analysis needs to be done based
on all the facts and the functional analysis as set down in Chapter IX.
There is a recognition that there can be other local market features such as a
skilled workforce or expansion or contraction in a market that can give rise to
The section on other local market features states that there may be intangibles,
such as contractual rights and government licences that should be considered.
Cross reference is made to Chapter VI of the TPG for further guidance and
examples are provided to distinguish between licences and rights that can “affect
the manner in which the economic consequences of local market features are
shared between parties to a particular transaction” and those that are available
to many, if not all, of those in the market.
Assembled Workforce
The 2010 version of the OECD TPG did not have a section on an assembled
workforce. One was added into the 2017 version following work on intangibles to
clarify the OECD position. The opening paragraph states:
It is also stated that if a workforce is transferred from one entity to another as part
of a restructuring, which will reduce the time, effort and expense that would have
been incurred hiring a new workforce, then it is possible that a comparability
adjustment might be required in respect of the arm’s length price.
This section is also an addition to the OECD TPG. With respect to group synergies it
is put forward that arm’s length remuneration is only required for deliberate
concerted synergies. Paragraph 1.161 states:
because the supplier hopes to attract business from others in its group is deemed
coincidental.
Even though there are a number of criteria for choosing comparables that are
easy to follow (e.g. industry, location, time, etc.), the decision whether to accept
or reject a potential comparable bears a certain level of subjectivity which is often
at the centre of challenges by the tax authorities (e.g. does the business
description give enough details to decide if the company should be added to the
set of accepted comparables? And even if the business operates in the same
industry, market and location how can we establish differences in strategy,
commercial goals, etc.?).
In theory, the larger the sample of comparables, the greater the likelihood of
identifying a tighter and more defensible range, since the impact of outliers will be
reduced. However the availability of comparables that can be used for transfer
pricing studies has become more of a concern in recent years.
A third party business can only be used as a potential comparable if it meets strict
independent criteria. The lack of independent comparables has made the
comparability analysis process even more difficult. One reason for this is that
globalisation and the most recent financial crisis have led to increased
competition and smaller players being taken over by the larger groups; hence, the
number of independent parties in all industries has decreased.
For example, if the tax authorities are challenging the comparability of some of the
businesses in the final set of comparables (i.e. the set used to build the arm’s
length range), having run sensitivity analysis and choosing a profit margin (or other
profit indicator depending on the transfer pricing method being chosen) that is
within the range for different sets of comparables could lower the risk of the tax
authorities demanding an adjustment.
When using transfer pricing methods (e.g. TNMM) where third party comparables
are used to generate the arm’s length range for the comparison with the tested
party, it can be often difficult to identify comparables, which deal with
comparable services or products and operate in the same industry. Running two
analyses based on functional and industry comparability then comparing the
results can help make the analysis more robust and support the pricing with the tax
authorities.
CHAPTER 4
In this chapter we are going to look at the methodologies set down by the OECD
Guidelines, in particular:
– Comparable Uncontrolled Price Method (CUP)
– Resale Price Method (RPM)
– Cost Plus
– Transactional Profit Methods
4.1 Introduction
Selecting the appropriate transfer pricing method is key both during planning for a
new transaction/product/service and when putting in place documentation to
support the current transfer pricing.
Testing an existing pricing policy by choosing one of the transfer pricing methods
does not always guarantee that the current pricing will be supportable (i.e. at
arm's length).
The OECD TPG deal with transfer pricing methods in Chapter II and provide a
description of all the acceptable methods and when they should or could be
applied. The methods are broken down into two types; traditional transaction
methods (CUP, RPM, Cost Plus) and transactional profit methods (TNMM,
transactional profit split method).
Up until the 2010 edition, the OECD TPG presented a hierarchy of methods;
therefore, the choice was dictated mainly by the availability of data and the tax
payer had to start with the preferred method and work his way down if the higher
ranking method could not be applied.
In 2010 the OECD TPG introduced a change in the way the method should be
chosen. The hierarchy no longer exists and the choice of method is based on the
optimal method and best fit method. In other words, the tax payer should choose
the method that best describes the transaction under test and that also reflects
the functional and risk profile for the transaction.
We find the methodologies in Chapter II of the OECD TPG. Note Chapter II was
updated following the final report on the BEPS Action Points 8 to 10. The updates
are noted below.
We will look first at each method and how they should be applied and then
understand how the appropriate method should be chosen and go through a few
examples.
“The CUP method compares the price charged for property or services
transferred in a controlled transaction to the price charged for property or
services transferred in a comparable uncontrolled transaction in comparable
circumstances. If there is any difference between the two prices, this may
indicate that the conditions of the commercial and financial relations of the
associated enterprises are not arm's length and that the price in the
uncontrolled transaction may need to be substituted for the price in the
controlled transaction”. (OECD TPG Chapter II, 2.14.)
We can subdivide CUPs into two types – internal CUPs and external CUPs. An
internal CUP is available when an enterprise sells the same product or service to a
third party as it does to an associated enterprise. An external CUP is a transaction
between two unconnected parties. As a general rule internal CUP will give rise to
more reliable data.
The CUP method makes reference to the basic arm's length principle under which
related parties should interact as if they were not related. Therefore, if an
enterprise sells a particular product to a third party for a certain price, the same
price can be used to sell the same product to a related party.
However, as the OECD text highlights, there might be differences between the
third party transaction and the related transaction. For example, a manufacturer
might sell a product to third party distributors for a certain price, which also
includes the sales and marketing efforts of the manufacturer to become the
product supplier of the distributor. However, when the same manufacturer sells to
a related party, the sales and marketing efforts are almost non-existent (as the
related party distributor is more likely to buy and distribute a product
manufactured by the group it belongs to). Therefore, using the third party price
might result in overcharging the related party (in this example).
Some adjustments might be required to ensure the CUP can be used to price the
intra-group transaction. The main comparability criteria to take into account when
deciding if a CUP is applicable or can be applied (after being adjusted) are as
follows:
• Functional profile (i.e. does the controlled party carry out the same functions
to deliver the service or product in the uncontrolled transaction as in the
controlled transaction);
• Risk profile (i.e. does the enterprise bear the same risk in both the controlled
and uncontrolled transaction);
• Cost base (i.e. does the enterprise bear more or less cost in the uncontrolled
transaction?); and
• Contractual terms (i.e. are there any differences between the contract for
uncontrolled and controlled transactions? For example, payment terms, return
policy, cancellation terms, etc).
Reliable adjustment may not be possible for trademarks. Adjustments also cannot
be made to account for material product differences – the CUP method may not
be the appropriate method in such a case.
The CUP method used to be the number one method in the hierarchy. Although
the hierarchy no longer exists, some tax authorities and tax inspectors in general
tend to always look for the existence of CUPs. Therefore, it is good practice to
always consider the CUP method and either provide an explanation why it cannot
be used for a specific transaction or to use this method (even when it is not the
most appropriate) as a complementary method.
The CUP will often be used where the controlled party enters into a similar
transaction with an unconnected party on similar terms. The CUP can also be used
for fungible products; some examples would be chemicals, pens, paperclips. CUP
can be used for animal products such as offal and harvested crops like oats and
barley. It is possible to use CUP for branded products that are fungible such as
contact lenses. These are just some specific examples - remember the key is
comparability so CUP can be used whenever we have sufficient comparability
taking account of all the comparability factors and their relative importance.
Additional paragraphs have been added to Chapter II following the final report
on the BEPS Action Points 8 to 10 clarify that the CUP method would generally be
the most appropriate transfer pricing method for determining the arm’s length
price for controlled commodity transactions, and that, under the CUP method, the
arm’s length price for the controlled commodity transaction can be determined,
not only by reference to comparable uncontrolled transactions, but also by
reference to a quoted price (see paragraph 2.18).
This is of course subject to the overall requirement of the TPG that the most
appropriate method should be used.
The guidance states that quoted or public prices can be used, provided the
conditions of the controlled transactions are comparable to the conditions of the
quoted prices. A relevant factor in determining the appropriateness of using
quoted prices is the extent to which such price is widely and routinely used in the
industry to negotiate prices between third parties (see paragraph 2.19).
Paragraph 2.20 stresses the importance of comparability and discusses when it will
be necessary to make adjustments for differences in comparability.
Paragraph 2.22 states that when using quoted prices the pricing date is
particularly relevant. Paragraph 2.22 also specifies clearly when the pricing date
can be disregarded and explicitly requires the tax authority to suggest any
alternatives based on market data, as opposed to choosing dates that maximise
the tax base.
Where information is not available from the taxpayer the tax authority may deem
the price based on the available evidence. This may be the date of shipment
based on the bill of lading for example. The result would be that the price would
be based on the average price for the day of shipment, subject to comparability
adjustments. The point is then made that in these cases it will be important to
ensure that cases can be resolved via the MAP procedure. (See paragraph 2.22.)
The use of quoted commodity prices is included in part of the explanation of the
application of the CUP method in the OECD TPG as noted in an earlier chapter.
The UN Practical Manual on Transfer Pricing for Developing Countries includes a
section on the commodity rule which it lists as the “sixth method”. The UN Manual
states:
“The resale price method begins with the price at which a product that has
been purchased from an associated enterprise is resold to an independent
enterprise. This price (the resale price) is then reduced by an appropriate gross
margin on this price (the “resale price margin”) representing the amount out
of which the reseller would seek to cover its selling and other operating
expenses and, in the light of the functions performed (taking into account
assets used and risks assumed), make an appropriate profit. What is left after
subtracting the gross margin can be regarded, after adjustment for other
costs associated with the purchase of the product (e.g. customs duties), as an
arm's length price for the original transfer of property between the associated
enterprises.
known
Associated ALP Associated 3rd party
→
Enterprise 1 → Enterprise 2 buyer
price
£
Selling price Known ↓
Transport costs (X)
Advertising (X)
Other costs (X)
Resale price margin* (X)
Arm's length price X
*This is a known.
For the RPM method the starting point is the sales company (Associated Enterprise
2 in the illustration above). The focus here is on the gross margin. The product
would be looked at to determine the gross margin that should be earned by the
sales company. The focus on gross margins means that there is less emphasis on
product comparability than the CUP method. However although product
differences are less important, if there are significant differences then this may
result in a loss of comparability (paragraph 2.31).
Gross profit is the net price for the products sold less the cost of goods sold.
Illustration 1
£
Sales 500,000
Cost of sales 350,000
Gross Profit 150,000
Illustration 2
The RPM is as the OECD TPG describe it the most appropriate method when testing
sales and marketing activities. This method is similar to the way a wholesaler
calculates the price to a distributor (i.e. by taking out its cost plus a margin and
arriving at a discount on the resale price for the distributor).
For the RPM method to be the most appropriate method, functional comparability
is very important - more important than product similarity although as stated
above major differences in product can have an impact.
What we are looking for is the impact the product has on the distribution method.
Going back to illustration 2, computer accessories take many forms but we don’t
need to look at each individual product line when doing the RPM analysis.
However we would start to lose comparability if we were comparing computer
accessories with let’s say cycle accessories which may require different transport
considerations.
The risks taken, contractual terms and the market place will also impact on the
suitability of the RPM as the most appropriate method. We will return to this topic
again in a later chapter when we look at entity classification.
What happens if there are no internal comparables (i.e. the wholesaler does not
sell products the same way to third parties as it does to related parties) and
looking for external comparables does not return significant results?
How can the taxpayer estimate the level of discount to the distributor ensuring the
overall gross margin retained by the wholesaler is at arm's length?
If we look at the overall supply chain for the product we can identify the following
steps:
• Procure;
• Make;
• Sell; and
The end price to the customer (i.e. the resale price) can be adjusted (i.e.
discounted) to the distributor by adjusting the price based on the functional and
risk allocation. Cost can be a useful allocation key to calculate the discount in
combination with the risk profile for each of the functions no longer carried out by
the manufacturer.
For example, if a manufacturer sells directly to customer a product for 100 and its
cost base (covering the entire supply chain) is 80 it makes a 20 profit.
However, when it sells via a related party distributor all the marketing, advertising,
selling and customer service efforts fall on the distributor. Therefore, if the cost of
these functions to the manufacturer when selling directly to customer is 16 and we
use cost as the main indicator or allocation key, 20% (i.e. 16/80) discount should be
applied to the resale price when selling to the related party distributor.
As noted above it is important to ensure that the cost base is homogenous (e.g.
comparing cost of labour for each of the supply chain steps and including where
necessary amortisation of assets when the assets add considerable value to the
process) and that the risk associated with each function is also taken into account.
For example, the cost of R&D might not be as high as the manufacturing cost, but
if the R&D process generates a very valuable intangible (e.g. a design that makes
the product much more sellable) the cost of R&D should be adjusted to reflect its
true value in the supply chain.
The RPM as you can see from the above is often used for distributors and
marketing companies. For example, the gross profit for a distribution company
The RPM can be used where we have a fully fledged manufacturer that owns the
intangibles selling to a related sales company that then sells to third parties. We
can also use the RPM when there is a commissionaire agreement to determine the
arm’s length commission that the commissionaire will receive.
Again in determining whether the RPM is the most appropriate method the five
comparability factors need to be considered as discussed in paragraphs 2.27 to
2.45 of the OECD TPG.
“The cost plus method begins with the costs incurred by the supplier of
property (or services) in a controlled transaction for property transferred or
services provided to an associated purchaser. An appropriate cost plus mark-
up is then added to this cost, to make an appropriate profit in light of the
functions performed and the market conditions. What is arrived at after
adding the cost plus mark-up to the above costs may be regarded as an
arm's length price of the original controlled transaction. This method probably
is most useful where semi finished goods are sold between associated parties,
where associated parties have concluded joint facility agreements or long-
term buy-and-supply arrangements, or where the controlled transaction is the
provision of services”. (See paragraph 2.45).
The cost plus method uses cost as the main driver to arrive at an arm's length
margin. The mark-up applicable to the cost reflects the return the enterprise aims
to achieve and should reflect the value added by the enterprise bearing the cost.
In the case of goods, we are looking at gross profit mark-up as the financial ratio.
Gross profit is defined as net sales minus cost of goods sold. The cost of goods sold
should be the cost of producing the goods sold - this will normally include direct
labour costs, material costs and the overheads from the factory/premises used to
produce the goods (a similar approach is taken for services). Clearly accountancy
consistency will be important as cost needs to be divided into direct and indirect.
Functional comparability will also be important if cost plus is to be used as each
additional function will have its associated costs. In applying this method we need
to decide whether to use actual costs or budgeted costs. Third parties will often
use budgeted costs with an adjustment clause in certain circumstances.
Illustration 3
Company T assembles computers and sells them to a related Company S who will
distribute them. It is established that the appropriate gross mark-up is 30%. The
costs incurred in assembly are 300,000. The formula we use is 1+ mark-up (30%)
which gives a transfer price of 390,000 so that Company T will have:
The gross profit 90,000 gives us a mark-up of 30% of the cost incurred.
Per the OECD TPG, this method is particularly useful when looking at semi-finished
products or when looking at services, which do not constitute or are only part of
the finished product or service.
However, although cost can provide a good basis for valuing the input of an
enterprise delivering a service or a product, the mark-up associated with the cost
can exhibit great variance depending on the value added by the enterprise.
To use a similar example to the OECD TPG, if the cost is used as a basis to
calculate an arm's length return for manufacturing a product, depending on the
value added at the manufacturing stage the return should be different. It might
help to use premium luxury goods as an example. Goods might be manufactured
in country A, but designed in country B where the brand is owned.
In the case of luxury goods, the brand allows the distributor to sell the product at a
much higher price than non-branded goods; therefore, even though the
manufacturing cost might exceed the cost of designing and branding the
product, it adds far less value to the finished product. That is the cost basis cannot
always be used as a proxy for determining the value and margin to be retained.
Another important factor to consider when applying the cost plus method is
determining the cost base for the mark-up. Also, should all cost be marked up?
In general terms and for the purposes of transfer pricing, third party cost can be
recharged without a mark-up as the mark-up should indicate that the enterprise
charging the related party has added some value. The concept of adding value is
very important as when subject to a tax audit and in particular in some jurisdictions
(e.g. Belgium) cost plus recharges can be challenged by tax authorities if there is
no clear value added.
This issue ties back to the cost versus value argument, where R&D cost might be
much smaller than manufacturing cost, but it is the R&D that makes the product
more sellable and allows the enterprise to charge a premium price.
comparability factors needs to be undertaken to ensure that the cost plus method
is the most appropriate. See paragraphs 2.45 to 2.61 of the OECD TPG for a
discussion of the cost plus method.
Action Point 10 of the BEPs Action Plan sought to clarify the application of the
transfer pricing methods, in particular the transactional profit split. The final report
on Action Point 10 scopes out the work that needs to be done, including
clarification of the circumstances in which transactional profit splits are the most
appropriate method for a particular case, and describes what approaches can
be taken to split profits in a reliable way. At the time of writing, this work is ongoing.
There are two categories of profits methods - the Transactional Net Margin Method
(TNMM) and the Profit Split Method which can be divided further into contribution
analysis (PSM) and Residual Profit Split (RPSM) as you will see as you work through
this section. We will begin with an overview of the transactional profit methods
then look at each one in turn.
“A transactional profit method examines the profits that arise from particular
controlled transactions. The transactional profit methods for purposes of these
Guidelines are the transactional profit split method and the transactional net
margin method. Profit arising from a controlled transaction can be a relevant
indicator of whether the transaction was affected by conditions that differ
from those that would have been made by independent enterprises in
otherwise comparable circumstances”. (OCED TPG Chapter II, 2.63)
The TNMM and PSMs are probably the most commonly used methods in transfer
pricing as apart from transactions which occur with both third parties and related
parties, the majority of large MNEs exchange a number of services and products
for which it is not possible to identify specific CUPs.
The following extract from the OECD TPG details when it is appropriate to apply
each of the two methods.
The extract above highlights the concept of “complexity” and makes reference
once again to “value.”
Here the focus is on the net profit margin relative to an appropriate base such as
sales or assets. These are referred to as profit level indicators (PLIs).
Here are some examples of profits level indicators together with an example of
when each one may be used - it is not an exhaustive list:
Example of use
Berry ratio Berry ratio Gross Intermediate
profit/operating activities. Where
expenses profit is linked to
operating costs.
Operating Margin OM Operating Where sales is the
profit/sales main driver of profit
e.g. distribution
companies
Return on capital ROCE Operating Industries that require
employed profit/capital a large capital
employed investment e.g.
Telecoms
Return on Assets ROA Operating Manufacturing or
profit/operating asset intensive
assets industries e.g.
construction industry
Return on total ROTC Operating Where costs are the
costs profit/total costs main driver of profit
e.g. services
It is possible to use other net profit indicators. The OECD TPG at paragraph 1.05 lists
some; they include floor area for retail spaces and employee numbers. It is
important that the denominator can be accurately measured and is appropriate
for the transactions being looked at.
It is often said that TNMM looks at net profit. As you can see from the above table
with the exception of the Berry ratio the PLIs are based on operating profit.
Operating profit can be defined as sales less cost of goods sold, less labour costs
and other costs connected with the business. It can include depreciation, but will
be before deductions are made for interest and tax.
To continue our earlier illustration where we calculated gross profit, here we will
calculate the operating margin.
Illustration 4
Sales 500,000
Cost of sales 350,000
Gross Profit 150,000
Operating costs 100,000
Operating profit 50,000
The thinking behind the TNMM is that companies in the same industry will tend
towards the same net profit levels over time. If one company had higher returns
than the rest then it would be able to expand at the expense of the others and
eventually the less efficient companies would go out of business.
The ideal comparison would be to compare the net margin of the controlled
transactions to the net margin earned by the same company in uncontrolled
transactions.
As with CUP, RPM and cost plus only one party to the transaction is tested when
using TNMM. This will be the least complex party as generally it is easier to get
information for the least complex party.
The TNMM looks at third party comparables that carry out similar activities to the
tested party and measures their profitability. Therefore, if the transaction to be
tested is complex and involves several parties contributing to the overall value
being created, the TNMM cannot be easily applied.
The independence criteria together with the overall globalisation trends (i.e. fewer
totally independent third party comparables are available for comparison), make
it more difficult to find a potential comparable third party company that fits the
specific functional and risk allocation of a tested party entering into a complex
transaction.
In cases where the TNMM can be applied it is very important to choose the right
profit indicator to test. It is possible to convert from one profit indicator to another;
however, each profit indicator is subject to a number of sensitivities, which might
lower the comparability and generate non arm's length results as detailed in the
extract below:
“In applying the transactional net margin method, the selection of the most
appropriate net profit indicator should follow the guidance... in relation to the
selection of the most appropriate method to the circumstances of the case. It
should take account of the respective strengths and weaknesses of the
various possible indicators; the appropriateness of the indicator considered in
view of the nature of the controlled transaction, determined in particular
through a functional analysis; the availability of reliable information (in
particular on uncontrolled comparables) needed to apply the transactional
net margin method based on that indicator; and the degree of comparability
between controlled and uncontrolled transactions, including the reliability of
comparability adjustments that may be needed to eliminate differences
between them, when applying the transactional net margin method based
on that indicator.” (OECD TPG Chapter II, 2.82).
The TNMM compares the net profit margin (relative to an appropriate base) that
the tested party earns in the controlled transactions to the same net profit margins
earned by the tested party in comparable uncontrolled transactions or
alternatively, by independent comparable. For example, return on total costs,
return on assets, and operating profit to net sales ratio (as shown in the above
table).
Illustration 5
Company A manufactures 500,000 designer ski boots. It has been decided that
TNMM is the most appropriate method to apply. It has been identified that the
company operates in an asset intensive industry where utilisation of assets is very
important to remain profitable and stay in business. A comparability study applying
the five comparability factors has identified that companies in the same industry
with the same functional profile make a return on assets (ROA) of 10%. This has
been measured based on the original cost of assets used.
It is established that Company A employs assets with an original cost of 10m. From
this we can calculate that a 10% return means it would expect to have profit of
1m.
We are told that the company produces 500,000 boots. We can now calculate
profits per boot as 1m/500K = 2.
It is established that the costs of production are 10 per boot. Therefore we can say
that the price for each boot needs to be 12. As the sale is to a related party that
means the transfer price is 12.
Illustration 6
Return on sales has been identified as the appropriate PLI. The comparability
analysis identifies 3.5% as the expected return on sales (sometimes referred to as
the operating margin).
We are told that the final sales income for Company B will be 800,000 and that
operating costs will be 72,000.
We know we want an operating margin of 3.5%. We can calculate that the net
profit needs to be 800,000 x .035= 28,000. Therefore the transfer price will be
700,000, calculated as 800,000 – (72,000+28,000) = 700,000.
Illustration 7
Company X has been asked to provide invoicing services to the rest of the
companies in the group as part of a centralisation exercise.
It has been established that there are comparable independent companies that
can offer the same service, these companies receive a return on total costs of
12.5%.
With a return on total cost of 12.5% we can calculate that the profit will be 43,750
(350,000 x 12.5%) giving a total transfer price of 393,750 (350,000+ 43,750).
As such, the TNMM is a more indirect method than the cost plus / resale price
method that compares gross margins. It is also a much more indirect method than
the CUP method that compares prices, because it uses net profit margins to
determine arm's length prices.
One should bear in mind that many factors may affect net profit margins, but may
have nothing to do with transfer pricing.
The TNMM is used to analyse transfer pricing issues involving tangible property,
intangible property or services. However, it is more typically applied when one of
the associated enterprises employs intangible assets, the appropriate return to
which cannot be determined directly.
In such a case, the arm's length compensation of the associated enterprise not
employing the intangible asset is determined by determining the margin realised
by enterprises engaged in a like function with unrelated parties.
This implies as stated above that the TNMM is applied to the least complex of the
related parties involved in the controlled transaction. The tested party should not
own valuable intangible property. The application of the TNMM is similar to the
application of the cost plus method or the resale price method, but the TNMM
involves comparison of net profit margins.
For example, in the case of a related party distributor applying the resale price
method to establish an arm's length transfer price, the market price of products
resold by the related party distributor to unrelated customers (i.e. sales price) is
known, while the arm's length gross profit margin is determined based on a
benchmarking analysis. The transfer price or cost of goods sold of the related party
distributor is the unknown variable.
The determination of an arm's length transfer price based on the TNMM is similar.
The main difference with a gross margin analysis is that operating expenses are
considered in calculating back to a transfer price. In applying the TNMM on the
tested party distributor, the resale price and the operating expenses of the related
party distributor are known, while the arm's length net profit margin (i.e. net profit
to sales ratio) is found on the basis of a benchmarking analysis. The cost of goods
sold and the gross profit are the unknown variables.
In the case of a manufacturer, applying the cost plus method to establish an arm's
length transfer price, the cost of goods sold of the related party manufacturer is
known. The arm's length gross profit mark-up is based on a benchmarking analysis.
The transfer price or sales revenue of the related party manufacturer is the
unknown variable.
In applying the TNMM to the tested party manufacturer instead of the cost plus
method, the cost of goods sold and the operating expenses of the related party
manufacturer are known. A benchmarking analysis will determine the arm's length
net profit of the related party manufacturer using a profit level indicator such as
the ratio of net profit to total cost. The sales price and the gross profit are the
unknown variables.
The TNMM can be used in setting transfer prices; it can also be used in testing the
transfer prices set under another methodology. We will see TNMM being used
where the parties are involved in continuing transactions and one holds valuable
intangibles. The tested party is likely to be a distribution company or contract
manufacturer. We will also see TNMM being used in respect of intra-group services.
This section was revised in July 2018; the references here are to the updated
version.
The guidance makes it clear that while a lack of comparables is, by itself,
insufficient to warrant the use of the profit split method, if, conversely, reliable
comparables are available it is unlikely that the method will be the most
appropriate.
We will begin with an overview of the profit split method then go on to look at how
profits may be split under contribution analysis (simply PSM) or residual analysis
(RPSM).
“The transactional profit split method seeks to establish arm’s length outcomes
or test reported outcomes for controlled transactions in order to approximate
the results that would have been achieved between independent enterprises
engaging in a comparable transaction or transactions. The method first
identifies the profits to be split from the controlled transactions—the relevant
profits—and then splits them between the associated enterprises on an
economically valid basis that approximates the division of profits that would
have been agreed at arm’s length. As is the case with all transfer pricing
methods, the aim is to ensure that profits of the associated enterprises are
aligned with the value of their contributions and the compensation which
would have been agreed in comparable transactions between independent
enterprises for those contributions. The transactional profit split method is
particularly useful when the compensation to the associated enterprises can
be more reliably valued by reference to the relative shares of their
contributions to the profits arising in relation to the transaction(s) than by a
more direct estimation of the value of those contributions. “ (OECD TPG
Chapter II, 2.114)
If we look at the OECD TPG paragraph 2.126 we see that the guidance states:
“A high degree of integration means that the way in which one party to the
transaction performs functions, uses assets and assumes risks is interlinked with,
and cannot reliably be evaluated in isolation from, the way in which another
party to the transaction performs functions, uses assets and assumes risks.”
In deciding if activities are highly integrated, a key area to consider is the extent to
which the same (or closely related) economically significant risks are shared
amongst the parties (see OECD TPG paragraph 2.136). It is also important to look
at the question holistically as a unique contribution by one party may have a
significantly greater value when considered in combination with the particular
unique contribution of the other party.
OECD TPG paragraph 2.128 makes it clear that a lack of closely comparable
uncontrolled transactions will not be enough by itself to justify the use of the PSM.
The availability of reliable CUPs does indicate that PSM will not be the most
appropriate method (see OECD TPG paragraph 2.133).
All previous methods we have discussed deal specifically with one transaction and
require a specific functional and risk profile. That is the other methods necessitate
a specific transaction, which can be identified, compared and weighed (i.e.
identify the risk profile to assess whether it should generate a routine or a non-
routine return).
The PSM looks at the overall value generated by the efforts of all the transacting
related parties and provides an arm's length apportionment of the profit based on
the value each party contributes to the business on the basis of its functional and
risk profile.
“The main strength of the transactional profit split method is that it can offer a
solution for cases where both parties to a transaction make unique and
valuable contributions (e.g. contribute unique and valuable intangibles) to
the transaction. In such a case independent parties might effectively price
the transaction in proportion to their respective contributions, making a two-
sided method more appropriate. Furthermore, since those contributions are
unique and valuable there will be no reliable comparables information which
could be used to price the entirety of the transaction in a more reliable way,
through the application of another method. In such cases, the allocation of
profits under the transactional profit split method may be based on the
contributions made by the associated enterprises, by reference to the relative
values of their respective functions, assets and risks. See section C.2.2 on the
nature of the transaction (OECD TPG Chapter II, 2.119)
The extract above further highlights the strengths of the PSM. The presence of high
value intangibles is rapidly increasing in the context of large multinational groups.
Technical intellectual property, business and industry know-how and brands are
often becoming the main driving force for large businesses. With brands valued in
The PSM provides a solution to the comparability problem. The PSM based on
contribution analysis and the Residual PSM based on residual analysis (“RPSM”) are
often used to price both value and the profit portion contributed by intangibles.
As stated above, the profit split method seeks to eliminate the effect on profits of
special conditions made or imposed in a controlled transaction by determining
the division of profits that independent enterprises would have expected to earn
from engaging in a transaction or a series of transactions.
The profit split starts with identifying the profits to be divided between the
associated parties from the controlled transactions. Subsequently, these profits are
divided between the associated enterprises based on the relative value of each
enterprise's contribution, which should reflect the functions performed, risks
incurred and assets used by each enterprise in the controlled transactions. External
market data (e.g., profit split percentages among independent enterprises
performing comparable functions) should be used to value each enterprise's
contribution when possible, so that the split of combined profits between the
associated enterprises is in accordance with that of third party enterprises
performing functions comparable to the functions carried out by the related party.
However, not all functions can be priced using comparables as we already briefly
discussed for intangibles.
As noted above two main methods to split the profits amongst the associated
enterprises can be used:
• Residual analysis.
With contribution analysis (or simply PSM), the aggregated profits from the related
party transactions are allocated amongst the associated parties on the basis of
the relative value of functions performed and risk borne by the associated
enterprises engaged in the controlled transactions.
Comparable market data should (when possible) be used to calculate the portion
of the profit due to each of the related parties based on their functional and risk
profile and as detailed in the functional analysis conducted for the purposes of
putting in place transfer pricing documentation.
The contribution analysis and TNMM are difficult to apply in practice and therefore
not often used, because reliable external market data necessary to split the
combined profits between the associated enterprises are often not available.
How does the Residual PSM (“RPSM”) differ from the simpler PSM, which we have
just analysed? The RPSM model differs from a standard PSM as it involves a two-
step approach. We have already mentioned how certain value contributions
cannot be easily priced by means of comparable benchmarking (e.g.
intangibles). The RPSM first allocates comparable functions' profits, which then
leaves a residual profit to be split amongst the more difficult to price functions such
as intangibles.
In the first step an allocation of arm's length profit to each related party is
implemented to provide a basic compensation for routine contributions (i.e.
functions where the risk profile can be regarded as low – e.g. support services,
limited risk distribution, toll manufacturing, etc.).
The routine profit allocation does not account for any possible valuable intangible
assets owned by the associated party. The routine compensation is determined
based on the returns earned by comparable third party enterprises, which (ideally)
work in a similar industry or that (at least) carry out comparable functions and
exhibit a similar low risk profile. The TNMM is usually employed to determine the
appropriate routine returns for the first step in the RPSM.
Once all routine functions have been remunerated, the residual profit is then split
to account for non-routine activities, which are usually associated with a higher risk
profile. It is interesting to note that as risk bearing functions, the residual does not
necessarily translate in profit allocation; as the routine functions take priority in
allocating the profit, it might be that the residual profit is negative.
Hence, the non-routine functions might end up being allocated a portion of the
loss. However, it is also true that when large profits are collected within a
multinational group, the RPSM is more likely to allocate the majority of the profits to
the risk taking functions within the group. These trends follow the standard
economic trends for risk and reward (i.e. the higher the risk, the higher the
potential for profit, but also losses).
The residual analysis is usually applied in cases where both sides of the controlled
transaction own valuable intangible properties.
The profit split put forward needs to be aligned with Chapter 1 of the OECD TPG
which sets down how transactions are to be accurately delineated. This may
require the segregation of financial information. Harmonisation of financial
information will also be required where the results of two or more related parties
are aggregated.
Where closely related economically significant results are shared then it is actual
profits that should be split according to the guidance. Where a party makes
unique and valuable contributions without sharing economically significant risk
then it is forecast profit that should be used (see paragraph 2.160). It is clearly
stated that hindsight must not be used (see paragraph 2.161).
Operating profit is put forward as the most appropriate point at which profit is to
be split, however it is recognised that in some cases the split can be made at gross
profit. Section C5 makes it clear that profit splitting at any level is acceptable so
long as it is objective, verifiable and supportable. Section C5.1 includes a non-
exhaustive list of profit splitting factors such as percentages, asset based or cost
based measures.
The OECD TPG give some guidance on possible allocation keys that can be used.
Factors that can be used for profit splitting include relative value of expenditure on
assets, capital employed, marketing spend, incremental sales, employee
remuneration, head count and time spent. Cost is also listed as a potential profit
splitting factor although it is recognised that it is a poor indicator of value for
intangibles. Relative costs incurred by the parties can still be used as a proxy for
share of relative value. The list provided is not an exhaustive list. (See paragraphs
2.169 to 2.172).
The local file and master file (which we look at later in relation to compliance
issues) are cited as good sources of information for determining the appropriate
profit splitting factors (see paragraph 2.173). The local file and master file are
explained in more detail in a later chapter on documentation).
The OECD TPG do not refer to specific allocation keys to be used when allocating
the residual profit, but it is good practice to investigate a number of allocation
keys and run sensitivity analysis to ensure that the split returns arm's length results.
Below are a number of examples to illustrate how the residual can be split
depending on the availability of data, comparables and allocation keys.
Third party market benchmarks can be used to assess the fair market value of the
intangible property or other non-routine function to be allocated as part of the
residual profit.
The capitalised cost of developing the intangibles and all related improvements
and updates adjusted to account for the useful life of the asset and its future
potential in providing the added value (i.e. advantage) can be used. However,
using cost as the base to allocate the residual profit might not provide the correct
allocation as some non-routine functions might incur lower cost, but generate high
value.
Illustration 8
Company E markets the adapted product in Europe under its own brand name. In
year XXXX Company P has no direct costs related to the license. The tax authorities
for Company P determine that a Residual Profit Split is the most appropriate
transfer pricing method. It is also determined that the first step of the profit split will
be undertaken based on a return to assets employed. It is established that the
assets employed by Company E are 500,000 and that the appropriate return is
15%, which gives a return of 75,000 to Company E. It is established that the pre
royalty profits for Company E are 400,000. After we deduct the 75,000 of profits for
Company E for its contribution this leaves 325,000 of residual profit to be split.
Investigations determine that Company P has 7.5M in its balance sheet and
Company E has 2.5M in its balance sheet.
This means that the residual profit of 325,000 will be split 7.5/10 to Company P,
being 243,750, and 2.5/10 to Company E, being 81,250.
The RPSM is becoming more popular following the recent restructuring trends of
large multinational groups, which are centralising some of the non-routine
functions and creating structures which present a complex setup and would not
lend themselves to the standard transfer pricing methods. The RPSM provides a
good alternative in such cases, as the residual approach splits up a complex
transfer pricing problem into two more manageable steps and allows the use of a
number of allocation methods to benchmark, value and weigh the non-routine
component to be transfer priced. Secondly, potential conflict with the tax
authorities is reduced by using the two step residual approach since it reduces the
amount of profit split in the potentially more controversial second step.
The list below highlights some of the strengths and weaknesses of the PSM and the
RPSM.
Both the PSM and RPSM are suitable for highly integrated operations for which a
one sided method may not be appropriate.
The PSM and RPSM are also useful when third party benchmarks cannot be
identified.
The PSM and in particular the RPSM are most useful when looking at non-routine
functions, highly integrated operations and intangible property, which cannot be
easily defined using the standard transfer pricing methods due to their uniqueness
(i.e. lack of comparables in the market that match the functional and risk profile).
However, both the PSM and in particular the RPSM require a higher level of
reviewing, testing and sensitivity checking when using allocation keys, which do
not necessarily generate arm's length results.
Both the PSM and the RPSM are highly dependent on having access to quality
information and data from group affiliates. The information and data have to be
reviewed and compared to ensure consistency, which is sometimes lacking in
large multinational groups, which have just gone or are undergoing restructuring or
acquisitions.
The PSM can be used in cases involving highly interrelated transactions that
cannot be analysed on a separate basis. This means that the PSM can be applied
in cases where the associated entities engage in several transactions that are
interdependent in such a way that they cannot be priced on a separate basis
using any of the traditional transaction methods. The transactions are thus so
interrelated that it is impossible to identify distinct comparable transactions. Due to
this particular strength, the PSM and the RPSM are suitable for use in complex
industries such as financial services.
The RPSM (in particular) is often used in complex cases where both sides to the
intra-group transaction own valuable intangible properties (e.g. technical IP,
patents, trademarks, and trade names). If only one of the associated enterprises
own valuable intangible property, the other associated enterprise would have
been the tested party in the analysis using the cost plus, resale price or TNMM.
However, if both sides own valuable intangible properties for which it is impossible
to find comparables, then the PSM is more likely to be the most reliable method.
As part of your study you should look at the worked examples that are provided in
the guidance on the profit split method.
Below is a table setting down some of the main strengths and weakness of the 5
methodologies that we have looked in this chapter - it is not an exhaustive list.
CHAPTER 5
FUNCTIONAL ANALYSIS
5.1 Introduction
Functional analysis plays a critical part in establishing arm's length transfer pricing.
It involves gathering information and analysing the businesses engaged in the
controlled transaction to ensure that the parties to the transaction and the
transaction itself are understood. This enables an understanding of the
economically significant factors on which the pricing and its analysis will be based.
The OECD TPG place great stock on functional analysis as a pre-requisite for an
appropriate assessment of the comparability of a controlled transaction (of the
‘tested’ party – we will look at this in more detail in a later chapter), the selection
of a transfer pricing method and for establishing the appropriate pricing by
reference to comparability, including where necessary, any adjustments.
It is the normal starting point for any examination of an enterprise's transfer pricing
and also the means by which businesses and tax authorities can form a high level
view of value chains and the role and reward of transfer priced entities within
them.
As you can see functional analysis is very important and has many rolls to play in
transfer pricing.
This chapter sets out an overview of functional analysis with later chapters focusing
on practical guidance in carrying out a functional analysis and how that feeds
into the selection of a method, and its role in entity characterisation.
In order to fully understand the importance of the functional analysis, we must look
at the role it plays in determining comparability between the controlled
transaction under review and uncontrolled transactions. We looked briefly at
comparability in an earlier chapter; if we now look at paragraph 1.33 of the OECD
TPG we can see that it sets out the essence of comparability in transfer pricing:
It then goes on to state that there are two steps to a comparability analysis:
The guidance from the OECD on the first step can be found in Section D1 of
Chapter 1 of the OECD TPG. In particular paragraph 1.36 sets down the
economically relevant characteristics or comparability factors that need to be
identified for Step 1.
We looked at these comparability factors in an earlier chapter. You will recall that
they may be summarised as:
• Contractual terms
• Functional analysis
• Economic circumstances
• Business strategies
The functions (taking into account also the assets used and risks assumed)
performed by an enterprise which is a party to a controlled transaction is one of
the key comparability factors to be understood. This is established by way of a
functional analysis.
Have a look now at paragraph 1.51 of the OECD TPG. It summarises the
importance of the functional analysis and its impact on arm's length pricing:
how they influence the context in which the MNE operates. In particular, it is
important to understand how value is generated in the group as a whole, the
interdependencies of the functions performed by the associated enterprises
with the rest of the group and the contribution that the associated enterprises
make to that value creation. It will also be relevant to determine the legal
rights and obligations of the taxpayer in performing its functions. While one
party may provide a lot of functions relative to the other party to the
transaction it is the economic significance of those functions in terms of their
frequency, nature and value to the respective parties to the transaction that is
important.”
An important aspect to this guidance is contained in the word ‘each’. Whilst the
eventual transfer pricing method selected may be essentially ‘one sided’ (i.e. it
tests and supports a price or targeted margin for one of the parties to the
transaction), a functional analysis should consider factors relevant to both parties
engaged in the transaction (for instance, those relevant to establishing their
relative bargaining power) as otherwise there might be a limited basis for
comparability which may in turn raise doubts about the appropriateness of the
selected method and the robustness of the support for the pricing of the
controlled transaction.
Increasingly tax authorities are taking such a ‘two sided’ view on examination of
pricing with their starting point being to corroborate the results of the application
of the selected transfer pricing methodology of the tested party with the results of
the counterparty to the transaction.
The functional analysis is the factual basis of transfer pricing and the right effort
and focus should be placed on capturing accurate and relevant information
concerning functions, assets and risks, which will be critical in determining the
economically relevant characteristics for comparison with an independent party
situation and therefore minimising adjustments to transfer pricing policies that have
been implemented. Many transfer pricing issues arise due to a lack of clarity on
the factual position.
As we have seen the OECD TPG, in paragraph 1.51, as set out above, reinforce the
need for the functions, assets and risks to be identified and the TPG further expand
on functions, assets and risk in paragraphs 1.42 to 1.106.
“The functional analysis should consider the type of assets used, such as plant
and equipment, the use of valuable intangibles, financial assets, etc., and the
nature of the assets used, such as the age, market value, location, property
right protections available, etc.” (paragraph 1.54)
As mentioned in an earlier chapter the analysis of risk has a key role to play thus
we see at paragraph 1.56 of the OECD TPG “a functional analysis is incomplete
unless the material risks assumed by each party have been identified and
considered since the actual assumption of risks would influence the prices and
other conditions of transactions between the associated enterprises."
Paragraph 1.60 sets down a six step process for analysing risk. There are two key
concepts related to risk allocation, being control over risk and financial capacity
to assume risk. The six step process is as follows:
5. Allocate the risk to the enterprise that has the control over the risk and the
financial capability to assume the risk
This six step process has formed the basis of a past exam question so you should
review it in the OECD TPG.
In order to have control over risk, an enterprise is not required to perform the risk
mitigation activities itself, but it is required to be actively involved in the decision
process when outsourcing these activities. Financial capacity refers to an
enterprise's capability to access funding when managing risk as well as absorbing
the consequences of risk in the event of an unfavourable outcome (see
paragraph 1.64).
Paragraph 1.61 states that risk management has three elements: "(i) the capability
to make decisions to take on, lay off, or decline a risk-bearing opportunity,
together with the actual performance of that decision-making function; (ii) the
capability to make decisions on whether and how to respond to the risks
associated with the opportunity, together with the actual performance of that
decision-making function; and (iii) the capability to mitigate risk; that is the
capability to take measures that effect risk outcomes together with the actual
performance of such risk mitigation."
The following paragraphs outline some key elements of control over risk, risk
management and risk mitigation. Some risk management functions can only be
undertaken by the party performing the functions and using assets to pursue the
commercial opportunity. Others can be undertaken by a separate party. Risk
management is not to be thought of as a separate function. In some cases where
a service provider is used, for example with R&D, elements of risk mitigation may
be included in the service and reflected in the pricing for the service.
Paragraph 1.71 defines risk for transfer pricing purposes as the “the effect of
uncertainty on the objectives of the business”. Some examples of risks are
provided in paragraph 1.72:
c. Financial risks.
d. Transactional risks
e. Hazard risks.
The next step is to look at the contractual terms as these will normally set out the
intended assumption of risk. Some risk will be explicitly assumed, such as inventory
risk, others will be implicit in the terms.
The OECD TPG say that for the contract to be relied on there must be evidence of
a commitment to assume risk prior to the risk materialising and that the tax
authority will need to see this evidence.
Care needs to be taken with the written contracts as in some cases written
contracts may be inconsistent or may not be followed in practice.
Risk will have a material impact on pricing, thus in a controlled situation it cannot
be concluded that the pricing arrangement alone sets the assumption of risk. The
facts will need to be looked at to determine how the parties manage and control
risks (see paragraph 1.81).
A successful functional analysis will draw out the functions, assets and risks in a
manner that will enable comparison to uncontrolled transactions. It is inevitably a
simplification of the complexity of the value drivers in a business and will rarely be
capable of being exhaustive.
As such, a successful functional analysis will identify and draw attention to the most
important and relevant factors. It should allow a reader unfamiliar with the
specifics of the industry to understand the functions, assets and risks of the
enterprise in sufficient detail for them to understand the key relevant economic
characteristics. It will also typically bring to light aspects of the other comparability
factors, for example characteristics of the service.
Step 4 takes the information that has been gathered via steps 1 to 3 and analyses
it.
In cases where the contractual assumption of risk is fully supported by the parties’
conduct, including an alignment with the exercise of control and financial
capacity to assume the risk, the analysis will be straightforward.
Step 5 states that the party which does exercise control over the risk and has the
relevant financial capacity should be allocated the risk. If multiple associated
enterprises are identified that both exercise control and have the financial
capacity to assume the risk, then the risk should be allocated to the associated
enterprise or group of enterprises exercising the most control.
Paragraph 1.99 points out that in exceptional cases it may be the case that there
is no party that both exercises control and has the financial capacity to assume
the risk. Such a scenario would rarely occur between independent enterprises and
therefore a thorough analysis should attempt to identify the reasons for this. An
assessment of the commercial rationality of such a transaction based on Section
D2 of Chapter 1 of the OECD TPG may be necessary (we looked at this section in
an earlier chapter when looking at business strategies; you will recall that this sets
down the circumstances in which a tax authority can disregard transactions
entered into; see paragraphs 1.19 to 1.125).
Once step 5 is complete then step 6 involves using the approved methodologies
to price the transaction to ensure that the party assuming the risk is compensated
for the risk via the price received.
It follows that the party that both assumes and mitigates risk will have more reward
than a party that only assumes risk or only mitigates risk (see paragraph 1.100).
While a full text explanation of the functional analysis is critical to robust and
effective transfer pricing documentation, a summary showing the key functions,
assets and risks and their location in the group is often useful. This will be a benefit
to the reader, who will be required to take in a lot of information, and for when the
preparer comes to characterise each of the entities involved.
This summary should work through the supply chain in a logical order. Any lack of
clarity in its preparation will identify insufficient understanding in the functional
analysis review.
Illustration 1
Here we have a functional analysis for the H Group which consists of HO Ltd (the
parent company), MO Ltd and distribution companies.
Assets
Raw materials stock X
Design intellectual property X
Production equipment X
Manufacturing know-how X
Stock of finished goods X
Trade mark and brand IP X
Customer lists X
IT support systems X
Website X
Risks
New product development X
Warranty X
Market X X
Foreign exchange X
Stock X
Regulatory X
Here we can see that the H group is what we would describe as a group with
devolved activities. The parent company just carries out head office activities with
the result that all the manufacturing functions, assets and risk are within MO Ltd
and the functions, assets and risks relating to distribution are in each of the DO Ltd
companies.
Illustration 2
Assets
Raw materials stock X
Design intellectual property X
Production equipment X
Manufacturing know-how X
Stock of finished goods X
Trade mark and brand IP X
Customer lists X
IT support systems X
Website X
Risks
New product development X
Warranty X
Market X
Foreign exchange X
Stock X
Regulatory X
If we compare the functions of the parent company in the C group to the parent
in the H group we can see that functions such as procurement are undertaken by
CP Ltd rather than by the manufacturing company. As a result it holds stock as an
asset and has the risk associated with holding stock.
As we said at the start of the chapter, the functional analysis has many important
roles; one such role is to help identify the key characteristics of an enterprise so
that it may be categorised.
The functional analysis along with information from the industry can be used to
characterise the entities. If we take a manufacturing company for example,
common characterisations include full blown manufacturer, contract
manufacturer or toll manufacturer.
Entity characterisation can be a helpful high level tool to assist in examining often
complex value chains (that is, how a business derives value from the various
activities involved in the production of a product or service) and the manner in
which component parts of the value chain relate to each other from a transfer
pricing perspective.
CHAPTER 6
In this chapter we are going to look at the practical aspects of preparing a functional
analysis, including:
– the audience and purpose
– the sponsor
– the interviews
– the functional analysis
6.1 Introduction
When preparing a functional analysis, the aim is to document the key functions,
assets and risks of the business. In many respects a functional analysis is the most
interesting aspect of a transfer pricing project. It involves meetings with employees
at all levels of the business, from the people at the coal face, the operational
team that support them through to the executives that develop, drive and
implement its long term vision and strategy.
This chapter has been prepared on the basis that a third party is preparing the
functional analysis, however the guidance can be equally applied by a company
preparing its own functional analysis.
Before beginning, consider the audience for the functional analysis. Is it a basic
document to support an uncontroversial tax filing position? Is there a dispute with
a tax authority and is it therefore a defence document setting out the company's
position on the issues? Is it to support a proposed transaction; maybe the
company is proposing to close manufacturing facilities in higher cost countries (in,
for example western Europe or North America) and move them to a lower cost
country in Asia? Such a restructure would need to be supported from a transfer
pricing perspective, clearly documenting the change in functions, assets and risks.
Whatever the purpose of the document, the effort required will depend on the
nature, size and complexity of the parties and transactions involved.
Chapter V of the OECD TPG points out at paragraph 5.4 that the overarching
consideration in determining the rules for documentation is to balance the
usefulness to tax authorities of data for risk assessment with the cost to the
taxpayer of providing the information.
The length and style of the functional analysis will need to reflect the complexity
and materiality of the arrangements it will support. For a basic, uncontroversial
cross border arrangement, a simple tabular functional analysis like the example
that we will look at later in this chapter would be appropriate. In contrast, a tax-
Tax authorities also have different approaches to functional analysis. For example,
some tax authorities will regularly conduct their own functional analysis where
there appears to be inconsistencies between the taxpayer's own functional
characterisation of the business and the returns achieved.
A good sponsor will help to arrange interviews, understand the internal politics of
the business, and provide guidance on how to best introduce the project to the
interviewees. Ideally they should be at every interview. A sponsor may also help to
keep interviews focused and on track, and assist in building a rapport with the
interviewee.
in mind that it may be more difficult to schedule interviews with senior people, and
they are likely to be available for a shorter length of time.
If the functional analysis involves interviewing many people, think carefully about
how to do this. It is not uncommon to go for a “big bang” approach, with a whole
day of back-to-back interviews. This has lots of advantages: it is efficient, quickly
giving an understanding of the company, and if any issues arise or there are
conflicting facts, it may be possible to clarify these in the next interview. However
this approach also comes at a cost: the interview team will get tired, and material
covered in the interviews will start to blend together. The big bang is particularly
hard on the note taker and even harder on them when they have to type up the
meeting notes. If the functional analysis interviews have to be back-to-back, try to
organise a 10-15 minute break between each interview to reflect on what has
been said and how this will impact the following interviews.
If possible, try to meet at least the first few interviewees in person even if time,
geography, schedules and budget constraints may mean that some or all of the
functional analysis interviews have to be conducted by telephone.
• Completes the introductions (if there is no sponsor or the sponsor chooses not
to do this), and provides context for the interviewee (for example, what
transactions and issues they anticipate examining, the nature of the
questionnaire, etc.).
• Leads the interviewee through the functional analysis questions, identifies any
interesting areas to explore, and moves the conversation in these directions.
• Considers what the interviewee is saying in the context of the project, the
business, and what the team understands from other information sources or
interviewees.
• Spots issues and is responsible for ensuring the interview covers all the areas
required in the time scheduled.
The Sponsor
• Introduces the interview participants and provides context for the interviewee
(for example, the framework for the exercise it proposes and its importance to
the business).
• Can act as a “tie breaker” when contradictory facts are raised at the
interview.
• Is the busiest person in the room: if people are talking they probably should be
writing.
The interviewee has made the time to talk to the team, so it is important to respect
that time and make the most of it. An agenda and a list of questions will give
structure to the meeting and will help with this. As a functional analysis interviewer's
experience increases, they will be able to prepare for interviews more efficiently,
but even the most experienced functional analysis interview leader can forget
critical questions to ask, so a list of key questions is a must.
While it is important to strike a balance and make efficient use of the interviewees'
time, if they offer a tour of their operations, warehouse, or factory, it is an
opportunity that should not be refused. The more real the business is to the
interviewer the easier it will be to write about it.
When trying to understand the unique attributes of the company it can be useful
to ask why would a customer use this company instead of a competitor, or when
trying to understand risks, ask what would happen if there was a catastrophic
incident; a key factory burning down for instance, or the product causing the
hospitalisation of a number of customers.
When the interview has finished, take some time to summarise the key points and
issues. It is surprising how often members of the interview team understand critical
facts mentioned in the interview differently.
Throughout this chapter there are examples to help describe key concepts and
issues when preparing a functional analysis. There will be a variety of examples
throughout the chapter, however the following is a Core Example to which we will
often refer.
Illustration 1
OTAKI CENTRAL
(New York) 3rd PARTY
Pricing, Logistics, Marketing Contract
Design selection, Stores Manufacturers
Trade marks
(Asia)
OTAKI OTAKI
Design Manufacturing
(Milan) (Philippines)
Develops designs 20% of products
To ensure that its products are leading the market, Otaki Central has set up a
dedicated design house in Milan (“Otaki Design”) with 100 top designers. Otaki
Design puts on four fashion shows a year, one for each season, and Otaki Central
buyers select garments they like for manufacture. Otaki Design is free to develop
any garment designs it likes, and typically, only 1 in 5 garments are selected.
Otaki Group operates on a high volume, low margin model for 80% of its sales, and
to keep costs down utilises third party contract manufacturers to produce its
garments.
Otaki Central selects its designs, colours, materials, and manufacturing quantities
12 months in advance and invites bids from third-party Asian manufacturing
plants.
Recently the Otaki Group established its own factory (“Otaki Manufacturing”) in
the Philippines to produce limited volume (20% of total sales), higher margin “fast-
fashion” garments, with a short delivery timeframe (6 weeks). These garments have
been very successful, and sell out in hours.
If Otaki Central selects the wrong garments from Otaki Design, or orders the wrong
volumes of garments from the manufacturers, it bears the costs of these failures.
The finished garments are sold in stores (“Otaki Retail”) designed by Otaki Central,
using store layout, staff training systems, and staff scheduling systems also
developed by Otaki Central.
6.5 Functions
When conducting a functional analysis the aim is to distil what are the most
important activities undertaken by the business, and also to convey an
understanding of the relative importance of each function as compared to the
other functions performed within the group.
The various functions should be addressed in an appropriate order: the list below
includes some common functions along with some further thoughts for
consideration, but please note that this is not an exhaustive list and that any
functional analysis will need to be tailored to the specific project to which it
relates.
R&D can cover a wide spectrum of activity, and depending on the industry can
be a core value driver in a business. For example, in computer processor chip
manufacturing R&D is key to developing smaller, more efficient and faster chips
and this area would likely be a significant area of focus in the functional analysis.
R&D can lead to valuable intangible property, which is discussed further below. In
general, if a business is undertaking R&D it is important to determine what is the
R&D being performed, which party directs the R&D at a strategic level and on a
day-to-day basis, who determines the budgets, who pays for the R&D, what party
owns the R&D, and what happens if the R&D goes wrong. Are multiple entities
within the group undertaking the R&D function? For example, does the R&D team
work on a technology platform that has been created, owned and maintained by
another entity within the group? Answering these questions will assist in preparing
the functional analysis and categorising the business or transaction.
In the Otaki Group's context, an R&D function is being performed by Otaki Design
which designs garments for Otaki Central. This is undoubtedly a valuable function,
but it needs to be viewed in conjunction with the functions performed and risks
born by Otaki Central. Otaki Central chooses which garments will be produced,
how many will be produced, organises manufacturing and logistics, prepares
marketing materials, and determines how the garments will be displayed in-store.
In this regard, Otaki Design could be viewed as a contract R&D house with Otaki
Central ensuring the benefit of the R&D and being entitled to any valuable
intangible property deriving from it.
Procurement
its coffee bean purchases from one coffee wholesaler, would the resulting
discount in bean prices be due to the negotiation skills of the procurement team
or the volume discount of the business (or perhaps a combination of the two?).
In our example, Otaki Central is responsible for organising the manufacturing of the
garments and the delivery of the final items to Otaki Retail. However, it would not
be unreasonable for this activity to be undertaken by a separate entity in the
group. In the garment industry, it is not uncommon to use purchasing agents which
will identify factories to produce garments and ensure that these are delivered on
time to the agreed destination, in exchange for a percentage of the purchase
price of the goods.
But it should be noted that these agents are bearing substantial risks relating to the
delivery of the garments.
Services
Many of the functions set out in this chapter relate to products in one way or
another, but many successful companies do not sell products; they sell services,
and some companies that once could have been described as selling products
are re-creating themselves as service companies (for example “Software as a
Service”).
Manufacturing
Manufacturing can range from low value, low skill functions like manufacturing
toys for a Christmas cracker, through to manufacturing a one-off, extremely high-
value item like a communications satellite. It should be noted that the value of the
item produced does not always relate to the value of the manufacturing function.
For example, having machinery and processes that can produce extremely high
volumes of plastic trinkets for Christmas crackers may be a highly valuable, critical
function for a company.
The functions, risks and assets of a manufacturer will also vary considerably. When
considering a manufacturer, it is important to understand exactly what functions
are performed by the manufacturer. Helpful questions to ask, and factors to
consider when categorising the manufacturer, are provided in a later chapter.
The Otaki Group relies mostly on third-party manufacturers for its sales, but its own
factory produces high margin “fast-fashion” garments which have been very
successful. Part of this success is the flexibility to identify a trend and exploit it
quickly. Once again, this is down to Otaki Central's ability to pick the right
garments. If there was something unique about the manufacturing know-how, or
technology developed by Otaki Manufacturing, then this would require further
consideration in the functional analysis.
A warehouse may be used to store inventory that has not yet been sold. The
company may use its own facilities or a third party's warehouse. It may also be
storing goods for other group members. Potential issues to consider include: which
party has title to the goods, when is title passed, and which party is responsible for
The importance of sales and distribution to the success of the business varies from
industry to industry. This is related to the type of products/services being sold, for
instance whether they are generic or highly technical, requiring sales people with
specialist skills. For example, a distributor of medical devices used in surgery may
require sales people with a different or higher skill set than a distributor of stationery
products. The former may involve a more in depth sales process involving specialist
medical or technical knowledge and include meetings with medical specialists
and doctors.
Marketing
The level and importance of after-sale customer support services varies from
industry to industry. For example, a company providing foreign exchange trading
software to a multinational bank may require substantial, experienced technical
support to be available to the customer 24 hours a day, 365 days a year. This
service may be critical to completing a sale, and an important function to
document. In contrast, a fast food restaurant would typically not require these
services. It is important to also consider who bears the cost of warranties, whether
the products require repair or replacement, when, how and by whom.
Strategic Management
Intra-group Services
Financing
Flows of debt around the group and how they vary can have an impact on
characterisations, such as whether a lender to a cash pooling arrangement is
effectively making a short term deposit or a long term loan. Depending on the role
of the individual(s) interviewed, the functional analysis interview may be able to
provide an insight into the character of loans and the relative lending risk of
various group members more easily than through examining spreadsheets.
6.6 Assets
“The functional analysis should consider the type of assets used, such as plant
and equipment, the use of valuable intangibles, financial assets etc., and the
nature of the assets used, such as the age, market value, location, property
right protections available, etc.”
As with the functions listed in the earlier section, the following list of assets should
not be considered exhaustive. It is important to keep an open mind when
considering a company's assets. Often, the most important asset is not initially
obvious. For example, some people may consider the trademark of their mobile
telecommunications supplier to be one of the company's most important assets,
but in order to provide the service the company first had to acquire a licence. For
instance, British Telecom spent just over £4bn to acquire its licence.
Tangible Assets
When considering tangible assets focus should be on the significant items: there is
no need to cover the routine items like office fittings. Some tangible assets which
may be relevant are described below.
Cash
Does the company have a large amount of cash? Perhaps this cash is on deposit
in a related party interest bearing account. Some groups may pool cash in a
central treasury account. If this is the case, consideration will need to be given to
whether the interest rate applied to the deposits can be supported from a transfer
pricing perspective.
Inventory
Inventory can be in the form of raw materials or finished goods that a company
has not yet sold. It is important to understand whether the company is responsible
for managing its level of inventory and how much risk is associated with this. For
example, if a company is acting as a distributor of products for a related party and
is selling the products to a third party, it may be required to carry a certain level of
inventory to meet the customers' demands. In contrast, a distributor selling
exclusively to related parties may not have to maintain a large inventory as orders
are more certain and predictable, which means purchasing can be clearly
planned.
Property
Does the company own significant amounts of property or have leases, and is this
normal for the industry? In the UK, particularly in the retail sector, holding a large
number of leases may be problematic, particularly if there have been significant
changes in where people shop. For example, a fast food restaurant may have
signed up for a 20 year lease, only to find that a new shopping mall has opened
nearby and footfall has significantly reduced. The fast food restaurant may then
have to open a new site in the mall, and bear the costs of the old premises unless
they can be sub tenanted.
Referring back to our Otaki Group example, what would happen if Otaki Central
made a decision to open a store three times the normal store size in an expensive
high-end mall as a flagship store? Should Otaki Retail have to bear the higher cost
of the store?
Intangible Assets
Manufacturing Intangibles
Marketing Intangibles
The definition of marketing intangibles in the OECD TPG is fairly wide. The definition
was updated as part of the BEPS Action Plan. It can include trademarks, trade
names, customer lists, customer relationships and proprietary market and customer
data that is used in or aids in marketing or selling goods (see paragraph 6.16).
6.7 Risks
In the past risk was often the most neglected area in a functional analysis, and in
many ways it is the most important area to focus on. The OECD and tax authorities
are placing increased attention on risk as demonstrated in the increased
guidance on risk in Section D of Chapter 1 following adoption of the final report on
BEPS Action Points 8 to 10. You will recall from an earlier chapter that Chapter 1 of
the OECD TPG now includes a six step analytical approach to risk allocation. The
list of risks set out below includes the common risks that people consider, but it is
critical to investigate what other risks are unique to the business during the
functional analysis.
As noted earlier, while companies do not like to discuss failures or significant issues
that they have experienced in the past, it is often these examples that are the
most illuminating when trying to determine which party bears risk in the wider
group when issues arise.
Market Risk
Market risk is the risk that a downturn in overall market trading conditions affects
either the turnover or profitability of a company operating in that industry. Using
Otaki Group as an example, assume that the company expanded rapidly in
China, positioning itself as a desirable new western brand in expensive upmarket
retail malls in major Chinese cities. If China was then to experience a downturn,
and sales dropped to a point that the Chinese shops could not cover rent or
wages, which party would pick up these costs? If a number of Chinese stores
closed, which entity would bear the costs of the closures?
Regulatory Risk
Contractual risk is the risk which an enterprise exposes itself to under contractual
arrangement with its customers, for example for the proper performance or
function of contracted services or products. Where remedy is required, enterprises
risk additional costs from fulfilling warranties, providing replacements and potential
compensation. The ability to secure future contracts within the industry can also be
at stake.
The refinery example above is also an example of contractual risk, as the energy
company failed to include protective language in the contract stipulating either
what the eventual emissions would be, or stating that it would comply with
emission standards at the date the contract was signed.
Procurement Risk
Procurement risk arises where an enterprise is responsible for securing its source of
goods or raw materials for processing and/or sale. During a recent construction
boom, a construction company failed to meet its delivery deadlines as it required
a very large crane to assemble a number of modules that had been constructed
off-site. The company had failed to procure the right tools at the right time to meet
its obligations.
Inventory Risk
Where an enterprise holds stock, inventory risk manifests around the maintenance
of required stock levels, and the cost this entails, together with the potential sunk
cost from unsold (or unsellable) stock retained in the inventory.
In the Otaki Group example, if the company had predicted that florescent
coloured wetsuits would be the next high street fashion trend and had
commissioned large volumes of stock from its third party manufacturers, it may
have to substantially discount the garments to move them out of inventory should
this trend not occur.
Employment Risk
Staff risk is the risk of employing, retaining and replacing sufficient numbers of
employees who are experienced or qualified enough to perform the tasks of the
business. This includes meeting the costs of retention or replacement payments
which may be required when this risk is realised. Staff may develop specialist
technical knowledge and it is important the company is able to transfer this
knowledge through the organisation so if the staff member is lost, the knowledge
remains and is able to be effectively utilised by the business.
Credit Risk
Where an enterprise is responsible for credit control and cash collection from its
customers, this risk manifests where there is non- or late-payment and steps both to
recover amounts due and maintain cash flow are required.
This will differ by the customer base, which should have been addressed in the
industry analysis and the specifics of the group's customers. For example, are there
many small customers or a few large ones, and is the industry as a whole in
difficulty?
Exchange rates can be quite volatile and generally, unless the subject is a
financial company, the company's core competence will not be in financial
markets.
Keep in mind that the purpose of the meeting notes is not to provide a
stenographer's record of what was said, but rather to be shaped for its specific
purpose.
The form and content of the final functional analysis will be determined by the
underlying transaction/business that is being documented. The more complex and
contentious a tax authority is likely to find the arrangement(s), the more substantial
the effort that is likely to be required.
A simple table summarising the key functions, assets and risks is useful as it provides
a snap-shot of the business under review. This is helpful when characterising the
respective entities (see later chapter) and when identifying comparables to
benchmark the arm's length nature of the business. However, for more complex or
contentious arrangements, it is common to include a narrative description for
each significant function, asset and risk. When writing a narrative for the functional
analysis, it is important to strike a balance between being too brief to convey the
detail required and providing too much information. All in all, it is beneficial to be
succinct, including the most economical amount of information required in order
to demonstrate the point that needs to be conveyed.
Tangible Assets
Trade receivables X
Inventory X X X
Property X X XX
Plant / equipment X X
Intangible Assets
Trademark XXX
Manufacturing X
Intangibles
Marketing XXX
Risks
Market XX X
Credit X
Inventory XX
Product selection XXX
Contract XX
Staff X X X X
When preparing the functional analysis, always keep in mind that it will need to be
updated in the future. In the case of factual information, such as the number of
employees in each division, consider that it will be necessary to locate this
information every time the functional analysis is updated. Consider how easy it will
be to get the information next time and whether it is necessary to include this
detail at all. Where information is presented in a reduced or summarised form,
such as in a table as above, it may be helpful to hold more detailed records
separately so the conclusions can be understood later for updating or in the event
of an enquiry.
Businesses never sleep, and the functional analysis will need to be reviewed
periodically when the transfer pricing documentation is being updated. An
efficient way to do this is to send the relevant sections to the respective
interviewees (or their successors) and have them review it ahead of the update
meeting. It is also not uncommon to have them just update the word document
using track changes. If the business undergoes a significant restructure it will be
critical to document how the functions of each entity have changed post-
restructure, and support the transfer pricing policy with robust benchmarking
analysis.
The functional analysis needs to be aligned to how the company portrays itself. If,
for example, the company is categorised as a low risk distributor, this will be
challenged by the local tax authority if the marketing spokesperson or CEO is
interviewed and claims the success of the group is down to the unique skills and
contributions of the local company. This is a difficult area to manage, but media-
facing company staff need to understand that their message must be aligned to
the functions, risks and assets of the company. Many audits have been started or
unnecessarily prolonged by a five minute interview in the media making grand
statements that are inconsistent with how the company actually operates.
Also, make sure that the categorisation of the company is consistent with its
website. Keep in mind that websites, press releases and other publicly available
information will be reviewed by tax inspectors. This publicly available information
should be in alignment with the functions, assets and risks of the company.
6.11 Conclusion
CHAPTER 7
In this chapter we are going to look briefly at how the functional analysis is used when
selecting the transfer pricing method, in particular looking at:
– An overview of the methodologies
– Most appropriate transfer pricing method
– Comparable Uncontrolled Price Method
– Cost Plus
– Resale Price Method
– Profit Split
– Transactional Net Margin Method
– Choice of tested party
– Some examples of profiles and links to transfer pricing methodologies
– The financial indicator where a transactional profit split method is selected
– Availability of comparables
– The identification of the significant comparability factors to be taken into account
7.1 Introduction
We have seen that the identification of the functions, assets and risks performed
and controlled by the enterprises which are parties to the transaction being tested
is the precursor to assessing and establishing the comparability of the transaction
under review to an uncontrolled transaction.
• To ensure that the functional and risk profile of the tested party is reflected in
the chosen comparable.
Chapter III of the OECD TPG sets out a 9-step process to a comparability
assessment in paragraph 3.4. Step 3 of the OECD process describes the relevance
of factual and functional analysis to establishing comparability. We look at the 9-
step process in a later chapter.
As stated in an earlier chapter, the OECD sets out five methods, together with a
provision for ‘other’ methods where none of those listed are appropriate.
• Cost plus
• Resale price
• Profit split
As mentioned earlier the TPG no longer contain a hierarchy for selection of the
transfer pricing method, however some countries continue to do so.
You will recall that the overarching guidance is that the aim should be to find the
most appropriate method for the particular case and that the selection of the
method be considered in the context of the nature of the controlled transaction
determined, in particular, through a functional analysis. It can often be the case
that a decision is made as to the type of entity which is the party to a transaction
(‘entity characterisation’) that will influence the selection of method and, where a
transactional profit method is selected, the financial indicator to be used.
‘The selection of a transfer pricing method always aims at finding the most
appropriate method for a particular case. For this purpose, the selection
process should take account of the respective strengths and weaknesses of
the OECD recognised methods; the appropriateness of the method
considered in view of the nature of the controlled transaction, determined in
particular through a functional analysis…;’ (paragraph 2.2)
HMRC challenged this on the basis that the substance of the Isle of Man entity –
the seniority and expertise of its personnel, its capital and risk, and its bargaining
power - were insufficient to support this arrangement. This led to selected
comparables being set aside and the initially selected method replaced with a
profit split that increased the share of income and profit to the UK.
While not a transfer pricing case, this is highly informative. Baird had supplied Marks
& Spencer for many years when Marks & Spencer terminated supply arrangements
between them. Baird sought damages for lost profits but failed as there was no
contract and none could be inferred. Where independent parties would not
expect remuneration, this will only be supportable between related parties where
it is possible to differentiate the third party position from a group’s facts and
circumstances.
Suzuki Motor Corporation owned over half of Maruti Suzuki India Ltd and provided
the Suzuki name for the company to co-brand cars (alongside the Maruti name)
for the Indian market. A royalty was paid to Suzuki for use of the name. The Indian
tax authorities successfully challenged the value of the Suzuki name in the Indian
market, looking closely at local marketing spending to conclude that Suzuki had,
in their view, ‘piggy-backed’ a better known local brand. This shows the
requirement to understand the functional analysis from both sides and
perspectives, as value may be perceived differently in different territories.
It is worth noting that the challenge in these cases has been to the nature of the
underlying transaction rather than to the method itself. However in almost every
instance where a transaction is not appropriately identified, the resulting transfer
pricing method will likewise be inappropriate.
The CUP method is often referred to as the most objective method. If we look to
the glossary in the OECD TPG we see that it is defined as a method that compares
the price for property or services transferred in a controlled transaction to the price
charged for property or services transferred in a comparable uncontrolled
transaction in comparable circumstances.
• The transactions involve commodity type products, but only those in which
product differences are adjustable; and
This method takes the direct and indirect costs of the controlled transaction and
adds the appropriate mark-up so that a profit is made on the controlled
transaction.
The cost plus method is often most appropriate where the cost of the product or
services provision, rather than sale price, is the key value driver. This will be
determined through the functional analysis.
For example, the cost plus method is typically applied in cases involving the
intercompany sale of tangible property where the related party manufacturer
performs limited manufacturing functions and incurs low risks, because the level of
the costs will then better reflect the value being added and the market price.
The cost plus method can also be used to price charging for services (e.g. legal,
accounting, information technology, marketing, tax, etc.) if the services can be
considered to provide a benefit to the service recipient. However for services,
often in practice TNMM is most commonly chosen with a cost based profit level
indicator (PLI). PLIs were covered in the earlier chapter on methodologies and are
also looked at again later in this chapter.
It is important to have good quality data and to ensure that the comparable
transactions are indeed comparable and a close match to the controlled
transaction.
This methodology is often described as going backwards from the sale price to
find the transfer price. The final selling price is reduced by the cost of getting the
product to market, e.g. transport costs and an appropriate profit margin.
The Resale Price Method is normally used in cases which involve the purchase and
resale of tangible property in which the reseller does not add substantial value to
the tangible goods by way of physically modifying the products before resale or in
which the reseller contributes substantially to the creation or maintenance of
intangible property, for example a local marketing intangible.
In the case of distribution activities, where the distributor takes ownership of the
goods being sold, the Resale Price Method lends itself best to test the arm's length
nature of the transaction (again, in the absence of a CUP).
The TNMM compares the net profit margin (relative to an appropriate base) that
the tested party earns in the controlled transactions to the same net profit margins
earned by the tested party in comparable uncontrolled transactions or
alternatively, the net profit margins earned by independent comparable parties.
For example, return on total costs, return on assets, and operating profit to net
sales ratio.
In all cases where individual products or services cannot be priced separately the
use of TNMM provides the optimal solution as it compares the profitability of a third
party with the related party entity. However, when using the TNMM it is very
important to choose the right profit indicator (i.e. cost plus for services, resale price
minus discount for distributors, etc.).
Another key issue when applying the TNMM is ensuring that the functional and risk
profiles match those of the selected third party comparables. However, when
running benchmarking studies it is important to understand that tax authorities can
always challenge the choice of comparables; therefore, running sensitivity analysis
on the set of comparables can be valuable as it shows how the arm's length range
vary. If the transfer pricing is chosen in a manner that makes it less sensitive to
changes in the set of comparable third parties the overall risk of adjustments by
the tax authorities can be reduced.
The transactional profit split method and the transactional net margin method are
known as the transaction profit methods, as they focus on the outturn of the
transaction rather than the price of the sale of goods or services themselves.
The profit split method takes the total profit for all the associated enterprises and
splits it amongst them in a way that reflects how it would have been split between
unconnected parties.
In general the profit split method should be applied when transactions cannot be
benchmarked using internal or external comparables or when the transaction to
be benchmarked involves the input of several parties, which might also be
contributing intangible assets to generate the overall value for the business.
The section on the profit split method in an earlier chapter includes considerable
detail on when the method would be used. You should refer to that chapter as
necessary.
Paragraph 3.18 of the OECD TPG indicates that it is usually the least complex party
to the transaction that should be tested, as this will allow for the greatest reliability.
“...The choice of the tested party should be consistent with the functional
analysis of the transaction. As a general rule, the tested party is the one to
which a transfer pricing method can be applied in the most reliable manner
and for which the most reliable comparables can be found, i.e. it will most
often be the one that has the less complex functional analysis.”
The following table shows some common examples of functional profiles together
with the transfer pricing methods that may be appropriate to a particular profile.
The TNMM (similar to the Comparable Profits Method ‘CPM’ under the US Regs, if
not in concept, in terms of application) is a popular pricing methodology. It relies
on comparing a margin earned from a transaction/function with comparables
that may either be internal or external (which typically rely on proprietary
databases of financial data).
Where this method is selected, and external data used, a decision needs to be
made on the types of company that the tested party will be compared against
(which the functional analysis will inform) and the appropriate profit level indicator
(‘PLI’) to make a comparison against. The selection of the PLI will usually be
determined by reference to the appropriateness as judged against the
transaction and entity, informed by the functional analysis.
For example:
Other transactional profit methods i.e. profit split, whilst not necessarily reliant on a
financial indicator, will be reliant on the functional analysis of the parties to the
transaction.
Again, case law can also provide examples of how functional analysis, selection of
method and PLI are considered together.
GAP International Sourcing provides procurement services for its group in India. The
Indian tax authorities sought to challenge the company’s transfer pricing policy of
a mark up on value added expenses, preferring a commission of 5% of the Free on
Board price. The taypayer’s position was upheld as the Tribunal found no evidence
of local intangibles that would move its transfer pricing method away from cost
plus and that any location savings would be passed on to customers by a third
party.
NB: “Free on Board” is a transportation term that indicates that the price for goods
includes delivery at the Seller’s expense to a specified point and no further.
NB: the “Bright line Test” was first put forward in a US case (DHL). The judge in this
case identified that test which notes that, while every license or distributor is
expected to spend a certain amount of cost to exploit the items of intangible
property with which it is provided, it is when the investment crosses the 'bright line'
of routine expenditure into the realm of non routine that economic ownership,
likely in the form of a marketing intangible is created.
The Australian company had used the comparable uncontrolled price using the
pricing of transactions between the suppliers and their arm's length customers. The
company incurred losses, in part due to commercial issues (including a low level of
sales per salesperson, competition in the Australian market, excessive stock levels,
and poor management) and partly due to a strategy to penetrate the Australian
market.
The Australian Taxation Office argued that the transactional net margin method
should be used, where a 'benchmark operating profit' should be determined with
reference to the operating profits achieved by other 'functionally comparable'
distributors.
The Federal Court accepted the company's pricing, and held that it could not be
concluded that the prices were artificially inflated.
This case is also interesting as it considered the importance of the OECD TPG. The
commissioner had put forward a strict definition of comparability defending it as
being in line with the OECD TPG. The courts agreed with his interpretation of the
OECD TPG but further went on to say that it was examining Australian domestic
law, not a treaty, and it was not obvious how the OECD TPG came to be relevant
to domestic law. However the case did involve countries where Australia had
concluded treaties containing Article 9 in line with the OECD Model DTC and
hence the treaties need to be considered when looking at domestic law.
It noted that the OECD TPG were not part of the Commentary and were
expressed to be “guidelines”. They went on to say that under the Vienna
Convention, the OECD TPG might be examined if they reflected subsequent
agreement or practice of the parties to the treaty which “establishes the
agreement of the parties regarding its interpretation”; on the facts they decided
this was not the case. This meant that the OECD TPG could not be used to interpret
the meaning of Australia’s domestic transfer pricing legislation.
SNF (Australia) Pty Ltd v Commissioner of Taxation (Full Federal Court Decision)
(2011) FCAFC 74
Following on from the above case, the Full Court concluded that SNF Australia was
not required to quantify and provide evidence to establish the correct arm’s
length price, but only had to establish that the Commissioner’s assessments were
excessive. This departs from the previous decision in WR Carpenter Holdings Pty Ltd
v Commissioner of Taxation [2007] FCAFC 103, where the Court interpreted the
domestic law as seeming to require “the applicant to prove the actual amount of
the arm’s length consideration”. The Full Court decision in SNF Australia makes it
clear that proving that amount is not required.
Unilever UK manufactured various products for Unilever Kenya. The transfer pricing
documentation included the following based on the capital used for production
of the goods:
• The price will not be less than full variable cost + 10% profit mark up plus actual
transport costs.
The Kenyan Tax Authorities tried to impose a CUP. Unilever said that there was no
CUP pointing out the functional differences between Unilever Kenya and third
parties that it sold to.
Although independent unrelated comparables are usually used for transfer pricing
purposes, in practice it is often observed that for certain countries it is not possible
to identify comparables or reliable company data that meet the comparability
requirements. In such cases, practical solutions must be sought in good faith by
taxpayers and the tax administration. A possible solution may include searching for
comparables in other geographical regions that share certain key similarities with
the country in which a company conducts its business (e.g. depending on the
industry, for manufacturers established in, for example, Africa, a search for
comparables could be carried out in Asia or Eastern Europe).
As we have seen the functional analysis will indicate, out of the functions, assets
and risks identified, which are the significant ones that will be critical in a
comparability exercise.
CHAPTER 8
ENTITY CHARACTERISATION
In this chapter we look at how functional analysis is used for entity characterisation and
how classification can affect the chosen tested party, in particular looking at:
– An overview of entity classification
– Entity classification comparing simpler and complex entities
– Sales functions
– Manufacturing entities
– Support service activities
– More complex or entrepreneurial entities
– Planning aspects of entity classification
One of the most helpful outcomes from a functional analysis review is to enable
entities in a group to be classified, based on each entity's functions, assets and
risks, from ‘simpler’ entities to the more ‘complex’.
A complex entity might own, manage and develop intellectual property and
make key strategic decisions. A simpler entity would normally undertake more
routine tasks with lower risk such as contract manufacturing or support service
provision. Simpler entities would typically not own valuable intellectual property.
Take the example of the pharmaceutical industry. A complex entity would be that
which manages the development of new drugs, and owns and manages the
intellectual property relating to existing drugs. If this entity sold the drugs to a
related party distributor in another country, the provision from a transfer pricing
perspective would be the price of these drugs as between the two entities.
From a transfer pricing perspective, it is difficult to quantify the arm's length return
to be made by a pharmaceutical company for selling drugs intra-group. The value
of drugs will be dependent on a number of factors such as the treated condition,
whether the drug is seen as revolutionary, the number of competitor products and
local market conditions (for example whether the main buyer of drugs is a single
national health service or whether there are multiple private providers).
Given the difficulty of looking at an arm's length provision from the perspective of
a more complex entity, transfer pricing work tends to focus on the simpler entities:
in this case, the local distributor of the drugs. From a transfer pricing perspective,
distributors of drugs should make relatively similar economic returns regardless of
the pharmaceutical company or the type of drug being distributed. This is due to
the fact that a pure sales activity requires essentially the same skill set and
practices for all pharmaceutical products – the functions, assets and risks of a
distributor is likely to be broadly the same.
In order to support the pricing between the parent and the distributor, if no
comparable uncontrolled price (CUP) is available it would be normal to look at
the profit margins earned by the distributor as a result of the purchase of the drugs
and compare these margins with those achieved by independent companies (for
instance, companies acting as distributors for third parties) performing the same
activities in that market. This is normally carried out by a benchmarking study using
an economic database that draws on data from different markets, for example
North America, Europe or Asia.
Some local differences may exist. For example, in markets such as the US it may be
necessary for pharmaceutical distributors to spend significant sums targeting
doctors and patients with promotions and advertising which arguably could
create a local marketing intangible. However, it could still be possible to
benchmark a local distributor's returns, taking into account this marketing
intangible by comparing them against the returns of other independent entities in
the market that bear similar costs. Effective functional analysis will guide these
types of decision.
Generally, the simplest entity becomes the tested party for transfer pricing
purposes. Where two parties are subject to a transaction or provision, the
economic analysis will be usually performed on the simpler entity. This arises from a
practical perspective, as comparable companies (and their financial data) are
easier to identify where there are fewer differentiating functions, assets and risks
involved.
While the transfer pricing analysis will normally be performed on the simpler entity,
there is still work to be carried out using the functional analysis to assess the precise
rewards of the tested party: there is a sliding scale between ‘simple’ and
‘complex’. Some simpler entities will have a much higher level of functionality and
risks assumed than other entities, and this could have a crucial impact on the arm's
length transfer pricing provision. It is also important not to generalise a specific fact
pattern into a generic classification; a service function that includes key business
risks – for example outsourced analysts who perform quality control of deliverables
going direct to a client – might not be appropriately rewarded as a routine, low-
risk function.
The next section looks at entity classification based on the functional analysis and
its impact on the reward achieved by different entities that are party to a
provision.
A value chain relates to the steps needed to deliver a product or service and
measures the contribution (in value terms) of each step or process to the overall
value chain. By understanding the value chain and in particular the contribution of
each entity, it is possible to classify each entity for transfer pricing purposes.
Entity classification is perhaps one of the most important and controversial areas of
transfer pricing. It requires groups to take a dispassionate look at the outputs of
their functional analysis and to assess the activities that each entity performs and
the value they add, and then to classify each entity accordingly. The entity
classification will feed directly into the selection of transfer pricing method and
economic analysis.
The diagram below shows how the entity classification, which is derived from the
functional analysis, can affect the transfer pricing policy and, through it, the level
of local profitability.
The key to successful entity classification is to draw evidence directly from the
functional analysis outputs without imposing an oversimplified view which is neater
but which may not reflect the variation of local activities. Where the latter occurs,
tax authorities are increasingly identifying and challenging the position, particularly
when in practice ‘limited risk’ operations are less limited than they are presented.
To achieve this, the table in the functional analysis, like the one we saw for Otaki
Group in an earlier chapter, summarising the location of key functions, assets and
risks is often valuable as this shows each entity's relative complexity.
Many group entities often carry out more simple or “routine” functions, especially
where key risks are managed centrally. These are normally the focus for the
economic analysis as the “tested party.”
These entities perform functions which, while part of the value chain, do not
contribute materially to the value added functions, assets and risks which
differentiate the business. They will normally undertake activities which can be
easily replicated (i.e. they are not protectable) and as such are neither unique nor
dependent on proprietary intellectual property. This might include distribution
activities, contract manufacturing or contract research and development, or the
provision of services, but as always the classification of these activities will depend
on the fact pattern concerned.
The type of entity classification that is applied depends on the nature of the
activity involved.
Whilst a sales function on its own is normally considered routine, its type of activity
and level of risk can vary widely. At one end of the spectrum is the example of a
full risk sales entity or a licensed distributor, taking stock risk or licensing a brand or
other intangibles. At the other, an entity may provide sales support, research the
market and facilitate logistics but not enter into customer contracts or take title to
products. Some of the terms commonly given to the spectrum of sales function
and the potential for profit (and profit volatility) associated with them are
illustrated below.
The information from the functional analysis may reveal evidence that a local sales
operation is in reality a sales support function. For example, it does not enter into
contacts directly with customers (these may be concluded between customers
and the entrepreneurial entity over the internet) or take product title or stock risk. It
may facilitate distribution logistics and/or local marketing under the close direction
of the entrepreneur in the value chain.
This may suggest that value driver in this sales support entity is primarily cost rather
than sales. This may then support the selection of a transfer pricing method based
on cost, such as cost-plus, as the most appropriate method.
Where an entity acts as a sales agent for a principal, more substance will be
shown through the functional analysis as the entity will negotiate with customers
within outlined parameters set by the principal. The entity will not take legal title,
and so not be exposed to stock, warranty or litigation risks, again leaving local
entity risk at a low level. How this is reflected through intercompany agreements
will be an important point for the functional analysis to confirm a characterisation
of sales agent (under common law) or commissionaire (under civil law).
As the name suggests, a commissionaire will receive a commission for the sales it
secures, suggesting that a transfer pricing method based on sales, such as the
resale price method may be most appropriate.
The commissionaire has a contract with the principal to buy the goods and pay for
them. The commissionaire company then receives a fee/commission. There is no
contract between the principal and the customer. The customer may not know
that the principal exists.
An entity may be a limited risk distributor (‘LRD’) where it is entering into contracts
on its own behalf, making sales in its own name, and performing local
implementation of a central marketing strategy. A LRD's title to a product may only
be brief, with ‘flash title’ passing at the moment of sale. Local risk will still be limited,
with key risks such as inventory, warranty, currency and bad debt risks borne by
the entrepreneurial entity, which also provides strategic management.
The most appropriate method for rewarding an LRD will depend on the fact
pattern and available data. For example a target operating margin may be
assessed under TNMM which is then implemented through the product price,
supported by periodic adjustments.
Licensed Distributor
In these cases, the functional analysis may show a significant level of local decision
making and risk, for example in relation to market strategy, pricing and inventory in
addition to the other risks assumed by an LRD. There will usually be a significant
profit potential from these activities, but also the downside risk of potential losses,
as results can fluctuate with this level of local risk.
The functional analysis becomes even more important in determining the most
appropriate method as, even with these fluctuations, profit or loss will need to be
allocated appropriately in the value chain. It may be that the entity's underlying
distribution functions are essentially routine and may be tested in a similar way to
those of an LRD (although at a higher level in the resulting pricing range), with any
balance of profit attributable to the licensor or franchisor. If the licensor is shown by
its functional analysis to be more passive or the licence of a limited or measurable
value, it may be that the licence transaction becomes tested with the balance of
profit or loss remaining in the distribution entity.
If the functional analysis shows a sales activity which begins to take on elements of
a smaller-scale replica of the whole entity, ‘full risk distributor’ may be appropriate.
This may be similar to a licensed or franchised distributor, but either replacing or
enhancing any bought-in intellectual property with local value adding assets. This
could include local marketing intangibles such as sub-brands, as well as greater
levels of local management and risk.
As its characterisation suggests, a full risk distributor may not be a simpler entity in
its relationship with other group entities – as always this will depend on the fact
pattern. The method will need careful consideration as profit split or TNMM may be
most appropriate, or it may be that counterparties such as the group's
manufacturer or brand owner should themselves become the tested party.
For all these arrangements, it is important that the functional analysis review shows
the risk borne by both entities, including the more complex.
• Who bears the cost of a market shortfall when demand is insufficient to cover
a distributor's costs?
• Who is liable for proper performance of customer contacts, for example in the
event of late delivery or warranty issues?
Toll Manufacturer
The lowest risk entity is a toll manufacturer. Here the complex entity retains title to
both the raw materials and goods throughout the manufacturing process. The
complex entity buys the raw materials or sub-assembled goods, although the
physical flow of goods will be directly to the manufacturer itself. As a result, the
complex entity bears all the inventory and sales risk, while the toll manufacturer (or
‘toller’) is primarily responsible for the management and effective utilisation of its
assets in the production process.
As this fact pattern suggests, an appropriate method to reward a toller will be one
based on cost, such as cost plus or a return on assets employed.
Contract Manufacturer
Functional analysis will show to what degree this exists: for example, a contract
manufacturer may perform its own procurement and may retain title to the
finished goods, or both of these could be centralised elsewhere in a group. It will
also show which entity has responsibility for increased unit costs from
undercapacity: these might be set out in an intercompany agreement showing
order volumes, or this risk may be assumed entirely by the entrepreneurial entity.
Again, the most appropriate method may be to apply a cost plus on product
pricing, or target a margin under TNMM which is then implemented through the
price of manufactured product sold to group entities.
Licensed Manufacturer
• Who takes inventory risk for raw materials and finished goods?
• Who takes procurement risk – i.e. securing appropriate raw materials at the
right price?
An effective functional analysis will also provide supporting evidence for the
benefit these activities provide to recipients in the group; this is something the
recipients' local tax authorities increasingly seek in tax audits.
Third parties often outsource the performance of services to centres with specific
skill sets while retaining overall direction and control in-house. These could include
engineers, chemists or software developers. Where this fact pattern exists, the
service provision – for example contract research and development – may be
rewarded on a routine basis, usually at cost plus.
For this to be appropriate, the functional analysis would need to show that the
complex entity or entrepreneur is making the key decisions on the scoping and
management of the projects, and that all key risks are borne by the entrepreneur.
It is also important to demonstrate that the activity concerned could potentially
be contracted out to a third party. Where the research and development activity
performed is cutting edge, it may be difficult to find a third party contract
research and development company able to do the work, or in practice much of
the development may be devolved to local specialists. Under those
circumstances, treatment of the activity as a routine service may not be
appropriate. As such, the research and development company may be deemed
to be a more complex entity from a transfer pricing perspective, and share in the
entrepreneurial rewards for its research and development effort.
The functions, assets and risks not found in the simpler entity will sit elsewhere in a
group. In summary, these will be the value added, differentiating elements of a
business such as intangible assets, strategic management, and research and
development. They may also extend to other functions, depending on the industry.
As discussed above, the more complex entity will not be the tested party as its
attributes may well be unique and so not comparable in practice. Typically it will
receive the balance of profit or loss on a transaction or share in the group's system
profit. This reflects its greater profit potential which comes from its greater share of
business risk. In some cases where business risk has been deliberately centralised,
this may be particularly noticeable.
The functional analysis may not provide a clear cut answer, however. Where a
group's functions are dispersed, such as between a manufacturer, distributor and
an intellectual property company, there may be no obviously ‘more complex’
entity at first glance. Here, the functional analysis and evidence such as legal
agreements should show where key business risks fall and the extent of
management in each entity (i.e. where the significant people in the business may
be found). Conversely, in groups which have grown by acquisition, more than one
complex entity may exist. Once identified, careful consideration must be given to
how these are rewarded when the economic analysis is performed.
Tax authorities are aware of the potential motivation for groups to operate through
limited risk entities in higher tax locations. Where an entity is purported to have
limited risk, a tax authority may raise detailed questions about the group functional
analysis or re-perform their own functional analysis during an investigation by
written correspondence, through meetings with management or reviewing
primary documentation such as board minutes, emails or mobile phone records.
Where a tax authority is able to show that the entity classification that has been
chosen is inconsistent with the functional analysis and the value chain of the
group, they may seek to recharacterise the entity or not recognise one or more of
the transactions, which could lead to a transfer pricing adjustment arising. This is
one of the major causes of transfer pricing adjustments in the current environment,
which underlines the importance of a robust functional analysis review.
Both the OECD and tax authorities are focusing more closely on key personnel
who are capable of making key decisions, and where they are located. Whilst an
entity could have its costs reimbursed and indemnified against any economic and
financial risk it still may not be successfully supported as limited risk based on the
functional analysis. A critical issue will be whether the entrepreneurial activity is
capable of directing the activities of the limited risk entity.
Illustration 1
In order to bring all these concepts together, the following is a practical illustration:
The three key differentiators of a smart phone to customers typically will be the
brand, the particular operating system (its user interface and availability of apps
etc.) and the hardware (its features and look). This market is highly competitive
and requires a significant investment in research and development and branding
in order to be successful. There are many different ways in which a mobile phone
manufacturer could structure itself. The diagram below shows one potential
approach illustrating the concepts above.
Brand & IP
management company
(complex entity)
In this example, there is a complex entity directing the group (in some groups this
may be located in a lower tax territory). The role of this entity is to own and
manage the group's brand and intellectual property. In order to be able to
operate on a global basis it needs to make use of professionals to assist in
designing the brand message, the software and hardware. These professionals will
typically be located in certain areas in the world such as Silicon Valley, California.
This will be typically achieved by limited risk development entities.
Many groups will outsource their manufacturing operations to third party contract
manufacturers in China, but equally they could use their own contract or toll
manufacturers. Typically the group would also centralise back office functions to
avoid duplication.
many individuals for personal reasons such as family, education and quality of life
would prefer not to work in an offshore location.
A detailed and regular functional analysis needs to be carried out to identify the
location of key personnel within the group and the decisions they make and assess
whether or not this is supportive of the overall structure from a transfer pricing
perspective. This personnel issue is one of the key practical issues that groups will
face and ultimately is the most important factor in a practical functional analysis
review.
CHAPTER 9
In this chapter we look at the OECD guidance on how to perform a comparability analysis
including:
– the process laid down in the OECD TPG
– choice of the tested party
– external comparables and sources of information
– selection of comparables
– comparability adjustments
– the arm’s length range
– timing issues
– compliance issues
9.1 Introduction
• Contractual terms;
• Functional analysis;
• Business strategies.
The OECD TPG set out in Chapter III Section A.1 (see paragraph 3.4 et al) a typical
process for the comparability analysis in nine steps. They indicate that this process
is accepted as good practice but is not compulsory; other methods that lead to a
reliable result are equally acceptable.
Step 3: Review of the controlled transaction and choice of the tested party.
Step 6: Selecting the most appropriate transfer pricing method and (depending on
the method) determining the relevant financial indicator.
Step 7: Identifying potential comparables. This will involve determining the key
characteristics that need to be met by an uncontrolled transaction in order to be
potentially comparable, based on the analysis at step 3 and the five
comparability factors set out above.
Step 9: Interpreting and using the data collected, in order to arrive at the arm's
length price.
The OECD TPG note that these steps will not necessarily be applied by a simple
progression from Step 1 to Step 9. In particular, Steps 5 to 7 may need to be
repeated a number of times if the sources of information initially identified at Step
5 do not prove adequate to enable the process to be completed.
The converse situation may also arise, where a contract gives a single price for a
package of supplies, but it is not feasible to apply transfer pricing methodology to
the package as a whole. In this case the elements of the package will initially
need to be considered separately, but it will be appropriate to consider whether
any adjustment is needed when they are ‘rebundled’, in order to arrive at an arm's
length result. For example, a computer may be sold with included items of
software, each of which has an easily identifiable arm's length price. However, in
considering the price of the package as a whole it may be appropriate to adjust
for the fact that the supply of anti-virus software below cost will be a sensible
commercial choice if this will encourage the customer to renew the subscription
automatically at the end of a trial period rather than seeking alternatives.
Intentional Set-offs
Associated enterprises may intentionally incorporate a set-off into the terms of the
transaction under examination, on the basis that the totality of the arrangement
gives an arm's length result. So, for example, two enterprises may each allow the
other to use their intellectual property on the basis that (with a balancing payment
where necessary) this leaves neither side worse off. Such arrangements may vary
in complexity from a simple case where each side makes supplies of the same
value to the other at an equally favourable price, to a situation where all supplies
of goods and services in either direction over a period are aggregated and a
single payment is made by one party to reflect the perceived net benefit it has
received.
When the transfer pricing method employed is a cost plus, resale price or
transactional net margin method, it is necessary to select the party to the
transaction for which a financial indicator is tested (the ‘tested party’). That
financial indicator will be, in each of those cases respectively, the mark-up on
costs, the gross margin, or the net profit indicator.
The OECD TPG indicate that, as a general rule, the tested party will be the one for
which a transfer pricing method can be applied in the most reliable way and for
which the most reliable comparables can be found, which will usually be the party
for which the functional analysis of the transaction is less complex.
The OECD TPG give an example under which company A manufactures product 1
and product 2, and sells both to overseas associated company B.
PARENT CO
↑
Tested Party
PARENT CO
↑
Tested Party
By contrast, in the case of product 2 company A uses its own valuable and unique
intangibles while company B only acts as a distributor, performing simple functions.
The tested party for this transaction would most often be company B.
Despite this guidance, in practice the choice of tested party will often be driven
by the structure of the relevant legislation in the jurisdiction in question. This may
specifically require consideration of the position of the resident taxpayer, rather
than of any other party. Even where the focus of the legislation is on the terms of
the transaction rather than the position of the taxpayer, so that in theory arm's
length terms could be established by considering either party, in practice there
may be an expectation by the tax authorities that the question should be
approached by reference to the party whose tax liability is at issue. In addition,
that will normally be the party in relation to which most information is available
both to advisers and to the tax authorities; in practice, obtaining sufficient
information from related companies in other jurisdictions may be difficult.
In order to select and apply the most appropriate transfer pricing method,
information is needed in relation to the transaction on the five comparability
factors, and in particular on the functions, assets and risks of all the parties,
including the foreign associated enterprise. While one-sided methods such as cost
plus, resale price or transactional net margin only require a financial indicator or
profit level indicator for the tested party, some information on the comparability
factors of the transaction, and in particular on the functional analysis of the non-
tested party, will still be needed in order to justify the choice of that method.
In General
Internal Comparables
The review of existing internal comparables is Step 4 of the typical process. Where
such transactions exist information is likely to be more complete and less costly to
assemble, and the financial analysis may be easier and more reliable because it
relies on identical accounting practice. Nevertheless, the comparability factors in
paragraph 1.36 of the OECD TPG must still be met, and comparability adjustments
may still be required as at A.6 of Chapter III. For example, an internal comparable
that relates to the same goods as the controlled transaction but to very different
quantities may not give a reliable comparison unless an appropriate adjustment
can be devised.
The search for external comparables is Step 5 of the typical process. It may not be
necessary to embark on this step if reliable internal comparables have been
identified.
Databases
c. They are not primarily compiled for transfer pricing purposes, with the result
that the information may be insufficiently detailed. In particular, it relates to
the results of companies rather than the results of transactions. Accounts are
therefore unlikely to be of any assistance in applying transfer pricing methods
based on comparable prices, as opposed to levels of profit. In addition, in
owner managed businesses (OMBs) margins may be affected by policy
decisions such as whether to reward owners by means of salary or dividend,
and it may be difficult to identify and separate out these factors.
f. The quality of the accounts may vary considerably, both between jurisdictions
and within any one jurisdiction. However comparable a company's activities, it
may not always be possible to extract reliable information to assist with transfer
pricing calculations.
databases, but these may be based on a more limited portion of the market than
commercial databases. In the next chapter we will see how databases can be
used in practice.
While tax administrations may have relevant information available to them from
dealing with the affairs of other taxpayers it would not be appropriate for them to
use this unless, unusually, they were permitted by their domestic confidentiality
requirements to disclose it to the taxpayer involved in the controlled transaction.
Third party data relating to results at company or segment level may sometimes
provide reliable comparables for controlled transactions, where those results
represent the aggregate of a number of similar transactions. Where the results are
for a segment, this may raise issues as to the way in which expenses have been
allocated.
Identifying potential comparables, which is one of the most critical aspects of the
comparability analysis, is Step 7 of the typical process. (Step 6, which is the
selection of the most appropriate transfer pricing method, is dealt with in Chapter
II of the OECD TPG.) There are two methods, which in practice may be operated in
combination.
The ‘additive’ approach involves drawing up a list of third parties who are
believed to carry out potentially comparable transactions, and then collecting
information on those transactions to see whether they provide acceptable
comparables on the basis of pre-determined comparability criteria. This may be
used as the sole approach where the taxpayer has knowledge of a few
appropriate third parties. It may also be combined with the use of internal
comparables.
The ‘deductive’ approach starts with a wide set of companies (typically obtained
from a database search) that operate in the same sector of activity, perform
similar broad functions and do not have obviously different economic
characteristics. This set is then refined using selection criteria and publicly available
information, informed by the guidance on identifying and assessing comparables.
The choice of selection criteria has a major influence on the outcome of the
comparability analysis and should reflect the most significant economic
characteristics of the transactions compared.
Examples of qualitative criteria are product portfolios and business strategies, and
tests to exclude special situations such as start-up companies or insolvent
companies. The most common quantitative criteria are:
a. figures for sales, assets or number of employees, and the size of the transaction
either in absolute terms or in proportion to the activities of the parties;
b. criteria related to intangibles, such as the ratio of the net value of intangibles
to the total value of net assets, or the ratio of R&D to sales, as compared to
the figures for the tested party. These criteria might, for example, exclude from
the potential comparables companies that had significant intangibles or R&D
expenditure, where those were not features of the tested party's business;
The deductive approach has the advantage of being more reproducible and
transparent than the additive approach, and easier to verify. However, its
outcome depends on the quality of the search tools on which it relies, which may
be a practical limitation in some countries. In practice in most countries there are
likely to be significant difficulties arising both from the fact that accounts often do
not disclose the necessary information and that, even where they do, it may not
be accurately reflected in the databases.
Comparability adjustments are only appropriate where they increase the reliability
of the results, bearing in mind the materiality of the difference for which the
adjustment is intended to compensate, the quality of the data subject to
adjustment, and the purpose and methodology of the adjustment itself. There is no
point in adjusting for small matters if there are major issues where adjustment is not
practical; nor in multiplying adjustments to give a spurious impression of accuracy
that is not justified by the underlying data. The need for numerous adjustments
may, indeed, indicate that the transactions in question are not in fact sufficiently
similar to provide valid comparables.
The OECD TPG warn that ‘it is not appropriate to view some comparability
adjustments, such as those for working capital, as “routine” and uncontroversial,
and to view certain other adjustments, such as those for country risk, as more
subjective and therefore subject to additional requirements of proof and
reliability’. It is not entirely obvious what this means. Clearly, as the paragraph in
question goes on to say, ‘the only adjustments that should be made are those that
are expected to improve comparability’. Nevertheless, it must remain the case
that some adjustments will be more subjective than others, and tax authorities can
hardly be blamed for paying particular attention to these.
Step 9 of the typical process involves interpreting and using the data collected, in
order to arrive at the arm's length price.
In General
In some cases the process may arrive at a single arm's length figure (whether that
be a price or a margin). In other cases a range of equally reliable figures may
result, either because of approximations employed in the process or because
independent parties would indeed vary in the price they charged for the goods or
services in question. It may then be possible to narrow the range by excluding
some of the uncontrolled transactions that have a lesser degree of comparability.
In practice single figures are perhaps more likely to result from identifying a
comparable uncontrolled price or from using other traditional transaction
methods, where specific comparable data exists; ranges are more likely to result
when dealing with more complex transactions that require the use of transactional
profit methods.
That may leave a range of figures based on comparables that (given the inherent
limitations of the process) are considered to include defects that either cannot be
identified or cannot be quantified. In this case, if the range includes a sufficiently
large number of observations it may be appropriate to apply statistical tools that
narrow the range around the centre; for example, by taking the interquartile
A range of figures may also result where different methods are used to evaluate a
controlled transaction. In such cases it may be appropriate to locate the arm's
length price where the ranges overlap, or to reconsider the accuracy of the
methods if there is no overlap; all depends on the reliability of the different
methods and the quality of the information they use.
If the relevant condition of the controlled transaction (e.g. the price or margin) is
within the arm's length range determined as above no adjustment should be
made. If it falls outside the range that the tax administration contends is
appropriate, the taxpayer should have the opportunity to present the case for a
different arm's length range. If that cannot be done successfully, it remains for the
tax authorities to determine the point in the range which it will treat as the arm's
length figure.
Where the range is made up of results of equal and high reliability, a case can be
made for any point within it. Where there are remaining comparability defects
within the results as discussed above, it may be appropriate to use measures of
central tendency such as the median, the mean, or weighted averages.
It will also be helpful to take into account the different ways in which extreme
results may affect different statistical measures. For example, in general they will
have more effect on the arithmetic mean than on the median. Where those
measures diverge significantly it may be helpful to identify the results that account
for this difference and consider how they should be dealt with. Where there are
extreme results it will always be necessary to consider the features of specific
transactions rather than simply applying mathematical formulae to narrow the
range of results.
Various issues arise as regards the time of origin, collection and production of
information on comparability factors and on uncontrolled transactions for use in
the comparability analysis.
Timing of Origin
Timing of Collection
Some taxpayers will establish transfer pricing documentation at the time they
undertake their controlled transactions, based on the information available at that
time (which necessarily relates to past transactions) together with information on
subsequent market and economic changes (‘arm's length price setting’).
However, independent parties in similar circumstances would not base their
pricing decisions on historic data alone.
Other taxpayers will test their controlled transactions after the event, typically in
connection with the preparation of their tax return for the period concerned
(‘arm's length outcome testing’), or the two approaches may be combined. This
raises issues concerning the use of hindsight. It is legitimate to use external data
such as other companies' accounts as evidence of what pricing decisions those
companies reached at the same time and in comparable circumstances. It is not,
however, appropriate to suggest that the taxpayer whose affairs are in issue
should have been aware of those decisions, and should have taken them into
consideration in its own pricing decisions, before the accounts or other data were
publicly available.
The purpose for which the transfer price is set may affect the timing of information
gathering. We will look at this and further issues on timing of collection in the next
chapter.
While care must be taken to avoid using hindsight, data from years after the year
of the transaction may be relevant in certain circumstances; for example, in
comparing product life cycles of controlled and uncontrolled transactions in order
to determine whether the uncontrolled transaction is an appropriate comparable.
Subsequent conduct of parties to a controlled transaction may also be relevant in
determining the actual terms and conditions operating between them.
The use of multiple year data may be useful in certain circumstances, but it is not
required as a matter of principle. Information from prior years may disclose facts
that have influenced, or should have influenced, the price in the current year; for
example, it may help to establish whether a loss in the current year is part of a
history of losses, the result of exceptional costs in the previous year, or the result of
a product nearing the end of its life cycle. This may be particularly useful where a
transactional profit method is applied.
Multiple year data may also be useful in providing information about the business
and product life cycles of the comparables, and perhaps identifying significant
variances from the comparability characteristics of the controlled transaction
which make the use of those particular comparables inappropriate. Similarly, if
economic conditions in an earlier year, which did not apply to the controlled
transaction, affected the comparable enterprise's pricing or profit for the current
year, it may not provide a reliable comparison.
The use of multiple year data does not necessarily imply the use of averages, but
this may be appropriate in some circumstances.
In practice the use of multiple year data may be more useful in stable industries,
where it can help to establish trends. Where there is a high level of volatility in the
market or in general economic conditions, the prices or profit of one year will be
much less useful in giving any indication of what the terms of trade are likely to
have been in the very different circumstances of another year. In particular,
figures derived by averaging widely varying results of different years are likely to be
unhelpful or positively misleading.
CHAPTER 10
10.1 Introduction
In this and the next chapter we will examine the practical aspects of implementing
the OECD TPG on comparability. Some reference will be made to UK practice
together with examples of differing positions adopted by other jurisdictions to
highlight some of the compliance difficulties thereby caused. We will mention
again some of the issues set down in the previous chapter where we examined the
comparability process.
It is useful at this point to remind ourselves of a section of the OECD TPG which we
have looked at previously. Section D (paragraph 1.33) states that there are two
steps to a comparability analysis:
Article 9(1) of the OECD Model DTC permits the profits of an enterprise derived
from a controlled transaction to be adjusted for tax purposes to the level that
would have accrued had the two enterprises been independent and dealing at
arm's length.
In fact, the Article does not specifically refer to “transactions” but the OECD TPG
assert that “ideally” the arm's length principle should be applied on a transaction-
by-transaction basis.
The CUP method can only be applied by using transactional data, whereas all
other pricing methods rely on non-transactional data.
As we saw in the last chapter the OECD recognises that, in practice, it may be
unrealistic to evaluate each transaction separately.
• Cash pooling
• Debt factoring
Let us consider the Canadian Case of GlaxoSmithKline (2010 FCA 201 (July 2010)).
Central to this case is a failed attempt by the Canadian tax authority to segregate
The tax authority disallowed a deduction to Glaxo Canada for the price
differential between the prices paid by Glaxo Canada and the generic
manufacturers, asserting that the latter was a CUP. This was upheld by the Tax
Court. The Federal Court of Appeal rejected this, holding that lower court should
not have disregarded the License Agreement which gave the Canadian
distributor access to Glaxo's trademark which gave the company access to the
premium prices paid for the product over its generic competitors. The lower court
had failed to consider the business reality of the situation: although an arm's length
purchaser could always buy the active ingredient at market prices from a willing
seller, the question is whether that arm's length purchaser would be able to sell this
under the valuable trademark. Therefore, Appeal Court remitted the case to the
lower court to determine the arm's length price based on the terms of the License
Agreement.
10.3 Set-offs
Illustration 1
BERG PLC
UK PARENT
During the year ended 30 June XXXX, Berg plc purchased 53 different chip
configurations from its Polish subsidiary, with volumes in the thousands of units for
each configuration. The 53 different chip configurations have similar attributes,
cost of production, cost of marketing and sale price per unit of memory.
Berg plc also granted a loan at a fixed interest rate of 18% to its Brazilian subsidiary
to support the development of the latter's consultancy business.
Looking at the UK approach to aggregation HMRC are likely to accept that all of
the purchases by Berg plc from its Polish subsidiary may be aggregated. On
enquiry, HMRC produces evidence the price paid in aggregate by Berg plc is
excessive. Berg plc claims that the interest received from its Brazilian subsidiary is
greater than an arm's length rate; with the effect that overall its return from
affiliated transactions approximates an arm's length amount. Berg plc is unable to
demonstrate a linkage between the purchase of inventory and the making of a
loan, and its claim to set off the two transaction types is unlikely to succeed.
• IFRS 8 and SFAS 31 only require disclosure for listed companies which may be
prima facie unsuitable potential comparables for small and medium size
taxpayers;
The OECD TPG distinguish between internal and external comparables. You will
recall that an internal comparable is a comparable transaction between one
party to the controlled transaction and a third party; an external comparable is a
comparable transaction between two independent enterprises.
Illustration 2
Whether the price paid for the sale of inventory from Copland Machines Inc. to
Delius Inc. passes muster as an internal CUP depends on an analysis of the five
comparability factors discussed in earlier chapters and, if appropriate, whether
sufficiently reliable comparability adjustments may be made (discussed in more
detail in the next chapter).
It is very unlikely that Copland will have access to detailed price data in relation to
the purchase of inventory by Hindemith and, consequently, Hindemith is unlikely to
be suitable for evaluation as a potential external comparable company at an
aggregated level.
In the event that sufficiently reliable transactional data cannot be identified, the
practitioner and tax official will need to look to other sources of data and
information. Such sources include:
• Commercial databases
• Proprietary databases
• Court documents (for example, anti-trust cases, i.e. cases were parties are
accused of limiting free competition)
• Investment research
Some of the databases may also be used with a commercially available “front
end” software tool designed to assist the user with efficient evaluation of the vast
amount of information that can be contained in the underlying databases. The
potential user of such databases will wish to make his or her own cost/benefit
assessment of such factors as:
Initial Search
• Geographical scope
• Periods covered
• Dormant companies
• Start-up companies
Standard Industry Codes (SIC) can certainly be a powerful search tool, but caution
is required. It is essential to understand the structure of the particular classification
system used in the database or software front-end.
There are a number of free lookup and conversion tools online. Companies vary
considerably in the diligence with which they disclose SIC codes; for example
many sophisticated businesses return a “other business activities” SIC code. SIC
codes can present a particular challenge when searching for transactional data
on intangible property.
Similarly, creativity and lateral thinking is sometimes required to make the best use
of keyword searches. Companies often do not classify themselves in the same way
as transfer pricing practitioners and a thorough grasp of industry jargon may assist
Independence screening should also be approached with care. For example, one
might reject all companies which are subsidiaries of a parent company. Some
writers take the view that it might be preferable to evaluate whether consolidated
financial statements of the parent (if they exist), which should eliminate intra-group
transactions, could in fact be used to assess an arm's length position.
The initial search may yield very few or very many hits. An iterative process can
then be applied to expand, narrow or vary the initial search criteria.
Second stage quantitative filters are typically applied to further refine the search
strategy. These may typically include number of employees, turnover or assets, or
financial ratios. Maxima, minima or a range can be set to mirror the characteristics
of the tested party.
Qualitative Evaluation
For example, the Companies Act 2006 requires financial statements of companies
(other than small companies) to include a business review with a description of the
main risks facing the company. This can be a useful tool for comparing the risk
profile of the comparable with that of the tested party, although the depth and
quality of the analysis varies widely.
Financial statements of listed companies should also address trends and factors
facing future development, performance and position of the business and
information about environmental matters, employees and social and community
issues.
Of prime relevance in the United Kingdom, the DSG Retail case contains important
lessons on the likely approach of the appellate tribunals to comparables. The
decision is described in detail in the Case Law Appendix, but the key points in
relation to comparables were as follows:
• DSG advanced a number of potential CUPs and a TNMM analysis. All were
rejected; a selection is summarised in the following table:
Some large accountancy and other advisory firms have developed in-house
pricing databases using proprietary data or proprietary data mining techniques.
The OECD TPG (paragraph 3.34) do not proscribe such databases; they urge
caution that the potentially more limited data, compared with commercial
databases, may support the tax administration being granted access to the
private database in the interests of transparency.
The flip side of proprietary data belonging to the taxpayer/adviser is that “private”
data is almost certainly possessed by the tax authority. Publicly unavailable
material collected from tax returns and tax audits of other taxpayers potentially
provides a very powerful platform on which taxpayer transfer pricing may be
challenged. The OECD TPG adopt an even-handed approach: such “secret
comparables” are unfair unless disclosed to the taxpayer. (See paragraph 3.36.)
Most OECD member countries also respect the OECD TPG with respect to secret
comparables, although the position for non-member countries is variable. For
example, the authorities in China and Japan have sanctioned the use of such
data.
Loss-making Companies
Transfer pricing studies may be prepared either for the purposes of setting the
prices and other conditions of prospective transactions to secure compliance with
the arm's length principle, or for the purposes of testing compliance after the end
of the accounting period. Typically the price setting process may need to be
carried out several months before the start of the accounting period, whereas the
testing process may not need to be completed until the corporate income tax
return is filed, perhaps a year after the end of the accounting period and more
than two years after a price setting process.
It is clear that different data will be available at different times to inform the
comparability analysis. National tax rules have widely varying requirements
regarding the time at which data must be compiled or made available to the tax
authorities. For example, in Vietnam the timing of documentation requirements has
always been very tight. In 2017 the requirements were updated to take account of
the post BEPS three-tier approach recommended by the OECD (see later
chapter). Companies are required to prepare their documentation before their
tax returns are submitted. This means they have only 90 days from the year end to
prepare their documentation. Many other countries refer to “contemporaneous”
documentation but often this amounts to a requirement to create the
documentation by the filing date for the tax return.
The OECD TPG recognise the different timing of data for the setting versus the
testing approach. There is recognition that double taxation may arise in controlled
transactions where two tax authorities take a different view on timing of
comparable data.
The OECD TPG also recognise that data from years following the year of the
transaction may also be relevant to the analysis of transfer prices, but care must
be taken to avoid the use of hindsight. The most notorious example of the use of
hindsight is the 1986 United States “commensurate with income” regulations for
intangible property transfers which require periodic after the fact revisions.
The UN Practical Manual on Transfer Pricing contains much the same wording on
timing issues as the OECD TPG. Paragraph B2.4.2.8 states that:
“Data from years following the year of the transaction may also sometimes be
relevant to the analysis of transfer prices, but care must be taken to avoid the
use of hindsight, perceiving the significance of facts and events with the
benefit of knowledge accruing after they have occurred.”
CHAPTER 11
11.1 Introduction
Illustration 1
The financial results of both companies for the year ended 31 March XXXX is as
follows:
Operating profit 59
Add: Exceptional costs 311
Revised profit 370
Revised operating margin 370/3,876 = 9.5%
Working Capital
Working capital adjustments are perhaps the most common type of adjustment
seen in practice. These are intended to equalise the tested party with the potential
comparable by adjusting for differences in capital actively employed in the
business. Working capital is defined as:
The need for adjustment is founded on the concept that, for two otherwise
comparable businesses, the profit will increase in line with working capital
employed: the company with the higher net capital will have higher sales revenue
because prices reflect the facility of extending credit terms to its customers, it will
have more stock and can benefit from volume discounts.
Illustration 2
In this illustration, the transfer pricing method is TNMM with a PLI of operating
margin, that is, earnings before interest and tax/sales.
1. Compute the working capital as a proportion of sales for both the tested party
and the comparable company;
2. Calculate the difference applied to a notional interest rate to reflect the time
value of money;
3. Adjust the result to reflect the working capital difference – here the adjustment
is made to the comparables results, but conceptually it could also be made to
the tested party or to both parties.
Tested Comparative
party company
£ million £ million
Sales 600 800
Earnings before interest and tax (EBIT) 6 24
EBIT/sales (%) 1.00% 3.00%
Working capital:
Trade debtors (receivables) (D) 40 80
Stock (Inventory) (S) 45 90
Trade creditors (C) 22 27
Working capital: 63 143
Working capital/sales 10.5% 17.8%
Fixed Assets
Also referred to as “property, plant and equipment” (PP&E) adjustments, these are
used to equalise the PLI between a tested party and a potential comparable with
different levels of productive assets. Again, an imputed interest rate is used. One
example of this is a start-up situation for the tested party which requires a large
initial investment in fixed assets but the comparables have lower fixed assets. The
validity of such adjustments is potentially controversial.
There are widely differing country practices and tax authority responses to the use
of comparability adjustments. In the UK, HMRC guidance is extremely cautious
(See INTM 485110). Their position is that adjustments can quickly become
meaningless, and the more fearsome the algebra, the more suspect they
become.
The OECD TPG emphasise that a range of “relatively” equally reliable results may
be a legitimate reflection that independent companies engaged in comparable
transactions to the controlled transaction in reality do impose different prices and
conditions to each other. However, every effort must be made to eliminate results
that have a lesser degree of comparability; excessively wide ranges stemming
from large deviations among data points may indicate inadequate comparability
of some data points.
Illustration 3
On the basis that the median of the above data points is 4.4%, and the mean is
5.08%, it is asserted that the pricing policy is thus supported. However, this is a very
wide range of results which may call into question the validity of some of the
companies used. It is noteworthy that eliminating companies 1 and 2 increases the
median to 8.8%. Any data set should be evaluated for the effect of eliminating or
including potential data points; volatility may call into question the comparables
or, more fundamentally, the pricing method.
Statistical tools
The OECD TPG contains a statement to the effect statistical tools that take
account of “measures of central tendency” may usefully be applied to larger
data sets where every effort has been made to ensure comparability or adjust for
non-comparability. (See paragraph 3.57.) The example of such tools cited is the
interquartile range or other percentiles.
The interquartile range includes the 50% of middle values from a sample and
removes the influence of the top and bottom 25% of values. The interquartile
range has long featured in US regulations and it is very commonly used in other
countries, although it should be noted that even the US regulations stipulate that
the interquartile range is only required where the data points are not sufficiently
equally reliable. (US Treasury Regulation Sec 1.482-1(e)(2)(iii)(B)) In the UK, HMRC
guidance summons little enthusiasm for the use of the interquartile range,
preferring a more qualitative assessment of where the tested party should be
placed in the (entire) arm's length range. A similar stance is taken by the tax
authorities in Canada and New Zealand.
The OECD TPG acknowledge the need for a risk-based and pragmatic approach,
particularly for SMEs. It is emphasised that there is no need for an exhaustive
search of all possible information sources (see paragraphs 3.2, 3.81). It may not be
necessary to perform a detailed comparability analysis each year for simple
transactions.
• Safe harbour arm's length range for “low value-adding” intra-group services;
Such safe harbours are certainly welcome, but they are all unilateral with widely
varying rules for similar transaction types.
We will look in detail at the OECD approach to safe harbours in a later chapter. It
is sufficient to note here that the OECD TPG recognise that bilateral or multilateral
safe harbours can provide certainty and reduce the compliance burden for
taxpayers whilst releasing valuable resources for tax authorities.
Illustration 4
The safe harbour position in the three subsidiary companies for low value-adding
intra-group services is:
The group's policy will not therefore satisfy two countries' requirements and it is
likely that a conventional transfer pricing analysis will have to be carried out.
CHAPTER 12
In this chapter we will look at what the OECD TPG say in respect to services, in particular
looking at:
– determining whether a service has been rendered
– the arm’s length charge
– the transfer pricing method
– low value-adding intra-group services
– EUJTPF Report on low value-adding intra-group services
– CCA
12.1 Introduction
Almost all groups will have intra-group services of some kind. Often, the services
arise because it is more efficient and economical to centralise certain activities.
For instance, it is particularly common for various back-office services to be
provided, including IT, legal, finance, human resources and so on. These are
typically carried out by the parent company or by a group service centre or by a
regional HQ.
This chapter primarily focuses on the main issues that arise in determining the arm’s
length price for services that have been rendered as part of an intra-group
transaction.
In the analysis of transfer pricing for intra-group services, the OECD TPG mainly
concentrate on two issues:
• Secondly, once it has been established that a service has been provided by
an enterprise to one or more related parties, it is then crucial to assess what
the charge should be, in accordance with the arm's length principle.
In order to assess whether an intra-group service has been rendered one must
consider whether the activity in question provides a related party with economic
or commercial value that enhances its commercial position.
Some intra-group services are carried out by one member of an MNE group to fulfil
an identified need and to the benefit of one or more affiliated members of the
group. In such a case, it is clear that a service has been rendered.
Illustration 1
Company A operates a call centre to provide support to the customers of its sister
company, B, which is in another country. Clearly this is an activity that company B
would have to perform itself or acquire from a third party if company A was not
performing it, and there is a clear benefit to company B. It almost certainly
qualifies as a service for which a charge should be made under the arm’s length
principle.
Illustration 2
The OECD TPG make special mention (at paragraph 7.14 under the heading
Centralised Services) of the type of services that are commonly referred to as
head office services or management services. These are services that benefit the
group as a whole and are often centralised at the regional headquarters or
parent company. Paragraph 7.14 lists many examples:
The OECD TPG say that these kinds of activities ordinarily will be considered intra-
group services because they are the type of activities that independent
enterprises would normally have been willing to pay for or to perform for
themselves. Most companies do need most or all of the above functions in order
to operate, and so if these functions are performed centrally by another group
company this will normally represent a service for which a charge should be
made.
• Shareholder activities;
• Duplicative activities;
• Incidental benefits.
The OECD TPG also discuss whether on-call activities are a service. All of these
situations are discussed below.
The OECD TPG also state that evidence that a payment has been made for an
alleged service or the existence of service agreements are not in themselves
sufficient to demonstrate that a service has been rendered and that it created a
tangible benefit (direct or indirect) for the related parties involved in the
transaction. Equally, the absence of payments or contractual arrangements does
not automatically lead to the conclusion that no services have been rendered.
Shareholder Activities
3. Costs of raising funds for the acquisition of its participations and costs relating
to the parent company’s investor relations such as communications strategy
with shareholders of the parent company, financial analysists, funds and other
stakeholders in the parent company;
4. Costs relating to compliance of the parent company with the relevant tax
laws; and
5. Costs which are ancillary to the corporate governance of the MNE as a whole.
Examples 1–3 were expanded on and examples 4 and 5 were added to the OECD
TPG on adoption of the final report on Action Points 8 to 10 of the BEPS project (see
paragraph 7.10 of Chapter VII).
The OECD TPG mention another type of activity that potentially falls within the
definition of “shareholder activity”, namely the costs of managerial and control
(monitoring) activities related to the management and protection of the
investment in the subsidiaries.
Illustration 3
• the head of sales in Argentina reports to the head of sales in Spain, who
monitors the performance of the Argentinian sales team;
• the group CEO splits his time between the two companies and a charge is
made for his time spent regarding Argentina.
The group head of sales is carrying out managerial and control activities which, in
part, are intended to ensure that the Argentinian sales operation is effectively
managed. However, detailed interviews identify that the managerial and control
activities are the same as are performed in relation to the sales managers in Spain,
and so the group head of sales is effectively acting as part of the Argentinian
management, albeit that she is normally located in Spain. Without this senior
managerial input, the Argentinian business would have to hire a more senior local
sales executive. Accordingly, this is not a shareholder service and a charge should
be made.
Detailed interviews show that the group CEO splits his time primarily on the basis of
one week per month spent visiting Argentina to manage and coach local senior
managers and review performance and meet key local clients. This is not a
shareholder activity. However, during these visits the group CEO often meets with
an Argentinian company which is a 25% shareholder of company E, to report to
them as shareholders. This is a shareholder activity and so it is not a service and no
charge should be made for the time spent on this activity.
Duplicative Activities
The OECD TPG also state that there will generally be no intra-group service arising
from activities undertaken by one group member for another group member that
merely duplicate an activity that the other group member is performing for itself, or
that is being performed for such other group member by a third party. This
principle is clearly correct, but in practice it is rare for activities to be duplicative,
because most multinationals go to some effort to ensure that their activities are
planned and controlled in a holistic, coherent manner in order to achieve
maximum efficiency and effectiveness. If the same activity is truly being
duplicated, the multinational is being wasteful, so apparent duplication should be
treated with some scepticism. The mere fact that more than one entity carries out
an activity that is labelled with the same description does not mean that there is
necessarily duplication. Multinationals often split activities between group
companies.
Illustration 4
Company G manufactures a certain product and sells it in its home market of the
USA. It is the parent company of companies H and I, which are responsible for
sales and distribution in Hungary and Italy, respectively, of the product
manufactured by company G. Company G carries out certain marketing activities
and makes a charge for marketing assistance to its two subsidiaries.
A transfer pricing analysis is carried out and it is identified that the two subsidiaries
each have their own marketing teams. However, on discussion with the head of
Illustration 5
Company J is a law firm which has recently been acquired by company K, a large
multinational law firm with its head office in France. Company J has developed a
knowledge management system consisting of a searchable database of its know-
how and previous work carried out.
Company K has its own knowledge management system which operates using
different, incompatible software. Its policy is that all group companies must use the
group knowledge management system, in order to maximise the sharing of know-
how.
A charge is made to company J for its share of the group system, on the grounds
that the group system is certainly being made available to company J and that if
no charge were to be made this would encourage the wastefulness to continue.
Although company J does use the group system it duplicates almost all of the
capabilities offered by its own system and therefore use of the group system is not
a service for transfer pricing purposes because this would be duplicative.
Incidental Benefits
Members of the MNE group involved in these activities are going to receive a
service from a coordinating related party which, in a comparable non-related
situation and circumstance, an independent party would have been willing to pay
for.
These activities may also produce economic benefits for other group members not
involved as parties in the transactions, by increasing efficiencies, economies of
scale or other synergies. The commercial position of the other group members
could be more valuable after the transaction has been entered into, but the
OECD TPG take the view that the incidental benefit would not cause the other
group member to receive an intra-group service, because an independent
enterprise would not be willing to pay for it.
This is a conclusion that is easy to agree with in cases where these benefits are truly
incidental. However, in some cases the primary purpose of the transaction is to
create efficiencies, economies of scale, or other synergies for group members,
even though they may not be directly involved. These situations are one example
of where the arm's length principle can be extremely difficult to apply, because
the transaction is one that would never arise for a company if it were an
independent enterprise, and yet the transaction makes economic sense for the
group and is carried out for the benefit of the company in question.
As noted in Chapter VII, each case has to be looked at individually and the
section in Chapter 1 of the OECD TPG on group synergies will also need to be
considered.
Illustration 6
The group has significant overcapacity in Europe in relation to this product line
and, after a review, it is decided that one of the factories should be closed down,
because this will allow the other two factories to operate at full capacity and the
group will boost profits through saving the costs of operating the factory that is
closed down and spreading the fixed costs of the other two factories over a much
higher volume of production.
It is decided that as the UK factory has the lowest utilisation it is the one that should
be closed down.
The group companies in Poland and Slovenia are not directly involved in the UK
company or the UK business, but they will clearly benefit from increased
profitability due to having additional volume of production and thus lower unit
costs of manufacturing their own products.
Nevertheless, the boost in profitability of the two surviving factories is the whole
purpose of the transaction and so is arguably not an incidental benefit that should
be disregarded.
The costs of closing down the UK factory could be argued to be a valid service to
the Polish and Slovenian companies. However, this approach could be
controversial with tax authorities. (Indeed, the approach could be controversial if it
is decided that this is not a service for which a charge should be made.)
Another type of incidental benefit that may not constitute a service is where a
group company obtains incidental benefits attributable solely to its being part of a
larger concern, and not to any specific activity being performed. The OECD TPG
(paragraph 7.13) give, as an example, a situation where, as a result of being part
of a wider group, a company has a credit rating higher than it would have if it
were not part of the group. The OECD TPG draw a distinction, however, between
benefits arising from passive association as opposed to active promotion that
Thus, if the higher credit rating is the result of an explicit guarantee given by
another group member, the benefit of the higher credit rating has not arisen from
passive association.
This distinction was recently scrutinised by the Canadian courts in a transfer pricing
case involving GE Capital (we will look at this case in more detail in the chapter on
finance).
The Canadian tax authority argued that although an explicit guarantee had been
given, the arm’s length guarantee fee would have been nil, because the
Canadian subsidiary could have derived the same benefits from mere passive
association with its US parent. Independent lenders would have perceived an
implicit guarantee, because the US parent would not have been willing to allow its
Canadian subsidiary to default on its liabilities.
GE Capital argued that any implicit guarantee arising from passive association
arises only from the shareholding relationship and the arm’s length test requires us
to disregard anything that arises from the shareholding relationship. This defence
arguably attempted to narrow the application of the passive association concept
or even overturn it.
The Canadian High Court, subsequently supported by the appeal court (case
reference 2010 FCA 344), did not agree with either side. It found that an implicit
guarantee would have existed and that this benefit from passive association
should not be disregarded, so in principle the arm’s length test would not allow a
charge for a benefit that would have arisen from the implicit guarantee.
The High Court also found that the benefit of the implicit guarantee should not
necessarily be assumed to be the same as the benefit from the explicit guarantee.
Based on the evidence presented to it, the court decided that if GE Capital
Canada had only benefited from an implicit guarantee, it would have paid
interest rates more than 1% higher than the interest rates it paid as a result of the
explicit guarantee.
The court concluded that the 1% guarantee fee was therefore justifiable under the
arm's length test.
It should be noted that this decision is controversial and would not necessarily be
respected in other countries.
On Call Services
Another important issue that arises when dealing with intra-group services is in
relation to “on call services.”
In the OECD TPG it is stated that in order to determine the existence of an intra-
group service we should expect an independent enterprise in comparable
circumstances to incur standby charges to ensure the availability of the service
when the need for them arises. However, it is unlikely that an independent
enterprise would incur standby charges where the potential need for the service
was remote, or where the advantage of having services on call was negligible, or
where the on call services could be obtained promptly and readily from other
sources without the need for standby arrangements.
In such cases, the most reasonable course to take, as the OECD TPG suggest, is
looking at the extent to which the service has been used over a period of several
years rather than solely the year in which the charge is to be made. In other words,
in determining whether a service has been rendered, we should concentrate on
the substance of this service and to what extent and measure it has affected the
group companies involved in the transaction.
Having determined that a service has been rendered and that a charge should
be made, the second step is to determine the appropriate quantum of the
charge, consistent with the arm's length principle.
The broad principle is the same as any other type of transaction: the charge
should be that which would have been made and accepted between
independent enterprises in comparable circumstances.
The main topics discussed by the OECD TPG in this respect are:
• cost allocations
In general large MNEs use a direct or an indirect method for charging for services.
The direct charge method is where each associated enterprise receiving the
service is charged directly for that service. This charge is on a clearly identified
basis; for example it may be using CUP or cost plus as appropriate.
The OECD TPG make it clear that although there is often no alternative than to use
cost allocation and apportionment, which generally necessitate some degree of
estimation or approximation, this should be done in a way that gives sufficient
regard to the value of the services to the recipients. The OECD TPG do not come
out with a categorical rule, but they appear to be pushing for direct charging in
cases where the intra-group service is one that is provided to third parties as well.
In practice, indirect charging methods using cost allocation are far more common
than direct charging methods.
Allocations
The OECD TPG state that if an indirect charging method is used, it should be
sensitive to the commercial features of the individual case (e.g., the allocation key
makes sense under the circumstances), contain safeguards against manipulation
and follow sound accounting principles, and be capable of producing charges or
allocations of costs that are commensurate with the actual or reasonably
expected benefits to the recipient of the service.
The OECD TPG go on to specify that the allocation method chosen must lead to a
result that is consistent with what comparable independent enterprises would
have been prepared to accept. This is to be achieved by choosing allocation keys
that are appropriate to the particular service being rendered and the benefits
that it creates.
Tax authorities are often sceptical when multinational groups bundle a whole
range of different services together and then split all of them across the group
using a single broadbrush allocation key, such as relative sales. They often argue
that this would not have been acceptable if independent enterprises were sharing
costs in this way. They prefer direct charges, but if this is truly not possible, they tend
to prefer the use of several different allocation keys chosen to give appropriate
allocations of the various services.
Illustration 7
For the purposes of these illustrations we assume that low value-adding services
(discussed below) are not in point.
Interviews with the head of human resources and with the users of its services
indicate that, in the long run, the amount of time spent by the HR team on each
country is roughly proportional to the headcount of staff in each country, so
headcount is used as the allocation key for the costs of the HR Department.
Interviews with the head of IT and with the users of its services indicate that IT
expenditure falls into two main categories. Firstly, every employee around the
world has a desktop computer and the IT department provides support for this.
Secondly, the IT department operates an extremely sophisticated system for
planning, scheduling, controlling, and costing production, which takes place in
two factories in Canada and Thailand.
The costs of these two categories are therefore determined separately and the
costs of desktop support are allocated in proportion to the number of desktops in
each country. The costs of the production system are allocated only to the
Canadian and Thai subsidiaries and are split between them based on the ratio of
production capacity in the two factories.
Illustration 8
The two main sponsorships are in relation to Manchester United football team and
a world champion (Chinese) table tennis player. Although Manchester United is a
UK football team, it was carefully selected by the head office marketing team
because it is extremely widely known and supported around the world. The table
tennis player is a well respected household name in China and Korea, where table
tennis is extremely popular as a spectator sport, but in most of the rest of the world
table tennis is a sport that is of interest to only a tiny minority.
The international fairs and the Manchester United sponsorship are of significant
benefit in all major markets, but the benefit cannot be objectively measured.
Direct charging is not possible, so it is necessary to allocate the costs across all of
the sales subsidiaries (and the Chinese parent).
In contrast, it would probably be inappropriate to use the same allocation key for
the table tennis sponsorship costs, because this would not reflect the
proportionately higher benefit in China and Korea. Perhaps in this case it would be
appropriate to weight the sales revenue in proportion to the popularity of table
tennis in the different markets, assuming that an objective measure of this can be
found.
OECD TPG Chapter VII makes clear that any analysis of intra-group services must
consider the perspective of both the service provider and service recipient.
Therefore, it is necessary to consider the value of the service to the recipient, the
amount that a comparable independent enterprise would have been prepared
to pay for the service in comparable circumstances, as well as the costs incurred
by the service provider. It is implicit in this that a one-sided analysis using just cost
plus or CUP is unlikely to be acceptable. (However, this does not necessarily mean
that both methods must not be used.)
Chapter VII says that the method to be used in determining the arm’s length
transfer price for intra-group services should be determined according to the
guidance in Chapters I, II and III.
Chapter VII says that the CUP and cost plus methods are often used for pricing
intra-group services, and this is borne out by practical experience. It would be rare
for any other method to be used (although the cost plus method is often applied
in a manner that could equally be described as being a TNMM using total mark-up
on costs as the profit level indicator).
CUP Method
The OECD TPG say that the CUP method is likely to be applied when the intra-
group service is either provided to third parties by the same entity or another
related entity or there are third party comparables, which can be used to price
the transaction.
Using the CUP method to price intra-group services can be very difficult as unless
the service is in relation to the main line of business for the group there will not be
any third party arrangements that can be used for the analysis. Furthermore,
independent enterprises are not likely to disclose the nature and the main
characteristics of services; therefore, even finding third party CUPs could prove a
very difficult exercise.
Illustration 9
Assume that the group is in the business of manufacturing and selling computer
hardware and providing IT services to customers.
In such a case, then it may well be possible and appropriate to use the CUP
method to charge for the intra-group IT services by treating these as if they were
being provided to an external customer and pricing them in a similar way.
It is possible that the CUP method would only produce a figure for the total charge
to be made for this service and that an allocation key would still be necessary in
order to split the costs between the group companies.
The OECD TPG confirm that the cost plus method is, in the absence of a CUP, the
most appropriate method when the nature of activities involved, assets used and
risks assumed are comparable to those undertaken by independent enterprises. In
practice, the cost plus method is by far the most commonly used for intra-group
services.
Many tax authorities have reservations about the use of cost plus for many
services, in part because services that are being provided between unrelated
parties are rarely priced on the basis of the costs of the service provider plus a
fixed percentage mark-up. Few independent service recipients are willing to
guarantee a profit to an unrelated service provider and few service providers are
willing to restrict their potential profitability to just a (usually small) mark up on costs.
Regardless of the method used in determining an arm’s length price for intra-
group services, it is important that the remuneration reflects the nature, functional
and risk profiles of the transaction. Typically, when cost plus is being used to set the
transfer price, this inherently means that the service provider has little or no risk. In
comparison, the pricing methods that are commonly seen between unrelated
parties will often expose the service provider to risks, for instance if they have cost
overruns or if they do not generate enough business to keep their staff fully utilised
and so fixed costs rise as a proportion of sales revenue. This can be a source of
controversy.
Issues related to risk are dealt with in depth in the OECD TPG Chapter IX. Although
this OECD chapter relates to transfer pricing issues arising from business
restructuring, many of the comments relate equally to transfer pricing if no business
restructuring has taken place. We will look at OECD TPG Chapter IX in detail later,
for now we will note that it does confirm that it should be accepted that using cost
plus means that the service provider has no risk. The risk allocation should normally
be respected unless certain narrow conditions are met.
Mark-ups
A common issue that arises when using the cost plus method is whether a mark-up
should be added for the service provider, so that it makes a profit. A number of
countries tend to object to a profit being made on inbound services that are only
carried out internally within the group.
The OECD TPG do not explicitly state a clear, unambiguous position on this, but
paragraph 7.35 does observe that:
Illustration 10
Company N prints and distributes fashion magazines. It has a subsidiary, SP, which
carries out the service of sourcing and procuring small products/gifts that can be
given as free gifts to customers to boost sales of the magazine or help penetrating
certain markets. It does not take title to the goods; it charges a fee for
procurement services.
In this case, SP would not see any financial benefit by providing these services to
the parent company at cost. The financial benefit manifests itself in larger volume
of sales of the magazine, which benefits the parent company only (or potentially
the distributors of the magazine).
Illustration 11
Imagine in the above illustration that SP does not just provide this service to its
parent company. Rather, it provides the service to many unrelated magazine
publishers, but to date these have generally been fairly downmarket publications.
This is a good example of a situation where it is particularly hard to apply the arm's
length principle, because the reality is that when an independent service provider
incurs costs in rendering a service that are equal to or higher than the market
value of those services, its customers will not normally be willing to pay more than
the market value, so the service provider faces the choice of discontinuing the
service or selling at cost (if this is equal to the market value) or even below cost. An
independent service provider is unlikely to be willing to continue selling at no profit
except in unusual circumstances, such as a price war with its competitors, which
the company considers it is in a position to win.
However, there may be a number of good reasons why it makes economic sense
to a multinational group for an intra-group service to continue to be performed
internally despite the fact that it costs more than the market value of the service.
The OECD TPG make it clear that if the market value of the service is known (and
so the CUP method is able to be used) it would not be appropriate to charge a
higher price than this, even if this would be necessary to ensure that the service
provider covers its costs and makes a profit.
Very careful analysis would be necessary in order to understand fully why the
group has decided not to obtain the service externally, despite this having a lower
price. Such an analysis might indicate that an ostensible CUP is not in fact properly
comparable, because the external service provider would not provide all of the
same benefits as the internal service.
Illustration 12
Q charges out the cost of this system to all group companies, splitting the costs in
proportion to relative sales in each country, and adding a 7% mark-up. The charge
to Mexico is £107,000.
Current Mexican projects are much more straightforward and could be handled
using simpler software, which would cost £80,000 for the Mexican company.
The group has decided that it is important that all group companies use the same
software, because this allows the group to market itself as offering the same
sophisticated capabilities in every country, even though it is accepted that
Mexican customers are not at present interested in these capabilities.
It might be appropriate in this case for the parent company to provide the
software at £80,000, even though this means it makes a loss on the £100,000 cost
attributable to Mexico. (The answer might change in the future, if the Mexican
company starts to take on more complex projects and it makes use of the full
capabilities of the software.)
Ideally, the mark-up percentage should be determined on the basis of the mark-
up made on comparable uncontrolled transactions. If, as is often the case, such
transactions cannot be identified, it is in practice necessary to resort to using the
profitability of independent companies that provide comparable services under
comparable circumstances. This is typically found by way of a search of a
database of the company accounts. As discussed above, it can often be difficult
to ensure full comparability, because independent service providers do not usually
operate on a cost plus basis, so risk levels are often different.
It is often supposed that services that require highly paid employees should earn a
higher mark-up than services that do not. Highly paid employees might be an
indication that the service in question is highly valuable and this may be reflected
in the fee charged by independent companies that provide such services, but it
does not necessarily follow that this will give rise to a higher profit margin. It is
perfectly possible that if the service in question requires skills or experience that are
scarce, competition may drive up remuneration to the point where most of the
benefit of the higher fees has been passed to the employees. The profit potential
of a company should reflect the economic value that it is adding over and above
its inputs.
It is beyond the scope of this chapter to discuss specific rules or practice in relation
to services transfer pricing in particular countries. However, it is perhaps worth
noting that the US takes a particularly pragmatic approach to the question of
mark-ups on certain services.
The US publishes a list of services on which it will not require a mark-up. Its rationale
is that if the appropriate mark-up would be low, the amount of tax revenue at
stake is also low, so it is willing to waive any requirement for a mark-up on such
services, in order to make tax compliance easier. In practice, this is only of
relevance to services provided by a US company. If the services are being
provided to a US company, by a company in another country, that other country
is likely to expect a mark-up.
Cost Base
It is often the case that most attention is given to the question of whether there
should be a mark-up and if so, what the percentage should be. Experience
suggests that frequently there can be much more at stake in relation to the cost
base.
Generally speaking, the cost base should include all relevant costs, not just the
salaries of the staff performing the service. For instance, all staff benefits should be
included, as should all overheads, such as rent, power, telecommunications,
human resources support, IT support, etc. This can often make a much bigger
difference than any error in the mark-up.
Illustration 13
Company S delivers intra-group services to all of its affiliated entities (let’s assume
we are dealing with a large multinational group) and the total cost for delivering
the services is 100 million. If the mark-up chosen is 7%, Company S will generate a
profit of 7 million.
However, a transfer pricing analysis identifies that only 10% of the costs of the head
office human resources department are being included in the cost base for the
recharge, because they only spend 10% of their time providing human resources
support direct to the rest of the group.
50% of the time at the human resources department is spent dealing with human
resources matters in relation to the other head office departments that are being
charged out to the rest of the group.
Therefore, a further 50% of the costs of the human resources department should
have been loaded into the calculation of the costs of the other departments that
are part of the head office charge.
Similarly, the costs of the head office IT department in supporting the other head
office departments have not been included. It is determined that the cost base for
the recharge should have been 10 million higher, so company S is actually making
a loss of 3 million.
There are other issues to consider in relation to the cost base. In deciding the
appropriate mark-up using comparables, it is important to consider comparability
of the cost base. If the comparables include in their profit and loss accounts types
of cost not included in the costs of the supplier of the intra-group services, the
mark-up percentage is not being calculated on a like-for-like basis.
The final report on Action Points 8 to 10 of the BEPS project resulted in a new
Section D to Chapter VII of the OECD TPG containing additional guidance with
respect to an elective, simplified transfer pricing approach for low value-adding
intra-group services (LVAS).
The simplified approach recognises that the arm’s length price for LVAS is closely
related to cost. It operates by allocating the cost of each category of LVAS to the
group companies that benefit from using them, then applies a standard mark-up.
The benefit of this approach is that it will reduce compliance effort and cost,
provide greater certainty to the MNE and targeted documentation to the tax
authorities (see paragraph 7.52).
When an MNE elects to use the simplified approach for LVAS in accordance with
the guidance then the charges so made are determined to be in accordance
with the arm’s length principle (see paragraph 7.53).
The guidance on LVAS is to be implemented in two steps; step one was that a
large group of countries agreed to implement the elective rules by 2018; step two
involves further work by the OECD on the potential threshold above which the
mechanism will not apply, this work will help persuade other countries that the
elective approach will not lead to base erosion. At the time of writing the OECD
had not published any further information on an agreed threshold, however,
countries have started to adopt the simplified approach. For example, New
Zealand announced in February 2018 that it would introduce it with a threshold of
NZ$1m.
There are four important areas covered in the simplified approach in Section D:
LVAS are defined as those which are supportive in nature, are not part of the
core business of the group, do not use or create unique and valuable
intangibles, and do not involve the assumption, control or creation of
significant risk. There are examples of services that would qualify (such as IT,
HR, accounting) and those that would not.
The OECD TPG emphasise via examples that it will depend on the nature of
the core business whether a service is low value. For example, credit risk
analysis for a shoe distributor is likely to be low value, but not for an investment
bank (see paragraph 7.50). When we are looking at the question of the core
business we look at it from the point of view of the group as a whole not the
service company.
Where services that would normally qualify for the simplified approach are
provided to unrelated companies the simplified approach cannot be used. In
these cases, it is expected that there is a reliable external CUP that can be
used for arriving at the arm’s length price.
The starting point for a group that elects to apply the simplified approach will
be to identify, on an annual basis, a pool of costs associated with categories
of LVAS. These costs will be the direct and indirect cost and, where relevant,
an appropriate part of operating expenses. The cost pool should exclude costs
attributable to activities that are 'shareholder activities', as defined earlier in
the chapter, and those that benefit only one other group company, which will
be charged directly. Any “pass-through costs” (costs where the service
provider is merely acting as an agent and not adding any value e.g rent)
should not be included.
The costs in the pool are then to be allocated among group members using
an 'allocation key' that is relevant to the nature of the category of services. For
example, IT costs might be allocated on the basis of the share of the number
of group users, and HR costs on the share of group headcount. A consistent
approach is expected, such that the same allocation keys should be used for
all recipient companies, and also from year to year, unless there is a valid
reason to change. Groups will need to be able to coordinate all costs and
allocation keys centrally, documenting the process and results accordingly in
order to ensure there is global consistency.
While LVAS may provide benefits to all recipients of those services, it may be
difficult to demonstrate whether the recipient would have been willing to pay
for the individual service from an independent party or perform it themselves.
The taxpayer need only demonstrate that assistance was provided rather than
being required to specify individual acts undertaken that give rise to the costs
charged. Tax authorities are to refrain from reviewing or challenging the
benefits test where the tax-payer has been fully compliant with the reporting
and documentation requirements of the simplified approach. This is because
the reporting and documentation requirements should provide all the
evidence needed for the simplified benefits test.
There will be cases where LVAS have benefited just one member of the group.
In this case it should be possible to provide separate documentation to
evidence the benefit to that group member.
The same mark-up should apply to all categories of LVAS, and should be 5% of
the relevant cost (see paragraph 7.61). This is lower than the range in the EU
Joint Transfer Pricing Forum's guidance for similar low-value added services as
noted below.
The OECD TPG encourage countries only to apply WHT to the profit element or
mark-up of the charge for LVAS.
The OECD observes that the levying of withholding taxes on these categories
of services can prevent the service provider from recovering the totality of the
costs incurred for rendering the services.
Alison Lobb from Deloitte writing in Tax Journal in November 2014 (when the
revisions were still in proposal stage) commented that: “The proposal is for a global
approach, and therefore in practice this simplification will only be of benefit where
it is adopted widely by countries. For countries with OECD-based double tax
treaties, amendments to the Transfer Pricing Guidelines will be likely to be sufficient
to implement the proposal for simplification; but it will remain to be seen whether
other countries, particularly those outside the OECD, choose to adopt it.”
She also observed that the simplified approach will be helpful for some groups for
whom it currently proves too difficult or too costly to provide sufficient evidence to
support small amounts of individual charges across a wide number of jurisdictions,
resulting in double taxation. In addition, there will be benefits for tax authorities
with limited resources in considering the appropriate mark-up and benefit.
Section D of Chapter VII has some similarities and some differences to the EU JTPF
report discussed below.
The European Union Joint Transfer Pricing Forum (“ EUJTPF”) published a report on
low value-adding services in July 2010. The report looks at a certain type of
services, those that are described as “the glue that holds the corporate structure
together to support its main function”; services that are routine in nature and do
not add high value to either the provider or the recipient.
One of the aims of the report is to limit the compliance burden in relation to such
services. The report suggests that this can be achieved by having a “narrative” to
provide sufficient correlative evidence that the service has been rendered and an
arm’s length price charged.
In relation to the form of the narrative the report states that: “a dedicated written
narrative could be provided in some cases. Some of the information, if
appropriate, may be given verbally. It might also be the case that the
examination of written contracts will provide an insight to the wider context and
will provide most of the information in any narrative. Each of the approaches or
some combination of them is valid. The important point is that the outcome is an
understanding of how any service provision system works.”
Once the narrative has been received the tax authorities can decide whether any
further information or explanation is required.
The report states that “in cases where it is appropriate to use a mark up, this will
normally be modest and experience shows that typically agreed mark ups fall
within a range of 3-10%, often around 5%. However that statement is subject to the
facts and circumstances that may support a different mark up”.
For such low value-adding services it is possible that there will not be written
documentation due to the nature of the service. The lack of such documentation
is (say the EUJTPF) not to be a justification for assuming that the arm's length
principle has not been applied.
The report suggests that a useful and a proportionate documentation pack may
contain:
• A narrative;
• Written agreements;
We will look in more detail at CCAs in the chapter on Intangible Property. Here we
will just note that CCAs can be used within a group to share the cost of services.
The chapter looks at two types of safe harbour for services: low value-adding and
“minor expenses”. For low value-adding there is a description of the types of
services it might apply to and possible parameters. It is not an examination of the
OECD approach, rather a generic explanation of the type of approach that could
be taken, as such safe harbours were in place prior to the OECD introducing their
guidelines. It was noted above that New Zealand have adopted the OECD
simplified approach; prior to this adoption they did have an existing safe harbour
for low value-adding services.
A minor expenses safe harbour is described as one where the tax authority will not
make transfer pricing adjustments if the total cost of either receiving or providing
intra-group services is below a stated threshold based on cost and a fixed mark-up
is used. Examples are given of the types of parameters that could be used for such
a safe harbour (see section B.4.5 of the UN Manual).
You may find it useful to have a look at a copy of the UN Manual at this point.
CHAPTER 13
In this chapter we are going to look at transfer pricing for financial transactions, in
particular:
– loans
– thin capitalisation
– interest free loans
– guarantee fees
– captive insurance
– financial services businesses
– OECD discussion draft on the transfer pricing aspects of financial transactions
13.1 Introduction
There are specific chapters in the OECD TPG relating to services and intangible
property, and although there is no specific chapter on tangible goods, much of
the first three chapters of the OECD TPG tends to be written in the context of
setting a price for tangible goods. In contrast, the OECD TPG have little specific to
say about loans and other financial transactions. However, this will change in the
future as in July 2018 the OECD issued its first public discussion draft on the transfer
pricing aspects of financial transactions. At the time of writing only the first draft
was available and this is looked at briefly at the end of this chapter.
You will recall from an earlier chapter that Chapter I of the OECD TPG has a
section on group synergies (see paragraphs 1.157 to 1.173). The section includes
two examples of group synergies in relation to financial transactions and expands
on the mention given in Chapter VI at paragraph 7.13 which considers the impact
on credit ratings of being in a group.
Not all countries have the same approach to the pricing of intra-group financial
transactions and the impact of being a member of a group when looking at credit
ratings and the cost of borrowing. The OECD TPG recognise the impact on
borrowing of implicit support although they do not look at entities in the financial
services business. Any transfer pricing analysis of intra-group funding will need to
consider if the impact of implicit support is relevant. This is an area that has also
been addressed in recent case law as we will see later in this chapter.
We will start by considering how to determine the arm’s length interest rate for a
loan and will then consider thin capitalisation, which relates to whether the
quantum of the amount lent meets the arm’s length test. We will then consider
other financial transactions, including guarantees.
This chapter does not primarily focus on transfer pricing within the financial services
industry (banks, insurance companies, and so on); it is instead concerned with
transactions of a financial nature, which can occur within multinational groups in
any kind of industry. There is, however, brief discussion of financial services transfer
pricing at the end of the chapter.
13.2 Loans
This chapter will not focus on the question of determining whether a loan is subject
to transfer pricing rules, because (as we saw in an earlier chapter) each country
sets its own rules about determining exactly how closely connected two
enterprises must be before they are required to meet the arm’s length test in
relation to transactions between them.
In most cases, the rules will be the same for loan transactions as for any other kind
of transaction. However, it is worth briefly noting that some countries do have
special rules which apply transfer pricing principles to loans in cases where the
level of connection between the lender and borrower would not be sufficient to
apply transfer pricing principles to other types of transaction between them.
An example would be the UK, which has special rules introduced in 2005 with the
intention of ensuring that transfer pricing principles apply to loans made to finance
private equity type investments. Typically, private equity acquisitions of businesses
are funded by high levels of debt advanced by syndicates of lenders who are also
shareholders of the business that is acquired. It is often the case that each
shareholder has a relatively small interest in the target business and would not
normally be considered to be associated with the borrower under the normal tests
of association (which, in the UK, boil down to 50% control or 40% control in cases
where there is another party with 40% control).
A loan transaction involves a lender lending money to a borrower in return for the
borrower paying interest and, at some point, repaying the money lent. The interest
is a percentage of the amount lent (the "loan principal").
The interest is the consideration paid in return for the use of the money and it is
therefore the relevant transfer price.
In order to determine whether the interest rate meets the arm’s length test, it is
necessary to understand how interest rates are determined, commercially. Interest
rates always have two components:
• Second, except in cases where the borrower is risk-free, there would normally
be a margin added on top of the base rate, to reflect the additional reward
required by the lender to compensate for the risk that the borrower might
default.
A commercial lender aims to charge interest rates on their portfolio of loans that
are low enough to be competitive with other lenders, yet high enough that it
receives enough interest income to cover its expenses and makes a profit.
The expenses of a commercial lender will include the interest it pays on its own
debt funding, which would normally be close to a risk-free rate for a healthy bank,
although this is not always the case and there will be exceptions, e.g. when there
is a global financial crisis. The expenses also include the running costs of the bank
and any write-offs of irrecoverable loans.
In practice, the most difficult part of setting the interest rate is judging how much
risk premium to add, and historically this has been a key role of banks: assessing
the creditworthiness of individual borrowers and setting appropriate interest rate
margins to reflect this.
Interest rates on loans are therefore normally expressed as a base rate plus a
margin (e.g. three-month LIBOR plus 2%). Sometimes, the rate is a fixed rate (e.g.,
4%).
However, even when the interest rate does not mention a base rate, it will have
been determined by reference to the relevant risk-free rate and a margin to
reflect the risk that the lender might default.
In practice, applying the arm’s length test to an intra-group interest rate should
therefore be carried out by considering the two components: the arm’s length
base rate and the arm’s length margin.
The base rate that is appropriate for a particular loan will vary according to a
number of factors, the key ones being:
Currency
Base rates vary according to the currency of the loan. This is because there is
normally a central bank which controls the base rate for a particular currency and
each central bank sets the rates according to priorities that are usually set for it by
the government that issues the currency and in reaction to the macroeconomic
circumstances of that particular currency.
For instance, interest rates on US dollar loans are affected by interest rate decisions
made by the US Federal Reserve, interest rates on British Pounds are affected by
the lending rate at which the Bank of England is willing to lend to UK banks and
interest rates on euros are effectively determined by decisions by the European
Central Bank about its lending rate to banks.
The country of the borrower or of the lender is not necessarily the same thing as
the currency of the loan. What matters is the currency.
Illustration 1
In practice, there are a number of alternatives that can be used as the base rate
for a currency. One option is the central bank rate, which is the rate at which the
central bank announces it is willing to lend to banks. This is normally what is referred
to as the repo rate.
Another option is the interbank rate, which is the rate at which banks are lending
to one another. This is usually determined using daily surveys of banks, which result
in rates such as LIBOR (the London Inter-Bank Offer Rate) which is the average of
rates reported by a panel of London banks.
It should be noted that there are LIBOR rates for many different currencies, not just
British Pounds. For instance, there is a Euro LIBOR rate, which is normally almost
exactly the same as EURIBOR, which is the equivalent for European banks lending
in Euros.
Historically, most commercial loans have used the relevant LIBOR rate as the base
rate.
It would normally be expected that the LIBOR rate would be almost exactly the
same as the relevant central bank rate, because the interbank rate would
normally be considered to be a risk-free rate. However, at times when there are
concerns about the financial health of banks, such as we have experienced since
2007, the interbank rate can sometimes be considerably higher than the central
bank rate.
It is generally the case that base rates vary depending on the term of the loan: the
length of time before the loan is due for repayment.
Ordinarily, base rates tend to be higher the longer the term of the loan, because
there is a premium to the lender for committing to make the money available for a
longer period.
However, this general tendency can at times be overridden by other factors, such
as expectations about how short-term interest rates will change in the long term. If
short-term interest rates are currently high, but there is an expectation that they will
fall, then the interest rate for a long-term loan might be lower than for a short-term
loan.
LIBOR rates are available for a variety of loan terms up to 12 months. For loans
longer than this, it is common to use interbank swap rates as the relevant base
rate.
Fixed/Floating Rate
Commercial loans will either have a floating rate of interest or a fixed rate of
interest.
A floating rate usually means that there is a fixed margin, but there will be a
floating base rate which reflects changes in the base rate in question. For
instance, if the base rate is defined as three-month sterling LIBOR, it will fluctuate
accordingly, reflecting changes in LIBOR. This will be to the benefit of the borrower
if the base rate falls over the term of the loan, but if the base rate rises the
borrower will find itself paying more interest.
The alternative is a fixed rate, which means that the interest paid will remain the
same over the course of the loan.
Borrowers often have the choice of whether to borrow at floating or fixed rates, so
they decide which they prefer depending on their views about whether floating
rates are likely to rise or fall and depending also on their willingness to take a risk.
For instance, if the intra-group loan is a fixed five-year loan, the relevant base rate
would be the interbank rate for five-year maturity (and, as mentioned above, this
would probably be determined using the rate for a five-year interbank swap). If
the loan is a five-year floating rate loan with the interest rate reset once a quarter,
the relevant base rate would be three-month LIBOR.
All three of the factors discussed above (currency, term, and fixed/floating) vary
over time. Therefore, in order to determine the appropriate base rate percentage,
it is necessary to match the currency and term as at the date that the loan was
made. If the loan is floating rate, then it is necessary to continue to do this
matching at each date that the interest rate is reset.
What is required is to determine the interest rate margin that would have been
agreed between the lender and borrower in an uncontrolled transaction. It will
often be the case that the lender in an intra-group transaction is not a bank and is
not in the business of making loans; it is generally accepted that this should be
disregarded in determining the arm’s length interest rate margin. It is difficult to
justify having a higher interest rate margin on the grounds that the lender is not in
business to make loans and would therefore require an extra reward in order to
make it worthwhile to go to the bother of making a loan to an unrelated party.
The interest rate margin should, in broad terms, reflect two key factors: the
creditworthiness of the borrower and the macroeconomic conditions affecting
credit spreads.
Creditworthiness
Sometimes the terms of a commercial loan will include a Cure Period. This allows a
debtor to catch up on a technical default on a loan. It is normally a fixed time
period of 30 to 90 days which allows the payment without there being a default on
the loan.
There is a very wide range of factors that potentially affect the creditworthiness of
a borrower, including the following:
• Asset backing for the loan. Companies with large amounts of assets that could
be sold in order to repay the loan if necessary, such as those with large
property portfolios, will generally be considered more creditworthy than
companies with proportionally fewer such assets, such as most companies in
the business of providing services.
• The level of other loans taken out by the borrower. The higher the total amount
of debt of the borrower, the greater the risk that the borrower might have
insufficient cash flow to service all the debt and, in due course, repay the debt
at maturity.
• The ranking of the debt. "Senior" debt is usually considered to be less risky,
because the loan agreement entitles it to be repaid first, in preference to
other debt, if the borrower is unable to repay all of its debt. Debt that ranks
behind senior debt is referred to as junior debt, or mezzanine debt, or
subordinated debt.
• Interest cover. Interest cover is a measure of the size of the interest burden
(and sometimes the repayments) as a proportion of the profits out of which
the interest will be paid. The more that the profits exceed the interest burden,
the lower the risk that if profits decline they will be insufficient to continue
servicing the loan.
• Cashflow. Interest is paid with cash, not with profits, so, strictly speaking, it is
better to measure interest cover using cash flow, but in practice EBIT (earnings
before interest and tax) is often used as a proxy. Sometimes, EBITDA (earnings
before interest, tax, depreciation and amortisation) is used as a halfway house
between profit and cash flow. Cash flow forecasts are sometimes used to test
whether the borrower is likely to be able to service the loan.
• Business risks and volatility. Some businesses are inherently highly risky and
therefore lending to them is highly risky.
• Track record. Commercial lenders will often take into account whether a
borrower has shown a successful track record of servicing and repaying earlier
loans.
• Purpose of the debt and business plan. Commercial lenders will often want to
assess the chances of success of the purpose for which the debt is being
borrowed.
Macroeconomic Conditions
• Supply and demand for credit. This is closely linked with market sentiment,
although there are other factors that affect the supply and demand for credit,
including government intervention, such as the quantitative easing policies
used by many governments when required. If supply rises, interest rates for a
given level of creditworthiness will fall, and vice versa.
It will be apparent that many of the above factors are not the sort of thing that
would normally be considered in a functional analysis or in a transfer pricing
analysis, so it is necessary to adapt the procedures of a normal transfer pricing
study to be appropriate when the study relates to an intra-group loan. In order to
understand the above factors, the study should examine or include some or all of
the following:
• Board papers
It will be apparent from the preceding discussion that carrying out a transfer
pricing study in relation to an intra-group loan requires different knowledge and
expertise than might be relevant for other transfer pricing analyses, and this should
be borne in mind in determining who will carry out the transfer pricing study.
Comparability Data
In some cases, the group might have loans to or from unrelated parties. Whether
or not these loans are comparable with the intra-group loan that is under
examination will depend on comparison of the factors described above.
However, it is relatively rare to be able to use this approach.
An approach that is sometimes used is to ask a bank to indicate what interest rate
it would have charged if it had been the lender. However, tax authorities are often
sceptical about this, because the bank may not necessarily have carried out
enough analysis in order to give a reliable indication of the right interest rate and
the bank might also have been influenced by the answer that the multinational
group is hoping to hear. For this reason, this approach is sometimes taken a step
further by asking the bank to carry out a formal loan review and issue a loan offer
approved by the bank's credit committee. Even in this case, it can be difficult to
satisfy a tax authority that the loan offer was genuine and is reliable evidence.
Illustration 2
Acme Ship Brokers (ASB) is a company which carries on business as a ship broker,
arranging leases of cargo ships. It acquires a foreign company, Prestige Cargo
Ships (PCS), which owns a fleet of cargo ships and leases them. As part of the
acquisition it acquires the debt issued by PCS to its former owner. In order to fund
the acquisition, it increases its own external borrowings and negotiates an interest
rate equal to base rate plus 4% margin. On the portion of this funding which it on-
lends to PCS, it charges a rate of base plus 5%, on the grounds that a profit of 1%
seems reasonable.
However, this approach disregards the creditworthiness of PCS. Let's assume that a
transfer pricing study is carried out and it is determined that the arm’s length
interest rate for PCS would be approximately base plus 2%.
What rate should be used? Should ASB on-lend at 2% lower than its own funding
cost, or should PCS pay more than its own creditworthiness would suggest?
The answer would be highly fact dependent, but let's assume that in this case it is
established that the creditworthiness of PCS is much stronger than that of ASB,
because PCS has significant asset backing in the form of its fleet of cargo ships,
whereas ASB is asset-poor.
The arm’s length principle suggests that PCS should pay interest at base plus 2%.
The explanation for why this would be acceptable to ASB is as follows.
Before acquiring PCS, ASB was paying an interest rate margin of 5.5%. Because
ASB owns PCS, the interest rate that it pays on its external borrowings fell, to reflect
the creditworthiness of ASB itself and its investment in PCS, so the 4% margin is
effectively a blended rate which reflects the 2% margin that is appropriate for the
PCS business and the 5.5% rate for the ASB business. Therefore, on the portion of
the external debt which is used by ASB to fund its own business, ASB is benefiting
by paying 1.5% lower than it would be paying without PCS. The "loss" made by ASB
on the on-lending to PCS is therefore offset by the interest rate saving on its own
funding.
In other cases, the explanation might be that the loans are in different currencies
and/or for different terms and/or one is floating rate and one is fixed. For instance,
if the lender is borrowing in Euros and on-lending to its Japanese subsidiary in yen,
it might be expected that the interest rate paid by the Japanese subsidiary is lower
than the euro rate.
Similar principles lay behind a court decision in Finland in 2010. The case was an
appeal to the Finnish Supreme Administrative Court and the decision is known as
KHO:2010:73.
same group, on which the interest rate was 9.5%, reflecting the cost of external
funding of the group.
The court confirmed that the price of external financing for the group was not a
relevant basis for determining the interest rate that should be paid by the Finnish
company, when, on a stand-alone basis, the borrower would have received
significantly better terms given its own credit rating and other circumstances. The
borrower's financial position had not deteriorated and the Swedish lender was not
providing any additional services that would have justified a higher rate.
Illustration 3
Global Oil is an oil company with many subsidiaries in a range of countries around
the world, some of which carry out oil exploration and extraction and others
operate petrol retailing businesses. The parent company makes loans to these
subsidiaries to fund their activities. It wishes to have a standard interest rate for all
intra-group loans, for the sake of simplicity and to avoid complaints by those group
companies that are paying higher rates than others.
A transfer pricing analysis is carried out and it is identified that there are significant
differences in the creditworthiness of the subsidiaries.
The petrol retailing subsidiaries are in a stable, reliable business and are highly
creditworthy.
The exploration and extraction subsidiaries are engaged in highly risky activities.
Any exploration is always risky, because there is no assurance that oil or gas will be
found. Furthermore, the level of risk can be compounded by the country in which
the exploration is taking place, due to risks such as civil war, terrorism,
expropriation, natural disaster, and so on.
Global recognises that a one size fits all solution is not possible, but it is anxious not
to have 50 different interest rates. After further consideration, it realises that the
subsidiaries can be sorted into three categories, each of which will contain
companies that will have creditworthiness similar to one another.
• The second category is the explorers in relatively benign countries, such as the
USA, where shale gas exploration is taking place.
The phrase is not just used within an international tax context. Any commercial
lender will want to determine whether a prospective borrower is thinly capitalised,
because this might indicate that it would be excessively risky to make further loans
to the prospective borrower.
The term ‘thin capitalisation’ is not included in the Glossary of the OECD TPG. It is
however, in the Glossary of the UN Practical Manual on Transfer Pricing where it is
defined as a high proportion of debt capital relative to equity capital.
Paragraph 4.103 of the OECD TPG mentions thin capitalisation without discussion.
In the UN Manual paragraph B1.7.8 there is an explanation of thin capitalisation
and how financing can be more advantageous by way of debt from a tax point
of view.
Let's first consider how levels of debt capital and equity capital are determined for
an independent company. Most independent companies will need capital to
finance the net assets of the business and they have two broad options. They can
raise debt capital by borrowing money and paying interest on this. Or, they can
use equity capital, by issuing shares or by retaining profits in reserves.
As a result, providing debt capital is less risky than providing equity capital, so the
rate of return required by a lender is lower than the rate of return required by a
shareholder. A further benefit is that the interest paid on debt capital is generally
tax deductible, whereas dividends paid on share capital are not tax-deductible,
so the net rate of return that the company must pay to the lender (the cost of
debt) is further reduced in comparison with the rate of return that the company
must pay to its shareholders (the cost of equity).
Most independent companies can therefore reduce their overall cost of capital by
including some debt capital. If the company is able to use the debt capital to
generate a return that is higher than the net cost of the debt, it generates an
incremental profit which therefore boosts the return to shareholders, which is the
mission of the company. However, as the proportion of debt capital increases, the
level of risk being taken by the lenders increases, because the buffer provided by
the equity capital is proportionately lower. Therefore, the rate of interest
demanded by the lender increases. In addition, the level of risk being taken by the
shareholders also increases, because any downturn in profit will be spread over a
smaller amount of equity capital and will therefore have a bigger proportionate
effect. Therefore, the rate of return expected by the shareholders increases and so
the share price falls.
Each lender and borrower must make its own subjective decision about whether
the proportion of debt has reached the point of being excessive, in which case
they will consider the borrower to be thinly capitalised. If they are excessively
cautious, they might be giving up profits that they could have made. If they are
excessively incautious, they might suffer losses or even endanger their businesses.
The reason that many countries have thin capitalisation rules within their tax
legislation is that the same considerations might not apply to intra-group funding. If
a parent company already owns 100% shareholding in a subsidiary and the
subsidiary needs additional capital, the parent company has an incentive to
choose to provide the capital by way of an intra-group loan, because the interest
will be tax deductible for the subsidiary. If the subsidiary suffers a decline in
profitability and it is unable to pay the interest or perhaps even to repay the loan,
the parent company is no worse off than if it had injected the capital as equity.
Either way, the parent will suffer the full loss, so there isn't the same limitation on the
proportion of debt capital that there would be if the lender was not also the
shareholder (or associated with the shareholder).
It is therefore common for countries to have specific rules intended to ensure that
multinationals cannot reduce the profits payable by a group company by having
excessive debt levels in that company. There is a variety of ways in which these
rules might work, but they are, generically, all known as thin capitalisation rules.
Most countries choose to use a clear, fixed debt:equity threshold. Typically, the
threshold is that the ratio of debt:equity should not exceed 3:1 or, sometimes, 2:1.
For instance, Canada has a maximum debt:equity ratio of 1.5:1.
In some countries, this is a firm limit and no deduction is allowed for interest on any
debt in excess of this ratio. In other countries, it is just a safe harbour, so no interest
deduction will be denied for reasons of thin capitalisation if the company is below
the threshold, but if the company exceeds the threshold it may still obtain a full
interest deduction if it can justify that its debt level is not greater than the arm’s
length amount. An example of the safe harbour approach would be China.
The other main approach is to restrict the amount of tax deductible interest to a
set proportion of the profits of the company, an approach often referred to as
earnings stripping rules. This approach is used, for instance, by Germany and Italy,
which restrict interest deductions to 30% of EBITDA. In some cases, any excess
interest can be carried forward and potentially offset in future years. This is the
approach used by Norway, which restricts interest deductions to 25% of EBITDA,
but allows carry forward of the excess for 10 years.
It is a grey area whether earnings stripping rules and thin capitalisation rules
involving fixed debt:equity ratios are transfer pricing rules at all. Arguably, fixed
limits are not consistent with the arm’s length principle, because the arm’s length
level of debt will vary for different independent borrowers. Therefore, some
countries use a different approach, which is to use the arm’s length principle as an
explicit test. That is, they require the transfer pricing analysis to consider not only
whether the interest rate on intra-group loans meets the arm’s length test, but also
whether the quantum of debt exceeds the arm’s length level of debt. This is the
approach used, for instance, by the UK, which deals with thin capitalisation within
its transfer pricing rules.
Experience in the UK for example suggests that there is no such thing as a standard
answer. Some industries tend to have high levels of debt, and some do not. For
one company, a 9:1 debt equity ratio might comply with the arm’s length test,
whereas for another company it might be difficult to justify debt of 1:1.
For instance, property investment companies tend to need high levels of debt to
finance their acquisitions and banks are willing to lend at high levels because the
property is available as security for the loan. In contrast, many businesses that
provide services have few assets that could be sold to repay a loan, so they tend
to have lower levels of debt. However, they may also have high levels of
profitability and so they may have strong cash flow to use to service loan interest
and repayments.
A second indicator was that scrutiny was more likely if interest cover (profits
divided by interest expense) was lower than three. However, although these
figures were never intended to be anything more than a broad guideline, they
were sometimes taken by taxpayers and even some tax inspectors to be safe
harbours, so they have now been fully repudiated.
The UK tax authorities insist that it is necessary to consider not only the question of
how much the company could have borrowed from independent lenders, but
also how much the company would have been likely to wish to borrow (which
might be lower than the amount they could have borrowed).
is not deductible against profits and/or it may be subject to withholding tax, unless
withholding tax on dividends is restricted by the relevant double tax agreement or
restricted for some other reason such as the European Union Parent Subsidiary
Directive.
Illustration 4
Clean Paws is comprised of two companies, one located in the South Pacific
country of Ockerland and the other located in Albion. Each company
manufactures dog food and dog care products and sells them in its region. Both
companies are directly owned by a private equity fund, but are operated as an
integrated multinational business. K9 negotiates a price of $300 million, split equally
between the two companies. To fund the acquisition it borrows $200 million from a
bank, on condition that the loan will be secured by a first charge on the shares
and assets of the acquired business.
The acquisition of Clean Paws Albion is carried out by K9 Albion and again K9
wishes to fund this by providing $100 million of debt capital and $50 million of share
capital. These capital increases will leave K9 Albion with $130 million of debt
capital and $55 million of share capital, which is a debt:equity ratio of 2.36:1.
Albion considers thin capitalisation to be a transfer pricing issue and includes in its
transfer pricing rules provisions that will deny a deduction for any interest on debt
to the extent that it exceeds the debt that would have been borrowed if K9 Albion
had been borrowing on an arm’s length basis.
into account its investment in Clean Paws Albion) and demonstrates that they
have debt:equity ratios of between 1.5:1 and 2.5:1. It argues that this demonstrates
that the desired level of debt is not excessive.
However, the Albion tax authority argues that it is also important to consider
interest cover. It calculates that the interest cover (EBITDA divided by interest
expense) of the comparable independent companies ranges between 3.25 and
5.3. In contrast, using the profit and loss account of K9 Albion (including notional
consolidation of the P & L of Clean Paws Albion) it calculates that interest cover
with the new level of debt will be 2.4, so it argues that K9 Albion will be thinly
capitalised and the arm’s length level of debt should be determined on the basis
of the level of debt that will give interest cover of at least 3.25.
Time is running out to agree the APA before the acquisition date, but swings in the
value of the Albion currency versus the Columbiana dollar mean that the $150
million of new capital that is to be provided by K9 will not quite be sufficient to
carry out the acquisition. Another $10 million of capital is needed and there is
insufficient time for K9 to negotiate an additional loan facility from its external
bank. Instead, K9 Albion approaches a local bank, which agrees to lend the
additional money despite the fact that the Columbiana bank will have a first
charge over the shares of Clean Paws Albion.
It is realised that this provides strong evidence that the arm’s length level of debt
for K9 Albion must be at least $110 million, because the top-up loan of $10 million is
an arm’s length loan and is in addition to the intra-group loan. This evidence is
presented to the Albion tax authorities and, after making enquiries to verify that
the top-up loan is not, in any way, guaranteed or otherwise supported by K9, they
agree to give clearance for the full amount of debt.
It should be noted that thin capitalisation and interest rates interact with each
other. The higher the debt level, the higher the interest rate, so increasing the level
of debt can have a double effect on the amount of interest, because interest is
payable on a larger amount of debt and the interest rate to be paid is also higher.
This interaction gives rise to a strange hybrid approach to thin capitalisation in the
case of a country with a fixed debt:equity threshold of 3:1. This necessarily means
that in some cases the debt will be higher than it would have been on an arm’s
length basis and yet because it is lower than 3:1, interest on all of the debt will be
deductible under the thin capitalisation rules.
to another group company and this amount is greater than it would have lent to
that other group company on a stand-alone basis.
Such situations may not always be caught by thin capitalisation rules; it depends
on the specific wording of the rules. The UK, for instance, has included specific
wording in its transfer pricing legislation to ensure that thin capitalisation rules apply
to external debt in cases where the amount lent has been increased as a result of
a guarantee or other support from another group company.
See also the further comments later in this chapter regarding guarantee fees.
Whether applying a fixed threshold or the arm’s length test, it is important to use an
appropriate definition of relevant financial figures, such as debt, equity and
interest cover. Some countries set out specific definitions in their thin capitalisation
legislation or in rulings/guidance, whereas others rely on general principles.
Often, it is obvious what counts as debt and equity, but there are some grey areas,
such as preference shares, which have some characteristics of debt and some
characteristics of equity. Another grey area is debt-like instruments such as finance
leases. And should the debt be net of cash deposits?
An issue that arises from time to time is that a group wishes to make an interest-free
intra-group loan. For instance, the group might prefer not to label an injection of
capital as being equity, perhaps due to regulatory restrictions or exchange
controls.
On the face of it, an interest-free loan would not be acceptable under the arm’s
length principle, because an independent lender would not normally be willing to
lend at an interest rate of 0%. However, in certain limited circumstances it may be
possible to justify an interest-free loan, on the grounds that the loan is in substance
fulfilling an equity function and therefore it is not appropriate to require there to be
interest. This is, in effect, a reverse application of the principle underlying thin
capitalisation rules.
This is, for instance, an argument that, in principle, is accepted by the UK tax
authorities, provided it can be shown that the loan is, in substance, equity. It is
helpful to be able to show that the borrower could not have obtained loan
finance from independent lenders if it were an independent company. The UK tax
authorities are usually only willing to accept this argument where there is clear
evidence that the loan is intended to remain in place in the long term, because
equity is rarely used for short-term funding.
We have seen in earlier chapters that the OECD TPG were amended following
adoption of the final reports on Action Points 8 to 10 of the BEPS Action Plan. The
executive summary to the final report on Action Points 8 to 10 makes reference to
the holistic nature of the BEPS Action Plan and the fact that work on other Action
In particular one of the aims of the work on Action Points 8 to 10 was to ensure that
cash rich entities (“cash boxes”) will not be entitled to excess profits. The profits
that the “cash box” will be able to retain will be no more than a risk free return. If
the return qualifies as interest or an economically equivalent payment then those
profits should be targeted by the interest deductibility rules (see below) that
countries will adopt as a result of the final reports on Action Point 4. In addition,
legislative changes as a result of Action Point 6 and Action Point 3 could mean
additional withholding taxes and that the CFC rules are in point.
Action Point 4 (Limiting Base Erosion Involving Interest Deductions and Other
Financial Payments) was aimed at preventing excessive interest deductions, in
relation to both outbound and inbound investments, that shift profits to low tax
jurisdictions and give an unfair advantage to multinational corporations over
domestic groups.
The final report on Action Point 4 recommended that countries implement a “fixed
ratio” rule that will limit net interest deductions claimed by an entity (or a group of
entities operating in the same country) to a fixed percentage of EBITDA. The fixed
percentage should be between 10-30% of EBITDA. The rule is applied to each
entity within a group, and compares its net tax deductible interest with its tax
based EBITDA. The report acknowledges that, in some circumstances, EBIT (or even
asset values) may be used instead of EBITDA. If the interest: EBITDA ratio exceeds
the fixed ratio, then the excess interest is not deductible.
In addition, countries should also adopt a “group ratio” rule to supplement the
fixed ratio rule, and to provide additional flexibility for highly-leveraged groups or
industry sectors. The role of the group ratio rule is to alleviate the impact of the
core ‘fixed ratio rule’ in appropriate circumstances. There is also the option to
apply an uplift of up to 10% to the group’s net third party interest expense to help
prevent double taxation. The final report gives the option to allow carry back and
carry forward of excess interest within limits.
There are also optional elements for a de minimis floor below which all interest
could be allowed plus carry forward and carry back provisions. There are a
number of ways a de minimis rule might be defined. One would be to allow all
interest deductions up to a fixed value of (say) Euro 1m, regardless of the core
restriction imposed by the ‘fixed ratio rule’.
The final report suggests that other limitations on interest expense, such as those
arising as a result a country’s application of the arm’s length principle or thin
capitalisation rules, also should be applied first.
In December 2016 an updated report was issued. The updated report does not
change any of the conclusions agreed in 2015, but provides a further layer of
technical detail to assist countries in implementing the group ratio rule in line with
the common approach. This emphasises the importance of a consistent approach
in providing protection for countries and reducing compliance costs for groups,
while including some flexibility for a country to take into account particular
features of its tax law and policy.
The OECD recognise that the common approach may not be suitable to deal with
risks posed by entities in the banking and insurance sectors. The OECD’s
recommendation is that countries should seek to identify specific risks in the
banking and insurance sectors. If no material BEPS risks are identified, banks and
insurers should be exempted from the “fixed ratio” and “group ratio” rules.
However, if risks are identified, specific rules should be enacted taking into
account the regulatory and tax regimes applicable to such sectors.
There is no agreed minimum standard for the group interest restriction under
Action Point 4. Countries are encouraged to implement similar rules; the OECD will
review implementation in practice by 2020.
As many of the EU members are also members of the OECD, the EU has also been
looking at limitation of interest deductions as part of its Anti-Tax Avoidance
Directive (ATAD). The ATAD was adopted in July 2016. Member States are required
to adopt and publish ATAD-compliant provisions by 31 December 2018 at the
latest (exceptions are provided), with the provisions applying from 1 January 2019.
As you will see later, provisions in relation to exit taxation will apply from 1 January
2020.
The EU ATAD restricts net borrowing costs to 30% of the taxpayer's EBITDA,
optionally with a EUR 3m threshold (for exceeding borrowing costs) before the
restriction will apply. Stand-alone entities may be excluded from the scope.
Within consolidated groups, Member States may allow full or partial deduction of
exceeding borrowing costs under ‘group ratio’ conditions. Member States may
exclude loans concluded before 17 June 2016, loans used to fund long-term EU
public infrastructure projects, and financial undertakings. Carry forward of non-
deductible exceeding borrowing costs may be allowed without time limit (with an
option also to include carry-back for up to 3 years or carry-forward of unused
interest capacity for up to 5 years). There is a grandfathering clause that will end
at the latest on 1 January 2024 for national targeted rules which are “as effective
as the fixed ratio rules” to be applied for a full fiscal year following the publication
date of an OECD agreement on a minimum standard.
Another issue that often arises in relation to loans is guarantee fees. If a loan to a
company is guaranteed by another company in the same group, this can reduce
the lending risk for the lender, because the guarantor is agreeing that it will meet
the liabilities of the borrower if the borrower defaults. Therefore, the lender will only
suffer a loss on the loan if the borrower defaults and the guarantor also defaults.
The borrower is effectively "piggybacking" on the credit rating of the guarantor. As
this is a clear benefit for the borrower, it would normally be expected that it should
pay a guarantee fee to the guarantor.
Determining the arm’s length guarantee fee is often not easy, but a key part of the
analysis is determining the benefit gained by the borrower, because clearly the
guarantee fee should not exceed the benefit gained. In practice, the guarantee
fee is normally set to be lower than the benefit, so that both the guarantor and the
borrower benefit from the transaction. It is often difficult to determine exactly how
the benefit should be split, but the decision should be based on the relative
bargaining power of the two parties.
In order to determine the benefit gained by the borrower from the guarantee, it is
first necessary to understand the nature of the benefit. In some cases, the
guarantee simply has the result that the interest rate is lower than it would have
been without the guarantee, because the lender has lower lending risk. If so, then
the benefit is the interest rate differential. A common approach to determining this
is to carry out a transfer pricing analysis to determine the interest rate that would
have been paid by the borrower on a stand-alone basis (using the approach
outlined earlier in this chapter) and compare this with the actual interest rate
The Canadian judgement takes this principle a step further by saying that even
where an explicit legally-binding guarantee has been given it is still necessary to
determine the benefit gained from this guarantee by comparing the actual
interest rate paid by the borrower with the rate that it would have paid if there
had been no explicit guarantee, but the borrower was still a member of the group
and therefore would potentially still benefit from an implicit guarantee.
In the GE Capital case it was held that the approach to take is to determine the
stand-alone credit worthiness then uplift this for the impact of any implicit support.
The judge noted that the multinational group had a widely-advertised AAA credit
rating that it would seek to protect, and, as such, would be economically
motivated to provide support to GE Capital Canada even in the absence of a
formal guarantee. The judge assigned a three-notch uplift to GE Capital Canada’s
stand-alone rating to account for the implicit support. The judge rejected the
notion that the implicit support would result in an equalisation of the rating of GE
Capital Canada to AAA. He equally rejected an approach of starting with the
parent rating and then notching down.
In other words, the Canadian judgement says that the benefit of the explicit
guarantee should not be determined by a comparison with the interest rate that
would have been paid by the borrower if it was a stand-alone entity. This is a
controversial view and would not necessarily be agreed with in other countries.
In Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (No. 4) [2015] FCA
1092, an Australian transfer pricing ruling provided guidance on what constitutes
'fair loan terms' among related parties — in this instance, a USD $2.5bn credit
facility from a US entity to an Australian entity. The arrangement permitted the US
entity to raise funds at a low rate, due in part to an explicit guarantee from the
ultimate holding company of both the US and Australian entities, and lend to the
Australian entity at a higher rate of interest. The company that borrowed the funds
at the lower rate, Chevron Texaco Funding, made a profit from the loan on to
Chevron Australia Holding PTY (CAH). This profit was later paid as a dividend to
CAH and was tax free in Australia.
The judge considered whether an independent lender would have taken into
account the 'implicit support' of a parent to a subsidiary, with the following points
being noted from expert witnesses: In the absence of a legally binding parental
guarantee, implicit credit support was found to have 'little, if any' impact on
pricing by a lender in the real world. One of the key reasons that agency ratings
are not solely relied upon by banks when determining credit ratings is precisely
because they may improperly give allowance for implicit support. This contrasts to
the GE Capital case where more importance was given to the impact of implicit
support.
On the facts of this case and looking at how the group operated the taxpayer was
not able to show that they had acted in an arm’s length way. The facts showed
that no security was given for the loan and that normally the group sought to
minimise its borrowing cost. The court found that a borrower acting at arm’s length
would have given security for the loan in order to lower its borrowing costs. The
case is also interesting as it looked at whether Article 9 of the Double Tax Treaty
gave a separate taxing power. The court held that it did not; in Australia Article 9
has to be read in conjunction with the transfer pricing legislation and could not be
relied on independently of the domestic legislation.
In April 2017 Chevron lost its appeal to Australia’s Full Federal Court (FFC). The three
Federal Court judges agreed with the initial trial judge. Matters considered by the
Court included independence assumptions required by the Australian rules – the
Court concluded these include an assumption that the parties to the loan
arrangement are independent. The FCC concluded that the 'independence'
hypothesis does not necessarily require the detachment of the taxpayer, as one of
the independent parties, from the group which it is part of, or the elimination of all
the commercial and financial attributes of the taxpayer. The FFC also agreed that
the parent would have sought to reduce the cost of borrowing. The evidence
revealed that the borrower was part of a group that had a policy to borrow
externally at the lowest cost and the parent would generally provide a third party
guarantee for a subsidiary borrowing externally.
In August 2017 Chevron announced that it would not appeal. The details of the
agreement reached by Chevron with the ATO were not revealed. However It is
understood that the ATO achieved a reduction in the coupon rate for the loan.
However, in some cases, the guarantee might also have induced the lender to
lend a higher amount than it would have lent to the borrower on a standalone
basis. Therefore, thin capitalisation issues might also arise, although this will depend
on the wording of the relevant thin capitalisation legislation. In the UK, thin
capitalisation is dealt with under the transfer pricing rules and guaranteed loans
are specifically caught. The UK approach is that the borrower should only be
entitled to an interest deduction for the interest on the portion of the loan that it
could have borrowed on a standalone basis. Accordingly, it would only make
sense for the guarantee fee to reflect the benefit from the reduced interest rate.
The guarantor might be entitled to a deduction for the rest of the interest, if it is a
UK company, as the UK rules allow for a guarantor to be treated as if were the
borrower in respect of disallowed interest.
For instance, an individual company with a single factory probably could not
afford to take the risk that, say, a fire might damage the factory and prevent
production, because the losses could be proportionately very high. However, if the
group has many such factories around the world, the group as a whole might
have sufficient resources to be able to bear the costs of such a loss, because it
would be low in proportion to the group. So it might make no sense to obtain
external insurance for each factory, because this will mean that on average the
group is paying a profit margin to the insurance companies on top of the statistical
average cost of losses.
In order to prevent the results of any individual group company being distorted by
a loss, it is common to have a group company which will act as the internal insurer
for the group, writing insurance policies for the other group members and
collecting premiums from them. These are known as captive insurance
companies. In some cases, the captive insurer will enter into reinsurance contracts
with other group members, under which the group member self insures, but part of
the risk is re-insured. Having centralised the risk in the captive insurer, the group
may sometimes decide to reinsure some of the risk externally, just as an
independent insurance company might choose to do. The captive insurer will
often be staffed with suitable staff to make these judgements.
Although the specific facts surrounding this intra-group service are different from
other kinds of services, the transfer pricing issues are generically similar to the issues
for other services. One must do the functional analysis, then look for comparability
data.
Tax authorities are sometimes sceptical about a CUP approach under which the
captive insurer charges insurance premiums in the same way that an independent
insurance company might do. They sometimes argue that the captive insurer
should not be viewed as taking the same risks as an independent insurance
company and a small cost plus-type reward on the captive insurer's own running
costs would be more appropriate. The correct position will depend on a very
careful analysis of the facts.
An example of this sort of argument is the 2009 UK case, DSG Retail Ltd & Others v
HMRC. This related to a captive insurer in the Isle of Man which insured (in some
years, reinsured) extended warranties sold to customers in a chain of electrical
retail shops in the UK. DSG based the premiums on what it considered to be
comparable uncontrolled transactions, being the premiums charged by
independent companies that provide extended warranties.
The Special Commissioners (the name then given to the lowest level of court for
tax cases) decided that the premiums charged by independent extended
warranty providers were not comparable, because they found that the bargaining
power was different. They took the view that if the UK retailer had been
negotiating with an independent extended warranty provider the UK retailer
would have had most of the bargaining power because the best opportunity to
sell an extended warranty to someone who has just bought, say, a television is to
sell the warranty whilst the customer is standing at the cash till, paying for the
television. They accepted evidence that the extended warranty providers
generally sold their extended warranties via the product manufacturer and they
considered that the balance of bargaining power would be different in this
circumstance. (This point appears to be crucial in the decision, but the case report
does not explain in any detail whether this distinction was just an assertion that was
accepted or there was hard evidence that there is indeed a difference in
bargaining power.) They also found as a matter of fact that the risks involved in
writing large numbers of extended warranties are low, because the claims cost
does not fluctuate much from year to year.
They concluded that on an arm’s length basis the UK retailer would have
negotiated a deal under which the insurer received just a small return on its capital
and the remainder of any profit from the extended warranties would be made by
the UK retailer. This effectively meant that it was held that the arm’s length level of
premium was far lower than the actual premiums paid.
Up to this point, this chapter has considered transfer pricing issues that apply
regardless of the business carried on by the group. Loans arise within groups that
manufacture automobile parts, or that provide legal services, or that design and
sell software, just as much as they arise within banking groups.
Carrying out transfer pricing analysis for financial services businesses such as banks,
insurance companies and asset management companies can be challenging,
but this is primarily because these businesses can be very complex and difficult to
understand. It is not the purpose of this chapter to attempt to explain the nature of
these businesses. By and large, the transfer pricing issues are not that different from
the issues that arise for other types of business, and so there is no need for special
discussion here.
For instance, within an asset management group it is likely that there will be
companies responsible for selling the product of the group (which in this case
happens to be investment funds), but the transfer pricing issues are much the
same as those which arise with a distributor of goods. Similarly, there will probably
be intra-group loans and there might be royalties for the use of, say, the group
brand name, but again the transfer pricing issues will be generic. Even if the
transaction is unique to asset management, such as subcontracting the
investment advisory function to a subsidiary in another country, the issues are the
same as with services in other industries. A functional analysis should be performed
and it should be determined whether there are comparable uncontrolled
transactions and if not, it may be necessary to use a database search for
comparable companies or a profit split approach.
There is, however, one relatively unusual characteristic of transfer pricing for banks
and insurance companies, which is that these businesses typically operate through
branches rather than subsidiaries. One of the main reasons for this is that these
businesses are heavily regulated in terms of their equity capital, because it is
important that there is sufficient equity capital to absorb potential losses.
Operating through branches means that the branch can use the capital of the
company of which it is part, and this is generally a much more efficient way to use
the capital of the company rather than parcelling it out amongst subsidiaries.
As noted in the introduction to this chapter, the OECD published its first draft on
financial transactions in July 2018 (“the draft”). As it is a first draft the following is a
summary of some of the main points it makes. The draft can be found here:
http://www.oecd.org/tax/transfer-pricing/BEPS-actions-8-10-transfer-pricing-
financial-transactions-discussion-draft-2018.pdf
Reference is made to the fact that Section D1 of the OECD TPG on correct
delineation applies to financial transactions. The factors to consider include
evaluating debt capacity of a borrower, including specific terms and conditions
applied, purpose of the loan, ability of the borrower to repay the debt, etc. In
looking at the borrower it is stated that the options realistically available need to
be considered.
The draft covers many aspects of finance as well as looking at the position of the
borrower and the lender (a two-sided approach). It also looks at guarantees, cash
pooling and captive insurance companies.
With regard to intra-group borrowing, CUP is the preferred method with an internal
CUP to be used where possible; the point is made that start-up companies are in a
different position to established companies and that lenders would take account
of this looking closely at anticipated cash flow. Credit ratings are very important -
commercial credit rating tools may be useful for benchmarking however care
needs to be taken to exclude controlled transactions from the analysis of credit
ratings. It is no surprise that the observation is made that bank opinions on the
amount group companies can borrow are not to be taken as providing evidence
of arm’s length terms.
With regard to cash pooling, the draft states that benefits should be shared
amongst those in the cash pool.
Turning to guarantees, the draft states that where there is full implicit support then
no fee can be charged for an explicit guarantee. In the case of guarantees that
result in an increased debt capacity, the draft proposes that there will be an
element of equity contribution (see paragraph 140). The complexity of cross
guarantees is considered and guidance is given on ways to price a guarantee -
these include CUP, the yield approach, cost approach, and capital support
method (see paragraphs 145 to 161).
The section on captive insurance companies includes six indicators that would be
expected to be found in an independent insurer (see paragraph 166). The draft
makes it clear that the guidance in the OECD TPG on allocation of risk applies to
insurance companies; the company must have the financial capacity to take on
the risk as well as being able to manage it. Pricing is dealt with in paragraphs 180
onwards - it includes using return on capital and combined ratios.
At the time of writing, feedback had not been received on the draft; it will be
interesting to see how this currently non-consensus document develops. You
should monitor developments in this regard.
CHAPTER 14
In this chapter we will look at transfer pricing in relation to Intangible Property, in particular:
– the life cycle of intangibles
– development of intangibles
– exploiting intangibles Principal Structure v Licensing Out
– valuation of intangibles
– case law on valuation of intangibles
– OECD TPG and Cost Contribution Arrangements (CCA)
– case law and CCA
14.1 Introduction
Intangibles have been at the centre of several debates and court cases in recent
years. The increasing attention of tax authorities on intangibles is mainly due to
intangibles gaining more and more value as part of large multinationals’ asset
base.
Globalisation and increasing competition have led large MNEs to work harder on
differentiating themselves from the competition and investing more in intangibles
to achieve the required competitive advantage.
Among the transfer pricing transactions of MNE Groups, transfer prices for
intangibles are the most significant and susceptible to manipulation. This is a result
of the high value and mobility of intangibles and the complexity of intangible-
related issues. Intangibles carry high value because they often produce or have
the potential to boost profitability as they provide the MNE with a competitive
advantage.
Given that an intangible asset does not have a physical presence, it is easily
transferable from one country to another. Intangible-related financial issues exist in
commercial practices, valuation, and accounting as well as in attribution of
income for tax purposes.
For example, MNE Groups often attribute research and development (R&D)
expenses to higher-tax countries which provide immediate expensing of these R&D
costs. However, in reality, the R&D costs of producing intangibles may be widely
dispersed among related entities. Subsequent transfer prices charged through
royalty fees to affiliate MNEs often fail to adequately adjust for the real risk
premium assumed for the original development of the intangibles. In other
When it comes to tangible assets it is easy to see their life cycle for a company.
Normally it begins when they are bought, then they are used, accounted for and
depreciated then normally the final step will be their sale. Intangibles also have a
life cycle. Generally we can identify similar stages for an intangible as a tangible
asset. To begin with they will either be bought or developed, they will then need to
be recorded and a valuation arrived at. The intangible will then be used in the
business and where appropriate amortised. Finally it will expire or be sold.
Contract R&D
The typical scenario will be that the MNE will set up a separate entity to provide
the contract R&D services. The MNE will often concentrate R&D into a few
locations as this helps to increase efficiency and keep down cost. However, where
the plan is that the benefits of the R&D will remain with the principal (normally
located in a low tax territory) the tax authorities will look carefully at the
arrangement. A third party contract R&D provider would have a contract and
hence it is important that there is a contract to support the in-house contract R&D
arrangement. Ownership of an intangible is a complex legal subject. In some
jurisdictions it will belong to the person who develops it – so this is a key aspect of
the contract with the contract R&D provider. Control is another area that the tax
authorities will look at closely. Many tax authorities would expect the principal to
retain some control of the development of the R&D for there to be a true R&D
contract relationship.
← Payment – royalty
PRINCIPAL
Licence
↑ ↓
Payment for
Contract R&D Intangible
contract
services Users
R&D
↓
CONTRACT
R&D PROVIDER
R&D
↑ Costs
Benefits ↓
We will look at the OECD TPG and Cost Contribution Arrangements later in this
chapter.
A typical principal structure will involve setting up a subsidiary in a low tax territory.
The principal will be the company that owns the intangible thus the principal will
earn the profits from the intangible. In the context of the intangible, the principal
company acts like a distributor as it receives income from the licenses as the other
companies in the group operate as the intangible developers. The agreement
between the companies and the allocation of risk will be important for ensuring
that the structure is tax efficient with income allocated to the low tax jurisdiction
conforming with the arm's length principle.
Licensing of intangibles within a group can lead to questions as to the arm's length
principle for the license to use the intangible. If the group company is a fully
fledged manufacturer then a separate license fee would be required as a third
party would need to pay such a fee. Without a central policy on intangibles it
could be that the fee ends up in a high tax territory. A structure that results in
centralisation of assets including intangibles would mean that the manufacturer
would be set up as a contract manufacturer and a separate licence fee is not
required.
This structure can give more scope for keeping the receipt of licence fees in a low
tax territory. However it may be that the manufacturer is in a high tax territory in
which case a separate license fee may be the preferred option.
A. Identifying intangibles.
It is clear from this that it is not just a case of ownership that will lead to the
recognition of an intangible.
Paragraph 6.8 states clearly that it is not necessary for an intangible to be capable
of being transferred separately for it to be characterised as an intangible in
transfer pricing:
Examples are given in paragraph 6.27 and include goodwill as the value of future
economic benefits associated with business assets that are not separately
identified and recognised. Future trade from existing customers is also mentioned.
Martin Zetter writing in Tax Journal in October 2014 points out that: “the absence or
presence of goodwill does not determine whether an intangible exists or not.
Where an intangible is not owned or controlled, it is necessary to consider whether
the use or transfer would be compensated by independent parties. For example,
when goodwill is reputational value and is transferred to or shared with an
associated party, then it should be taken into account in determining arm's length
compensation.”
The glossary to the OECD TPG includes a definition of the term “marketing
intangible”:
“An intangible (within the meaning of paragraph 6.6) that relates to marketing
activities, aids in the commercial exploitation of a product or service, and/or
has an important promotional value for the product concerned. Depending
on the context, marketing intangibles may include, for example, trademarks,
trade names, customer lists, customer relationships, and proprietary market
and customer data that is used or aids in marketing and selling goods or
services to customers.”
Paragraph 6.17 states the definition of “unique and valuable” intangibles as:
• Patents
• Group synergies
• Contractual terms for ownership, funding and risk may differ from what would
be found in independent enterprises.
To try to deal with these difficulties there is a six step analysis to analyse
transactions involving intangibles between associated enterprises. This framework is
comparable to that introduced in Chapter I of the OECD Guidelines for analysing
risks, consisting of the following six steps (see paragraph 6.34):
3. Identify parties performing functions, using assets, and assuming risks related to
development, enhancement, maintenance, protection, and exploitation of
the intangibles through a functional analysis;
6. Where possible, determine arm’s length prices consistent with each party’s
contribution of functions performed, assets used, and risks assumed.
“For transfer pricing purposes, legal ownership of intangibles, by itself, does not
confer any right ultimately to retain returns derived by the MNE group from
exploiting the intangible, even though such returns may initially accrue to the
legal owner as a result of its or contractual right to exploit the intangible.”
• Perform and control all of the functions (including the important functions
described in paragraph 6.56; these include control over strategic decisions
and being responsible for determining the course of “blue-sky“ thinking)
related to the development, enhancement, maintenance, protection and
exploitation of the intangible;
• Bear and control all of the risks related to the development, enhancement,
maintenance, protection, and exploitation of the intangible.
The guidance distinguishes between ex-ante and ex-post returns, clarifying that
the compensation that must be paid to members of the MNE group that
contribute to the development, enhancement, maintenance, protection and
exploitation of intangibles is generally determined on an ex-ante basis. The
allocation of actual ex-post profit or loss will depend on the facts and
circumstances of the case.
Section C sets downs the two main types of transactions considered relevant for
purposes of identification and characterisation of specific transactions involving
intangibles:
ii. transactions involving the use of intangibles in connection with the sale of
goods or the provision of services.
3. Arm’s length pricing when valuation is highly uncertain at the time of the
transaction;
a. Exclusivity
c. Geographic scope
d. Useful life
e. Stage of development
Looking at risk in relation to comparability the six step analysis that is found in
paragraph 1.60 of the OECD TPG must be applied. The risks that need to be
considered for intangibles include:
“The transfer pricing methods most likely to prove useful in matters involving
transfers of one or more intangibles are the CUP method and the
transactional profit split method. Valuation techniques can be useful tools”
(See paragraph 6.145).
The guidance covers the use of valuation techniques. The OECD TPG recognise
that they can be very useful in helping estimate the arm’s length price when a
CUP is not available (see paragraph 6.153).
Thus, the OECD TPG recognise that it is often difficult to attribute a distinct value to
each intangible on an ongoing basis.
The valuation of intangibles poses difficulties for transfer pricing decision making
and government oversight for three major reasons:
• Comparables for such assets seldom exist. Patents are rarely traded on
external markets. Usually MNEs are unwilling to sell their patents, but might
license out some of the rights to use the intangible asset.
• Intangibles other than patents are particularly difficult to detect because they
are not reported in financial statements.
As mentioned above Section D3 of Chapter VI looks at how the arm’s length price
can be found where the transaction involves intangibles where the value is highly
uncertain at the time of the transaction.
Paragraph 6.182 of the OECD TPG suggests that a possibility for dealing with
uncertainty is to use an anticipated benefits approach. This approach takes into
account all relevant economic circumstances at the outset to establish the price
at this point. The OECD TPG suggest that it may be that independent enterprises
would agree that subsequent outcomes are sufficiently predictable to fix the
price.
If this approach is not possible the OECD TPG go on to suggest that short term
agreements be entered into with price adjustment clauses (see paragraph 6.183).
The final possibility put forward (in paragraph 6.184) is that independent enterprises
might be willing to take some risk at the outset with a joint understanding that
there will be a renegotiation of the pricing agreement if required later. The
paragraph includes an illustration of when this might happen.
An income based approach seeks to generate a single present value from the
quantum, duration and risk associated with expected future economic benefits of
the business asset. An appropriate discount rate must be applied reflecting a rate
of return on investments appropriate to the asset being valued and the relevant
market conditions. IFRS 3 does not provide guidance on the appropriate discount
rate to apply – it is generally appropriate to look at the rates an acquirer would
receive on similar investments.
The discounted cash flow (DCF) method in particular involves a rigorous review of
projected performance and is often preferred as a valuation method where
credible financial data is available.
The OECD TPG recognise the value of income flow techniques at paragraph 6.157.
In addition three of the worked examples (27 to 29) in the Appendix to Chapter VI
illustrate its use. However, the TPG also point out concerns with the use discounted
cash flow projections (see paragraphs 6.158 to 6.180).
Note that market information will often be critical in informing income based
approaches; by way of example, market information on discount rates, multipliers
and forecasts can help increase the credibility of assumptions applied in income
based methods.
Historic cost, in isolation, is less useful as a business valuation tool. It can provide
some background or useful context to value.
Replacement cost is often more relevant; a potential buyer can always consider
the cost of generating a business asset as opposed to purchasing one.
The OECD TPG at paragraph 6.142 state that valuation of intangibles based on
cost is generally discouraged. Paragraph 6.143 points out when it may be
appropriate to use cost based valuations.
The DCF method of valuation is based on projecting cash flows into the future,
which are then discounted to a present value.
It is often useful to run two methods in parallel to ensure that the results are
comparable and increase accuracy.
The OECD TPG look at the tax authorities approach to valuation of intangibles in
paragraph 6.182 onwards. They state that the tax authority needs to take the
approach that would be taken by an independent enterprise. This is illustrated by
giving the example of an independent enterprise fixing a price based on a
particular projection. In this case the tax authority could enquire as to whether
sufficient investigations were made regarding the chosen projection.
The Glaxo group recently settled a transfer pricing dispute in the US for $3.4 billion.
The magnitude of this settlement helps illustrate the scope of the problem in
valuing intangibles and exploiting it correctly without triggering potential tax
avoidance. Glaxo is headquartered in the United Kingdom and holds several
subsidiaries in the US. Glaxo's primary business is the development and
manufacturing of pharmaceutical drugs. Cross-border transactions of valuable
pharmaceutical drugs generating large profit margins have attracted the
attention of revenue authorities.
Glaxo's sales of drugs in the United States generated almost $30 billion in revenues
from 1989 to 1999. During this period, Glaxo paid about $1.3 billion in U.S. taxes.
Glaxo claimed that the United Kingdom had already taxed the MNE Group's
profits under dispute with the IRS, arguing that any reallocation by the United
States would result in double taxation of Glaxo.
The drug had been patented in the UK and hence, the US subsidiary was acting as
distributor for the US market. However, the IRS argued that the US subsidiary of
Glaxo overpaid its UK parent for the patent it held. The IRS also argued that
marketing efforts by the US subsidiary were the determining factor in the success of
Zantac. Also, as the US was the largest market for the drug, which was also
manufactured in the US, the economic ownership of the intangible was
challenged. The IRS demanded about $8 billion in tax adjustments and penalties.
Glaxo tried to reach settlement with the IRS by referring the dispute to a
competent authority under the MAP procedure. The governmental discussions did
not reach common ground and the IRS took Glaxo to court to preserve evidence
in preparation for the anticipated trial.
In settling the Glaxo case, IRS Commissioner Mark Everson stated that transfer
pricing issues “are one of the most significant challenges” tax agencies face.
The success and profits of Glaxo's “number two” drug in the United States were
primarily based on successful marketing and sales in the US market, rather than the
patents that led to the new drug. Glaxo also was not able to prove clear
ownership of the intangible especially in relation to research activities within Group
(economic ownership versus legal ownership).
There is an argument that just as the law on intangibles merged with international
trade law to form international law on intangibles, it is now time to consider
merging transfer pricing regulation for intangibles with international law on
intangibles to create more uniform and sophisticated international transfer pricing
regulation. While a tax policy goal is to acquire a fair share of taxes and prevent
abusive tax avoidance, the goal in international law on intangibles is to promote
Some would say international transfer pricing regulation should consider all of
these policy goals. It is possible for both the international legal system in respect of
intangibles and governmental tax regimes to adopt these fundamental goals
while simultaneously creating a more effective legal system regulating the transfer
pricing of intangibles.
The fast growth in transfer pricing legislation and regulations represents cross-
border expansion in the law. This expansion of transfer pricing regimes arises mostly
from the legitimate concern that if a country does not adopt detailed transfer
pricing regulation and penalties, MNE Groups will favour attributing income to a
related MNE located in a second country that has transfer pricing laws and
regulations in place.
The update to the OECD TPG following the final report on Action Points 8 to 10
included the addition of a new section relating to Hard to Value Intangibles (HTVI).
HTVI are defined in paragraph 6.189 as intangibles or rights in intangibles for which,
at the time of their transfer between associated enterprises:
ii. at the time the transaction was entered into, the projections of future cash
flows or income expected to be derived from the transferred intangible, or the
assumptions used in valuing the intangible are highly uncertain, making it
difficult to predict the level of ultimate success of the intangible at the time of
the transfer.
The guidance recognises that tax authorities do not have access to the same
information as MNEs and that the time delay between the valuation by the MNE
and the scrutiny by the tax authority also makes it difficult for tax authorities to
assess if an arm’s length price has been used.
To assist the tax authorities, the OECD TPG now provides that ex post outcomes
(actual outcomes) can be used in some cases to help assist in assessing the ex
ante (pre -transaction) pricing. The OECD TPG say that ex post evidence provides
presumptive evidence as to the existence of uncertainties at the time of the
transaction, whether the taxpayer appropriately took into account reasonably
foreseeable developments or events at the time of the transaction, and the
reliability of the information used ex ante in determining the transfer price for the
transfer of such intangibles or rights in intangibles. In other words, tax
administrations may use such ex post evidence to determine the pricing
arrangements that would have been made at the time of the transaction
between independent enterprises, including any contingent arrangements (such
as milestones payments or renegotiation clauses) that might have been agreed
(see paragraph 6.194).
• Where the taxpayer can demonstrate that ex ante projections used at the
time of the transfer to determine the pricing arrangements were reliable,
taking into account risks and reasonably foreseeable events that might have
affected the outcomes. In addition the taxpayer also needs to provide reliable
evidence that any significant difference between the projections and actual
outcomes is due either to unforeseeable developments, or to the playing out
of foreseeable outcomes whose probabilities were originally reasonably
estimated.
• The difference between financial projections and actual outcomes does not
reduce or increase compensation arising from the HTVI by more than 20% of
the compensation determined at the time the transaction was entered into.
Further guidance on HTVI was issued in June 2018. The aim is to help tax authorities
and ensure consistency when applying the HTVI approach. The guidance includes
examples and a section dealing with the interaction with MAP. It will be added to
the OECD TPG as an annex to Chapter VI.
The guidance makes it clear that the focus is on the avoidance of double taxation
and ensuring that the approach is applied in a timely manner.
It is recognised that difficulties may arise as the actual outcomes may have long
gestation periods and don’t necessarily tie in with audit cycles. Wherever possible
tax authorities should identify HTVI, and apply the appropriate audit approach to
flag up any issues, as soon as possible. It is noted that this may not always be
practical and states that the guidance doesn’t seek to amend time limits which
are a matter for national sovereignty for the countries concerned.
It is stated in the guidance that tax authorities may make appropriate adjustments,
including an alternative pricing structure that reflects one which would have been
made by independent enterprises in comparable circumstances, to take account
of the valuation uncertainty in the pricing of the transaction (for example,
milestone payments, or price adjustment clauses, or a combination of these
characteristics). The nature of HTVI means that the tax authorities cannot be
expected to justify the changes by reference to comparable uncontrolled
transactions for similar intangibles.
As part of your study we recommend that you look at the examples in this
guidance - you can find it at http://www.oecd.org/tax/transfer-pricing/guidance-
for-tax-administrations-on-the-application-of-the-approach-to-hard-to-value-
intangibles-beps-action-8.htm
With regard to the interaction with the MAP, the guidance on HTVI makes specific
reference to the fact that Article 25 of the OECD Model DTC makes provision for
the taxpayer to set the MAP in motion without having to wait until the taxation
considered by him to be not in accordance with the convention has been
charged against or notified to him. The taxpayer only has to establish that the
actions of one or both of the Contracting States will result in taxation not in
accordance with the DTC, and that the risk of this is not merely possible but
probable (see paragraph 14 of the Commentary to Article 25).
The guidance also makes reference to the fact that one of the best practices
recommended in the BEPS Report on Action Point 14 is that, subject to the
requirements of paragraph 1 of Article 25, countries implement appropriate
procedures to permit, in certain cases and after an initial tax assessment, taxpayer
requests for the multiyear resolution through the MAP of recurring issues with
respect to filed tax years, where the relevant facts and circumstances are the
same and subject to the verification of such facts and circumstances on audit.
Chapter VIII of the OECD TPG sets down the OECD view on cost contribution
arrangements (CCA). The OECD recognises that CCA can be used in other
contexts not just for the development of intangibles.
Chapter VIII of the OECD TPG adopts the same principles as that contained in
Chapter I of the OECD TPG - that is to say they require correct delineation of the
transaction and the risks involved. They also take account of the principles in
Chapter VI for intangibles. The requirements relating to substance and control and
the restrictions to using cost as a basis for valuation of contributions, both pre-
existing and current, are likely to have an impact for participants in CCA.
The main aim is to ensure that the contributions made under a CCA are
commensurate with the benefits received.
There is also a requirement that CCA participants must have the capability and
authority to control the risks associated with the CCA activities (see paragraph
8.15I). This means they must be capable of making the decision to take on the
initial financial risk of participation in the CCA, and must have the ongoing
decision-making capacity to decide on whether or how to respond to the risks
associated with the CCA. It is recognised in paragraph 8.17 that it is not necessary
for all CCA activities to be performed by the personnel of CCA participants. Thus,
participants in a CCA may outsource certain functions to a separate entity outside
the scope of the CCA. In this case, the relevant CCA participants must exercise
the requisite control over the specific risks they assume under the CCA.
The OECD TPG recognise that there are many types of CCA. Independent
enterprises may come together to share costs. There are two key concepts to the
chapter on CCA; firstly that there will be mutual benefit from sharing costs and
secondly that each enterprise will contribute according to the amount of benefit
they expect to receive.
A CCA will meet the arm's length principle if the participants’ share of the cost is
commensurate with their share of the benefits (see paragraph 8.13).
In deciding whether the arrangements are arm's length the earlier chapters of the
OECD TPG will be in point – that is to say factors such as the contractual terms,
economic circumstances and how risks are shared.
In deciding whether the arm’s length principle is being met account will be taken
of any balancing payments or receipts. The documentation drawn up for the CCA
should include clauses for balancing payments where the amount of a
participant’s benefit is greater than that anticipated at the outset. If one party is
receiving a greater part of the benefits than that anticipated at the outset, it
follows that another is receiving less so they should receive a balancing amount to
reduce the proportionate amount of their contributions.
Balancing payments need to be distinguished from buy in and buy out payments
which are made when participants join or leave after a CCA has been entered
into. Buy in and buy out payments must also meet the arm’s length principle and
these are discussed further below.
It is important to take account of all contributions made not just cash, so account
must be taken of services and property. The guidance makes reference to
contributions of pre-existing value and current contributions. For example, the
contribution of patented technology to be used in the development of an
intangible would reflect the contribution of pre-existing value, whereas the
contribution of current R&D would constitute a current contribution. The value of
the pre-existing intangible (e.g., patented technology) should be determined
under the arm’s length principle using guidance in Chapters I-II and Chapter VI,
including the valuation techniques as set out in Chapter VI (see paragraph 8.26).
The OECD TPG state (at paragraph 8.28) that the value of each participant’s
contribution should be determined in line with the value that would be placed on
it by independent enterprises in comparable circumstances. While contributions
should be measured based on value, the OECD recognises that it may be more
practical for taxpayers to compensate current contributions at cost. However, this
approach may not be appropriate where the contributions of different
participants differ in nature (for instance, where some participants contribute
services and others provide intangibles or other assets). Examples are also
provided in the Annex to Chapter VIII to illustrate this.
The OECD TPG also recognise the problem of estimating benefits that will arise in
the future and suggests this might, as noted above, be dealt with via a balancing
payment at a later date (see Section C5 of Chapter VIII).
If it is found that the arrangements are not in keeping with the arm’s length
principle, then adjustments will need to be made. Again the adjustment required
will be dependent on the facts but will likely lead to the need for a balancing
payment from one party to the CCA to another. The OECD TPG recognise the right
of the tax authority to make adjustments where a participant’s contribution has
not been correctly calculated, for example as a result of miscalculation of the
value of property or services contributed or as a result of unexpected benefits. The
OECD TPG do counsel against minor amendments; they also state that
adjustments should not be made in respect of a single fiscal year if overall the
arrangements are being carried out in good faith (see paragraphs 8.36 and 8.37).
Section C6 of Chapter VIII OECD TPG deals with the issue of disregarding part or all
of the terms of a CCA. Where arrangements viewed in their totality lack
commercial rationality in accordance with Section D2 of Chapter 1, the CCA can
be disregarded in its entirety (see paragraph 8.40).
Section D of Chapter VIII looks at buy in and buy out payments plus termination of
a CCA. Changes in the membership of a CCA would generally trigger
reassessment of the shares of contributions and the expected benefits for each
participant. When a new participant joins then effectively a share of the existing
benefit is moved to the new participant and this should be compensated using
the arm’s length principle. This would be a buy in payment. Similarly, if a
participant leaves, a buy out payment would be expected using the arm’s length
principle to compensate them for the interest they are giving up. The guidance set
down in earlier chapters of the TPG will apply including that in Chapter VI on
intangibles.
The structure of a CCA should conform to the arm’s length principle. Anyone who
will benefit from the CCA should contribute to the CCA. Those who will not benefit
should not be participants. The nature and extent of each participant’s beneficial
interest should be clearly documented. The payments made should only be those
required under the arrangement including any balancing payments.
The participants should have full access to all information in relation to the
activities and the projections used to estimate contributions and benefits under
the CCA.
All of this plus any other information of interest to a tax authority will need to
documented. The OECD TPG give a list of the information that may be relevant
(see below) but note that this is neither a minimum compliance standard nor an
exhaustive list (see paragraph 8.52):
a. A list of participants;
b. A list of any other associated enterprises that will be involved with the CCA
activity or that are expected to exploit or use the results of the subject activity;
c. The scope of the activities and specific projects covered by the CCA and how
the CCA activities are managed and controlled;
g. The form and value of each participant’s initial contributions, and a detailed
description of how the value of initial and ongoing contributions is determined
(including any budgeted versus actual adjustments) and how accounting
principles are applied consistently to all participants in determining
expenditures and the value of contributions;
h. The anticipated allocation of responsibilities and tasks and the mechanisms for
managing and controlling those responsibilities and tasks, in particular those
relating to the development, enhancement, maintenance, protection or
exploitation of intangibles or tangibles used in the CCA activity;
j. Any provisions for balancing payments or for adjusting the terms of the
arrangement to reflect changes in economic circumstances.
In addition records will need to be kept over the life of the CCA of any changes to
the arrangements, comparisons of actual outcomes to projections, details of
actual cost and actual contributions made (see paragraph 8.53).
Paragraph 8.51 brings in the importance of the documentation complying with the
requirements in Chapter V of the OECD TPG. When you come to look at the three-
tier approach to documentation in a later chapter you will see that the master file
will include details of important service arrangements and agreements related to
intangibles, including CCAs. In addition, the local file will contain transactional
information, including a description of the transactions, the amounts of payments
and receipts, identification of the associated enterprises involved, copies of
material intercompany agreements, and pricing information, including a
description of reasons for concluding that the transactions were priced on an
arm’s length basis. As a result, it would be expected that in order to comply with
these documentation requirements, the participants in a CCA will maintain
materials describing the arm’s length nature of the CCA. You will note that
paragraph 8.51 states that the level of detail of the materials prepared should be
commensurate with the complexity and importance of the CCA to the taxpayer.
VERITAS Software Corp., 133 TC No. 14, Dec. 58,016 (Dec. 10, 2009)
This was a US case looking at “buy in” costs for a cost contribution arrangement.
The IRS argued that what had taken place was akin to a sale or spinoff of Veritas
operations hence the sum to be paid should be valued on this basis.
Based on the licensing agreement, Veritas Software granted Veritas Ireland the
right to use certain “covered intangibles,” as well as the right to use Veritas
Software's trademarks, trade names, and service marks. In exchange for the rights
In 2000 Veritas Ireland made a $166 million “lump sum buy-in payment” to Veritas
Software. This amount was later adjusted downward to $118 million. At issue, from
a tax perspective, is whether the buy-in payment was “arm's length.”
The court rejected the IRS approach agreeing with Veritas that the amount to be
paid should be based on comparable uncontrolled royalties payable over the life
of the agreement. Further the court said that the IRS determination was arbitrary,
capricious, and altogether unreasonable.
In noting the comparability, the court also pointed out the following:
(1) Veritas Ireland and the OEMs undertook similar activities and employed similar
resources in conjunction with such activities, (2) there were no significant
differences in contractual terms, (3) the parties to the controlled and uncontrolled
transactions bore similar market risks and other risks, and (4) there were no
significant differences in property or services provided,
Therefore, the court was happy that the unbundled OEM agreements were
sufficiently comparable to the transaction they were looking at thus giving the
result that comparable uncontrolled transaction method (CUT) (as set down in the
US regulations) was the best method to determine the appropriate buy-in price.
The buy-in payment charged met the arm's length standard and the IRS's
contention was rejected.
On March 23, 2017, the US Tax Court issued its long-awaited opinion in a transfer
pricing dispute involving Amazon's cost sharing arrangement ("CSA") with its
Luxembourg subsidiary.
The IRS challenged Amazon's valuation method, claiming that Luxco's buy-in
payment was not arm's length. The IRS asserted that the contributed intangibles
had an indefinite useful life (because it served as the basis for future intangibles
development) and used a discounted cash flow valuation method. This approach
increased the buy-in payment to approximately $3.5 billion.
The IRS was making essentially the same arguments that the court had
emphatically rejected in the Veritas case above. In Amazon, the court noted that
the IRS formulation of "indefinite" useful life was in substance identical to the
"perpetual" life it had argued in Veritas. In both cases, the IRS valuation method
included the present value of income projected to be derived from future
intangibles not yet developed. This violated the regulations' prescription that a
buy-in payment equals the value of only the existing intangibles contributed to the
CHAPTER 15
In this chapter we are going to look at the transfer pricing implications of business
restructuring, in particular:
– the rationale for restructuring and the role of tax
– typical models applied during restructuring
– the OECD approach
– tax authority response to business restructuring
15.1 Introduction
There have been many headlines accusing large groups of trying to evade tax by
setting up principal entities in low tax jurisdictions with the “excuse” of restructuring
and making the group more efficient. Whilst it would not be fair to comment on
individual cases, it is reasonable to say that companies have adopted a wide
range of strategies to business restructuring, with some moving thousands of
employees to different locations and others simply changing the form of
transactions.
Although it is true that some groups have viewed business restructuring as a means
of driving down the group effective tax rate, there are a wide range of
operational reasons why companies seek to restructure.
These include:
It should also be noted that tax efficiency is in fact the responsibility of a company,
rather than a negative characteristic. Companies have a duty to shareholders to
optimise the value of a business, albeit in a responsible manner. Tax costs are
simply one element of cost to a business, and need to be factored into any major
business decision. As the OECD TPG note:
“MNEs are free to organise their business operations as they see fit. Tax
administrations do not have the right to dictate to an MNE how to design its
structure or where to locate its business operations. They are free to act in their
own best commercial and economic interests in this regard. In making this
decision, tax considerations may be a factor.” (See paragraph 9.34).
Structural changes will almost invariably lead to changes in the intra-group pricing,
financing and allocation of risk and functions; therefore, transfer pricing is a key
subject and a planning tool when setting up the new structure.
The first step is to establish the entity that will undertake increased activities. This
entity is commonly known as the Principal. Location will often be determined by a
number of factors, including amongst other things:
• Cost and standard of living (since often senior personnel will need to be
located there)
• Tax profile
In many cases, the location chosen will have a low tax rate. This could be for a
number of reasons, including a low underlying corporate tax rate, the availability
of significant tax losses to offset future profits, or tax incentives offered by the local
government to encourage the relocation of certain qualifying activities to that
territory.
Having established the Principal, some or all of the business value chain is
reorganised to move value to the Principal. These may involve:
The Principal may undertake the planning and scheduling process, take
responsibility for capacity and inventory planning, and insulate the
manufacturing entities from key risks beyond the delivery of core
manufacturing processes.
For new IP, this will involve either direct development within the Principal entity,
or engaging related parties (or third parties) to undertake development work
on a contract R&D basis. This would require sufficient management and
control of the R&D process from the Principal, which would need people with
For existing IP, this would need to be transferred to the Principal in some form
(discussed in more detail below), and would require active management to
protect and maintain its value.
The term LRD is a catch-all term, and can actually involve a range of functions
being undertaken.
The above are just some examples of the shift in functionality seen in business
restructuring. Some industries, such as consumer goods, have seen many
companies adopt all aspects of these within their value chain. For others, it is more
common to see only some aspects.
Many companies find it difficult to transition to a full centralised model in one go,
either because of system constraints, lack of resources to manage the transition or
the scale of disruption that it would entail. Therefore, these Principal structures may
initially involve only one aspect (such as procurement) but develop into a full
Principal over time.
It should also be noted that often the Principal may not be part of the title chain.
This may again be due to system constraints, or else complexities arising from
where the manufacturing and sales activities take place in the same country. In
those cases, the Principal may be rewarded through some form of service fee that
is sufficiently high to reflect the value that it contributes.
As mentioned in Chapter 1 of this manual, the OECD TPG were reissued in 2017.
Many of the amendments had already been seen when the OECD TPG were
updated in May 2016 following endorsement of the BEPS reports. Chapter IX was
not directly affected by the BEPS Action Plan, however the conforming changes
that were needed to ensure that Chapter IX reflected the changes to earlier
chapters of the OECD TPG means that the chapter is quite different in
appearance to the 2010 version.
The focus of the chapter is the application of Article 9 of the OECD Model DTC in
the context of business restructuring; it does not cover the attribution of profits
under Article 7 (see later chapter).
The principles that are established earlier in the OECD TPG regarding the
treatment of related party transactions apply equally to business restructuring:
“This chapter starts from the premise that the arm’s length principle and these
Guidelines do not and should not apply differently to restructurings or post-
restructuring transactions than to transactions that were structured as such
from the beginning.” (See paragraph 9.9)
The OECD TPG recognise that the process of business restructuring itself may give
rise to a cross-border transfer of something of value. A payment to reflect such a
transfer is commonly known as an ‘exit charge’. In some cases, this may be
obvious, such as tangible or intangible assets. In those cases, the same principles
apply as would be the case if those assets were being sold in normal
circumstances.
The first step of this process is to understand the nature of the restructuring.
Specifically see OECD TPG paragraphs 9.13–9.18; it is important to identify the
difference in functional and risk profile pre- and post-restructuring, and the
economic nature of what has been shifted.
Contracts will be an important starting point (see paragraph 9.17). As with other
transactions, the contractual allocation of risk should not be immediately
discounted. Nevertheless, tax authorities are entitled to consider whether the
behaviour of the parties accords with the written contracts. Where there are no
written contracts or the behaviour of the parties differs from the written agreement
then the facts will need to be used to deduce the actual transaction. Again the
principles in Chapter 1 of the OECD TPG need to be applied, in particular Section
D1.1 of Chapter 1.
The functional analysis will have a key role in accurately delineating the
transactions and recourse needs to be had to Section D1.2 of Chapter 1 (see
paragraph 9.18).
As noted above, the guidance on the analysis of risk in the context of business
restructuring is found in Part 1 of Chapter IX paragraphs 9.19 to 9.23. The guidance
stresses the importance of identifying economically significant risk. It is only
economically significant risk that will have an impact on profit. When analysing risk
the six step process set down in Section D1.2.1 of Chapter 1 of the OECD TPG must
be applied.
A key consideration is the economic importance of the risk; the OECD TPG point
out (see paragraph 9.22) that only where economically important risk is transferred
would we expect to see a significant reallocation of profit potential.
To fully understand the restructuring, the OECD TPG state that consideration should
be given to the options realistically available to the restructured party (see
paragraphs 9.27 to 9.30). By evaluating the restructured entity as if it were
operating independently from the rest of the group, it should be established
whether it would be prepared to accept the restructuring or whether it would
have had more profitable options available to it. This is not to say that the mere
reduction in its future profits should give rise to compensation. Nevertheless, if it
can be established that the restructured entity had material profit potential that it
has given up, then at arm’s length, this would be rewarded.
When addressing this question, the rights of the party need to be considered. Take
the case of a distributor with long-term contractual rights (either written or implied
by behaviour) to distribute a product. In the event of a restructuring, it would need
to be questioned whether the distributor would accept a lower, more stable return
for its activities. If margins pre-restructuring were volatile, or there are declining
margins in the industry, it may be possible to make the case that no compensation
would be required as it would be rational to accept the terms of the restructure.
However, if the party would expect to maintain higher, stable profits, and would
ordinarily have the contractual rights to be able to do so, then some
compensation must be given to recognise this profit potential foregone.
In general, tax authorities should only disregard the structure of the transaction in
exceptional circumstances as set down in paragraph 1.122 of the OECD TPG. In
summary this states that an accurately delineated transaction can only be
disregarded and replaced with an alternative transaction where the transaction
viewed as a whole differs from the one that would have been entered into by
independent enterprises in comparable circumstances behaving in a
commercially rational manner taking into account the options available to them
(ie. the same circumstances that apply to any transaction, not just business
restructuring).
Even if the tax authority were to disregard the transactions as structured by the
taxpayer, the alternative transaction used for taxation would nevertheless need to
recognise certain commercial realities. For example, if the restructuring involved
the closing of a factory, any substituted transaction would need to recognise that
the factory is no longer available (see paragraph 9.35).
There is recognition that a restructure may include the transfer of loss making
activities; as with profitable activities the options available need to be considered.
Rather than transfer a loss making activity it can be closed down, however it may
be commercially more profitable to transfer it. (See paragraphs 9.71 to 9.73.)
The OECD TPG also address whether it is necessary for the restructured party to be
indemnified against restructuring costs (such as plant closure and redundancy
costs). (See paragraphs 9.75 to 9.97.) In doing so, consideration is given to the
terms of the agreement(s) between the parties, both written and what is implied
by the behaviour of the parties pre-restructuring. This should be evaluated in the
context of local commercial law. The overriding principle is whether at arm’s
length another party would be willing to indemnify the restructured entity.
Although the answer is heavily dependent on the specific facts and
circumstances, it could be the case that Principal, the parent company or a new
entity benefitting from additional business (or a combination of all three) could be
willing to pay.
One issue is that comparability analysis may be harder to apply (see OECD TPG
Part III Section A2 Chapter IX). There are already inherent difficulties in identifying
comparable data from independent parties to test related party transactions
given there are often fundamental differences in the way that multinational
groups and independent firms operate. This is often placed under further stress
following business restructuring where transactions are frequently structured in a
way that is not seen between unrelated parties, with substantial differences in the
division of responsibility and risk. Such a fact pattern does not necessarily mean
that a controlled transaction is not arm’s length, and it is necessary to find a
reasonable solution. This places increased importance on a thorough functional
analysis to identify the key economic drivers of the transaction.
When we are looking for comparables there is the added complication that it may
not be appropriate to compare a restructured entity with a new entity. Paragraph
9.102 cites the case of a previously successful fully fledged distributor that has
been converted to a limited risk distributor and points out although it is new to
being a limited risk distributor it may not be comparable to a newly set up limited
risk distributor as the company that has been restructured will still be operating
from a base of many years of successful operation as a distributor. In addition, it
will not need to go through a market penetration exercise in the same way as a
newly set up company. The application of comparability analysis as set down in
Chapter III of the OECD TPG will be very important.
The OECD TPG also consider the concept of location savings (see paragraphs
9.126 to 9.131). In many cases, business restructurings result in the shift of labour-
The OECD TPG do not directly rule out the case for sharing the savings. However,
they note that in the case of routine activities operating in a competitive market, it
is likely that the Principal would have the option realistically available to use third
parties in that territory. As such, at arm’s length, very little would be attributed to
the routine entity, and standard benchmarking could be used to determine the
appropriate return. However, in the case where the new entity performs more
specialised services, there may be a case for attributing greater returns. However,
it is arguable that these additional returns relate more to the nature of the services
being provided than to a share of location savings.
The issue of business restructuring is a major concern for many tax authorities, given
the significant erosion of the tax base that it can create. Tax authorities have
sought to address the issue in a number of ways:
The most obvious step taken by tax authorities has been to focus efforts on
identifying where business restructuring has taken place. In some instances, this
involves formal disclosures – in Australia, the International Dealings Schedule
requires taxpayers to disclose any business restructuring as part of the tax return,
whilst in the UK, any taxpayer hoping to maintain a low risk status with HMRC would
be expected to discuss the restructuring with the Customer Relationship Manager
at an early stage in the process.
In other cases, tax authorities are looking for the signs of potential restructuring. This
might be in the form of significant changes to the profit profile of the taxpayer, as
disclosed through the tax return, or through news and media releases about
organisational changes. Tax authorities will often look at public disclosures about
business restructuring (including the purpose and expected benefits) to determine
whether they accord with tax position being taken, and challenge any
discrepancies.
At the other end of the spectrum, some countries, such as Germany, will seek to
apply an exit charge based on the net present value of profits transferred out of
the jurisdiction, with considerable efforts required to demonstrate that such a
charge is not payable.
The European Union Anti-Tax Avoidance Directive (ATAD) which was approved by
the ECOFIN in July 2016 (as we saw in an earlier chapter) includes a requirement
for an exit charge (taxing market value minus tax value for assets) when a
taxpayer moves a permanent establishments or residence of a company out of a
Member State’s taxing jurisdiction. A five-year deferral is possible subject to certain
requirements being met. The Directive applies from 1 January 2020 for exit charges
(the other provisions of the ATAD will apply from 1 January 2019).
Although there is considerable focus on transfer pricing, there are a range of other
avenues that tax authorities will consider when challenging business restructuring:
• Withholding tax (WHT) – WHT may well apply to certain payments made by
local operations to a Principal. Although this is not relevant to a basic buy-sell
Principal structure where the only transactions involve the flow of physical
goods, it is relevant to more complex models where payments to the Principal
may be in the form of variable royalties or value-added service fees. Under
such circumstances, the local tax authorities may not accept the transaction
and seek to substitute it with other transactions in such a way that carries the
largest WHT burden.
• Controlled Foreign Company (CFC) rules – Where the Principal entity is not the
parent company within a group, consideration needs to be given to CFC
legislation in the parent jurisdiction (and any jurisdictions for holding
companies between the parent and the Principal). CFC legislation is complex
and requires separate analysis, but broadly speaking, depending on the tax
rate in the Principal, the nature of the income it earns and the extent of the
activities it undertakes, the tax authority might seek to deem the Principal to
be a CFC of the parent and tax the profits it earns. Mitigation against this risk
depends on the specific rules of the jurisdiction in question but generally
requires an appropriate level of substance in the Principal through undertaking
sufficient economic activities.
• Indirect taxes – Changes to the transaction model will have a knock-on effect
for indirect taxes, which can be an area that tax authorities will seek to
challenge. Following conversion to a typical Principal structure, it is often the
case that prices for goods sold into distribution territories will increase. In some
cases this will be a dramatic increase. Whilst this is of benefit to customs
authorities charging duty on an ad valorem basis, this nevertheless brings with
it the challenge of why prices have changed. It can be difficult to justify to
customs officials why prices have significantly shifted when the underlying
product entering the country has not changed at all. The challenge to defend
against is that historic pricing has been incorrect, and business restructurings
can often lead to customs audits for periods prior to the restructuring.
15.7 Conclusion
Disputes may occur between a parent company and tax authorities in relation to
whether business decisions are commercial and not purely tax driven. Furthermore,
tax authorities are likely to be concerned if valuable intangibles are transferred
from existing manufacturers without adequate compensation.
Documentation, proof of sound commercial rationale and risk analysis are key to
supporting the business decision. The fact that transfer pricing is high on the to-do
list of most tax authorities is a clear warning. It is also important to understand that
although most countries comply with the OECD TPG on business restructuring there
are still differences in approach and methodology amongst different jurisdictions,
so it is very important to look at the overall picture when considering a
transformation project, map the tax effects in each jurisdiction and consider any
transfer pricing issues that may arise. Any cost or tax benefit should be checked
against any tax risk or exit charge, which might be triggered by the restructuring
process. Last, but not least, robust documentation, clear intra-group agreement
and strong proof of commercial rationale driving the transformation are essential
in reducing the risk of potential tax audits and consequent adjustments.
CHAPTER 16
NON-RECOGNITION ISSUES
In this chapter we are going to examine the circumstances in which a tax authority may
seek to disregard or not recognise a transaction between associated enterprises.
16.1 Introduction
Non-recognition refers to the extent to which a tax authority may, for tax purposes,
set aside the contractual terms of a controlled transaction. The tax authority may
take one of two approaches:
These approaches are illustrated in paragraphs 1.127 and 1.128 of the OECD TPG
(see below).
The arm’s length principle certainly governs the prices and other conditions of the
controlled transaction. However, there are cases where it is not just the prices or
other conditions associated with the controlled transaction which are being
challenged by the tax authorities, but also the nature of the transaction.
There is a wide variety of domestic tax law anti-avoidance approaches which may
permit non-recognition of transactions other than through transfer pricing
measures per se. These approaches include:
• “Substance over form” and “abuse of law” doctrines: these are, respectively,
common law and civil law concepts which require that the purpose of the
legislator prevails over the actual form of a transaction if that form is not
specifically contemplated by the law and the same economic results could
have been obtained in another manner.
• “Sham” doctrine: legal form of the transaction does not cover the reality
intended by the parties.
they are not put into place for valid commercial reasons which reflect economic
reality. The GAAR will apply from 1 January 2019.
However, the main focus of this chapter is on the OECD approach to non-
recognition in a transfer pricing context. The content of the OECD TPG in this
context is important because in many countries there is an explicit or implicit
requirement to respect the OECD TPG in domestic tax law.
Following adoption of the final reports on Action Points 8 to 10 of the BEPS Action
Plan, Section D2 of Chapter I of the OECD TPG looks at when a transaction can be
disregarded. It is still the case that transactions can only be disregarded in the
exceptional circumstances as laid down in the OECD TPG (see paragraphs 1.122
to 1.125). The OECD TPG also include some worked examples.
The OECD TPG recognise that associated enterprises may enter into a much wider
variety of arrangements than non-related enterprises. Therefore the OECD TPG
state that when tax authorities are considering non-recognition:
“the key question is whether the actual transaction has the commercial
rationality of arrangements that would be agreed between unrelated parties
under comparable economic circumstances, not whether the same
transaction can be observed between independent parties” (see paragraph
1.122).
The emphasis in the OECD TPG is on commercial rationality as per the above
quote. Further the guidance goes on to say:
"the mere fact that the transaction may not be seen between independent
parties does not mean that it should not be recognised." (see paragraph
1.122).
The OECD TPG point out in the same paragraph that it is also relevant to look at
whether the multinational group as a whole is left worse off on a pre-tax basis as a
result of the transaction.
Section D2 finishes with some worked examples. The first looks at an internal
insurance arrangement in the illustration the transaction is not recognised (see
Para 1.127). The second looks at the sale for a lump sum payment of all the future
Illustration 1
The UK and Romanian subsidiaries are established with nominal equity capital of
£1/€1 respectively. They are both financed by Zeta Holdings Ltd by way of loans of
£1 million each at an interest rate of 6%. They have both incurred substantial losses
and have few assets.
In the UK, it is likely that transfer pricing rules would operate so as to deny a tax
deduction for the interest charged on the basis that taking into account all
factors, at arm’s length, Zeta (UK) Limited could not have borrowed £1 million
However, that is the full extent of the transfer pricing impact – the UK rules would
not then provide for the loans not to be recognised as share capital and the
interest payable to be substituted for a payment of dividends.
In Romania, the thin capitalisation rule of 3:1 debt:equity applies. Because this is
breached, a tax deduction will be denied to Zeta Romania SRL for the interest
charged. Moreover, the interest is classified as a dividend and withholding tax is
applied accordingly.
Factors to be Considered
The OECD TPG note, at paragraphs 1.38 and 1.122, that an independent
enterprise will compare a proposed transaction with the other “options realistically
available” to it. This is in the context of comparability analysis rather than non-
recognition, but if faced with an “irrational” controlled transaction it would appear
instructive to ask the question “Is there another option realistically available which
independent parties acting at arm’s length might have chosen?” If so, that option
may provide a means of substituting the actual transaction undertaken.
This concept is clearly not without difficulty. Practical issues include: How are the
options identified? What is “realistic”? When is that judgement to be made? The
OECD TPG do not seek to answer such questions. Paragraphs 9.27 to 9.31 of
Chapter IX of the OECD TPG do expand on the question; however the discussion
focuses on the fact that the question has to be looked at taking into account the
In the absence of objective tests, there is clearly scope for disagreement between
taxpayers and tax authorities and a risk that tax authorities will use hindsight to
argue that the taxpayer could at arm’s length have chosen a “clearly more
attractive” option.
Risk
When looking at the question of non-recognition the allocation of risk between the
parties of a transaction is important. You will recall from earlier chapters that the
allocation of risk is an important part of the functional analysis and that the
contractual allocation may not reflect the actual position. The OECD TPG pay
special attention to the allocation of risks, underlying the contractual terms as well
as the capabilities and responsibilities to manage those. Section D.1.2.1 sets out a
six step analytical framework for identifying risk and who has control over risk.
As we have seen in earlier chapters, in recent years a large number of MNEs have
embarked on complex value chain restructuring projects leading to the formation
of principal entities in lower tax jurisdictions, which are meant to take on the more
“non-routine” functions and the major business risks (e.g. stock, customer, product,
etc.) and therefore, attract a large portion of the group profits.
However, when centralisation also generates a tax advantage it is crucial for the
contractual arrangements to match the economic substance in each of the
parties.
For example, the common use of limited risk distributors or sales agents, which act
on behalf of a main super distributor, is often challenged by tax authorities. If
successful, the transaction as drawn up would not be recognised; instead it would
be replaced with a transaction between a local entity which is taking on more risk
and functions than the main distributor.
not just the pricing reflects the nature of the transaction (e.g. using net cost plus to
remunerate the R&D service provider), but also the risk and functional profile (e.g.
a clear direction on the R&D has to be provided, all losses that might arise from
unsuccessful launch or use of the IP should be covered by the paying enterprise
and not by the R&D service provider, etc.).
The existence of official documents (e.g. board papers) clearly showing the
commercial goal to be achieved when setting up a contractual arrangement
between related parties does not prevent challenges from tax authorities, but it
provides evidence that the reason for entering into the contract was driven by
commercial needs (e.g. cost reduction, market penetration, volume discounts,
etc.).
Paragraphs 9.34 to 9.38 in Chapter IX of the OECD TPG address the issue of non-
recognition from a business restructuring perspective. This confirms the following:
• The taxpayer has the freedom to decide whether and to what level they
perform the functions and take on the risks, and what resources they employ.
The entrepreneurial freedom of disposition also includes that the taxpayer can
freely decide if the functions are performed by the taxpayer themselves or by
another company within the group, are allocated to several companies or are
assigned to a subcontractor.
• Tax authorities do have the right to determine the tax consequences of the
structures put in place by MNE subject to their obligations under DTC; in
particular Article 9 of the OECD Model DTC and their domestic law.
• MNE groups implement business models that may be rarely, if ever, found at
arm’s length. That does not automatically make them irrational.
• The restructuring must make commercial sense for the individual members of
the MNE group, as well as the group as a whole.
Illustration 2
Pre-reorganisation
Post-reorganisation
Company A in
Country A: Head
Office
Transfer of
brand
↓
The MNE group headed by A manufactures and distributes branded goods. The
group derives most of its revenues and profitability from its valuable brand which is
owned by Company A and maintained and developed by 125 staff in Country A.
Company Z is formed in Country Z. The brand names are transferred from
Company A to Company Z in exchange for a lump sum. Thereafter, Company A is
remunerated on a cost plus basis by company Z (and Companies B and C) for the
services it performs, but the excess profits after remunerating companies A, B and
C for their “routine” functions now accrue to company Z.
• Company Z lacks substance: it has no staff to control risks associated with the
brand development. Those functions in fact continue to be performed in
Company A whose senior management team visit Company Z once a year to
formally validate strategic decisions already taken in Country A.
There is a disconnect between the legal ownership of the brand on one hand and
the economic substance and continuing beneficial ownership on the other hand.
A tax authority may well be expected to seek to set aside the brand transfer. In
practice, one would not expect a properly advised taxpayer to enter into a cross-
border reorganisation so blatantly lacking in substance. The correct delineation of
the transaction following a full investigation and the application of the principles
set down in Chapter 1 of the OECD TPG may lead to the conclusion that this
transaction is in substance a funding agreement between Company A and
Company Z.
There are only a limited number of cases in which national courts have agreed to
set aside for tax purposes contractual arrangements entered into between related
parties, or substitute different notional arrangements. That reflects the fact that
most national tax systems will, unless there is a huge variation between substance
and form, respect the actual transactions undertaken and instead challenge the
transfer pricing. Each proposed transaction nevertheless needs to be evaluated
against the landscape of the national tax systems of each of the associated
enterprises. Relevant developments in Canada and the US are considered below.
Canada
• How the OECD TPG are applied within the local legislation; and
The court case revolves around the fixing of the price paid by a Canadian
subsidiary (Glaxo Canada) of a pharmaceutical company to a related non-
resident company for ranitidine (the main ingredient used for manufacturing a
branded prescription drug).
Glaxo Canada was paying a price over five times higher to buy the ranitidine from
the Glaxo Group than it would have paid to buy the ranitidine from generic
manufacturers.
However, Glaxo Canada was also obliged to acquire the main ingredient for the
drug (i.e. ranitidine) from a Glaxo approved source (i.e. Adechsa S.A., (Swissco)
subsidiary of the GSK Group).
The price paid by the Canadian subsidiary for the active ingredient was
significantly higher than the price paid by Canadian generic manufacturers.
The CRA reassessed Glaxo Canada by increasing its income on the basis that the
amount it had paid Swissco for the purchase of ranitidine was “not reasonable in
the circumstances” within the meaning of the transfer pricing rules.
Glaxo Canada's position was that the price paid to Swissco was reasonable in the
circumstances when viewed in consideration with the License Agreement and its
business to sell Zantac.
Glaxo Canada appealed the CRA's reassessment to the Tax Court of Canada
(TCC), which affirmed the CRA's adjustment of the transfer price on the basis of
the prices generic drug companies were charged for ranitidine. The TCC
supported the CRA's position that, in determining the reasonableness of the
amount paid, the License Agreement was an irrelevant consideration because
“one must look at the transaction in issue and not the surrounding circumstances,
other transactions or other realities”.
Without the licensing agreement the Canadian subsidiaries would not have been
in a position to use the active ingredient patent and the Zantac trademark.
Therefore, the only way for Glaxo Canada to conduct business in Canada would
have been to enter the generic market where the cost of entry would have been
much higher.
The CRA's position was that the appropriate analysis is what is the arm's length
price for the active ingredient and any other circumstances should be
disregarded. According to the CRA, it is not important whether the buyer wanted
to acquire the ranitidine for the generic market or the premium brand market.
As far as the value proposition (from the branded product), a third party might
decide to acquire a product from a “well-known” manufacturer because it
guarantees better quality and/or it could be used as a way to better market the
product (e.g. computer manufacturers advertise the “Intel inside” to let potential
customers know their laptops/computers are built using premium hardware). The
choice might result in higher purchasing costs.
On the other hand, the Canadian entity already held an agreement with the UK
parent that allowed it to use its intangible property (already subject to a fee);
hence, the question is whether the fee includes the use of the IP in relation to other
products purchased from related parties.
The CRA viewed the transaction as a separate item and not in the context of the
larger picture. The lack of clear guidance in the legislation left room for
interpretation.
The Supreme Court of Canada has now upheld Glaxo Canada’s appeal that the
licence agreement must be taken into account in examining the purchase price
for ranitidine; the case has been remitted back to the TCC to determine pricing.
The Supreme Court decision was also interesting in holding that OECD TPG are not
binding.
This case shows how difficult and controversial the application of transfer pricing
principles can be. The taxpayer should carefully consider all the implications when
making decisions on contractual arrangements for intra-group purposes. When the
transactions are particularly complex (e.g. involving IP or where several related
parties are involved) or the figures associated with the transactions are large, it is
good practice to consider all the transfer pricing implications and how the
transactions might be viewed by the tax authorities in the relevant jurisdictions.
United States
US transfer pricing regulations permit the Internal Revenue Service to not recognise
transactions that lack economic substance to a form which more closely equates
to the economic substance. (Treasury Regulation s.1.482–1(d)(3)(ii)(B))
There are a number of leading cases where the IRS has failed to persuade the
Courts that non-recognition is appropriate. For example, in Eli Lilly v Commissioner
856 F.2d 855, a US corporation transferred patents and know-how to a Puerto Rica
manufacturing subsidiary. The IRS asserted that this transfer should be disregarded
on the basis that the US company could have retained the revenue streams from
the intellectual property transferred. That was rejected by the Tax Court and Court
of Appeals.
In a 1992 decision of the Tax Court, Kwiat v Commissioner 64 TCM (CCH) 327, a
purported lease with reciprocal put/call options was substituted for a secured
loan. This was not a transfer pricing case as such because the parties to the
transaction were not associated enterprises. However, it serves as a contextual
reminder of the need to consider all possible legal tools at the disposal of the tax
authority which might ultimately result in the disregard or non-recognition of a
transaction.
In the Kwiat case, the appellant taxpayers leased shelving equipment to another
party. There was a put option permitting the taxpayers to sell the equipment at a
projected profit to the taxpayers.
The Tax Court held that the rights and responsibilities of ownership of the shelving
had passed to the purported lessee: the lease was in substance a sale and the
taxpayer was denied tax depreciation in respect of the assets in question.
In June 2016 the US Tax Court ruled in favour of the taxpayer in Medtronic Inc. &
Consolidated Subsidiaries v. Commissioner (T.C. Memo. 2016-112).
The IRS contented that the royalties payable from a Puerto Rico affiliate to
Medtronic, Inc should be increased. by $US1.4 billion. The Tax Court rejected the
IRS's proposed transfer pricing method as arbitrary, capricious, and unreasonable.
The court instead accepted Medtronic’s use of the Comparable Uncontrolled
Transaction (CUT method) but made adjustments to take account of differences
between the licenses and the comparable transaction relied on by Medtronic.
The IRS argued that the Puerto Rico company was merely an assembler which only
had a minor role in design manufacturing and development. The court disagreed;
they found that the company in Puerto Rico was involved in every step of the
manufacturing process and that the functions it performed were critical to overall
profitability of the group. It was found that product quality was a critical factor. An
interesting point is that the court found that a license could add to the assets of
the licensee. The rights under the license can become an intangible asset for the
licensee.
CHAPTER 17
PERMANENT ESTABLISHMENTS
The concept of permanent establishments (PEs) are covered in this chapter. We will
consider:
– basic features – fixed place of business PEs, construction sites and dependent agency
PEs
– the application of the concept to specific activities such as offshore activities
– the auxiliary and preparatory activities exclusion
– the multilateral instrument
– case law
– double taxation
Understanding the rules relating to permanent establishments (PEs) has two steps
to it. The first step is to understand when a PE exists. The second step is to look at
how profits are attributed to that PE (this is done in conjunction with considering
the tax implications). We will look at the second step in the next chapter.
At the same time, if that person is carrying on business through the PE then tax may
be due in the state in which the PE is established as well as in the state of
residence (Article 7 OECD Model Treaty, see later chapter).
Therefore, on its own, without a business activity through it, a PE may not of itself
give rise to a tax liability.
In its simplest form a PE exists where a company is resident in one country (referred
to as the head office) but also has a business conducted from a fixed base in
another country (the branch). The income attributable to the other fixed base
usually attracts a tax liability in the second country. In many businesses the branch
will have its own management structure maintaining separate accounts. It will not
have a separate legal persona as it is just part of the company.
The fundamental rationale behind the PE concept is to allow, within certain limits,
the taxation of non-resident enterprises in respect of their activities (having regard
to assets used and risks assumed) in the source jurisdiction.
In its more complex form of deemed PE, it is a tax “fiction” enabling tax authorities
to impose corporate taxes on the deemed branch. A third type of PE is again a
tax “fiction” where there is a deemed branch providing services.
Paragraph 12 of the 2017 commentary to the OECD Model Treaty tells us that:
“Whilst no formal legal right to use a particular place is required for that place
to constitute a permanent establishment, the mere presence of an enterprise
at a particular location does not necessarily mean that that location is at the
disposal of that enterprise.”
The first example is that of a salesman who regularly visits a major customer to take
orders and meets the purchasing director in his office to do so. The commentary
states:
“In that case, the customer's premises are not at the disposal of the enterprise
for which the salesman is working and therefore do not constitute a fixed
place of business through which the business of that enterprise is carried on
(depending on the circumstances, however, paragraph 5 could apply to
deem a permanent establishment to exist).”
Dr. Juris Arvid Aage Skaar (academic and author of the seminal 1995 book
“Permanent Establishment: Erosion of a Tax Treaty Principle” Kluwer Law
International) makes the following comments in relation to this example:
“it is not convincing if the Commentary suggests that a salesman who visits
customers to take orders is an example of a person who is merely present in
the office of the purchasing director. Is the salesman's activity (taking orders
from the customer) not a business activity? The premises are factually used by
the salesman in connection with sales work, and this is the enterprise's core
business. This can hardly be considered to be “mere presence”. However, the
essence is that the OECD countries have agreed that a salesman's regular
and lasting use of the facilities of the customer in such a way shall not
constitute a PE.
The example shows that if the requirement of a legal right of use test for PE is
abandoned, a PE may be constituted on the basis of facts that the OECD
countries otherwise agree should be kept outside source-state taxation.
Because of this, it is necessary regarding the “examples” to explain situations
that will not be considered to be a PE anyway.”
“In that case, the employee is carrying on activities related to the business of
the former company and the office that is at disposal at the headquarters of
the other company will constitute a permanent establishment of his employer,
provided that the office is at his disposal for a sufficiently long period of time
so as to constitute a “fixed place of business” (see paragraphs 28 to 34) and
that the activities that are performed there go beyond the activities referred
to in paragraph 4 of the Article.”
“The use of examples by the 2003 OECD Commentary [which remain in the
2017 version] is confusing because no distinction between factual use and
implied legal right of use to a place of business is made. It is unclear to what
extent and under what circumstances factual use is sufficient for a PE to exist.”
The fact that a PE is a fixed place of business suggests that there is some
permanency and that there is a space of some kind taken up by the business. If it
is possible to demonstrate that there is temporary nature to an operation, it may
not be a PE. However, if the intent at the outset is one of permanence, then even
in circumstances of a sudden curtailing of the operation in unforeseen
circumstances (such as a death) then there is more likely to be a PE. Frequent use
of an office/premises for short bursts of time is suggestive of permanence.
Broadly, use of different premises in a locality may also constitute a PE. Even the
use of moveable (but substantially fixed and solid) premises may constitute a PE.
The latter is illustrated by the fact that a drilling rig used in the exploration of oil
may move from place to place and still be considered a PE.
Equipment leased to a lessee in a state should not create a PE of the lessor, even
where staff operate the equipment, provided that the staff are there to look after
the operation or maintenance of such equipment only, and they are under the
direction and control of the lessee (see paragraph 36 of the 2017 commentary).
Article 5(2) of the OECD Model Treaty tells us that the term PE includes:
• a place of management;
• a branch;
• an office;
• a factory;
• a workshop, and
• a mine, an oil or gas well, a quarry or any other place of extraction of natural
resources.
When it comes to construction sites under Article 5(3) there are a number of
practical questions that are raised, including whether different parts of a locality
can constitute different construction sites – these issues depend on facts and
circumstances such as whether there is a commercial and geographic coherence
to a project. The kind of sites and activity included for this purpose include that of
the installation or construction of buildings, roads, bridges, canals, pipelines,
excavating and dredging. Demolition and clearance of sites fall under this
category as well. Even assembling movable property may be included.
The final BEPS Report also considered certain concerns with regard to the
possibility of related parties splitting up contracts into several parts – each covering
a period of less than 12 months and attributed to a different company in the
group, in order to prevent the creation of a PE under this paragraph. It was
considered that the principal purpose test (PPT), suggested as part of the work
undertaken on Action Point 6 on preventing treaty abuse, would be sufficient to
deal with this type of problem. An example of how the operation of the PPT could
counteract such actions has now been included in the commentary on the use of
the PPT rule (see paragraph 182 to commentary on Article 29 Example J). Where
the PPT was not present in a particular treaty, an alternative specific rule will also
be included in the OECD commentary to Article 5(3) (see paragraph 52) which
could be used by a contracting state when drafting their treaties which applies
automatic aggregation under certain conditions.
Certain circumstances are deemed not to give rise to a PE (per the 2017 version)
(Article 5(4)):
e. the maintenance of a fixed place of business solely for the purpose of carrying
on, for the enterprise, any other activity; or
provided that such activity, or in the case of sub paragraph (f) the overall activity
of the fixed place of business is of a preparatory or auxiliary character.
The key element of Article 5(4) is the concept that activities which are preparatory
or auxiliary to the business in nature are not sufficient to create a PE.
Amendments have been made to this paragraph of Article 5, to ensure that these
exclusions are up to date with the modern business environment. A problem with
the previous version (2014 OECD Model Treaty) is that it did not deal sufficiently
with modern, sophisticated and highly integrated supply chains. The provision of
locally held stock, accessible to the customer at short notice, may in itself create
significant value for a business, and this should be taken into account.
The qualification added to Article 5(4) (as part of the 2017 update following the
BEPS report) such that each activity identified in the paragraph (eg. using facilities
for storage, or maintaining stock for the purposes of storage, display or delivery,
etc.), regarded alone or collectively, is itself limited to being preparatory or
auxiliary in character, or the overall activity of the fixed place of business is of a
preparatory or auxiliary nature, is there to combat the opportunities for abuse of
the exceptions.
At the heart of these changes is the desire to ensure that the profits from the core
activities performed in a country can be taxed in that country. When an enterprise
used a fixed place of business not only for the activities listed in paragraph 4, but
also for other activities which are not preparatory or auxiliary in nature, then the
exclusions listed in this paragraph will not apply and a PE will be created (the
profits of which, in respect of all its activities, will be attributable to such PE).
17.5 Agency PE
The ‘agency PE’ concept set down in Article 5(5) was updated in 2017 such that
an enterprise is treated as having a PE where a person habitually concludes
contracts on behalf of an enterprise, or where the intermediary “habitually plays
the principal role leading to the conclusion of contracts that are routinely
concluded without material modification” by the overseas company. In addition
the 2017 version includes the activity of an intermediary that results in contracts for
the transfer of ownership, or the granting of the right to use, property owned by
the non-resident enterprise, or for the provision of services by the non-resident.
As noted in the 2017 commentary, this means that an agency PE will now exist
where a non-resident company’s goods or services are being sold in a local
market by a sales entity that is doing all the work to secure the sales and establish
contractual terms, with the limited involvement of the non-resident – so even
where the contracts do not legally bind the enterprise to third parties. This covers
commissionaire arrangements where the commissionaire does not enter into
contracts with third parties that legally bind the non-resident, but the non-
resident’s property is nevertheless transferred to the third party. A key
consideration would then be whether the commissionaire had played a ‘principal
role’ leading to the conclusion of the contracts (see the updated commentary at
paragraph 94).
The 2017 commentary does note (at paragraph 96) that arrangements whereby a
person concludes contracts on their own behalf, and in order to fulfil this obligation
obtains the goods and services from the non-resident, does not create a PE. Thus
the actions of a local distributor, including a so-called “low-risk” distributor, should
not cause the creation of a PE of the non-resident enterprise, where title to the
property passes from the non-resident enterprise to the distributor and then to the
customer.
At this point it is worth having a brief look at how Article 5(5) was in the 2014 version
of the OECD Model Treaty as this will help you understand why Action Point 7 of
the BEPS report lead to the changes that resulted in the 2017 version.
In the 2014 version of the OECD Model Treaty, Article 5(5) stated that even if the
enterprise does not fall under paragraphs 1 and 2 there may still be a PE where:
The Norwegian court referred to the 2010 French Supreme Court case, Zimmer
(France V Zimmer Ltd CE 31/3/2010 304715). Under this case the French court had
held that “something additional” had to be present in the arrangement between
the commissionaire and the principal, beyond an ordinary commissionaire
agreement, for the principal to be bound legally towards a third party. This was
held to be the case in Zimmer regardless of the fact the commissionaire is
dependent on the principal. The discussion draft of amendments to the
commentary on Article 5 picks up on these issues, however the final BEPS report
also considered these problems and as noted above Article 5(5) of the OECD
Model Treaty has now been amended to try to deal with PE avoidance via
commissionaire structures.
Independent Agents
Article 5(6) states that an enterprise is not deemed to have a PE where it carries on
business in a state through an independent agent provided that such persons are
acting in the ordinary course of their business.
The commentary to Article 5 also notes that a person acting almost exclusively for
one enterprise or related enterprises over an extended period of time is unlikely to
fall within the definition of an independent agent (see paragraph 111 of the
commentary to Article 5).
Article 5(7) acknowledges that where one company in one state controls another
in the other state, the fact that there is control shall not of itself give rise to a PE in
either state.
Thus a parent company may have a PE in the state of a subsidiary, by virtue of the
fact that space owned by a subsidiary is at the disposal of the parent company
and is used by it to carry on part of its own business in that state. A subsidiary can
also act as a dependent agent (under Article 5(5)) of a parent company. Similarly,
the same comments can be made generally in relation to related companies in a
multinational group.
Paragraph 8 was added to Article 5 as part of the 2017 update to define a closely
related person (this term was used when we looked at Article 5(3) and Article 5(6)
above). The commentary to Article 5(8) notes that it is not the same concept as
associated enterprises that we will see in a later chapter when we look at Transfer
Pricing and Article 9, although it does state that there will be some overlap.
17.8 Services PE
As seen above, the 2017 (sometimes referred to as post BEPS) wording in respect of
the agency PE allows for the possibility of a PE being created where a person (the
agent) has been involved with regard to the arrangements/ contracts for the
provision of services by the non resident company. This type of PE would be an
agency PE, as it requires a person to act as agent/ play a principal role, with
regard to an agreement for the provision of services. This differs from the type of PE
envisaged below which can be created when a person (such as an employee) is
actually providing services in the other state – the provision of those services itself
being the nexus to create a taxable PE presence (regardless of where the
contract for such services was signed or negotiated).
The commentary since 2008 has provided an alternative services PE. This addition
does not amend the definition of a PE but allows states to include alternative
wording into the PE article. The example given at paragraph 144 in the 2017
commentary is as follows:
the activities carried on in that other State in performing these services shall be
deemed to be carried on through a permanent establishment of the
enterprise situated in that other State, unless these services are limited to those
mentioned in paragraph 4 which, if performed through a fixed place of
business, would not make this fixed place of business a permanent
establishment under the provisions of that paragraph. For the purposes of this
paragraph, services performed by an individual on behalf of one enterprise
shall not be considered to be performed by another enterprise through that
individual unless that other enterprise supervises, directs or controls the manner
in which these services are performed by the individual.”
The introduction of this alternative has given rise to much comment. The
alternative has been criticised for leading away from a consensus of opinion
approach. Some think that it will lead to conflicts with the definition of construction
sites which can also fall under services. There are existing treaties with such
provisions in them and some comment that the OECD could have drawn more
heavily from these. There is also of course the comparable provision in the UN
Model Treaty.
Of course, the articles in the OECD Model Treaty are not or will not always be
adopted in full in all international tax treaties and therefore when looking at
specific cases specific country treaties have to be examined together with any
specific country legislation and international tax cases.
The UN Model Treaty is designed to aid developing states to tax a larger part of
the overseas investor's income. In particular, the UN Model Treaty recognises
services PEs without a fixed base (discussed later).
The 2016 US Model Treaty in general reflects the OECD Model Treaty articles
relevant to PEs.
However, there are various national observations and reservations with regard to
the commentary. For example, a controversial Spanish case, the 2012 Dell case
(ruling of Mar.15.2012, Central Tax Court), reflected the reservation noted by Spain
in previous versions of the commentary. In line with Spain’s position on software
driven PEs, the Spanish court ruled that an Irish Company had a Spanish PE, as the
online store (the website through which Spanish sales were made) could qualify as
an ‘online PE’, even though the server was situated outside Spain. Whilst the server
was not located in Spain, and there were no employees of the Irish company in
Spain, the Spanish subsidiary company did employ people to translate the
website, review the contents and administer the site, which was considered a
factor. In addition, the Court noted the observations on the commentary made by
Spain in the 2003 and 2005 versions, which stated that Spain had a number of
reservations on the OECD approach.
The changes to the OECD Model Treaty as a result of Action Point 7 are to be
implemented for many countries under the multilateral instrument (MLI) (pursuant
to Action Point 15 of the BEPS Project). This puts into place the various changes
arising from the BEPS project on a multilateral basis, without the need for countries
to renegotiate all their existing double tax treaties. Supplementary guidance on
how to determine the profits to attribute to a PE was the subject of consultation at
the end of 2016, see a later chapter in this regard.
The provisions of Action Point 7, on PEs, are not considered a minimum standard.
Therefore under the MLI contracting states will have the flexibility to opt out of the
provisions entirely (or in part) and therefore out of the BEPS changes. This is
accomplished through the mechanism of reservations, which are specifically
defined for each article of the MLI. Part IV of the MLI contains the provisions with
regard to Action Point 7 and the artificial avoidance of PE status, in its Articles 12 to
15. Where changes are to be implemented to existing treaties, the parties need to
notify the depositary (the OECD acts in this capacity) of their tax agreements
which contain a relevant provision which will be subject to change.
The UK, for example, (when it signed the MLI in June 2017) has opted into the
provisions with regard to anti-fragmentation (with regard to preparatory and
auxiliary activities), however, it has not opted into the other provisions with regard
to changes to the definitions of a PE. There are reports and databases available
from the various accountancy firms which indicate which countries have opted
into/out of which BEPS provisions. In addition the OECD maintains a matrix on its
website of which provisions countries have opted into.
In addition to the case law analysed above, the issue of whether a PE exists or not
has, over the years, given rise to many disputes, which have been litigated. Some
notable cases are highlighted below. Although these cases pre-date the 2017
update they are still relevant.
In a further Spanish case, Roche Vitamins, January 2012 (STS 201/2012) the
subsidiary of a non-Spanish company was considered to be the overseas
company’s PE.
• In 1999 the group undertook a restructuring and the Spanish activity was
changed.
Roche Vitamins SA concluded two contracts with its related party Roche Vitamins
Europe Ltd, a Swiss company:
The Supreme Court also considered the general PE clause found at Article 5(1) of
the treaty and held that the Spanish Subsidiary (Roche Vitamins SA) constituted a
“fixed place of business” of Roche Vitamins Europe. The Supreme Court upheld the
position of the tax authorities in that the Subsidiary was held to constitute a fixed
place of business of the foreign related company on the basis that all the activity
of the Spanish company was directed, organised and managed by the Swiss
Company (Roche Vitamins Europe). Some commentators consider the decision in
this case to be controversial.
In a 2014 case before the Indian High Court, which result was confirmed by the
Supreme Court (2017) (Director of Income Tax v e-Funds IT Solutions) it was held
that an (indirect) Indian subsidiary of a US company was not a PE, notwithstanding
the close association between the US company and the Indian company, the
division of functions, the assets used and the risks assumed. The High Court held
that a consideration of these factors was not the appropriate test to determine
whether a PE was present. The Court considered the PE definition in the US-Indian
double tax convention and focused on the conditions necessary to fulfil these PE
tests. As the Indian Revenue was not able to prove the “right to use” test and
having space at “the disposal” of the company test were satisfied, no fixed PE was
found to exist. Similarly in the absence of any evidence that employees of the
Indian subsidiary were under the control or supervision of the US parent and
providing services on behalf of the US company, or that the Indian employees
were participating in negotiations with customers, no service PE or agency PE were
found to exist either.
The Supreme Court also noted that even though there was a mutual agreement
between the states that referred to PEs in India, this did not establish a binding
decision on the matter.
It is notable that the availability of information such as that found on social media
sites may have an impact. In GE Energy Parts Inc v ADIT (ITA No. 671/Del/2011) –
July 2014 - the ITAT (Indian tax tribunal) held that the LinkedIn profiles of the
employees of the GE group submitted by the tax authorities were admissible as
evidence in determining the existence of a PE in India. The tribunal's view was that
the LinkedIn profiles were not hearsay, but were akin to admissions made by a
person; and they had considerable bearing on the subject matter of this appeal.
However, the taxpayer is free to rebut the information contained in their LinkedIn
profile by bringing on record contrary facts to dislodge the claims made.
As noted by some commentators (see Tax Journal, ‘Analysis – the international tax
briefing’ - 29th August 2014) notwithstanding the stayed order, it is possible that the
tax authorities in India may continue to use social media platforms to collect
factual evidence for use in assessment/appellate proceedings, not only for
pending assessments, but potentially also to reopen completed assessments. The
case is very similar to Reuters' special report on Google's taxable presence in the
UK, published in 2013, with research that included 'CVs and endorsements on
networking website LinkedIn'. The case shows the importance for firms of ensuring
that anything in the public domain, including all the various social networking
websites such as Facebook, LinkedIn and Twitter, is properly reviewed and
accurate.
In a 2016 Swedish case, at the Kammarrätten i Göteborg, ref KRG 2276-15, the
Swedish Administrative Court of Appeal considered the issue of a physical PE. The
Court determined that a foreign company which regularly conducted business
from the same place in Sweden had a PE there. The case concerned a German
company that developed and sold software for tyre inflation pressure systems. The
company annually performed tests in winter conditions in Sweden, and the test
results were then used for software development in Germany. The annual testing
period ranged from three to four months, but the company was only on the
ground for a few weeks at a time.
The Court decided that the company regularly conducted business from the same
place in Sweden; and that the activities that it undertook, i.e. the testing, could
not be considered to be of a preparatory or auxiliary nature. Therefore, the
company was considered to have a fixed place of business in Sweden through
which part of the company's core business was conducted. Consequently, it was
determined that there was a PE in Sweden.
In the case AB LLC and BD Holdings LLC v SARS ([2015] ZATC 2 – judgment 15 May
2015) the South African Tax Court had to determine whether a US company,
providing strategic and financial advisory services for the South African airline
industry had created a PE in South Africa. The Court reviewed Article 5 of the US-
South Africa double tax treaty, (which differs from the OECD Model Treaty) in
particular the second paragraph of the article (para (5)(2)(k) in this case), which
“includes especially” as a PE “the furnishing of services including consultancy
services”.
It is notable the Court held that a PE had been created, on two counts. Firstly, on
the basis the US company employees had been in South Africa for over 183 days.
The Court considered that the wording of the second paragraph of Article 5 in the
treaty, which is preceded by the words ‘includes especially’, creates a standalone
definition of a PE by way of an extension to the first paragraph of the Article.
Secondly, it found there was in any event a fixed place of business created by the
use of the boardroom (it had exclusive use during relevant working hours). The US
company was liable for tax on the profits attributable to the services rendered. In
addition the Court held that the penalties imposed by the tax authorities (100% of
the tax) were not disproportionately punitive and that the US company had been
negligent in not considering the tax consequences of the agreement it had
entered into. The company had argued that it did not deliberately ignore South
African law, but just misunderstood it. Interestingly the Court commented that the
enterprise had a global reach and that it was “not a novice in the area of tax
liability”, and therefore should accept responsibility for its own error.
A central issue in the appeal was whether the use of facilities for storage, display or
delivery in para (a) of the Article also needed to be 'preparatory or auxiliary'. This
was a matter of some discussion, and the Japanese court concluded that the
activities must be preparatory or auxiliary for the exemption to apply. There is a
contrary view that paras (a) to (d) are 'per se' preparatory and auxiliary, and that
only paras (e) and (f) require activities to be preparatory or auxiliary. The Court
also commented on the role of the OECD Commentaries, and of the 2012 OECD
Discussion Draft on Permanent Establishments in this context. In addition the Court
discussed whether it was significant that Japanese-language manuals were
inserted in the products at the locations in Japan, and that the address of the
premises was listed on the website of the US business.
Another case of note relates to the collection of information and whether it is core
to the business, or merely preparatory and auxiliary. In the French Conseil d’Etat
case of Al Hayat Publishing Co Ltd (28 May 2014, No 360890) the court considered
the application of Article 5(4) in the France-UK treaty. Al Hayat UK publishes the
Arabic language daily, Dar Al Hayat. Its Paris bureau researches French current
affairs and writes articles for publication in the newspaper. The court held that the
bureau's activities were not core to Al Hayat's business and so did not constitute a
taxable PE in France. The core activity of the business was the editing and
commercialisation of the business, rather than the writing of articles. The bureau's
activities were confined to the collection of news and its transmission to the UK
head office. The decision is in line with para 22 of the OECD commentary on
Article 5.
The case related to the UK company holding the commercial rights to stage, host
and promote the Indian Grand Prix in 2011 through to 2013 at a location owned by
an Indian company. The existence of a PE was upheld as the Court found that the
racing circuit constituted a fixed place from which a business/economic activity
was conducted. In addition the various agreements between the Indian company
and the UK company (together with its affiliates) could not be looked at in
isolation. In the Court's view, the facts pointed to the conclusion that the UK
company had made its earnings in India through the racing circuit over which it
had complete control during the event. The duration of the event and the number
of days for which the UK company's personnel had access to the circuit would not
make any difference.
In this case, a Scandinavian sales manager was required under the terms of his
contract to work from home in Denmark. Although he spent the majority of his
employment duties travelling and visiting clients, the Danish tax board ruled that
the manager’s use of a home office for administrative work (for which he was not
reimbursed) constituted a PE of his German employer. It was held to be irrelevant
whether the home office was owned or rented or in any other way made
available to the foreign corporation. As long as the business of the non-resident
entity was carried out effectively and habitually (and these activities were not
preparatory), then a PE was in existence. It was also emphasised that there must
be recurring work from the home office not just sporadic or occasional. The Danish
tax board determined that the administrative work was directly related to the
main business of the company and could not be said to be non-core or
preparatory.
In the April 2014 case of Centrica India Offshore Ovt Ltd v CIT [WP(C) No.
6807/2012] heard at the Delhi High Court, employees seconded to India from
group companies in the UK and Canada were deemed to constitute PEs of those
companies in India.
The decision arose because of the way the secondments themselves were
structured. The court distinguished between the concepts of economic employer
and legal employer. It also referred to the OECD commentary which says that the
foreign company will not constitute a service PE if the seconded employees work
exclusively for the Indian enterprise and are released for the period in question by
the foreign enterprise — that was not the case here. The court further observed
that there was no purported employment relationship between the Indian
company and the secondees and, notably, that the company had no right to
terminate the employment contract and the employees had no right to sue the
company for non-payment of salary.
This case highlights the need to ensure that secondment arrangements are very
carefully managed to avoid the risk of PE exposure when employees are
seconded to India, but could also have wider implications.
It is important that you are familiar with the commentary to Article 5 as this is an
important area of the syllabus.
Prior to BEPS, the OECD had launched a consultation (in November 2011) with
regard to updating the commentary on Article 5. In October 2012 the OECD issued
a revised discussion draft based on the results of the consultation, with a working
party meeting in February 2013 to further consider the latest draft. The OECD
Model Treaty and commentary were updated in 2014 but the proposed changes
to the PE article were not included.
As noted above, changes to the PE article per the final BEPS report have been
implemented through the MLI and in the 2017 update to the OECD Model Treaty –
and thus some of the proposals outlined below (per the 2012 discussion draft) have
been covered. However, the 2012 proposals discussed some 25 issues, and so
certain issues have not been dealt with.
Some of the key areas highlighted in the 2012 discussion draft proposed
amendments to the commentary in the following areas: the meaning of the
phrase “at disposal of” with regard to a physical presence; amendments to clarify
the meaning/use of a home office, with a focus on the employer's ‘right to use’
the premises; amendments to introduce exceptions to the general practice of
taking 6 months as a signifier of permanency, in particular with regard to activities
of a ‘recurrent nature’; further clarification of the position of secondees in the host
country; the creation of a deemed PE where a main contractor uses a
subcontractor in the host state (time spent by such subcontractor counts towards
the 12 months); non-inclusion of time spent on ‘snagging’ and other repairs in the
guarantee period; and, clarification of the meaning of “to conclude contracts in
name of the enterprise” with regard to agency and commissionaire arrangements.
The update to the 2017 OECD Model Treaty has been discussed above, and
clearly addresses some of these issues where a state opts in. However, only
amendments to Article 5(4), (5) and (6) have been made. Whilst this does deal
with the problems surrounding commissionaire arrangements, the preparatory or
auxiliary exemption, and some construction site issues, many of the other matters
raised in 2012 remain. It is unclear whether we will see any additional changes so
soon after the 2017 update, however, further amendments at some point in the
future are possible.
Finally, double taxation relief is a connected issue that arises from a company
having a PE. In most of the examples the companies would incur double taxation
in country 1 and 2. Therefore the OECD Model Treaty under Article 23 grants
double taxation relief i.e. either the amount of tax paid in country where the PE is
situated to be offset against the tax payable in the country of residence of the
legal entity or the income is exempted in country of residence of the legal entity.
Of course if the company is located in a tax haven then there is the potential of
double taxation as this relief is rarely available. We will look at double taxation in
more detail later in the manual.
CHAPTER 18
18.1 Introduction
Having established the existence of a PE the second and probably more difficult
issue is how to attribute profits to the PE.
Again the starting point of the analysis is OECD Model Double Tax Convention
(DTC). The OECD Model DTC determines in several of the articles the countries
rights to tax income dependent on residence or source. The two articles that are
most directly relevant to transfer pricing are Articles 9 and 7.
In these articles the OECD Model DTC distinguishes between the attribution of
profits to a PE and transfer pricing between separate entities by including different
articles for each of these situations:
How to attribute profits to a PE has been an issue that has been looked at as far
back as 1977. Yet still the methodologies used by both OECD and non-OECD
member countries in attributing profits to PEs have varied considerably. Some tax
authorities have attributed profits to PEs on a global formulary or profit split
approach, regardless of the functional, asset and risk profiles of the PEs.
The OECD rejects the force of attraction principle (see below). The two
approaches that have been used are referred to as the functionally separate
approach and relevant business approach. The ‘relevant business approach’
interpretation refers only to profits of the business activity in which the PE
participated.
Under the relevant business approach the profits of the PE are limited to the profits
earned by the company. If the company is in a loss position then the PE must be in
a proportionate loss position. In the functionally separate approach it is possible for
a PE to be profitable when the company is loss making.
The OECD have rejected the relevant business approach. The current Article 7 of
the OECD Model DTC embodies the functionally separate approach which is
discussed in detail below.
The first overriding principle of double taxation treaties is that a company resident
in one country will not be taxed on its business income in the other State unless it
carries on that business in the other country through a PE situated in that country.
The second principle is that the taxation right of the State where the PE is situated
does not extend to income that is not attributable to the PE.
The interpretation of these principles has differed from country to country. Some
countries have pursued a principle of general force of attraction, which means
that all income such as other business profits, dividends, interest and royalties
arising from sources in their territory was fully taxable in that country if the
beneficiary had a PE there, even though such income was clearly not attributable
to that PE. The approach has been rejected by the OECD.
The AOA sets out in detail the principles that the OECD concluded should be used
when attributing profits to PEs together with detailed guidance as to how to apply
those principles in practice. The document itself is over 200 pages. It is split into four
sections:
• General application;
“the profits to be attributed to a PE are the profits that the PE would have
earned at arm's length, in particular in its dealings with other parts of the
enterprise, if it were a separate and independent enterprise engaged in the
same or similar activities under the same or similar conditions, taking into
account the functions performed, assets used and risks assumed by the
enterprise through the permanent establishment and through the other parts
of the enterprise”.
Of course this is only a model convention and the 2010 updates to Article 7 in the
OECD Model DTC (which remain unchanged following the 2017 update) have not
yet been implemented into all specific country treaties. Therefore specific country
treaties or local tax legislation may also deal differently with profit attribution issues.
It may also be possible that countries do not accept the revision to Article 7. The
current Article 7 is considered in greater detail below.
There is also the ancillary point as to whether the commentary contained in the
latest OECD Model DTC can be applied to interpret previous OECD Model DTC.
Article 31 (3) (b) of the Vienna Convention on the Law of Treaties 1969 states that
“Subsequent practice is not only considered to the extent it reflects the parties'
intention upon conclusion of a treaty. Separate from the original intentions of the
parties, their current understanding of the treaty, as established through
subsequent practice, is held to be relevant” e.g. through agreement to revised
commentary in the Model Taxation Convention. However the relevance of the
Vienna Convention is limited and what is more important is local practice and
local court decisions.
The OECD states that amendments to the Articles of the OECD Model DTC and
changes to the commentaries that are a direct result of these amendments are
not relevant to the interpretation or application of previously concluded
conventions where the provisions of those conventions are different in substance
from the amended Articles.
However the OECD adds that other changes or additions to the commentaries are
normally applicable to the interpretation and application of conventions
concluded before their adoption, because they reflect the consensus of the
OECD member countries as to the proper interpretation of existing provisions and
their application to specific situations.
As outlined above Article 7 of the OECD Model DTC was revised in 2010 (with no
further update in 2017) to reflect certain proposals contained in the AOA. The
basic rule of Article 7 on profit allocation is that it follows the arm's length principle
contained in Article 9 and that a direct method approach should be used in profit
allocation i.e. the PE would be treated as a “fictional” separate entity.
The former Article 7 (discussed later in the chapter) recognised that countries can
use an apportionment of total profits. This has meant that taxpayers have had
double taxation problems as one country’s methodology may not match that of
another country. To alleviate this problem the OECD considered this and issued the
AOA and the current Article 7. The current Article 7 is reproduced below:
Article 7
2. For the purposes of this Article and Article [23A] [23B], the profits that are
attributable in each contracting State to the permanent establishment
referred to in paragraph 1 are the profits it might be expected to make, in
particular in its dealings with other parts of the enterprise, if it were a separate
and independent enterprise engaged in the same or similar activities under
the same or similar conditions, taking into account the functions performed,
assets used and risks assumed by the enterprise through the permanent
establishment and through the other parts of the enterprise.
The PE is treated as a separate enterprise that will deal at “arm’s length” (as
defined in Article 9 of the OECD Model DTC). This means that the PE can be
loss making and the enterprise can be profitable or alternatively the PE can be
profitable and the whole enterprise is loss making.
The separate and independent enterprise concept does not extend to Article
11 of the OECD Model DTC as this does not apply to a payment within a
company. (Article 11 is the Interest article within the OECD Model DTC and
determines the taxation rights of states on interest payments). Nevertheless if
there is an actual interest payment from a PE (and borne by the PE) it can be
taxed under paragraph 2 Article 11 by the PE host country.
The profits determined under paragraph 2 are taxed according to the laws of
the taxing state. Paragraph 2 does not cover deductibility or method of
calculation of taxable profits. Normally this is determined by local law subject
to paragraph 3 of Article 24 of the Model DTC (Non-discrimination article) i.e.
the principle is that PEs should have the same rights as resident enterprises to
deduct the trading expenses from taxable profits.
Article 7 of the OECD Model DTC deals with deductibility although as always
there has to be a check against the domestic law and specific treaties.
One of the differences between the current Article 7 and the former version is
to remove from the article the right of the PE to deduct “executive and
general administrative expenses” even if not incurred in the country where the
PE is established.
The rationale for this change was that it was considered that the former Article
limited the deduction for expenses to the actual amount rather than the arm’s
length amount. In respect of general and administrative expenses this limited
the expenses charged to the cost of those services.
The commentary to the both the current and former Article 7 goes on to say
(paragraph 30 on Article 7) that although paragraphs 2 and 3 determine the
amount of profit or loss they do not deal with the deductibility of those
expenses in the corporate tax return. This is determined by domestic tax law,
subject to Article 24 paragraphs 3 and 4 (Non-discrimination).
The commentary (paragraph 40) on Article 24 states that PEs must be given
the same right as resident companies to deduct trading expenses from
taxable profits. These deductions should be allowed without any restrictions
other than those also imposed on resident companies. The requirement is the
same regardless of how the expenses are incurred i.e. directly incurred (e.g.
salaries) or attributed (e.g. overhead expenses related to administrative
functions performed by the head office for the benefit of the PE).
4. Where profits include items of income which are dealt with separately in other
Articles of this Convention, then the provisions of those Articles shall not be
affected by the provisions of this Article.
• Where other activities are undertaken by the PE, profits can be attributed to a
purchasing function. (paragraph 5 of former Article 7 removed)
• The removal from the article of the right of the PE to deduct “executive and
general administrative expenses” even if not incurred in the country where the
PE is established.
When we are looking at the current Article 7 and its related commentary we must
read them together with the AOA as the OECD states in paragraph 7 of the
commentary to Article 7 that “the report represents internationally agreed
principles and to the extent that it does not conflict with this commentary provides
guidelines for the application of the arm’s length principle incorporated in the
article”.
The key principle arising from the report is that a PE is treated as “a legally distinct
and separate enterprise”. The profits attributable to the branch are the profits it
would have earned if it was trading at arm’s length as a separate legal entity.
Remember that the AOA sets a limit on the amount of attributable profit that can
be taxed in the host country of the PE. It is not intended to set the methodology for
the domestic taxation of the PE. In addition the object of the AOA is not to tax a
PE and subsidiaries in an identical way. It is recognised that legal form can have
economic effects that can be taxed differently e.g. a PE is often used in some
sectors (banking and insurance) for efficient capital utilisation.
The OECD has recommended a two-step approach to the transfer pricing process
for both deemed and fixed PEs (Appendix B-5 paragraph 47 of the AOA).
There are some differences between the attribution of profits to a fixed PE and the
attribution to a dependent agent PE which are discussed below.
Step One
The OECD TPG on functional analysis are applied to the analysis of the PE. The key
issues are to determine assets used and risks assumed. One key issue that has to be
borne in mind is that there can be no valid legal contracts to analyse, as a PE
cannot contract with its head office.
Transactions between the PE and its head office are referred to as “dealings”. A
great deal of scrutiny is required before a dealing is accepted as equivalent to a
transaction that would have taken place between independent enterprises
acting at arm’s length. Thus only once a threshold has been passed can a dealing
be reflected in the attribution of profits. This requires a great deal of functional and
factual analysis to establish that a real and identifiable event has occurred.
• Normally all parts of the company have the same creditworthiness. Any
dealings between a PE and the rest of the company are based on the same
creditworthiness;
The OECD has introduced the concept of significant people functions i.e. the
entity’s transfer pricing profile is determined by the location of significant people
functions (and for financial entities key entrepreneurial risk takers). Therefore the
risk analysis has to be based on a factual analysis of the functions performed by
staff of the PE and head office.
In line with the OECD TPG, the AOA observes that the division of risks will have to
be “deduced from their [the parties?] conduct and the economic principles that
generally govern relationships between independent enterprises”. It is suggested
that internal compensation arrangements can be used for guidance.
It follows that risk will determine the amount of capital that needs to be attributed
to a PE i.e. the greater the risk the more capital is required. This is especially the
case for the development of intangibles where free capital has to be available to
support the risk assumed e.g. pharmaceutical research as a principal. This capital
requirement is also very relevant for financial enterprises where the assumption of
risk drives the demand for capital.
This means that a PE can be treated as the economic owner or lessor of tangible
assets. A PE can also be the economic owner of developed intangible assets. This
ownership can be established by identifying significant people functions where
they are making decisions often relating to risk management and portfolio analysis
relating to the intangibles being developed. The key factor is whether the PE
undertakes the active decision-making with regard to the taking on and active
management of the risks related to the creation of the new intangible.
For marketing intangibles similar considerations apply. The role of the significant
people has to be examined e.g. control over branding strategies, trademark
protection decisions and maintenance of intangibles. However where intangibles
are developed over a period of time ownership is often difficult to establish.
The specifics items that have to be covered in the analysis are detailed in the
bullet points below:
• The attribution to the PE, as appropriate, of the rights and obligations arising
out of transactions between the enterprise of which the PE is a part and
separate enterprises.
Integral to the functional and factual analysis is an analysis of all the assets
and obligations of the total company. This analysis is linked to establishing
what assets are used and what risks are assumed by the PE.
The analysis has to establish a link between the significant people functions
and the economic ownership of assets. As already discussed the analysis will
look at the decision making on ownership and on-going management of
assets.
Allocation of risk will be based on finding the significant people functions who
accept the risk and then manage that risk e.g. stock risk will be linked to the
person making decisions on stock levels. Credit risk will be linked to the
significant people functions making a sale and who are also responsible for
creditworthiness.
The analysis examines the functions performed by the staff of the whole
company and then links to the significance those functions have in generating
profits. People functions can range from support or ancillary functions (routine
functions) to significant functions linked to the economic ownership of assets
and/or the assumption of risk.
The analysis has to identify dealings between the PE and its head office.
• The attribution of capital based on the assets and risks attributed to the PE.
The initial assumption is that under the arm's length principle a PE should have
sufficient capital to support the functions it undertakes, the assets it
economically owns and the risks it assumes.
In the financial sector there are minimum levels of regulatory capital needed
to cover business risk and financial loss. In non-financial sectors capital
provides a reserve to cover risk e.g. research failure.
Step Two
The second step is the pricing on an arm's length basis of recognised dealings
through:
• Application of one of the OECD TPG traditional transaction methods or, where
such methods cannot be applied reliably, one of the transactional profit
methods to arrive at an arm's length compensation for the dealings between
the PE and the rest of the enterprise.
Step 2 applies the five comparability factors contained in the OECD TPG.
However, as there can be no legal contract or actual transactions between the PE
and the head office (HO), the functional analysis and contractual terms cannot
be applied directly to the analysis.
As noted above in March 2018 the OECD released additional guidance on the
AOA. The additional guidance is very much high-level and is focussed on two
particular aspects of the amendment to Article 5 (stemming from Action Point 7 of
the BEPS project) in the 2017 update to the OECD Model DTC.
The additional guidance looks at the application of the AOA where paragraph 4.1
of Article 5 (anti-fragmentation – see earlier chapter) has been applied and the
changes to Paragraph 5 of Article 5 (dependent Agent PEs “DAPE”).
The additional guidance recognises that not all tax treaties use the current Article
7 and that not all jurisdictions have adopted the AOA. However it then goes on to
analyse four examples using the AOA without any comment on how an alternative
approach may be taken to each.
The additional guidance does state that the principle from Article 7 — that the
profits attributable to a PE are those that the PE would have derived if it were a
separate and independent enterprise engaged in the same or similar activities
under the same or similar conditions — applies regardless of whether a tax
administration adopts the AOA.
The additional guidance went through several drafts before it was finalised. One of
the issues that was raised was the priority between the Article 9 analysis for a DAPE
(to deal with the transaction with the subsidiary as an intermediary) and Article 7
(for dealings with the DAPE). The conclusion reached is that the order of the
analysis should not result in an overall difference in the profit allocation. The
additional guidance goes on to state that risk analysis under the Article 9
approach as set down in Chapter 1 of the OECD TPG (see earlier chapter) and the
allocation of significant people functions (see above) are not aligned and that
care must be taken to ensure that the same risk is not allocated twice as this would
led to double taxation. Unfortunately, the additional guidance does not go further
on this topic and explain the areas of non-alignment.
The additional guidance does state that the profits attributable to the PE may be
positive, nil or negative and that in some cases they will be minimal or zero.
The remaining three examples all deal with DAPE. Two are sales and marketing,
one is procurement. They also show how the two step AOA approach is applied
with the dealing being priced based on the payment a third party would require
for the service. In all three of these examples it is assumed that the amount paid to
the subsidiary under Article 9 is arm’s length. This amount is deducted from the
profit attributed to the PE to ensure it is not double counted. The lack of detail on
pricing and expenses that can be deducted together with the fact that they all
assume clear segregation of activities has resulted in criticism of the additional
guidance.
Firstly, the functional analysis is used to determine the pricing methodology. This is
done by selecting the functional profiles that will be linked to the pricing
methodology. This will be determined in most cases by the location of the
significant people functions.
By analogy with the principles in the OECD TPG it is necessary to determine the
least complex part of the organisation (PE or HO) in order to test for compliance
with the arm's length principle.
This is done by using the information obtained from the results of the functional
analysis. The tested entity is usually the entity where the pricing method can be
applied to give a reliable result and where comparable data can be located.
Normally this is the least complex entity (see paragraph 2.59).
So what is the least complex entity? It is the entity generally performing the routine
functions, owning limited intangible assets and incurring the least risks. This can
either be the PE or the HO.
Of course entities exist that do not completely fall directly into these categories as
they may be performing multi-functions and more than one pricing method has to
be applied.
As noted in the earlier chapter, the functional analysis provides the information
required for performing the comparability studies (also referred to as economic
analysis or benchmarking) i.e. the information obtained from the functional
analysis will be used to select comparables using the available comparability
factors contained in the OECD TPG (which we have looked at in earlier chapters).
The first is the dependent company operating in its own right and secondly that
company acting as the dependent agent PE. For transactions with the dependent
company and the non-resident company, Article 9 of the OECD Model DTC will
apply i.e. the arm’s length principle. An example of the type of income would be
a commission paid by the non-resident to the dependent company.
Where the dependent company is acting as the dependent agent, Article 7 will
be the relevant article to apply. Profits are attributable to dependent agent PEs
following the same principles as used in attributing profits to other types of PEs. A
functional and factual analysis needs to be undertaken; this will have two
elements to it as it will cover both the functions undertaken by the dependent
company firstly on its own account and then in its role as a dependent agent of
the non-resident enterprise.
The dependent company will be rewarded for the services it provides to the non-
resident enterprise with reference to its own assets and risk. In addition, it will be
rewarded in its role as the dependent agent PE; to achieve this it will be attributed
with the assets and risks of the non-resident company relating to the functions
performed by it in its role as a dependent agent on behalf of the non-resident. It
will also be allocated sufficient capital to support those assets and risks, allowing
profit to be attributed to it for undertaking this role as a dependent agent PE.
Key here is the functional analysis which determines the significant people
functions performed by the dependent company in its role as dependent agent
PE for the non-resident company. If it does not perform any significant people
functions in this role then it will not be possible to attribute assets, functions and risk.
In this case, even though the dependent company is acting as a dependent
agent PE, it is unlikely that any profit can be attributed to it in this role.
The AOA considers that acting as a sales agent may well be unlikely to represent
the significant people functions leading to the development of a marketing or
trade intangible so that the dependent agent PE element of the dependent
company would generally not be attributed profit as the economic owner of that
intangible.
When looking at the profits attributable to the dependent agent PE, any arm's
length profits earned by the dependent company have to be deducted from the
profits attributable to the dependent agent PE functions that it performs. In many
cases it is possible that no additional profits are left as attributable to it as a
dependent agent PE.
Although Article 7 was updated in 2010, the former Article 7 will still be applied in
existing treaties and the current article will only be introduced as treaties are
renegotiated. In fact as can be seen in the commentary to the OECD Model DTC,
several countries were opposed to the changes to the article. Therefore it is
possible that the former Article 7 will continue to operate in many treaties.
As it is still relevant the former Article 7 of the OECD Model DTC is reproduced
below:
Article 7
Business Profits
7. Where profits include items of income which are dealt with separately in other
Articles of this Convention, then the provisions of those Articles shall not be
affected by the provisions of this Article.
The OECD issued a final report on Treaty rules and E-commerce (available on the
OECD website). The main conclusions reached by the OECD that are relevant to
PEs are as follows:
• web site hosting arrangements typically do not result in a PE for the enterprise
that carries on business through the hosted web site;
Another issue is whether the profits of a PE can be higher than the profits of the
enterprise as a whole. This is a question of interpretation of Article 7. Paragraph 1
talks about the attribution of profits as we saw above.
Therefore the view is that paragraph 1 does not restrict the amount of profits that
can be attributed to a PE to the amount of profits of the enterprise as a whole.
(OECD Model Treaty 2010 commentary Paragraph 17).
Therefore how far can the principle of attraction of profits to “significant people
functions” be applied to the interpretation of Article 9 i.e. the primary transfer
pricing article of the OECD Model DTC?
CHAPTER 19
19.1 Introduction
The layout of the UN Model Double Tax Convention (DTC) is very similar to the
OECD Model DTC. Permanent Establishments (PEs) are defined in Article 5 and the
allocation of business profits to PEs is dealt with in Article 7.
19.2 Definition of a PE
If you have a copy of the permitted text Kees van Raad Materials on International,
TP and EU Tax law, you will see that there is a copy of the UN Model DTC in there.
Article 5 looks very similar to Article 5 in the OECD Model DTC although there are
some differences.
You will recall from an earlier chapter that the OECD Model DTC includes an
option to insert a paragraph relating to services in the commentary.
In the 2017 update to the UN Model DTC, paragraph 4 has been aligned with the
OECD Model DTC Article 5 paragraph 4 and anti-fragmentation provisions
identical to those in the OECD Model DTC have been added as paragraph 4.1.
In summary, we can say that the definition of a PE in the UN Model DTC is wider in
scope than the OECD Model DTC. This remains the case following amendments to
both Model DTCs in 2017 as a result of the final report on Action Point 7 of the BEPS
Action Plan as noted in the previous chapter, although the gap is narrowing.
We see a greater divergence between the two models when we look at Article 7.
Paragraph 2 is the same as paragraph 2 of the 2008 OECD Model DTC; that is to
say it includes the distinct and separate enterprise approach. The commentary to
the UN Model DTC stresses the importance of the arm’s length approach and
states that normally the starting point will be the records kept by the enterprise of
the amounts paid.
As in the case of the OECD Model DTC, the rules on deductions are for the
purposes of establishing the profits attributable to the PE. They do not impact on
domestic law which will have the final say on which deductions are allowed for tax
purposes.
With regard to royalties, the commentary refers to the inherent difficulty of trying to
allocate ownership of IP when there is only one legal entity.
In the case of services, a distinction is drawn between the situation where services
are provided by an entity where this is its main business and services that are just
part of the general administration of a business. A profit is only appropriate in the
first case with the proviso that a benefit is also received by the recipient.
The rules relating to the deduction of interest often cause debate. It is noted that
at paragraph 41 the commentary states:
• From the legal standpoint, the transfer of capital against payment of interest
and an undertaking to repay in full at the due date is really a formal act
incompatible with the true legal nature of a permanent establishment.
• From the economic standpoint, internal debts and receivables may prove to
be nonexistent, since if an enterprise is solely or predominantly equity funded it
ought not to be allowed to deduct interest charges that it has manifestly not
had to pay. Whilst, admittedly, symmetrical charges and returns will not distort
the enterprise’s overall profits, partial results may well be arbitrarily changed.
Paragraph 4 & 5 mirror the 2008 OECD Model DTC allowing apportionment of
profits in some cases and requiring consistency in treatment year by year.
The final paragraph mirrors paragraph 4 in the current Article 7 giving priority to
other articles.
In summary we can say that the UN Article 7 is the “former” OECD Article 7; that is
to say the 2008 version plus some extensions.
CHAPTER 20
COMPLIANCE ISSUES
20.1 Introduction
• Maintenance of primary documents and records, including (but not limited to)
accounting records, invoices, and intercompany agreements;
• Disclosures to be made to the tax authority at the time of filing the tax return;
Whereas the first two tend to be factual or quantitative information, the third
aspect tends to be more qualitative in nature. It is analysis that provides the
evidence upon which taxpayers rely to demonstrate the arm's length nature of
their pricing, and is referred to as transfer pricing documentation. In terms of
resources used and cost to the taxpayer, transfer pricing documentation tends to
be by far the most significant aspect of transfer pricing compliance.
It is worth considering the role of documentation for both the taxpayer and the tax
authority. It is generally the objective of tax authorities to ensure that taxpayers
pay appropriate taxes based upon the application of the arm's length principle. In
the absence of documentation, tax authorities would have only limited
information on which to evaluate transfer prices.
They would have access to statutory accounts, tax returns and publicly available
information, but none of these are sufficient to undertake anything but a high level
assessment of whether transfer prices are arm's length. From the perspective of the
tax authority therefore, the objective of documentation is typically not to provide
an exhaustive assessment of all aspects of transfer prices, but rather to allow them
to be able to assess whether or not to pursue a transfer pricing enquiry.
Furthermore, if a tax authority does start a transfer pricing audit, documentation
allows them to be a lot more focused on the issues with the highest risk. Thus, for
tax authorities, documentation is a crucial part of the process in allowing them
optimal use of their resources in the policing of transfer pricing.
Documentation provides a platform for the taxpayer to present its case. Clearly
any analysis needs to be factually accurate and economically sound.
There are two key reference points for taxpayers when considering transfer pricing
compliance. Clearly, local country legislation, regulation and tax authority
guidance are crucially important. However, in many cases, such guidance is built
(either explicitly or implicitly) upon the principles set out in the OECD TPG.
Therefore, it is important to consider in the first instance what the OECD TPG have
to say about compliance and documentation.
The BEPS Action Plan released in July 2013 contained proposals relating to
documentation.
Thus it was proposed that there should be a common template for documentation
going forward.
1. A master file, containing specific information relevant for all MNE group
members. The master file is intended to provide a complete picture of the
MNE’s global operations.
The OECD believes that use of the three-tier approach that requires MNEs to
prepare a CbC of the master file and the local file will result in MNEs articulating
consistent transfer pricing positions. This will provide the tax authorities with useful
information to assess transfer pricing risk and to make decisions about where
resources can best be used to commence and carry out audits. This will allow the
tax authorities to be able identify more easily when MNEs are using transfer pricing
and other methods to artificially move substantial amounts of income to low tax
environments.
The master file is intended to provide a high-level overview in order to place the
MNE group’s transfer pricing practices in their global economic, legal, financial
and tax context. It is not intended to require exhaustive listings of minutiae (see
paragraph 5.18). The information will be organised into 5 categories:
1. Organisational chart;
2. Business description - this will include profit drivers, supply chains, main
geographic markets, a functional analysis and any important business
restructures;
The local file will provide more detailed information relating to MNE group
members’ specific intercompany transactions. This local file is required to contain:
• Local entity financial information, including local entity financial accounts for
the financial year; information on allocation schedules showing how financial
information used in applying the transfer pricing method can be tied to the
financial statements and summary schedules of data for comparability and
the source of trial data.
Paragraph 5.22 states that where a requirement of the local file can be fully
satisfied by a specific cross-reference to information contained in the master file,
such a cross-reference should suffice.
The CbC information is to be reported to tax authorities and only used at a very
high level. In September 2017 the OECD issued guidance on “appropriate use “ of
the CbC report:
Both the final report on Action Point 13 of the BEPS project and the bilateral and
multilateral Competent Authority Agreements (CAA) for exchange of Information
(see below) state that the CbC report should not be used by itself as a basis for
proposing changes to transfer prices using global formulary apportionment. The
CbC report can be used by tax authorities when planning a tax audit or as the
basis for making further enquiries on transfer prices and other matters during an
audit. The OECD Forum on Tax Administration has prepared a handbook to
support tax authorities in making effective use of CbC information for the purposes
of tax risk assessment. The OECD has also issued guidance on the inappropriate
use of CbC reports.
Action Point 13 and the CAA contain consequences for non-compliance with the
appropriate use of a CbC report. Non-compliance can result in the loss of the right
to receive and use the CbC report. The countries using CbC reporting have given
a commitment to monitor compliance by other jurisdictions and report failures.
Some of the reporting will be via peer reviews.
The data points that will be required to be reported for each country will be the
following:
• Stated capital;
• Accumulated earnings;
Further guidance on each tier and a CbC template are provided in the annexes
to Chapter V. You should be familiar with these templates. The clear implication is
that the template is designed to highlight those low-tax jurisdictions where a
significant amount of income is allocated, without some 'proportionate' presence
of employees. This means, in practice, that there will be pressure to ensure that
profit allocations to a particular jurisdiction are supported by the location in that
state of sufficient appropriately qualified employees, who are able to make a
'substantial contribution' to the creation and development of intangibles.
Concerns have already been noted regarding the confidentiality of this data, as
well as the potential for adjustments by tax administrations based on a formulary
apportionment approach, leading to many more transfer pricing controversies.
The OECD has also noted that some countries (for example Brazil, China, India and
other emerging economies) would like to add further data points to the template
regarding interest, royalty and related party service fees. These data points are not
included in the current template, but the compromise is that the OECD has
agreed that it will review the implementation of this new reporting. Before 2020, at
the latest, it will decide whether there should be reporting of additional or different
data. A concern in this context is that there may well be a tendency to expand
CbC reporting, particularly in developing countries. The emerging market
economies that implement CbC reporting will likely require the reporting of
interest, royalty and related party service fees; they will also be likely to require
CbC reporting for any company doing business in their jurisdiction, regardless of
where the MNE parent is located.
With regard to timing, paragraph 5.30 suggests that the best practice is to require
that the local file be finalised no later than the due date for the filing of the tax
return for the fiscal year in question. The master file should be reviewed and, if
necessary, updated by the tax return due date for the ultimate parent of the MNE
group. Paragraph 5.31 goes on to recognises that the CbC reporting may need a
longer time frame and states that in some cases it may be extended to one year
following the last day of the fiscal year of the ultimate parent of the MNE group.
to developing regimes for reducing compliance obligations for small and medium
enterprises (SMEs).
Chapter V recommends that taxpayers review and update the master file, local
file and CbC report annually, although significant leverage from prior year
documentation is permitted where appropriate. Database searches for
comparable companies may be updated every three years instead of annually,
however the financial data for the comparables should be updated each year.
There is a section on penalties recognising that each country will have their own
and that care needs to be taken to ensure that penalties regimes do not result in
taxpayers favouring one jurisdiction rather than another. It is suggested that
protection from penalties could be used as a mechanism to encourage
compliance.
Confidentiality is covered with the tax authorities being told that all steps should be
taken to maintain the confidentiality of information provided for transfer pricing
purposes.
Paragraph 5.46 states that “The requirement to use the most reliable information
will usually, but not always, require the use of local comparables over the use of
regional comparables where such local comparables are reasonably available.”
In June 2015 the OECD published its package of model legislation and competent
authority agreements to help tax administrations implement the requirement for
multinational companies to report transfer pricing information on a CbC basis. The
guidance on implementation has been updated several times, the latest being in
April 2017. The updates provide guidance on the treatment of minority interests
and various definitions within the model legislation such as the definition of
revenue. It is likely that these updates will continue. As noted above the OECD
issued guidance in September 2017 for how tax authorities will use and analyse the
financial data within the CbC report.
including backup filing requirements when that jurisdiction does not require filing.
The package also contains three Model Competent Authority Agreements to
facilitate the exchange of CbC reports among tax administration. The model
agreements are based on the Multilateral Convention on Administrative Assistance
in Tax Matters, bilateral tax conventions and Tax Information Exchange
Agreements.
The model legislation includes an exemption for a group with consolidated total
revenue of less than €750m (or an equivalent local currency). This means that CbC
reporting will not apply to all groups.
In principle, the report should be iXBRL tagged and filed electronically by the
ultimate parent entity (UPE) of the group with its home tax authority by the filing
deadline — which can be anything up to 12 months from the end of the
accounting period. The report should then be automatically shared by the UPE's
tax authority with the relevant countries mentioned in the report.
In cases where the UPE is not required to file a report in its home tax jurisdiction, or
the automatic exchange mechanism does not work, most countries have
implemented a backstop in the form of a secondary filing requirement. In this
case, constituent entities of the group must file a CbC report directly with their
local tax authorities. Alternatively, in certain circumstances the UPE can elect to
file the CbC report as a surrogate in another territory, thereby making use of the
tax authority automatic sharing mechanism and reducing the compliance burden
of multiple secondary filing obligations.
The OECD model legislation defines a group as:“a collection of enterprises related
through ownership or control such that it is either required to prepare Consolidated
Financial Statements for financial reporting purposes under applicable accounting
principles or would be so required if equity interests in any of the enterprises were
traded on a public securities exchange'”.
For example, it would be prudent for taxpayers to understand whether CUPs exist,
and whether conditions have changed from previous years to inform whether
transfer prices should change. Taxpayers should apply the same prudent
management principles that would govern other business decisions of similar
complexity, and should therefore expect to prepare and obtain certain materials
to help achieve this.
For their part, tax authorities are discouraged from being too onerous in their
expectations of taxpayers. They should seek from taxpayers only the minimum
documentation needed to make reasonable assessment of transfer prices. They
should request information to be prepared only if it is indispensable for verifying
arm's length nature of transactions.
It is not possible to set out all the requirements in all countries. Nevertheless, there
are common themes of which taxpayers should be aware:
• Specific content – taxpayers should be aware that some tax authorities impose
specific requirements on the content of documentation. This may be as simple
as requiring documentation to be maintained in local language or a specific
format. Alternatively, tax authorities may require specific information to be
included, such as transactional data or information relating to the local
business operations. In addition, the tax authority may specify the form of the
analysis, such as requiring the local entity to be the tested party irrespective of
the policy applied by the taxpayer, or requiring the use of local comparable
data rather than regional or global sets.
• Safe harbours – These are simple rules or provisions that taxpayers can follow to
have certainty over tax treatment (eg. Cost plus a defined margin for
specified services). The existence of safe harbours may provide relief from tax
compliance burdens, where taxpayers meet the defined criteria. We look at
these in more detail below.
Many countries use the OECD TPG as the starting point for establishing
documentation requirements. However, taxpayers should avoid the assumption
that preparing documentation consistent with OECD principles will be sufficient to
avoid compliance penalties. In particular, for countries where taxpayers are
aware that they have significant transfer pricing risk (typically arising from
losses/low profit or complex transactions), careful consideration should be given to
local tax authority requirements and expectations. Australia is an example of this -
the local file requirements go beyond the template set down by the OECD. It will
be important to ensure that the local file requirements as set down by the OECD
are customised if a MNE wants to be sure of compliance with Australian rules.
The range of different environments created by tax authorities (not all will adopt
the OECD approach outlined above) provides taxpayers with a choice of how
best to approach compliance. Once mandatory compliance issues have been
dealt with, the most fundamental choice to be made is around approach to
documentation, both in terms of the level of resources to commit and the degree
of global co-ordination.
The functional analysis and benchmarking are likely to be focused on the country
being documented, rather than a broader perspective of the supply chain.
Such an approach has the obvious drawback that it can be highly inefficient, as
there is likely to be significant duplication in effort where unilateral documentation
is prepared in multiple territories.
There have been several initiatives to address this matter. The Pacific Association
of Tax Authorities (PATA) has provided guidance on a documentation package
that, if followed by taxpayers, would be accepted as appropriate documentation
in Australia, Canada, Japan and the US.
The PATA Documentation Package has three operative principles that need to be
met to avoid the imposition of PATA member transfer pricing documentation-
related penalties. First, MNEs need to make reasonable efforts, as determined by
each PATA member’s tax administration, to establish transfer prices in compliance
with the arm’s length principle. Second, MNEs need to maintain contemporaneous
documentation of their efforts to comply with the arm’s length principle. Third,
MNEs need to produce, in a timely manner, that documentation upon request by
a PATA member tax administrator.
• Background documents: these are documents that provide the foundation for
or otherwise support or were referred to in developing the transfer pricing
analysis.
Although the PATA countries are adopting legislation to bring in CbC reporting
based on the OECD rules, they still have local rules that differ from the template
laid down by the OECD. As mentioned above the Australian reporting
requirements require more detail in the local file and the proposed legislation in
the US contains additional guidance not in the OECD template.
Within Europe, the EU Joint Transfer Pricing Forum has also provided guidance on
documentation that should meet compliance requirements in Member States. The
guidance is in the form of a code of conduct issued in June 2006. The approach
supported is that of the masterfile concept.
i. contractual terms,
Any MNE that opts for EU TPD should apply the approach collectively to all
associated enterprises.
Each member of the MNE should inform its tax authorities if the documentation is
adopted.
“Since the EU TPD is a basic set of information for the assessment of the MNE
group's transfer prices a Member State would be entitled in its domestic law to
require more and different information and documents, by specific request or
during a tax audit, than would be contained in the EU TPD.”
It should be irrelevant for tax administrations where a taxpayer prepares and stores
its documentation as long as the documentation is sufficient and made available
in a timely manner to the tax administrations involved upon request. Taxpayers
should, therefore, be free to keep their documentation, including their EU TPD,
either in a centralised or in a decentralised manner.
In June 2017, the EU's Economics and Legal Affairs committee voted to approve a
draft report containing the European Commission's proposals on mandatory CbC
reporting, with possible exemptions in the case of commercially-sensitive
information. However, the draft report did not receive enough votes to go to
negotiations with the Council, and so it will now go to a plenary session of the EU
Parliament, meaning any implementation of the report's proposals is likely to be
some way off.
• standardising the format of the reporting documents for all companies within
the scope of the directive.
As well as analysis to ensure that transfer prices are set on arm's length basis,
companies must also ensure that several other factors are addressed before
transactions are even entered into. Most notably, there is the issue of
intercompany agreements. From the perspective of the OECD TPG, intercompany
agreements are relevant, insofar as they can provide a starting point for
understanding the expected division of responsibility, risks and assets between the
parties. However, from an OECD perspective they are not essential, and in their
absence the terms of the legal arrangements between the parties can be
deemed from the behaviours exhibited.
Related to this is the interaction between transfer pricing and foreign exchange
controls. Foreign exchange controls are particularly prevalent across BRIC (Brazil,
Russia, India and China) and developing economies, and can restrict
multinational companies' ability to remit payment for services provided. Thus, even
where it can be demonstrated that the terms of a transaction meet the arm's
length standard, executing the transaction on the terms desired may not be
possible. For countries where foreign exchange controls are relevant, appropriate
approvals should be sought before the transaction is entered into where possible.
Many companies manage their transfer pricing through the use of adjustments.
These adjustments are made either periodically through the year, or at year end,
to ensure that the group's transfer pricing policy is met. For example, there may be
retrospective adjustments to intercompany selling prices to ensure that a
distributor earns an operating margin within a targeted range. Consideration
should be given to the acceptability of such adjustments for local tax authorities.
Furthermore, there should be awareness of the potential customs implications of ex
post adjustments to the transfer price.
Where adjustments result in a downward adjust to the price, then the taxpayer will
have overpaid customs duties. However, claiming refunds from customs authorities
can be an arduous process, and indeed is not always possible. A more significant
risk arises where the adjustment results in an increase to the transfer price. This
could result in additional customs liability that may need to be disclosed, with
potential penalties and likely increased attention from customs authorities in future.
Up to May 2013, the OECD TPG concluded that transfer pricing safe harbours were
not generally advisable, and consequently the use of safe harbours was not
recommended. Despite this recommendation many member countries did have
some form of safe harbour rules.
Section E was updated in May 2013 and the position on safe harbours was
changed. Paragraph 4.96 acknowledges that the original guidelines were
generally negative towards the use of safe harbours.
The OECD TPG state that safe harbours will be most appropriate when directed at
low risk transactions and/or taxpayers (see paragraph 4.96).
The OECD TPG recognise that safe harbours can be a benefit to tax
administrations as well as taxpayers.
Certain forms of safe harbour are not covered by the definition in Section E; these
include administrative simplifications and exemption from certain documentation
requirements, APAs and thin capitalisation rules (see paragraph 4.103).
The OECD TPG set out a discussion on the pros and cons of safe harbours.
• Provision of certainty;
• Use of safe harbours may mean that the arm’s length principle is not adhered
to;
• Unilateral adoption of safe harbours may increase the risk of double taxation
or double non taxation;
The OECD TPG go on to state that for complex and high risk areas it is unlikely that
safe harbours can offer a workable solution.
The final recommendation is that tax administrations should carefully weigh the
benefits of and concerns regarding safe harbours, making use of such provisions
where they deem it appropriate. We can see this as somewhat of a move from
the previous negative stance on safe harbours.
20.8 Summary
Ultimately taxpayers must decide how much resource they are willing and able to
commit to transfer pricing compliance, based upon their risk profile and their own
appetite for risk. Having done that, they must then use that resource to produce
analysis that best persuades tax authorities of the arm's length nature of their
pricing.
The OECD TPG, as well as local country guidance, provides some direction as to
what might be appropriate, but not certainty. As such, the approach taken to
transfer pricing compliance is a fundamental part of the strategic approach to
global tax risk management for many companies.
CHAPTER 21
21.1 Introduction
Despite the OECD TPG and the arm's length principle being accepted by the
majority of countries, tax authorities often seek to apply the methodology in the
OECD TPG differently. These differences can often leave MNEs in the middle
seeking to avoid double taxation as a result of the differences in interpretation.
Juridical double taxation occurs when tax is imposed in two (or more) territories on
the same taxpayer in respect of the same income. This may arise where, for
example, a company resident in one territory derives source income in another
country and the domestic tax legislation of both countries taxes that income. It
can also arise when more than one tax authority considers the taxpayer to be
locally tax resident.
Economic double taxation occurs when more than one tax authority includes the
same income in the tax base of different taxpayers. Transfer pricing disputes can
trigger both economic and juridical double taxation.
There are a number of ways to reduce or eliminate the impact of double taxation.
The OECD TPG Chapter IV covers avoiding and resolving dispute resolution.
Taxpayers therefore need to consider the various ways in which the risk of double
taxation can be reduced or eliminated and/or whether a certain level may be
considered acceptable. This is often carried out by the tax department as part of
a MNEs transfer pricing risk management strategy. In considering their strategy,
taxpayers should weigh up the advantages and disadvantages of dispute
management versus dispute avoidance. The various options are illustrated in the
following diagram:
Transfer pricing audits are the process whereby a tax authority undertakes a
review of an enterprise's transfer pricing affairs to ensure it is compliant with local
legislation. The OECD TPG note that examination practices will vary widely among
OECD member countries (see paragraph 4.6).
The burden of proof in determining whether pricing arrangements are arm's length
will also differ. Although in many jurisdictions it will be with the tax administration,
(see paragraph 4.1) the UK is one of a growing group where the onus is on the
taxpayer via self-assessment.
Transfer pricing audits constitute a significant business risk to MNEs. Transfer pricing
risk management is therefore crucial for taxpayers to identify risks areas prior to a
potential audit. Pre-audit planning can include defence strategies such as the
preparation of contemporaneous transfer pricing documentation or negotiation of
a unilateral or a bilateral/multilateral APA to obtain certainty going forward.
Transfer pricing disputes will include factual enquiries. The interpretation of the
facts in a transfer pricing context rarely offer one ‘correct answer’. As a result,
disputes may arise and the transfer pricing audit can be a long, drawn out
process.
The resolution of a transfer pricing dispute rests in an area where judgement and
degrees of differences apply. By working with the tax authorities to focus their
enquiries on relevant information and providing the information in a way that
supports the reasonableness and accuracy of the taxpayer's transfer pricing
policy, the company increases its chances of resolving transfer pricing audits
quickly. The best strategy for an early settlement involves:
• a cooperative approach;
1. A joint team of individuals from more than one tax authority acting as one
team to jointly identify issues. Independence would need to be protected, as
there may be a loss of individuality for tax authorities.
The conclusion of transfer pricing audits may result in the agreement of a transfer
pricing adjustment arising from the application of Article 9(1) of the OECD Model
Double Tax Convention (DTC). (See OECD TPG paragraph 1.6.) Where a transfer
pricing adjustment has been made in one territory and there is no corresponding
adjustment in the second territory, prima facie there is double taxation.
Illustration 1
To prevent the 2 million adjustment being taxed in both State A and State B, there
needs to be a corresponding adjustment.
Article 9(2) of the OECD Model DTC seeks to address this by providing that where
an adjustment has been made as envisaged under Article 9(1):
“then that other State shall make an appropriate adjustment to the amount of
the tax charged therein on those profits. In determining the adjustment, due
regard shall be had to the other provisions in this Convention and the
competent authorities of the Contracting States shall if necessary consult with
each other.” (OECD Model DTC Article 9(2))
The commentary to the OECD Model DTC notes that the adjustment is not
automatic and is therefore subject to the agreement of the other tax authority.
(See commentary on OECD Model DTC Article 9, paragraph 7.)
DTCs mitigate the risk of double taxation by providing agreed rules for taxing
income and capital. They also provide guidance on effective tax dispute
resolution mechanisms to be applied in cases where the competent authorities of
the contracting territories to a transaction are in disagreement.
OECD member countries use different methods to provide relief in cases where a
primary adjustment has resulted in double taxation. Tax authorities bilaterally agree
on what method is appropriate depending on the facts and circumstances of
each case. (See commentary on OECD Model DTC Article 9, paragraph 7.)
Article 9 does not impose specific time limits within which corresponding
adjustments should be made and therefore the provisions of the tax treaty or
domestic laws of the relevant territory apply.
Relief under Article 9 may not be available if the time limit provided by the treaty
or domestic law for making corresponding adjustments has expired. (See
commentary on OECD Model DTC Article 9 paragraph 10.)
problem some territories have introduced provisions into domestic legislation that
require secondary adjustments to be made.
Secondary adjustments attempt to account for the difference between the re-
determined taxable profits and the original profits. They will treat additional profits
resulting from primary adjustments as having been transferred in some other form
such as a constructive dividend, equity contribution or loan and tax them
accordingly. (See OECD TPG paragraph 4.68). Whilst they do not themselves
restore the financial situation of the parties to what it would have been had the
transaction which gave rise to the transfer pricing adjustment been made at arm's
length, secondary adjustments can be administered to encourage the restoration
of funds to their proper place or, failing this, allow adjustment of the tax effects of
the distortion that might otherwise arise. (See OECD TPG paragraph 4.70).
The OECD Model DTC does not address the topic of secondary adjustments.
(Commentary on OECD Model DTC Article 9 paragraph 8). Secondary
adjustments are however, discussed in the OECD TPG although many countries do
not actually require or recognise them. (See OECD TPG paragraphs 4.68-4.78).
The UK does not require secondary adjustments although the UK will consider
certain corresponding adjustments for secondary adjustments required by other
jurisdictions on their own merits. (SP1/18 paragraph 22).
Where countries have introduced provisions into their domestic legislation that
require secondary adjustments to be made they are usually compulsory, although
tax authorities will generally allow taxpayers to prove the exact nature of the
transaction and in some cases to repatriate funds, for example by way of a
constructive dividend, in order to avoid the secondary adjustment.
The exact form that a secondary transaction takes and the consequence of the
secondary adjustment will depend on the facts of the case and on the tax laws of
the country that asserts the secondary adjustment. (See OECD TPG paragraph
4.68). This example, taken from the OECD TPG, illustrates the point:
Related parties located in Territory A and Territory B enter into a related party
transaction. As a result of the transaction being deemed not to occur at arm's
length, Tax authority A makes a primary adjustment that results in an increase
in taxable profits in Territory A. Tax authority A then elects to make a
secondary adjustment that treats the additional profits as being a loan from
the related party in Territory B. In this case, an obligation to repay the loan
would be deemed to arise. The loan approach therefore affects not only the
year in which the secondary transaction is made but also a number of
subsequent years until such time as the loan is considered to be repaid.
(Paragraph 4.69).
Tax Authority A could alternatively treat the additional profits as being a dividend
in which case withholding tax may apply.
Illustration 2
The following illustrates the application of transfer pricing adjustments between the
UK and a foreign territory, in this case, the US:
UK Ltd, a subsidiary of US Inc, purchased finished goods and services from US Inc
for resale into the European market but left the amounts due outstanding on inter-
company account.
The Internal Revenue Service (IRS) challenged the accumulation of the trading
balance and contended that part of the trading debt should be re-categorised as
long term funding debt on which an interest charge should be imputed. The
pricing basis for the underlying transactions was not challenged.
After lengthy negotiations, a settlement was reached and signed between US Inc
and the IRS.
Interest income was imputed by the IRS on a deemed loan for the four calendar
years 2000 to 2003. In 2006, US Inc raised an invoice to UK Ltd for this interest, which
was recorded as a profit and loss charge in UK Ltd's statutory accounts and paid in
2007.
HMRC initially refused UK Ltd's deduction claimed for the interest on the basis that
there was no legal obligation for UK Ltd to pay interest to US Inc.
HMRC also stated that a taxpayer may not make a corresponding adjustment
unilaterally and the only mechanism by which to achieve deduction is through
MAP (we look at the MAP below).
A MAP application was made on the basis that a corresponding adjustment was
being claimed in the UK for a transfer pricing adjustment made in the US in
accordance with Article 9(2).
The application was successful and UK Ltd were granted a deduction for the
interest charged from US Inc. In this case, it is noted that as the interest was
actually charged and paid, no secondary adjustment would have arisen.
The process took around nine months to complete once the application was
made to HMRC. Much of this time was waiting for the competent authorities to
discuss the matter in the first instance.
21.5 Article 25 of the OECD Model Double Tax Convention (DTC) (MAP)
Introduction
The taxpayer states its case to the competent authority of either state (2017 OECD
Model Treaty). If the competent authority is unable to resolve the matter
unilaterally, the competent authorities of both contracting states consult to
endeavour to resolve the matter by mutual agreement.
The taxpayer must present his case within three years from the first notification of
the action resulting in taxation not in accordance with the provisions of the treaty.
This can be problematic as it means although the MAP process may have been
initiated, the issue under dispute may never actually be resolved.
This phrasing has thus long been problematic. However the 2017 update to the
OECD Model Treaty amended the commentary, and implemented so far as
possible the aims of the minimum standards set under the BEPS project, at Action
Point 14, which are discussed further below. A new paragraph 5.1 notes that ‘shall
endeavour’ means that the competent authorities are obliged to seek to resolve
the case in a fair and objective matter, on its merits, in accordance with the terms
of the convention. It is perhaps hoped that this phrasing will push states to actually
come to a resolution with regard to matters placed before them.
Paragraph 3 also provides for the competent authorities to consult together for the
elimination of double taxation in cases not provided for in the convention.
MAP is covered by Article 25 of the OECD Model DTC. Paragraph 5 which covers
arbitration was added to Article 25 in the 2008 update to the OECD Model DTC
meaning that taxpayers can request arbitration if an outcome is not achieved as
a result of competent authorities consulting with each other. MAP arbitration,
together with the EU Arbitration Convention and the new EU Directive on Tax
Dispute Resolution, which are separate mechanisms for EU countries, is discussed in
further detail below.
• Situations regarding 'thin capitalisation' when the state of the debtor company
has treated interest as dividends, based on Article 9 or paragraph 6 Article 11;
The BEPS Action Plan contained a commitment (Action Point 14) to address
obstacles that prevented countries resolving treaty related disputes under Article
25. The final report on Action Point 14 is discussed below together with the MLI that
is being used to implement the outcomes of the final report.
Transfer pricing adjustments may give rise to economic double taxation (OECD
Model DTC, commentary to Article 9, paragraph 5). To eliminate double taxation
that may be caused by transfer pricing adjustments, Article 9(2) of the Convention
states:
"..that other State shall make an appropriate adjustment to the amount of the
taxes charged therein on those profits."
However, this adjustment is not automatic and only applies when the second state
agrees to the adjustment both in terms of the quantum and principle (OECD
Model DTC, commentary to Article 9, paragraph 6)
To prevent economic double taxation, the taxpayer may request the competent
authority of the first country to discard or decrease the transfer pricing adjustment.
Alternatively, the taxpayer may call for the competent authority of the second
country to enforce a corresponding adjustment. The UK competent authority for
example is open to receiving such representations from taxpayers although the
decision will of course be made between the competent authorities.
Article 7 of the Convention and the OECD Report on the Attribution of Profits to
Permanent Establishments, provides a mechanism for entering MAP where a
branch or permanent establishment exists, similar to that in Article 9 of the
Convention.
Administration of MAP
MAP can be entered into either at the request of the taxpayer or the request of
the tax authorities.
Dealings between the taxpayer and either state – this allows the taxpayer to
apply to the competent authority of either contracting state regardless of any
remedies available under domestic law.
Dealings between states – when the competent authority of the resident state
considers MAP to be the appropriate route in addressing the case, an
approach is made to the competent authority of the other state.
Note, the UK stipulates that a taxpayer cannot pursue domestic legal remedies
and MAP simultaneously (HMRC manual - INTM 423050). This approach is the same
as that adopted by most countries and is discussed in the commentary to Article
25 (OECD Model DTC, commentary to Article 25, paragraph 76).
The competent authorities of both states are obliged to use their best endeavours
to reach mutual agreement and resolve difficulties arising through the
interpretation or application of the Convention to eliminate double taxation.
However, Article 25 of the Convention does not guarantee relief from double
taxation. Nevertheless, for MAP cases involving transfer pricing adjustments, this
can be a very effective mechanism for eliminating double taxation.
The MAP allows competent authorities to resolve, where possible, difficulties in the
application or interpretation of the Convention. MAP may also address more
complex situations of double taxation, such as cases of a resident of a third state
having a PE in both contracting states.
The OECD has issued an illustrative process and timeline as part of its report issued
in 2007 (OECD Report: Improving the Resolution of Tax Treaty Disputes). The key
steps and illustrative time frames for MAP included in this report are detailed
below. The illustrative timeframe is generally applicable to the majority of MAPs,
which are initiated by taxpayers (as opposed to a tax authority) except where
specific treaty clauses state otherwise. The BEPS best practices should also be
noted going forward.
The taxpayer initiates MAP by submission of a MAP request. A three year time limit
is provided for by the Convention, or a time period may be outlined by domestic
provisions. The taxpayer then receives confirmation of the receipt of the MAP
request from its domestic competent authority and the MAP request is forwarded
to the other competent authority.
Stage 2 – Negotiation
MAP consultations with the other state are initiated and a position paper is issued
by the adjusting competent authority. Ideally, this occurs within four months, but
no later than six months after agreement between the competent authorities to
enter into MAP consultations.
The taxpayer is not a formal party to the consultation, however experience has
shown that it is advantageous for taxpayers to be involved at an early stage, in
particular where the case involves transfer pricing adjustments.
Stage 3 – Implementation
The approval process for MAP includes a one month deadline for the taxpayer
and other 'interested parties' e.g. where the administrative-territorial subdivisions or
any local tax authorities' consents are necessary or required to respond.
The mutual agreement is then confirmed with the relevant terms and conditions
and an exchange of closing letters occurs.
How it is implemented will depend on the domestic rules of the adjusting state.
Guidance on the methods of giving relief in the UK (for example) is included within
SP1/18 (previously SP1/11) Para 15 and will depend on the facts and
circumstances of the particular case.
Taxpayers can invoke MAP under a UK treaty under domestic legislation at s124(1)
TIOPA 2010.
The time limits applicable will depend on the specific terms of the treaty. In older
treaties to which the UK is a party, the relevant time period may not be stated,
hence the UK domestic limit applies (four years from the end of the chargeable
period to which the case relates).
Time limits for invoking MAP are usually addressed in newer treaties. Typically
Article 25 of the Convention is applied by the UK. Under the Convention the
taxpayer is obliged to present its case within three years of the first notification of
the action which results or is likely to result in double taxation. The first notification
may occur after the four year limit; thus the relevant tax treaty extends the basic
domestic four year time limit.
The taxpayer does not play a formal part in the consultation and negotiation
process of MAP. However, as a major stakeholder, the taxpayer should always be
kept informed of important milestones in its case. In addition, the taxpayer has the
right to decide to accept (or decline) the agreement between the competent
authorities. MAP cases, especially transfer pricing cases, are often complex and
highly fact specific. Therefore it may be useful for the taxpayer to present facts
and related questions in person. So the taxpayer may be asked to informally
participate in the MAP process at the discretion of the competent authorities,
despite not being part of the consultations. The UK will support this where it
perceives such participation to be beneficial, although this will also depend on the
approach of the relevant treaty partner.
MAP is not an alternative to the usual transfer pricing enquiry process. A transfer
pricing enquiry seeks to determine an arm's length level of profits for the entity /
branch in question relating to the inter-company transaction(s) at hand. MAP
establishes how the double taxation of these profits will be relieved in principle by
the treaty partners.
Of course there have been some instances where the MAP procedure has not
produced a solution, a key one being the Glaxo case in the US. The disagreement
between Glaxo and the IRS had been ongoing for many years (since the late
1980s). The IRS position was to challenge the transfer pricing used by Glaxo UK to
remunerate (or better “under remunerate”) the US subsidiaries for marketing drugs
developed in the UK.
Once Glaxo realised that the IRS would enforce the adjustment on the US profits,
the enterprise invoked its right under the DTA to force the tax authorities in the UK
and US to enter into negotiations under MAP and to arrive to a common
agreement as to the arm’s length transfer pricing.
Glaxo had possibly wished for the UK tax authorities to help convince the IRS that
they were being unreasonable and should perhaps reconsider the size of
adjustment.
The worst case scenario envisioned by Glaxo was probably that in case the IRS
had convinced the UK tax authorities that the adjustment was legitimate, on the
basis that the transfer pricing was wrong there should be a corresponding
adjustment to reduce UK taxable profits by the same amount.
However, as per previous paragraphs, the MAP does not force the two competent
authorities to come to an agreement. The competent authorities are asked to
“endeavour” to resolve “any difficulties or doubts arising as to the interpretation or
application of” the DTA. Unluckily for Glaxo, the tax authorities did not reach an
agreement.
Nevertheless, it is clear the MAP has become an increasingly important tool for
taxpayers and tax authorities alike in addressing double taxation, as it allows for
competent authorities to consult with each other on the application of double
taxation treaties. A collaborative global environment has allowed the process to
become more efficient, where authorities exchange information to reach an
appropriate outcome.
The EU Arbitration Convention and the new (2017) Directive on Tax Dispute
Resolution Mechanisms also provide alternatives to MAP and tax treaty arbitration,
in dealing with the elimination of double taxation related to adjustments of
associated enterprise profits (the former), and more generally (the latter), and
these are discussed further in the sections below.
Article 25(5) was added in the 2008 version of the OECD Model Treaty. It makes
provision for arbitration to be used if agreement has not been reached within 2
years of the date when all information needed has been provided to both
competent authorities (per the 2017 update). Prior to 2017 this paragraph referred
to 2 years of the presentation of the case to the other competent authority. The
procedure is not based on prior authorisation by the competent authorities. This
article was updated as part of the BEPS process – see Action Point 14 below.
Arbitration under Paragraph 5 is only available for cases brought under Paragraph
1 of Article 25 - it does not extend to those brought under Paragraph 3.
A request for arbitration must, per the 2017 update to the OECD Model Treaty, be
made in writing. It will not be granted where a decision has already been
rendered by a court or administrative tribunal of either state. Arbitration can only
be requested where there are unresolved issues.
The above time line is taken from the commentary on 2017 OECD Model Treaty
Annex – Sample Mutual Agreement on Arbitration. See also below for Arbitration
under the MLI changes, on which the 2017 update was based.
The aim of Action Point 14 was to “Develop solutions to address obstacles that
prevent countries from solving treaty-related disputes under MAP, including the
absence of arbitration provisions in most treaties and the fact that access to MAP
and arbitration may be denied in certain cases”.
The final report on Action Point 14 was published in October 2015 and contains
measures aimed at strengthening the effectiveness and efficiency of the MAP,
such as specific actions to be taken by countries, suggested changes to legislation
and administrative practices, and changes to the OECD Model Treaty and its
commentary. The measures are being implemented by the MLI that came into
force on 1 July 2018. We look at this in more detail below.
The final report sets out three core proposals, the first of which is to be adopted by
all countries involved. This requires countries to commit to minimum standards on
the resolution of international tax disputes. Agreement is also required to a peer-
based monitoring mechanism to ensure the countries are meeting the new
standards, which is being executed through the Forum on Tax Administration’s
MAP Forum.
1. To ensure that countries implement Article 25 of the OECD Model Tax Treaty in
good faith. This would mean that states should ensure all their treaties have at
least paragraphs 1 to 3 of the OECD Model Treaty Article 25, and to ensure the
MAP is available for transfer pricing disputes and anti-treaty abuse provisions.
3. To allow taxpayers access to the MAP process when the requirements at para-
graph 1 of Article 25 for taxpayers to access the MAP process are met. This
deals with the issues surrounding the ability of the state of residence of the
taxpayer to decide whether the claim is justified. The standard requires
contracting states to either use an amended version of Article 25 such that the
taxpayer can choose which state to approach with their claim or to
implement a bilateral notification or consultation process when the home
state does not consider the request to be justified.
The second core proposal relates to “best practices”; the best practices
complement the agreed minimum standards. However they are voluntary and it
should be noted that only some of the OECD BEPS / G20 countries were willing to
commit to them. The final report contains 11 best practices. We have set out
below some examples of the best practices. We recommend that you read the
final report.
The third core proposal relates to the need for a compulsory, binding arbitration
procedure, and identified 20 countries (at that time), including the UK, the US,
Australia, Canada, France and Germany, that had agreed to implement
mandatory binding MAP arbitration in their bilateral tax treaties. According to the
OECD, the 20 countries that made this commitment were involved in more than
90% of the outstanding MAP cases at the end of 2013. Therefore, this is considered
a significant move forward and over time it is likely more countries will follow suit.
In September 2017 the OECD published the results of the first of the peer reviews
(including one on the UK) assessing the performance of participating tax
authorities with regard to the new MAP processes. The reports were broadly
positive which it is hoped will push taxpayers to engaging with the MAP process.
However it is notable that the countries taking part in the first set of reviews all
have a good reputation on MAP anyway. It is likely that subsequent reviews may
well be more critical.
The 2016 US Model Treaty includes such a mandatory binding arbitration process
where agreement under MAP is not reached within 2 years. The treaty provides for
a three-person arbitration panel, with two of the arbitrators chosen by the
countries involved, and the third selected by the other two. The provisions apply a
“last best offer” approach in which each country submits a position paper with a
proposed resolution and the arbitration panel chooses between them.
A typical issue raised by MNEs is the amount of time and resources used in
resolving international tax disputes. Thus even the threat of a mandatory binding
arbitration process, even if it is not ultimately invoked, will provide an incentive for
the contracting states involved to look in good faith for a resolution.
In November 2017 the OECD published statistics on the the MAP these statistics
looked at the position the end of 2016. The key points highlighted by the OECD
include:
• In comparison with the 2015 MAP statistics, both the number of MAP cases in
start inventory and the number of started MAP cases have increased, which
results from both an increase in the number of reporting jurisdictions and
modified counting rules. Transfer pricing cases account for slightly more than
half of the MAP cases in inventory.
• Transfer pricing cases take more time on average than other cases:
approximately 30 months are needed for transfer pricing cases and 17 months
for other cases.
• Over 85% of MAPs concluded in 2016 resolved the issue. Almost 60% of MAP
cases closed were resolved with an agreement fully resolving the taxation not
in accordance with the tax treaty and almost 20% of them were granted a
unilateral relief while almost 5% were resolved via domestic remedy. Finally, 5%
of the MAP cases closed were withdrawn by taxpayers while approximately
10% were not resolved for various reasons.
The following diagrams are taken from the report which can be found at
http://www.oecd.org/tax/dispute/mutual-agreement-procedure-statistics.htm.
Article 16 of the MLI provides that the modified version of MAP will apply to treaties
in place of, or in the absence of, MAP provisions. States can make limited
reservations. These include not allowing claims to be made to either state, but
implementing a process whereby the state receiving the taxpayer's notification will
notify or consult with the other state, if it does not consider the taxpayer's case to
be justified.
Article 19 of the MLI sets out a mechanism for mandatory binding arbitration (MBA)
where competent authorities are unable to reach agreement under MAP. It is
optional and will only apply to treaties where both states choose to apply it. States
can choose to allow three years (rather than two years) for agreement to be
reached under MAP before MBA is possible; and can choose to exclude issues
which have already been decided by a court.
States can reserve the right for the MBA provisions in the MLI not to apply to
treaties which already provide for MBA. The UK for example will reserve the right to
maintain any existing stronger MBA provisions. States can also reserve the right for
the MBA provisions not to apply to cases entering MAP before the MLI comes into
force for a given treaty, unless the parties agree to MBA applying to that specific
case.
As we have noted, when the report on Action Point 14 was published in October
2015, 20 states were committed to MBA, being Australia, Austria, Belgium, Canada,
France, Germany, Ireland, Italy, Japan, Luxembourg, the Netherlands, New
Zealand, Norway, Poland, Slovenia, Spain, Sweden, Switzerland, the UK and the US.
When the MLI was signed in June 2017 the US (as they didn’t sign the MLI), Poland
and Norway did not commit. However Andorra, Fiji, Finland, Greece, Lichtenstein,
Malta, Portugal and Singapore added their commitment making the total 25 at
that time.
The arbitration panel will consist of three independent and impartial members with
expertise or experience in international tax. Each competent authority will appoint
one member and then those two members will appoint a third member to chair
the panel, who cannot be a national or resident of either state. There are
provisions for an OECD official to appoint panel members, if states or the panel
members do not make the necessary appointments.
States can choose which type of arbitration they want to adopt for their 'covered
agreements'. Either:
• 'final offer' or last best offer arbitration ('baseball arbitration'): this is the default
option, under which each competent authority will submit to the arbitration
panel its proposed resolution; and (if it chooses) a supporting paper and a
response to the other state's proposed resolution. The panel will decide, by
simple majority, which resolution to accept. It will not give any reasons for its
decision and the decision will have no precedent value; or
If one party to the treaty has chosen independent opinion arbitration and the
other has chosen final offer, independent opinion will apply to the treaty, unless
the state which has chosen final offer has chosen not to apply MBA to treaties with
states that have chosen independent opinion arbitration. In that case, MBA will not
then apply unless the parties reach agreement on the type of arbitration process
that will apply to that treaty.
The arbitration decision will be binding on both states unless the taxpayer does not
accept the decision. It will also not be binding if a court holds that the decision is
invalid or if a person directly affected by the decision pursues litigation in relation
to the issues.
The states concerned will agree how costs will be borne. In the absence of
agreement, each state will bear its own costs and those of the panel member
they appointed, and the cost of the chair and any other expenses will be shared
equally.
There is also an optional provision for the arbitration decision not to be binding and
not implemented if the states concerned agree on a different resolution of all
issues within three months of the arbitration decision. This will only apply to a
particular treaty if both states have made the reservation. The reservation can be
made in respect of all treaties or only those where independent opinion arbitration
applies.
Disputes settled under the EU Arbitration Convention should reach their conclusion
within a three-year timescale from the commencement of proceedings. (See
revised code of conduct for the effective implementation of the Convention on
the elimination of double taxation in connection with the adjustment of profits of
associated enterprises, paragraph 4.).
The procedure is a two stage process: firstly, following a request by a taxpayer, the
tax authorities should negotiate under a mutual agreement procedure (similar to
MAP) to agree a resolution to the double taxation and then a second, arbitration
phase, if resolution is not reached, whereby the tax authorities consult
independent experts to make a binding decision.
When an application for relief under the EU Arbitration Convention is made, the
onus is on the taxpayer to initiate the relief; this may be done at the same time as
a MAP application under a DTT.
• Copies of the tax assessment notices and details of any appeals, the result of
which have led to double taxation.
The code of conduct states that the competent authority should respond within
one month.
If the competent authority believes that the enterprise has not submitted the
minimum information necessary for the initiation of a mutual agreement
procedure as stated under point 5(a), it will invite the enterprise, within two months
of receipt of the request, to provide it with the specific additional information it
needs.
Member States undertake that the competent authority will respond to the
enterprise making the request in one of the following forms:
i. if the competent authority does not believe that profits of the enterprise are
included, or are likely to be included, in the profits of an enterprise of another
Member State, it will inform the enterprise of its doubts and invite it to make
any further comments;
The competent authority initiating the mutual agreement procedure will also
inform – on the basis of information available to it – the competent authority(ies) of
the other Member State(s) and the person making the request whether the case
was presented within the time limits provided for in Article 6(1) of the Arbitration
Convention and of the starting point for the two-year period of Article 7(1) of the
Arbitration Convention. (See paragraph 6.3 f to g of the Revised code of conduct
for the effective implementation of the Convention on the elimination of double
taxation in connection with the adjustment of profits of associated enterprises.)
The taxpayer is not a formal party to the negotiation although in practice they
may have some involvement such as presenting their case to the competent
authorities. The taxpayer should also be kept informed of any developments to the
application for relief of double taxation as the case progresses. (See Revised code
of conduct for the effective implementation of the Convention on the elimination
of double taxation in connection with the adjustment of profits of associated
enterprises, paragraph 6.3 (b)).
If the authorities are able to agree a suitable resolution, then the tax authorities are
advised in the code of conduct to sign a declaration of acceptance.
The taxpayer should be part of the negotiation at this stage and is permitted to
reject an agreement that has been reached between the two tax authorities if it
believes that the outcome is not consistent with the arm's length principle. (See
Revised code of conduct for the effective implementation of the Convention on
the elimination of double taxation in connection with the adjustment of profits of
associated enterprises, paragraph 6.3 (b).)
If the tax authorities are unable to agree a resolution within a two-year period from
the application date, then the tax authority that initiated the proceedings is
responsible for setting up an advisory commission to arbitrate on the matter.
The advisory commission should be provided with all of the information necessary
to make their judgement and make their decision within six months of being
established. Within the next six months, the tax authorities may agree an
alternative decision which differs to that of the Advisory Commission. If no
alternative is agreed, then the tax authorities must act in accordance with the
decision of the Advisory Commission. (See Convention on the elimination of
double taxation in connection with the adjustment of profits of associated
enterprises (90/436/EEC), Article 12.)
Once the decision has been made, the decision should be communicated to the
taxpayer and it may be published if the taxpayer agrees.
In October 2017 the EU Council formally adopted the Directive on Tax Dispute
Resolution Mechanisms (EU 2017/1852), which has come out of the work of the EU
as part of its Corporate Tax Action Plan, and the work undertaken in the BEPS
Project. This directive will operate alongside the Arbitration Convention (discussed
above), and provides a wider scope for the use of arbitration for intra EU cross
border double tax disputes.
With the processes in the MLI (discussed above) and this new Directive, the way
tax disputes are resolved is likely to change significantly in the near future. The
directive will apply to disputes relating to tax year commencing 1 January 2018, for
cases submitted from 1 July 2019, however states may agree to apply the
procedures to disputes from earlier tax years.
Whilst the Arbitration Convention is limited to transfer pricing disputes, this directive
is wider in scope and applies to disputes arising from the interpretation and
application of agreements and conventions entered into for the elimination of
double taxation on income and capital. The directive encourages arbitration as a
way to resolve such disputes, after a MAP procedure, however it also allows
Member States the option of choosing other methods, under its Alternative Dispute
Resolution procedure. Notably if a dispute is covered by both the arbitration
provisions in the MLI and the directive, the directive will take precedence where
the dispute has been brought to the attention of the Member States under the
provisions of the directive. However, as an area prone to disputes, it remains likely
that future arbitration cases will still be transfer pricing disputes.
The basis of the mutual agreement concept included in the directive is the
procedure found in Article 25 of the OECD Model Treaty, but with some further
refinements. Any person who is a resident of an EU Member State for tax purposes
and whose taxation is directly affected by a matter giving rise to a dispute may,
within three years from the receipt of the first notification of the action resulting in
or that will result in the dispute, submit a complaint simultaneously to each of the
concerned EU competent authorities. If the affected person is an individual or
‘small’ undertaking then the complaint only has to be submitted to their state of
residence, and that competent authority will then inform the other states involved
within 2 months.
Within the same six month period (from having received all the necessary
documents), any of the competent authorities involved can decide to resolve the
dispute on a unilateral basis. Otherwise, under Article 4 the Member States
concerned shall endeavour to solve the dispute by way of MAP within a period of
two years. If the Member States reach an agreement under this process within this
time, then this is binding on the competent authorities and enforceable by the
taxpayer subject to his acceptance of the agreement. If the Member States fail to
reach an agreement the competent authorities will inform the taxpayer of the
reasons for their failure.
Where the MAP fails, or where the MAP was not commenced as the complaint
was rejected by one (but not all) of the competent authorities concerned (and
there are no rights of appeal in the domestic courts), the taxpayer may request
the competent authorities of the Member States set up an Advisory Commission.
Such a Commission consists of three to five independent arbitrators and up to two
representatives of each Member State. If the Member States do not set up such a
Commission within the relevant timescale then the taxpayer may apply to their
national courts to do so – which is a significant benefit as it allows the processes to
move on and not be ‘locked’ by a Member State not complying. Although it is not
entirely clear in the wording of the directive, this Advisory Commission will proceed
to give a reasoned opinion on the dispute (there is reference to this approach in
Article 10).
However, the directive does provide Member States with the flexibility to set up an
Alternative Dispute Resolution Commission instead of the Advisory Commission
(Article 10). This Alternative Dispute Resolution Committee may take on a different
composition and form, as agreed between the parties, and can consider any
dispute resolution process or technique to solve the question in dispute in a binding
manner. It is interesting that Article 10 does indicate that as an alternative to the
independent opinion process (used by the Advisory Commission), the Alternative
Dispute Resolution Commission could use the ‘final offer’ arbitration process
(otherwise known as ‘last best offer’ arbitration) – which notably is the default
option for arbitration under the MLI, as discussed above. Arguably this latter
approach is likely to offer a quicker and more cost-effective method of dispute
resolution.
The taxpayer does have more extensive rights under the Directive, as they can
provide the deciding panel with information, evidence or documents that may be
relevant for the decision. In addition, taxpayers may also appear (or be
represented) before the Commission with the consent of the competent
authorities.
The Advisory Commission, and the Alternative Dispute Resolution Commission, must
deliver their decisions within six months, with a possibility to extend by a further
three months (see Article 14). Decisions are by majority vote, with a casting vote to
the chair as required. The competent authorities are bound by the decision unless
they agree a different resolution within six months of notification of the decision
(Article 15). The taxpayer must agree to the decision in order to be bound by it. If a
Member State fails to implement the decision then the taxpayer is able to enforce
implementation of the decision by resorting to national courts in that Member
State (Article 15(4)).
If the competent authorities agree, and the taxpayer consents, then the final
decisions may be published in full, excluding any information on trade, business,
industrial or professional secrets or processes. Where full publication is not agreed
then the competent authorities must publish an abstract of the decision and
details of the arbitration method used.
The set time limits for the different processes, of MAP and arbitration, should mean
proceedings will actually be resolved, and within shorter time-frames. This fact,
combined with improved access to the process and more involvement of the
taxpayer, does indicate that this directive should be a great improvement on the
existing rules.
The UN Model Tax Treaty also contains MAP procedures in Article 25. The UN Article
25 contains Alternative A and Alternative B. Paragraph 1 of both alternatives
differs from the OECD version as it only allows a case to be brought to the
competent authority where the taxpayer is resident unless it is a claim under Article
24. Alternative B includes a provision for mandatory binding arbitration although
there are differences to the OECD version:
II. The arbitration procedure may be initiated if the competent authorities are
unable to reach an agreement on a case within three years from the
presentation of the case rather than within two years;
III. The competent authorities can depart from the arbitration decision if they
agree on a different solution within six months after the decision has been
communicated to them.
The commentary to Article 25 suggests that states that do not wish to include
Alternative B may wish to include provision for voluntary arbitration.
CHAPTER 22
In this chapter we look at further aspects of avoiding double taxation and dispute
resolution in particular:
– Advance Pricing Arrangements (APAs)
– international perspective and trends
– APAs and the BEPS Action Plan
22.1 Introduction
Agreeing an APA allows taxpayers to gain certainty over their tax affairs from a
transfer pricing perspective.
The OECD TPG include commentary on APAs in Chapter IV, together with an
annex to Chapter IV, which details ‘Guidelines for conducting APAs under MAP’
(MAP APAs). The process gives tax authorities and taxpayers the opportunity to
consult over transfer pricing issues in a less adversarial way than may be the case
as part of an enquiry or during litigation. (See OECD TPG paragraph 4.143).
A unilateral agreement is made between the taxpayer and their respective tax
administration. As unilateral APAs only deal with tax issues within one jurisdiction
there is still a risk that double taxation can occur (as the counter-party tax
authority may take a different stance on the matter).
Some tax authorities may still agree unilateral APAs in particular circumstances, for
example where the amounts at stake are small so there is very little to gain with a
bilateral agreement and/or the majority of the transfer pricing risk lies in the
taxpayer's home country or where the other party to the transaction is resident
within a jurisdiction with which there is no treaty or the treaty partner has no formal
APA process.
There may be good reasons why unilateral APAs may be preferred not least, as
they only involve one tax authority, they tend to be easier to agree.
Bilateral or multilateral APAs are often referred to as MAP APAs and will be agreed
under mutual agreement procedures with the other tax authority.
MAP is covered in Article 25(3) of the OECD Model DTC, although this article does
not expressly mention APAs. It is however considered within the OECD TPG that this
article covers MAP APAs, as the specific transfer pricing cases subject to an APA
are not otherwise provided for in the OECD Model DTC. (See paragraph 4.150.)
Article 25 does not oblige a competent authority to enter MAP and the willingness
may depend on the policy of the two countries involved. (See Annex to Chapter
IV paragraph 16.)
There is flexibility over which transactions can be the subject of an APA, although
some tax authorities prefer all issues to be covered. (See paragraph 4.147.) The
criteria that is to be agreed can include the transfer pricing method to be used to
demonstrate arm's length pricing, the comparables and/or method of selection
and appropriate adjustments to the comparables and the critical assumptions in
relation to future events. (See paragraph 4.135.)
It is difficult for APAs to go beyond agreeing methodology and for example agree
fixed results as these would rely potentially on forecasts and budgets. For example,
it may not be reasonable in the case of a financing transaction to agree a fixed
interest rate but it may be reasonable to agree a percentage point pegged to an
index such as LIBOR or EURIBOR. (See paragraph 4.136.)
There are four separate steps to the APA process, which are: expression of interest
or preliminary discussions, formal submission of an application, evaluation and
agreement.
Prior to the expression of interest or pre-filing meeting stage some tax authorities
may require certain documents, pertaining to the APA, to be submitted for
consideration.
This is a feature of many domestic APA processes, which can assist in dealing with
the actual APA application more quickly. (See OECD TPG Annex to Chapter IV
paragraph 29.) The expression of interest stage makes the process more efficient
and limits waste of resources by determining whether the APA process will be
beneficial for the parties. For MAP APAs this will also allow the relevant competent
authorities to have preliminary discussions, which will also help clarify expectations
from the process.
The information provided should include the critical assumptions in respect of the
operational and economic conditions that will affect the transactions under
consideration during the course of the APA. An assumption will be critical if, where
the assumption is incorrect, this will result in the methodology not reflecting an
arm's length price.
Once an application has been received, the tax authorities will evaluate its
contents and continue to liaise with the business as necessary.
Step 5 – Negotiation
The MAP APA process is a two-stage process: Stage 1 fact finding, review and
evaluation and Stage 2 the competent authority discussions. Under the first stage
all the relevant information is gathered and the taxpayer may have a high level of
involvement in this process. The second stage is a government to government
process and so may have less taxpayer involvement. (See Annex to Chapter IV
paragraph 63.)
Both a MAP APA and a unilateral APA will be normally a written document, signed
and agreed by all parties to the agreement.
The amount of time taken to complete the APA process is dependent on the
complexity of the case and the type of agreement sought.
Tax administrations will want to monitor compliance with the APA. This can be
carried out either by way of the filing of annual reports on compliance with the
APA requirements and/or the tax authority continuing to monitor the compliance
with the APA as part of the regular audit cycle. (See paragraph 4.148.)
Where the terms of an APA have not been complied with or there has been a
change in circumstance that for example affects one or more material
assumptions, the APA will be reconsidered. In these circumstances, an APA may
be revoked from an effective date, cancelled either from an effective date or
from the start or renegotiated. (See Annex Chapter IV paragraphs 74-85.)
Many countries have an APA process in place, including the US, Australia,
Canada, France, Germany, Russia, and Japan. Many countries such as
Switzerland do not have formal APA programs, but have previously allowed
informal unilateral and bilateral APAs to be completed.
The APA programs will be at varying stages of development and will also vary as to
whether a territory will allow unilateral, bilateral or multilateral APAs, a combination
of all three or not at all.
The regulations relating to the APA process are found in the domestic legislation of
each country and therefore differ from one country to another. In order to illustrate
the different approaches to the APA process, and the various stages of
development, we will summarise the approaches to the APA process in the US,
China, India, Ireland and the UK.
US
The US was the first country to introduce a formal APA process by outlining a set of
procedures for a business to follow. The most recent guidance was issued in
December 2005 (See IRS website) which was modified in 2008. The process has
been popular in the US and the IRS has a backlog of claims. In order to reduce the
backlog of claims and align process with MAP, the IRS underwent a period of
reorganisation and the APA program is now included within an advance pricing
and mutual agreement program.
The US will agree all forms of APAs including unilateral, bilateral or multilateral. The
taxpayer has to propose and present to the IRS a transfer pricing method and all
relevant facts so that a proper transfer pricing analysis can be performed. As with
the APA process in the UK, the administration evaluates all the information and
liaise closely with the taxpayer to ensure all information is disclosed so the analysis
is a fair representation of the taxpayer's affairs.
Following agreement, the taxpayer must submit an annual report for the duration
of the agreement. The APA applies for the agreed term from the effective date of
the APA, which can be prior to the agreement being finalised. Rollbacks are also
possible with the permission of the IRS, allowing the APA to cover earlier tax years,
which can resolve existing enquiry issues.
A report published by the IRS in 2017 indicated that the length of an APA can vary
from 2 years to 14 with the majority being for 5 years. The average for APAs
executed in 2016 was 6 years. Only 20% of the APAs executed in 2016 included
rollback.
A user fee is charged for participation in the programme, which ranges from
US$10,000 to US$50,000, and is dependent on the specific circumstances. The US
also has a slightly different, simplified and more streamlined, program for taxpayers
with either less than US$200 million total income or covered transactions less than
US$50 million (or less than US$10 million for intellectual property).
China
Most APAs completed within China have been unilateral APAs, however bilateral
and multilateral APAs are also available. Applications for APAs should be sent to
the SAT and the municipal tax authority simultaneously. The APA process follows
the same process as described in the OECD TPG and pre-filing meetings are
encouraged. This is followed by examination, evaluation and negotiation, which
usually leads to completion of the APA. The overall processing time for most APAs
in China is less than two years, and this is likely to reduce over time.
SAT allows for APAs to be rolled back to previous years as long as the relevant
transactions are the same or similar to those covered by the APA.
In 2017 China agreed its first APA for a cost sharing agreement (CSA) with a
fortune 500 company in Guangdong Province. This agreement is further evidence
that APAs are a viable means of reducing transfer pricing risks in China for
intangibles which can be high risk.
India
To address the increasing number of transfer pricing disputes arising in India, the
Union Budget 2012 introduced APAs into the Indian transfer pricing regime. The
APA scheme formed a part of the direct taxes code (DTC) (Section 118(7) of the
direct tax code), which was proposed in 2010 but had not yet been implemented.
The basic framework has been inserted in the Finance Act 2012.
Access to the APA program is available to all taxpayers falling within the ambit of
Indian transfer pricing legislation as no threshold limit is currently prescribed.
In 2017 India published its first annual APA report. Over the 5 year period 19% of
filed cases were resolved. The number of resolved cases was 152 of which 94%
were resolved in the last two years covered by the report. The average processing
times were 29 months for unilateral cases and 39 months for bilateral. More than
50% of the agreed cases included roll back. The top countries for filing bilateral
APAs are US, UK, Japan and then Switzerland.
Ireland
The Irish Revenue Commissioners introduced a formal system for APAs from 1 July
2016. Prior to this Ireland did not have a formal system but did accept requests
from treaty partners. The formal system only applies to requests for bilateral APAs; it
does not cover unilateral APAs. The Irish revenue has confirmed that they would
be open to negotiating multilateral APA, but not unilateral. The system was
introduced as a result of Action Point 14 of the BEPS Action Plan. As noted in the
previous chapter the best practices put forward in the final report include having a
bilateral APA program.
There is no fee for requesting an APA. For the application to go forward there must
be a double tax treaty in place with the other state. Multilateral APAs will be
achieved via a system of concluding bilateral APAs with the parties concerned.
The Irish system will only be open to complex cases. The revenue authorities have
stated that they will attempt to complete formal applications within 24 months.
The typical period for an APA will be 3 to 5 years, rollback is possible in certain
cases. Once an APA is agreed the company will need to file an annual report
which is due on the date for filing the annual corporation tax return. Non-
compliance with the terms of an APA could lead to cancellation or revocation of
an APA.
UK
HMRC have operated an APA programme since 1999 and so now have
considerable experience of working on and negotiating APAs. The APA program is
open to UK taxpayers, including a non-resident entity trading in the UK through a
permanent establishment. Due to limited resources allocated to the APA process,
HMRC generally only consider more complex and challenging transfer pricing
issues. This is in line with the OECD TPG as it is noted by the OECD that the APA
program will not be suitable for all taxpayers due to the expense and time taken
by the procedure. (See paragraph 4.158.)
As we saw earlier in this chapter bilateral or multilateral APAs are often referred to
as MAP APAs and will be agreed under mutual agreement procedures with the
other tax authority. MAP is covered in Article 25 of the OECD Model DTC. From a
UK perspective, access to bilateral and/or multilateral APAs will only be possible
where the relevant clause is included within the tax treaty in question.
HMRC currently aim to complete an APA application process within 18-21 months
of formal submission. Unilateral APAs are generally completed in a shorter time
frame.
The UK also has advance thin capitalisation agreements (ATCA) which are a form
of unilateral APA.
The BEPS Action Plan is likely to have a significant impact with regard to APAs. You
will recall from an earlier chapter that the 11 best practices put forward in the final
report on Action Point 14 (issued in October 2015) included the implementation of
APAs (Best Practice 4).
APAs are included in the categories of information which tax authorities will be
required to exchange with each other, pursuant to the work undertaken on Action
Point 5 – with respect to countering harmful tax practices. One area targeted
under this Action Point is the need for greater transparency. This is envisaged by
implementing a framework for the compulsory spontaneous exchange of
information on certain taxpayer specific rulings. This will include details of unilateral
APAs or other cross border unilateral rulings in respect of transfer pricing.
The 2017 OECD Model DTC includes references to bilateral and multilateral APAs in
the commentary to Article 25; in particular in the commentary to paragraph 3.
The European Union has also taken up this approach with regard to countering
harmful tax practices. Under the December 2015 amendments to the Directive on
Administrative Cooperation (2011/16/EU) the scope of the article on automatic
exchange of information has been extended to include the details of advance
cross border tax rulings and APAs entered into by a Member State. The provisions
apply post 1 January 2017, with the scope being sufficiently broad to cover a wide
range of situations, including both unilateral and bilateral /multilateral advance
pricing arrangements and decisions.
In 2014 the Commission published a letter sent to the Irish government which
accused it of having given illegal state aid to the US technology multinational
Apple. The Commission was starting an investigation and it argued that the Irish
Revenue granted tax rulings in favour of the Apple group which were apparently
'motivated by employment considerations'. The letter suggests that profit
allocation was a result of 'negotiation rather than [transfer] pricing methodology'.
There was a lack of explanation behind the methodology for the 2007 ruling, which
failed 'to explain the choice of operating costs as net profit indicator rather than a
larger cost basis, such as costs of goods sold'. It indicated there were additional
inconsistencies in the application of the transfer pricing method chosen such that
it did not appear to comply with the arm's length principle. Apple denied that it
received any special treatment.
In 2016 the Commission decided the tax rulings issued by the Irish tax authorities
constituted illegal state aid, allowing Apple to allocate profits in a way that
reduced the taxes payable in Ireland by up to €13bn over ten years. The decision
required Ireland to recover this amount, plus interest, from Apple. In October 2017,
the European Commission referred Ireland to the European Court of Justice for
failure to collect the illegal state aid from Apple. Ireland has been slow to
complete its calculations of the total that needs to be collected. (The money
should have been collected by 3rd January 2017.)
Luxembourg has put forward its defence against the decision, mainly based on
purported illegitimate ‘covert fiscal harmonisation’, wrong selectivity frame of
reference and violation of the legal certainty principle. It is likely that the case will
go to the Court of Justice of the European Union.
On 27 March 2018, following an investigation under the state aid rules, the
European Commission made publicly available the non-confidential version of its
opening decision.
It focuses on two APAs granted by the Netherlands in 2006 and 2011 to Inter IKEA
systems (BV).
The Commission’s opening decision concludes that the 2006 APA may have given
a tax advantage to IKEA systems (BV). The opening decision includes the
statement that when applying the transactional net margin method (TNMM) the
2006 APA incorrectly may have considered IKEA Systems (BV) as the less complex
entity and therefore the tested party. Alternatively, even if Systems had been
correctly identified as the tested party, application of the TNMM appears to
contain certain methodological ’mistakes’.
In 2011, Inter IKEA changed the way it was structured. As part of this restructure
Inter IKEA Systems bought the intellectual property rights formerly held by I I
Holding, financing this by an intercompany loan from its parent company in
Liechtenstein.
The Dutch authorities issued an APA in 2011, which endorsed the price paid by
Inter Ikea Systems to acquire the intellectual property, including a price
adjustment clause. It also endorsed the interest to be paid to the parent company
in Liechtenstein and the deduction of these payments from Inter Ikea Systems'
taxable profits in the Netherlands. As a result of the interest payments, a large part
of Inter Ikea Systems' franchise profits after 2011 was shifted to its parent in
Liechtenstein.
The Commission believes that the 2011 APA may have granted an advantage to
Systems since it endorses a tax treatment that does not seem to reflect a reliable
approximation of a market-based outcome in line with the arm’s length principle,
when considering the price paid for the intellectual property aspects of the price
adjustment clause and the loan terms; in addition some aspects of the interest
payments may not comply with Dutch law.
22.5 Conclusion
In the future, it is anticipated that the number of APA programs will increase and,
as the US has recently implemented, will increasingly be closely aligned with the
MAP programs. Although there is no fee in a number of territories, like the UK where
there does not seem to be a plan to introduce one, the APA process is resource
intensive for tax authorities and so it is likely that an increasing number of them will
impose fees to access the program. As APA programs are perceived as difficult for
all but the largest taxpayers, additional fees may be a good thing where this
allows tax authorities to increase resources to allow greater access to the
program.
CHAPTER 23
23.1 Introduction
The taxation of profits deriving from e-commerce has been a problem in the
sphere of international tax for some time. The traditional mechanisms used, in
particular in double tax treaties (which allocate taxing rights in various ways), do
not deal well with the particular issues arising from the flexible and dynamic
business models and structures found in the e-commerce environment.
Domestic tax legislation of states, and the work of bodies such as the OECD, have
struggled to keep up with this rapidly changing aspect of the world economy. This
in turn has, arguably, led to the erosion of the tax base of many jurisdictions as
global businesses are able to maintain a profile and sell to customers without the
creation of a traditional physical presence in a country.
This chapter examines some of the earlier work of the OECD in this area,
specifically the results of the 1998 Ottawa Conference and Report, and the
subsequent reports issued by the TAGs on various relevant issues, including the
interaction with the PE concept. We then consider the more recent work of the
OECD under the BEPS Project, which commenced in 2013, leading to a final report
in respect of Action Point 1, on the ‘Tax Challenges of the Digital Economy”, issued
in October 2015. We will also consider the post BEPS developments in this area,
including the recent further reports on e-commerce and digitalisation and the
proposed unilateral actions of some states.
23.2 Earlier Reports: The OECD Advisory Groups' Work on Tax and E-
commerce
The OECD report also suggests that “neutrality” should mean that similar
transactions in similar situations have the same tax consequences. The principles
noted in this report were referred to in the final 2015 BEPS Report on Action Point 1.
However problems arise with this approach. For example, there is a difference
between a physical transaction of actually buying a book in a bookstore from an
assistant and a “virtual” transaction of downloading the contents of a book from
the internet.
It is not clear whether the virtual transaction is the same, or whether it is more
specifically the payment of a royalty of some form for the right to use and store the
material. The latter is possibly less likely, since the end use is probably just the same
as buying the physical book.
However, the buying of software over the internet does more obviously present
different considerations and the issue as to whether it is a royalty payment is more
immediate. Withholding taxes potentially apply on cross-border royalty payments,
whereas they do not on trading payments. Amendments to the OECD Model
Treaty commentary attempt to address such issues, as noted below.
Limited uses of copyright, such as the ability to copy material onto the hard
disk of a computer, are not to be regarded as giving rise to a royalty.
Although the normal distinction is between royalties and trading income, some
tax treaties contain technical service fee articles, and articles dealing with the
use of scientific equipment or know-how. In the latter cases it may be that
withholding taxes still apply if the payments are classified as being within the
terms of those articles;
3. transfer pricing issues. A discussion paper produced by the Business Profits TAG
in 2001 specifically focused on the transfer pricing issues arising in respect of e-
commerce transactions through a potential PE (discussed below).
4. tax residence. This is a further area investigated by the Business Profits TAG.
We will not look at this as our concern is with areas of the TAG relating to
transfer pricing.
The Final Report was published in December 2005 ‘Are the Current Treaty Rules for
Taxing Business Profits Appropriate for E-Commerce’. The underlying principles of
these reports are that;
• A PE should be treated as a notional separate entity from its head office: this
forms the basis of the “working hypothesis”.
• An arm's length price is then ascertained based on those functions and risks.
This is a very broad outline of the range of the OECD discussions on transfer pricing
which have taken place over a number of years (see earlier for the detail of the
2010 report on attribution of profits to a permanent establishment and the
changes made to Article 7 and its commentary which reflect these principles).
In March 2018 the OECD published a final report to give additional guidance on
attribution of profits to permanent establishments (Action Point 7). This final report
replaced an earlier draft released in July 2017. The 2018 report sets out high level
general principles for the attribution of profits to PEs, confirming the principle that
PEs are treated as separate entities for these purposes. The paper considers in
particular the application of the 2017 amendments to Article 5 of the OECD Model
Treaty, and the examples focus on this.
It is notable that previously the Business TAG had issued a discussion paper in
February 2001 on the transfer pricing aspects of permanent establishments
carrying on e-commerce activities.
Four scenarios were used in the 2001 discussion paper to illustrate the areas that
deserved further consideration in relation to e-commerce and which we also see
being discussed further in the 2014 and 2015 BEPS Reports on Action Point 1. A
summary of the scenarios are as follows:
Where the location server operations are purely retail in nature then it is
unlikely that there will be significant profits attributable to those operations,
since there are unlikely to be substantive assets bearing any significant risks.
Head office is also likely to own from abroad the hardware and intangibles
associated with the local operation.
2. The second scenario refers to the use of mirror servers for the retailing activities.
The same profit attribution principles apply as in the first scenario, but it is
admitted that it is not always possible to precisely identify the value added by
each server. Therefore the allocation of profits between server locations on a
possible “cost plus” basis may require a reasoned approximation.
3. The third scenario deals with the situation where there is an existing PE having
people, providing, say, technical support and after-sales services, and the
server happens to form part of that PE.
Again the attribution of profits to the server itself is not likely to be significant.
The activities of the personnel may or may not have a significant profit
attribution, depending on the nature and risks of the operations.
In some circumstances, the OECD Model Treaty Article 5(6) (prior to the BEPS
Action Point 7 changes now in the 2017 OECD Model, see earlier chapter)
deems there to be a PE where an agent habitually exercises “authority to
conclude contracts in the name of the enterprise”. The OECD in its revised
commentary has considered in the context of e-commerce whether an
Where the ISP provides services to others and enables them to access the
internet, or provides general hosting services or designs web-sites, then it is
likely that the ISP will be regarded as an independent agent and therefore not
a PE.
However, where the ISP provides a more pro-active part in the actual conduct
of the trade or business of an enterprise then it may constitute a PE of the
enterprise.
4. The fourth scenario in the February 2001 OECD TAG discussion paper assumes
that the PE has developed intangible assets essential to the business and owns
hardware used in the server/web-site operation.
Some countries, such as the UK and Ireland, have made clear that, of itself, a
web-site and server will not give rise to a PE for domestic direct tax purposes.
Clearly, if there are other operations/activities then there may be a PE. (See UK
HMRC press releases dated 11 April 2000 and 12 February 2001, also Irish
Revenue statement in March 2001.) Some countries, such as Spain, have
maintained that a local website (so a software driven presence) is enough to
trigger a taxable presence.
Clearly, prior to the work undertaken as part of the BEPS Project, the aim of the
OECD has been to “fit” e-commerce within the existing OECD Model Treaty
without making alterations to the Model Articles, but to change the commentary
to the Model where appropriate, and such approach has been effective, up to a
point.
It is interesting to note that it was only during 2009/ 2010 that a review of the
original 1999 OECD e-commerce guidelines was proposed, including a report to
identify areas where the principles in the Guidelines could be further elaborated or
modified. At a conference in April 2009 on the future directions with regard to e-
commerce the planned review was highlighted, the purpose being to determine
whether the existing principles adequately address new or evolving consumer
issues related to the internet economy in both OECD and non-member states.
It seemed as if case law was overtaking such developments. In the 2012 Dell case
(Ruling of Mar. 15. 2012 R.G. 2107–07, Central Tax Court), the Spanish lower court
introduced the concept of an “online permanent establishment” for the first time.
In line with Spain’s previous position on software driven PEs, the Spanish court ruled
that an online store could qualify as an online PE, even though the server was
situated outside Spain and no activity was performed by the Irish company itself in
Spain. However, on appeal in 2015, the Appellate Court, whilst confirming the
existence of a PE on the basis of both a physical presence and dependent
agency through the Spanish subsidiary, did not confirm the lower court’s finding of
a “virtual” PE. Such issues relating to the digitised economy are highlighted in the
July 2013 BEPS Action Plan (Action Point 1) and considered in the later reports
issued on this matter (see below).
As noted above, the issues surrounding e-commerce and the digital economy
have been at the forefront of discussions within the BEPS project. Action Point 1 of
the BEPS Action Plan related to consideration of how to correctly approach the
taxation of the digital economy. A discussion draft on the Tax Challenges of the
Digital Economy in response to Action Point 1 was released by the OECD in March
2014. This was followed by an initial report in September 2014, and a final report in
October 2015.
It was noted in the earlier discussion drafts that in connection with direct taxation,
key points on tax planning opportunities that raise BEPS concerns are:
In similar fashion to the earlier reports, the final October report initially examines the
key tax policy considerations and makes reference to the Ottawa principles which
were developed at the time of 1998 OECD Report (see above), such that any
proposed legislation should reflect: neutrality; efficiency; certainty and simplicity;
effectiveness and fairness; and flexibility. It then discusses the evolution and
expansion of information and communication technology across the economy,
and provides an overview of the new business models now seen, and key aspects
of such models. For example: e-commerce such as business-to-consumer, or
business-to-business, models; cloud computing (such as providing infrastructure-as-
a-service, platform-as-a-service, content-as-a-service etc.); payment services; high
frequency trading, and online advertising.
Features of these business models which are relevant for tax purposes are
discussed further, including: the mobility of business users, functions and assets (eg.
intangibles); the importance of data (whether it is collection, analysis or storage);
network effects; the possibility of monopoly (or oligopoly) with certain business
models; and volatility (on basis there are low barriers to entry). The report also
notes possible issues with emerging technologies such as 3D printing, and virtual
currencies. Tax planning opportunities which raise concerns, as highlighted in
earlier reports (as above), are also noted.
The final report reiterates the approach highlighted in earlier drafts, based on the
premise that the digital economy cannot realistically be separated and dealt with
independently from the rest of the economy – as it is, in essence, the economy.
This report comments that the work undertaken with regard to all the BEPS Action
Points (as discussed in the various relevant chapters herein) takes into account the
problems associated with the key features of the digital economy. Thus the
solutions proposed for such Action Points will also have an impact in this regard. In
particular the work and deliverables on the CFC rules (Action Point 3), artificial
avoidance of a PE (Action Point 7), and on transfer pricing (Action Points 8 to 10)
will be relevant.
With regard to Indirect Tax matters the report refers to the OECD’s international
VAT/ GST Guidelines, which now take into account digital issues (for example at
Guidelines 2 and 4), particularly with regard to the matters such as the remote
supply of digital goods and services to VAT exempt businesses or to a centralised
location for resupply within an MNE (not subject to VAT).
In direct tax matters three main policy concerns are noted: nexus (ability to have a
presence without being liable to tax); data (how to attribute value to the
generation of data through digital products and services and how to determine
profit share on the basis of this value); and how to properly characterise the
income within these new business models. Four key recommendations were put
forward in this respect:
• Amend the exceptions to the definition of PE found in Article 5(4) of the OECD
Model Treaty. This work has been carried out under Action Point 7 (as we saw
in an earlier chapter) and attempts to ensure each of the exclusions in that
paragraph is restricted to activities that are “preparatory or auxiliary”, and
introduces anti-fragmentation rules (see further the discussions in the earlier
chapter on Article 5 – permanent establishments).
• Update the OECD Transfer Pricing Guidelines – this has been actioned within
the context of the work being undertaken on Action Points 8 to 10. It is notable
that digital economy companies place heavy reliance on intangibles for
creating value and generating income. Information technology improvements
mean global value chains are more prevalent, which allows MNEs to become
more integrated. Therefore there is a greater need now for value chain
analysis and more scope for use of the transactional profit split method.
• Improved Controlled Foreign Company (“CFC”) rules (see later chapter for
more detail) – the Report notes that the work undertaken with regard to the
design of effective CFC rules, and the proposed recommendations (the six key
building blocks) under Action Point 3, should help combat some of the
planning opportunities highlighted. In particular using appropriately drafted
CFC rules could assist a country in shifting profits earned through the digital
economy back to the parent entities within a group. By way of example, the
definition of CFC income could include revenues typically generated in the
digital economy such as license fees and income from sales of digital goods
and services.
Some of the options put forward in the earlier drafts were not recommended in this
final report, such as creating a new nexus test (eg. a significant presence test) or
the imposition of a withholding tax on digital transactions. However, the report
does leave it open to countries to introduce such measures within their territories as
additional safeguards against BEPS. In 2018 we started to see such unilateral
action, as noted below.
Post the final BEPS reports from October 2015, we are already seeing some
changes. For example the new 2016 US Model Treaty includes anti-fragmentation
provisions within the PE article, and the UK has already introduced a Diverted
Profits Tax regime that aims to counter arrangements whereby the creation of a
taxable UK presence is artificially avoided.
However, it is also notable that much work on the digital economy was delegated
in the final 2015 report to the Task Force on the Digital Economy which will be
issuing a further report in 2020. For example, the following matters are areas which
the Task Force is examining further:
– The evolution of tax policy as the digital economy evolves, for example basics
such as revenue characterisation require further analysis;
The OECD delivered a report to the G20 finance ministers in March 2017, which
highlighted key challenges ahead, including specifically the need to explore and
address the tax consequences of the digitalisation of the economy.
The OECD has also initiated a major horizontal report – which is a cross disciplinary
project within the OECD - on how digital transformation affects policy making
across many different areas, including tax. Digital transformation is seen as the
transition towards a digital economy and society, evidenced by more people and
things becoming connected to networks, which generates significant amounts of
data, leading to the development of new technologies and breakthroughs in
areas such as artificial intelligence. This digital transformation project aimed to run
for two years – 2017 and 2018 – and it envisages the production of a range of
reports and recommendations on select policy issues produced by each policy
area involved in the project, as well as policy brochures, country profiles and
databases, all representing a synthesis built on horizontal insights and good
practices. The OECD overview of the project mentions that the analysis may lead
to a toolkit of policy “dos” and “don’ts” for the digital era.
Since the original report of 2015 it has become apparent that the taxation of the
digital economy is now, and will remain for the future, one of the most
fundamental and challenging aspects of international taxation. Trying to steer
action on a global scale and to maintain a global approach is proving difficult,
even amongst the many countries which worked on and agreed to coordinated
action under the BEPS project.
Currently we are seeing different countries and groups of states unilaterally move
in a direction of their own, frustrated by the lack of actual coordinated action
from the OECD. For example, in 2018 both the OECD and the EU issued significant
reports on the digital economy, however, the approaches taken in each are very
different (and some would say inconsistent). The OECD continues to examine the
complexities of the digital economy, considering how the different business
models now seen work, and how they add value – which the OECD hopes will be
a key in determining how to tax such models. By contrast the EU have taken the
approach that this is all about ‘fair’ taxation, and have put forward concrete
suggestions to capture income and tax it.
In addition states like the UK and India have also issued proposals in this regard,
which leads to the inevitable conclusion that we are likely to end up with multiple
independent approaches to this problem, rather than the originally hoped for
collective global stance under the BEPS project.
As noted, a key aim of the work of the OECD in this area, and in the BEPS project,
has been to examine ways in which taxation can be aligned with value creation –
which may not be easy to determine with regard to the types of business
undertaken in the digital economy.
The post BEPS March 2018 OECD Interim Report covered a multitude of areas and
notably it highlighted that differences still exist between various states over the
action needed. The report was concerned with analysing how digitalisation
affects business models which in turn affects the international tax framework;
looking at whether the BEPS measures in place are having an impact; considering
whether interim proposals were appropriate; and also examining how tax
authorities and companies can take advantage of digitalisation to improve the
tax compliance process.
The report provides an in-depth analysis of new business models and attempts to
explain how these models give rise to value-creation, and how to reconcile this
with the allocation of income rights. The report examines in particular how digital
platforms create ‘size without mass’, so how income or profits (i.e. business) can be
extracted from a territory without any physical connection in the form of a PE, and
notes the importance of user participation and data exploitation, and also the
heavy reliance on intangible assets.
It seems that many of the OECD states feel that the changes to the 2017 OECD
Model Treaty, most of which are in the BEPS MLI, do not go far enough to combat
these types of issues. Tech giants such as Google and Facebook have a significant
worldwide presence, and yet continue to pay little tax in jurisdictions where they
have a large number of users.
One problem, as the OECD identifies in its report (on adapting the international tax
system), is how to equate the creation of value with the business generated from
large numbers of users in a territory. Different countries have differing opinions on
whether it can be said such users are creating value, and if they are, how this
should be captured. There is some divergence as to whether the existing tax
framework can deal with this type of problem. Could income or revenue from a
number of users, consumers or clients be treated as a proxy to value, and
therefore taxed?
So the report does not provide a solution, but rather indicates that members have
very different opinions on these points and on the way forward, although they
have agreed there is a common interest in maintaining a single set of relevant
international tax rules in this area, not least to promote economic efficiency and
global welfare. On that basis further review is needed of the ‘nexus’ and ‘profit
allocation’ rules for determining taxing rights.
With regard to benefitting from these changes in respect of tax compliance, the
report considered how digitalisation is also having an effect on other areas of tax
system, such as the use of online forms and payments, and the online submission of
tax returns etc. It also notes how tax authorities can make use of available digital
information to undertake reviews/ audits and ensure compliance.
The report also takes stock of progress made in the implementation of the BEPS
package, which it notes has had an effect with regard to opportunities for double
non-taxation - it is becoming evident that some multinationals have already
changed their tax arrangements to better align with their business operations. In
addition the measures are already delivering increased revenues for governments,
for example over €3 billion in the EU alone as a result of the implementation of the
new International VAT/GST Guidelines. The report does note some of the unilateral
measures introduced in the digital area already, grouped in four categories:
alternative PE thresholds; withholding taxes; turnover taxes; and specific regimes
for large multinational enterprise groups.
However, one key issue which is also evident is that this is only an interim report,
and so it aims for consensus of approach on the digital economy by 2020, with
action later. This is not considered ideal by many states, who feel there is a need
for something more immediate.
As discussed above, the lack of firm action on a global cross border scale from the
OECD has driven many OECD members, and other countries, to unilaterally
introduce their own rules to target these types of businesses.
The EU approach
In March 2018 the European Commission published its digital tax package. This
included an explanation of why it was considered that the ‘digital economy’ was
undertaxed, in addition to two draft directives and one recommendation. Whilst it
did not include changes to the current proposals on the Common Consolidated
Corporate Tax Base (CCCTB – see Appendix 2) the Commission does indicate that
changes to those proposals could ensure digital activities are caught.
In the long term the package put forward draft proposals for a directive which lays
down rules relating to the corporate taxation of a significant digital presence. This
would mean changing existing PE thresholds where ‘digital services’ are provided
and which fulfil any one of the following tests:
– more than 100,000 users of the digital service in a Member State in a taxable
year; or
– there are over 3,000 business contracts for digital services in a taxable year
with individuals or businesses who are resident in that Member State.
In the short term a draft directive is proposed which introduces a digital services
tax, which would be a tax on revenues where users play a major role in value
creation. For example, taxable revenues created by selling online advertising
space; or where a digital intermediary allows users to interact with other users; or
where revenues are derived from the sale of data generated from user-provided
information. This would be taxable in the Member State of the users, and would
apply to companies/ groups with annual worldwide revenue of €750m and EU
revenue of €50m. The suggested tax rate of 3% on gross revenues could generate
€5bn a year.
The UK approach
At about the same time, in March 2018, the UK published its own proposals with
regard to corporate taxation and the digital economy.
This paper looks more closely, and provides more detailed explanation, on how
user participation creates value for digital businesses, in particular looking at the
generation of content and engagement with platforms which then contributes to
the brand. This is very different from the role that a customer serves in a traditional
business and the mere collection of customer data. The customer is effectively
performing supply-side functions which the company would have previously
undertaken itself.
However, it is clear that different digital business models do not derive a common
value from such user participation, which makes matters more complicated. For
example, the link to value is evident for online networks (such as social media,
search engines and intermediation platforms) but it would seem less relevant for a
typical e-retailer or digital software/hardware provider. Therefore the relevance of
user participation for the digital provider is an area where further investigation is
required.
The paper proposes a solution which would involve reforming the international
framework and using profit reallocation rules to benefit the user jurisdictions, to
reflect the value of user participation.
The paper also suggests that small business (or loss making entities) could fall within
a safe harbour mechanism. In addition a ‘one stop shop’ approach for
compliance, similar to that used for VAT, could be used to reduce the burden on
However, one recent proposed change to UK tax law which is likely to impact on
the digital economy is the proposal with regard to withholding tax on royalties (at
20%). In November 2017 plans were announced to introduce a withholding tax on
royalties paid by a non-UK resident company to another non-resident company in
a no or low tax jurisdiction if the royalty is “in connection with” the sale of products
and services to UK customers. It would only apply to payments to territories without
an appropriate double tax treaty (this would include Bermuda, BVI, Cayman
Islands, Gibraltar, Guernsey, Jersey, Isle of Man and Brazil). It is a response to MNEs
who sell to UK customers but where the group’s intangible assets are located in
such a jurisdiction. Global tech firms are clearly within the provisions, in particular
as the proposal notes that the consumption of goods or services in the UK,
including digital content and the provision of software services, would be a core
connecting factor. The tax is intended to apply from April 2019.
However the proposals would lower this business connection threshold, as from 1
April 2019. The changes would allow the profits of a foreign company to be taxed
in India where the company has a “significant economic presence” in India
(subject to the operation of an applicable tax treaty, and the definitions
contained therein). As in the proposed UK changes to royalty withholding tax, the
Indian authorities make it clear in their proposals that such a change is in response
to recent advancements in information and communication technology which
has enabled new business models to carry on business activities in the source state
remotely and through digital means, without the need for establishing a physical
or representative presence. On this basis the traditional nexus to tax of a PE does
not “hold good anymore” and it was considered necessary to supplement such a
connection with a new nexus, based on a digital or virtual economic presence,
which would be in line with the approach already seen in the Dell Spanish case
from 2012.
In addition, as noted above, this also reflects one of the possible options discussed
in the Final Report on BEPS Action Point 1, although it was not a recommendation.
The proposals consider such a presence would be established if the aggregate of
payments arising from a transaction carried out by a non-resident during the
financial year exceeds a set amount (to be decided); or where there is systematic
and continuous soliciting of business activities or engaging in interaction with a set
number of Indian users through digital means.
There are some concerns that the proposals are a step too far, as the international
tax framework has not been amended to take into account such changes to the
Indirect Tax
In the meantime, one area where developments have been very evident, and
governments are themselves moving ahead, is in the introduction of legislation to
apply VAT/ GST on the provision of cross border business to consumer digital
services. This has become more commonly known as the “Netflix” tax – and is an
attempt to capture revenue that is being lost on the local level to untaxed, non-
local digital streaming services (in particular). The EU introduced provisions which
came into force at the start of 2015 in this area, but we are now seeing other
countries around the world also introducing provisions with regard to the taxation
of such cross border services. For example in May 2016 Australia passed a cross
border digital services tax which requires businesses outside the country to register
and collect GST on sale of digital services to consumers in Australia – effective from
1 July 2017. New Zealand had already introduced similar rules which went into
effect on 1 October 2016, and on 1 January 2017 Russia passed similar tax rules
(under Russian VAT legislation) on cross border digital services sales to consumers,
joining other countries such as Japan, Korea and India which have also
introduced such rules.
During 2018 this trend appears to have continued and even picked up pace. In
February Singapore indicated the introduction of such a tax, commencing on 1
January 2020. In March Quebec province in Canada revealed its plan to
introduce a digital sales tax. In the same month Thailand announced they were
putting together a draft bill on an e-business tax which would be a levy on online
purchases, advertisements and website rent in Thailand earned by foreign-based
digital service providers. In June Bangladesh proposed a 5% VAT on all types of
‘virtual business’, which includes digital platforms such as Facebook, YouTube, and
Google. In July Colombia released draft legislation aimed at taxing foreign
suppliers of digital services. In addition we should not forget the Gulf States which
have introduced or are in the process of introducing VAT (which allows them to
put in place systems to tax the digital economy from the outset).
This approach also fuels the debate with regard to e-commerce, as to whether
taxation should be on the basis of source, or on the basis of residence. Clearly the
source approach (based on where the services are being consumed) is being
seen as a practical and viable first approach. It is arguable that these approaches
are themselves outdated with regard to e-commerce – which seamlessness and
intangibility itself challenges the suitability of the traditional tax system. The results
of the aforementioned OECD report on digitalisation will undoubtedly prove
interesting. Whilst digital service providers themselves may not be too keen on such
VAT/GST provisions, it is notable that they are now becoming widespread - both
globally and also at the level of state and city sales taxes within the US.
Clearly work with regard to the digital economy on the part of the OECD, and
globally, continues to develop.
CHAPTER 24
In this chapter we are going to look at the broader role of transfer pricing, beyond tax
planning and compliance, within a multinational organisation, including:
– transfer pricing and public affairs
– the impact of taxation on business decisions
– transfer pricing as a management tool
– customs duties and transfer pricing
24.1 Introduction
Most of the analysis of transfer pricing so far in this manual has focused on its role
for corporate tax purposes. Broadly speaking, two key dimensions have been
identified: the challenges for compliance created by complexities surrounding
transfer pricing, and the opportunity for tax planning due to the relationship
between transfer prices and taxable profit.
However, transfer pricing is not only important for corporate tax purposes. It also
has an important role to play across a range of important aspects of the internal
operation of multinational groups. In particular, in this chapter, we will consider the
relationship between transfer pricing and each of the following:
• Public affairs
• Business decisions
• Management incentives
• Customs Duties
For a long time, transfer pricing has had very little profile amongst the broader
public, with few people being aware of the term, much less what it means. That
situation has changed dramatically in recent years. One of the main reasons for
this is the increased focus on the level of corporation tax paid by subsidiaries of
global multinational groups.
As we have seen in earlier chapters, Amazon, Google, Apple, IKEA, Starbucks and
many other household names have all been subject to high profile tax
investigations.
As a result, in the short term, there are strong associations for the public between
transfer pricing and tax evasion. In many parts of the media, transfer pricing has
been portrayed as purely a planning tool, ignoring the complex compliance issues
faced by any company seeking to operate in multiple jurisdictions. Thus, the
consequences for any transfer pricing controversy issues that arise are likely to be
magnified.
In the longer term, transfer pricing seems to have shifted from a policy issue for tax
authorities to a political issue. As you have seen throughout this manual, transfer
pricing issues have played an important role in the BEPS Action Plan, in addition
many governments are implementing fundamental overhauls of tax legislation.
The consequence of all this is that for most multinationals, transfer pricing has been
elevated from purely an issue to be resolved within the tax function to a board-
level consideration. The potential consequences of a tax strategy that might be
perceived as overly aggressive is no longer limited to the risk of double taxation,
plus interest and penalties. It is instead a potential threat to brand value, revenue,
profitability and ultimately share price. There is much to be played out before the
tax environment can again be said to be in a stable state. In the meantime, there
are a much broader set of parameters and stakeholders for taxpayers to consider
in respect of their transfer pricing than simply seeking an appropriate balance
between compliance and tax optimisation.
There is a clear link between transfer pricing and the tax cost to a business. The
transfer prices that are acceptable to the tax authorities will affect the tax charge
in each section of the business. Non compliance with transfer pricing legislation
can lead to penalties which in turn will impact on the cost to the business.
Thus, we can see a direct link between the transfer price for taxation purposes and
the company’s overall performance. Managing tax cost is as important to a
company as any other costs, since dividends are paid out of post-tax profits.
Transfer pricing has an important role to play in managing cash flow within the
business, since it determines where profits are earned. By managing transfer
pricing to ensure that profits are earned in the right location, companies can
make sure they have cash available to fund dividends, capital investment or
acquisitions without need for recourse to external borrowing. Furthermore, it is
important to consider that some countries, such as China and India, have tight
foreign exchange controls, making it difficult to take cash out of those markets. An
appropriate transfer pricing strategy is required to avoid having trapped cash in
those countries.
In addition to being a potentially high cost to the business, tax and transfer pricing
carry a significant degree of uncertainty. As new strategic initiatives are
developed and rolled out by companies, it is important for them to manage the
tax consequences. This means considering the most likely tax treatment, the
possible alternatives and related costs, and the mitigation of unnecessary risk
through appropriate business activity. Failure to do so can lead to significant
additional cost to the business through unmanaged transfer pricing exposures. It is
impossible to decouple significant business decisions from tax (and typically
transfer pricing) consequences.
• Expansion into a new territory – As companies seek to grow, they will often
seek new markets for their products. In setting up a new business, transfer
pricing considerations will affect the legal structure (branch or subsidiary), how
the new operations will be financed (debt or equity), where the set up costs
will be borne, how the new entity will transact with the rest of the group and
forecast expected benefits (based on the tax impact of where profits will be
earned). In addition, if the business decides to enter a new territory through a
strategic relationship with a third party, this will be of relevance to transfer
pricing as the terms agreed may create a CUP (which may support or
undermine existing transfer pricing arrangements).
• Change of brand name – Companies that maintain a brand portfolio will need
to actively manage it, and in some cases that might involve brand refreshes.
Transfer pricing will inform the company where costs relating to brand
refreshes should be borne and will help to determine the value of the new
brand to the brand owner through the mechanism by which it is remunerated
by other group entities.
Illustration 1
Contract Manufacturer
Product
Contract →→→→→→→
Principal
manufacturer ←←←←←←←←
Payment
Illustration 2
Consider now the case of a fully fledged manufacturer selling direct to distributors.
Fully fledged
manufacturer
Product ↓
Now let’s assume that the manufacturer also sells to Country C through a third
party distributor. If Price C is higher than both Price A and B (for reasons of different
economic circumstances, rather than creating a CUP), this will further impact
behaviour. In the event of capacity constraints, the manufacturer may be
incentivised to prioritise sales to Country C rather than either of the two related
party markets. This would maximise profit for the manufacturer, but reduce overall
group profit as profits earned in Country A and Country B would be lost to the third
party in Country C.
Illustration 3
Procurement Company
↑Payment ↑Payment
(Price A) (Price B)
Fully fledged ← Material Related Party
Manufacturer → Payment (Price C) Procurement
Company
↓Material
↑Payment
(Price C)
Related Party
Manufacturers
Assume that the fully fledged manufacturer requires Material as part of the
manufacturing process, which it sources from the Supplier. Given its size, it is able
to negotiate Price A as the price for Material.
The Procurement Company then purchases Material from the Supplier and sells on
to all manufacturers at Price C. This price includes a margin for the Procurement
Company that covers its costs and provides it with an economic return for its
activities. For all other manufacturers, Price C represents a saving on what they
could have purchased Material for on their own. However, for the fully fledged
manufacturer, the addition of a margin means that Price C exceeds Price A – the
price it was able to negotiate by itself.
In each of the illustrations above, the conflict that arises could be alleviated by a
different transfer price that creates an alternative incentive for the manufacturer.
The question therefore arises: is it possible to operate with two sets of transfer prices
– one for statutory reporting purposes and the other for management accounts to
assess performance? Management accounts may not reflect certain
intercompany charges, such as management fees or royalties, and may set
product prices on a different basis than the statutory accounts (for example, with
reference to total system profit).
A report by Czechowitcz et al in 1982 stated that 89% of MNEs used one transfer
price for both internal and taxation purposes. More recently (1999) Ernst & Young
found that MNEs are now more inclined to use two sets of prices. An article in The
European Financial Review in October 2012 by Hieman and Reichelstien noted
that most MNEs rely on one set of transfer prices but that a growing number are
moving towards “decoupling” their internal transfer prices from those used for tax
purposes. Hieman and Reichelstien believe that taxation cannot be ignored in this
analysis. They conclude that:
The use of two sets of accounts has some appealing features. It allows greater
control for management over their area of the business. It also reduces the time
spent by senior management on dealing with internal charges. Ultimately,
intercompany pricing determines how profit is shared within a group, but does
nothing to directly increase the amount of pre-tax profit that a group earns. As
such, management time and resource would seemingly be better spent
elsewhere. The tax function could put in place charges necessary to meet
statutory and fiscal requirements, and the business could be run based on
management charges.
However, this approach has two discernible drawbacks. Firstly, it is very time-
consuming and burdensome to run two sets of accounts. It adds complexity to the
management of the business that may be difficult to justify.
Consider the case of a limited risk distributor (LRD). If an LRD is remunerated based
on a low stable operating margin, it would be assumed that its activities could be
characterised as relatively routine, and that the key economic decisions
managing risk and driving profit would be made elsewhere. If however, there is a
second set of management accounts whereby the management of the distributor
is incentivised to maximise profit in the country (rather than for example maximising
sales within certain profit parameters), this implies that management is able to
exercise control over that profit. It suggests there is local decision making that is
capable of materially influencing local profit, and therefore undermines the
characterisation on which the transfer pricing is based.
Much of the focus on transfer pricing is on the impact for corporate tax purposes.
However, as we have seen, many related party transactions will involve cross
border transactions. Customs duties are normally applied when goods enter a
territory.
Customs duties are a further way of raising tax revenues; the higher the value of
the goods at importation, the greater the customs duty, which is normally applied
on an ad valorem basis. This means that the value of the product imported (ie. the
transfer price) is directly correlated with the customs duty payable. As such,
strategic consideration of the customs duty impact is required when determining
transfer prices.
Regulatory Overview
The OECD TPG recognise that the valuation methods for customs purposes may
not be aligned with the OECD recognised transfer pricing methods (see
paragraph 1.137). Having recognised this, the OECD TPG go on to state that the
customs valuation may still provide useful information as customs will have
contemporaneous information on the taxpayer and documentation.
There are of course some key differences between the valuation methods used for
customs duties and the transfer pricing methodologies. Customs pricing does not
take account of related party transactions; they deal with both related and
unrelated parties and include individuals. For customs purposes the focus is on the
value at the point of import; for transfer pricing there is more focus on profits that
are made and how they need to be split across an organisation.
The World Customs Organisation (WCO) and the OECD organised two
conferences (2006 and 2007) to discuss how the gap could be bridged between
direct and indirect taxation on the valuation of transactions between related
parties, and to explore possible areas for strengthening coordination between
customs and tax specialists. The conferences concluded that more analysis is
needed and that harmonisation will require changes and adjustments on all sides.
The OECD TPG at paragraph 1.138 suggest greater cooperation between income
tax and customs administrations within a country.
Countries are recognising the need for co-ordination and cooperation. Canada
and the US have provided guidance on the acceptability by customs authorities
of transfer pricing valuations and adjustments. In the UK HMRC can conduct audits
into both taxes.
Practical Considerations
From the perspective of strategically managing transfer prices, there are a range
of practical issues that need to be taken into consideration:
• Dutiable items – For physical items imported, it is clear that duty is payable,
subject to rates applied under local regulations. However, there may also be
other transactions that are dutiable. For example, if separate payments are
made for IP or services that might otherwise be considered an inherent part of
the product, these may well also be subject to duty. For example, if a
distributor imports chocolate bars from a related party manufacturer, and
separately pays the distributor a royalty for the brand name used on the
wrapper, most customs authorities would consider the royalty payment
dutiable.
In June 2015 the World Customs Organization (WCO) published the WCO Guide to
Customs Valuation and Transfer Pricing. The aim of the publication is to assist
customs officials responsible for customs valuation policy or who are conducting
audits and controls on MNEs in understanding the relationship between customs
valuation and transfer pricing. The Guide consists of six chapters including an
explanation of transfer pricing and technical information on customs valuations.
As with transfer pricing, customs valuation seeks to ensure the price between
related parties has not been influenced by the relationship. The guide emphasises
some of the similarities between the aim of customs valuations and transfer pricing
seeing the ability to use transfer pricing information and documentation as positive
where it is possible.
Chapter 6 includes guidance on good practice for business. These are listed as:
• Ensure the customs and tax advisors (either internal or external) of an MNE
communicate with each other regarding the mutual needs of the customs
and tax authorities in respect of transfer pricing and customs valuation;
• Work with customs to provide and help interpret transfer pricing analyses and
data related to imported goods.
There are also good practices for customs valuation policy makers, and tax
authorities. Customs administrations and tax authorities are encouraged to work
together and exchange information and knowledge in this area.
Annex VIII to the guide gives an overview of the key elements that may be found
in transfer pricing documentation which may be relevant for customs valuation.
The key elements are listed as:
1. Description of the MNE Group, its business activities and the industry in which it
operates;
3. Relevant aspects of the group’s transfer pricing policy, including details of how
prices are set and reviewed and whether the group has any relevant APAs;
5. Explanation as to why the transfer pricing method selected was selected, with
reference to local legislative requirements (where applicable);
http://www.wcoomd.org/en/search.aspx?q=Guide%2520to%2520Customs%2520V
aluation%2520and%2520Transfer%2520Pricing
APPENDIX 1
CASE LAW
For ease of reference we have listed some important transfer pricing cases below. You will
have come across many of these cases as you worked through the manual. All of the
following cases are long and complex. No attempt has been made to provide a full
analysis of each case; instead the following focuses on the aspects of the case that have
been most talked about in the Transfer Pricing press and that are likely to be most relevant
to the exam. There are of course other cases that you may have come across that you
can equally use to demonstrate a point in the exam room where necessary.
In this case, the South African Tax Court had to determine whether a US company,
providing strategic and financial advisory services for the South African airline
industry had created a PE in South Africa. The Court reviewed Article 5 of the US-
South Africa double tax treaty, (which differs from the OECD Model Treaty) in
particular the second paragraph of the article (para (5)(2)(k) in this case), which
“includes especially” as a PE “the furnishing of services including consultancy
services”
In its judgment of May 2015, the Court held that a PE had been created, on two
counts. Firstly, on the basis the US company employees had been in South Africa
for over 183 days. The Court considered that the wording of the second
paragraph of Article 5 in the treaty, which (as noted above) is preceded by the
words ‘includes especially’, creates a stand-alone definition of a PE by way of an
extension to the first paragraph of the Article. Secondly, it found there was in any
event a fixed place of business created by the use of the boardroom (the US
employees had exclusive use during relevant working hours). The US company was
liable for tax on the profits attributable to the services rendered. In addition, the
Court held that the penalties imposed by the tax authorities (100% of the tax) were
not disproportionately punitive and that the US company had been negligent in
not considering the tax consequences of the agreement it had entered into. The
company had argued that it did not deliberately ignore South African law, but just
misunderstood it. Interestingly the Court commented that the enterprise had a
global reach and that it was “not a novice in the area of tax liability”, and
therefore should accept responsibility for its own error.
1.2 Amazon State Aid: Luxembourg and Amazon state aid [SA.38944V]
the application of the ruling given by Luxembourg for a period of more than 10
years without an apparent obligation to review the facts.
Luxembourg has put forward its defence against the decision, mainly based on
purported illegitimate ‘covert fiscal harmonisation’, wrong selectivity frame of
reference and violation of the legal certainty principle. It is likely that the case will
go to the Court of Justice of the European Union.
This decision concerns tax rulings which validate advance pricing arrangements
(“APAs”).
In October 2014 the Commission published a letter sent to the Irish government
which accused it of having given illegal State Aid to the US technology
multinational Apple. The Commission was starting an investigation and it argued
that the Irish Revenue granted tax rulings in favour of the Apple group which were
apparently 'motivated by employment considerations'. The letter suggests that
profit allocation was a result of 'negotiation rather than [transfer] pricing
methodology'. There was a lack of explanation behind the methodology for the
2007 ruling, which failed 'to explain the choice of operating costs as net profit
indicator rather than a larger cost basis, such as costs of goods sold'. It indicated
there were additional inconsistencies in the application of the transfer pricing
method chosen such that it did not appear to comply with the arm's length
principle. Apple denied that it received any special treatment.
In 2016 the Commission decided the tax rulings issued by the Irish tax authorities
constituted illegal state aid, allowing Apple to allocate profits in a way that
reduced the taxes payable in Ireland by up to €13bn over ten years. The decision
required Ireland to recover this amount, plus interest, from Apple.
In October 2017, the European Commission referred Ireland to the European Court
of Justice for failure to collect the illegal State aid from Apple. Ireland has been
slow to complete its calculations of the total that needs to be collected. (The
money should have been collected by 3 January 2017.)
The facts of the case were that a Scandinavian sales manager was required under
the terms of his contract to work from home in Denmark. Although he spent the
majority of his employment duties travelling and visiting clients, the Danish tax
board ruled that the manager’s use of a home office for administrative work (for
which he was not reimbursed) constituted a PE of his German employer.
It was held to be irrelevant whether the home office was owned or rented or in
any other way made available to the foreign corporation. As long as the business
of the non-resident entity was carried out effectively and habitually (and these
activities were not preparatory), then a PE was in existence. It was also
emphasised that there must be recurring work from the home office not just
sporadic or occasional.
The Danish tax board determined that the administrative work was directly related
to the main business of the company and could not be said to be non-core or
preparatory.
The point was raised that in India the transfer pricing law was designed as an anti-
avoidance tax measure, thus the Revenue could invoke the provisions only under
specific circumstances where there is existence of material evidence to suggest
avoidance of tax. Since Aztec-India enjoyed a tax holiday, there was no plausible
reason or motive for avoidance of tax (in India). Thus, the application of the
transfer pricing regulations (per se) under such circumstances was entirely
misplaced.
The Tribunal held that there was nothing in the statutory provisions to require that
the Assessing officer must demonstrate avoidance of tax.
It was further found the TP law can apply even if the income is exempt as was the
case here because of the tax holiday.
The case looked in detail at the methodologies used. It observed that the while
the use of cost plus was not disputed, not enough attention had been paid to the
computation of the cost. In this particular case it was stated that single year data
was more appropriate. The Tribunal approved of the Revenue's contention that for
the purposes of arm's length analysis, profits earned by Aztec–India (and not
Aztec-US) should have been benchmarked under TNMM analysis.
1.6 Baird Textile Holdings Limited v Marks & Spencer Plc (2001)
While not a transfer pricing case, this is highly informative. Baird had supplied Marks
& Spencer for many years when Marks & Spencer terminated supply arrangements
between them. Baird sought damages for lost profits but failed as there was no
contract and none could be inferred. Where independent parties would not
expect remuneration, this will only be supportable between related parties where
it is possible to differentiate the third party position from a group’s facts and
circumstances.
1.7 Centrica India Offshore Pvt Ltd v CIT [WP(C) No. 6807/2012] Heard at
the Delhi High Court
Employees seconded to India from group companies in the UK and Canada were
deemed to constitute permanent establishments (PE) of those companies in India.
services in the first year of their operation, some overseas employees with
managerial and technical expertise were seconded to India. The court decided
that under the terms of the India-UK and India-Canada tax treaties, these
secondees constituted a PE in India that was providing technical services.
The decision arose because of the way the secondments themselves were
structured. The court distinguished between the concepts of economic employer
and legal employer. It also referred to the OECD commentary which says that the
foreign company will not constitute a service PE if the seconded employees work
exclusively for the Indian enterprise and are released for the period in question by
the foreign enterprise — that was not the case here. The court further observed
that there was no purported employment relationship between the Indian
company and the secondees and, notably, that the company had no right to
terminate the employment contract and the employees had no right to sue the
company for non-payment of salary.
In Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (No. 4) [2015] FCA
1092, an Australian transfer pricing ruling provided guidance on what constitutes
'fair loan terms' among related parties — in this instance, a USD$2.5bn credit facility
from a US entity to an Australian entity. The arrangement permitted the US entity to
raise funds at a low rate, due in part to an explicit guarantee from the ultimate
holding company of both the US and Australian entities, and lend to the Australian
entity at a higher rate of interest. The company that borrowed the funds at the
lower rate, Chevron Texaco Funding, made a profit from the loan on to Chevron
Australia Holding PTY (CAH). This profit was later paid as a dividend to CAH and
was tax free in Australia.
The judge considered whether an independent lender would have taken into
account the 'implicit support' of a parent to a subsidiary, with the following points
being noted from expert witnesses: In the absence of a legally binding parental
guarantee, implicit credit support was found to have 'little, if any' impact on
pricing by a lender in the real world. One of the key reasons that agency ratings
are not solely relied upon by banks when determining credit ratings is precisely
because they may improperly give allowance for implicit support. This contrasts to
the GE Capital case where more importance was given to the impact of implicit
support.
On the facts of this case and looking at how the group operated, the taxpayer
was not able to show that they had acted in an arm’s length way. The facts
showed that no security was given for the loan and that normally the group sought
to minimise its borrowing cost. The court found that a borrower acting at arm’s
length would have given security for the loan in order to lower it’s borrowing costs.
The case is also interesting as it looked at whether Article 9 of the Double Tax
Treaty gave a separate taxing power. The court held that it did not; in Australia
Article 9 has to be read in conjunction with the transfer pricing legislation and
could not be relied on independently of the domestic legislation.
In April 2017 Chevron lost its appeal to Australia’s Full Federal Court (FFC). The three
Federal Court judges agreed with the initial trial judge. Matters considered by the
Court included independence assumptions required by the Australian rules – the
Court concluded these include an assumption that the parties to the loan
arrangement are independent. The FFC concluded that the 'independence'
hypothesis does not necessarily require the detachment of the taxpayer, as one of
the independent parties, from the group which it is part of, or the elimination of all
the commercial and financial attributes of the taxpayer. The FFC also agreed that
the parent would have sought to reduce the cost of borrowing. The evidence
revealed that the borrower was part of a group that had a policy to borrow
externally at the lowest cost and the parent would generally provide a third party
guarantee for a subsidiary borrowing externally.
The MNE operates through a direct sales model so that purchase orders are
placed in a web page or call centre. Dell Spain had operated as a fully fledged
distributor, undertaking strategic activities in Spain until 1995, when it entered into
the commissionaire agreement with Dell Ireland to serve medium and large sized
customers of the MNE. These latter customers, in many cases, require specialised
attention and Dell Spain’s relationship personnel are available to serve them. Sales
to Spanish small sized customers are made by Dell France, through a call centre
and a web page.
The Spanish court ruled that Dell Ireland had a Spanish PE, as the online store (the
website through which Spanish sales were made) could qualify as an ‘online PE’,
even though the server was situated outside Spain. Whilst the server was not
located in Spain, and there were no employees of the Irish company in Spain, Dell
Spain did employ people to translate the website, review the contents and
administer the site, which was considered a factor. In addition, the Court noted
the observations on the Commentary made by Spain in the 2003 and 2005
versions, which stated that Spain had a number of reservations on the OECD
approach. However, it is notable that on appeal, the Spanish National Appellate
Court (decision of June 2015) and the Supreme Court (in June 2016) decided the
matter with regard to the fixed place of business PE and the agency PE concept
(Dell Spain acted as commissionaire and Dell Ireland was bound by the contracts
under Spanish law), without referring to the creation of a ‘virtual PE’. It is interesting
that the Appellate Court did comment that according to the OECD commentary
to the model treaty, an online website does not in itself have a location that can
constitute a PE, although the place where the server is located could constitute
one. The Supreme Court confirmed the point as to the commissionaire
arrangement, which is the issue of most importance in this case. In so concluding
the Spanish court differs from courts in France and Norway which have concluded
that commissionaire arrangements do not give rise to permanent establishments,
although notably such conclusions have been overtaken by the changes to the
Agency PE definition in the treaty put forward under the BEPS Action Point 7.
The Norwegian subsidiary Dell AS (Dell Norway) performs two kinds of activities: on
the one hand, it sells accessories on its own account to end users (sales to small
companies and consumers in the Scandinavian market through a call centre in
Denmark) and, on the other hand, it sells Dell Ireland’s products under a
commissionaire agreement with it. This second activity is performed by Dell Norway
in its own name, but at the risk and on account of the principal (i.e. Dell Ireland).
This commissionaire agreement covers sales to large customers and customers in
the public sector. The commission for these services amounts to approximately 1 %
of sales.
The Norwegian tax authorities assessed the taxpayer (i.e. Dell Ireland) on the basis
that it had a dependent agent PE in Norway, under Article 5, paragraph 5 of the
Ireland–Norway tax treaty, and that the profits to be attributed to the PE could be
determined by an indirect method of apportionment in accordance with Article 7,
paragraph 4 of the Ireland–Norway tax treaty. Therefore, they allocated 60 % of
the profits to the Norwegian PE and 40 % to the Irish Company.
Dell appealed.
On December 2nd, 2011, the Norwegian Supreme Court overturned the two
previous judgments and stated that Dell Ireland did not have a PE in Norway. The
arguments of the Supreme Court were based on the Vienna Convention, on
Article 5, paragraph 5 of the tax treaty, on the OECD Model and its commentaries,
and on case law. First of all, the court looked at the wording of the Ireland–Norway
tax treaty (in the English version) and stated that the expressions “acting on behalf
of an enterprise” and “authority to conclude contracts in the name of the
enterprise” clearly suggest that the contracts must be legally binding for Dell
Ireland, in order to have a PE in Norway.
Second, the court approached the OECD Commentary on Article 5, para. 5 of the
OECD Model and sustained that paragraph 32.1 was introduced under a
common law system point of view irrelevant to the Norwegian civil law approach.
Then, the court also referred to the abovementioned French Zimmer case:
According to the French Supreme Court, a commissionaire acts in its own name
and cannot bind its principal. As a result, a commissionaire cannot constitute a
dependent agent PE of its non-resident principal, even if the commissionaire is
clearly not independent.
Finally, it was also stated that using a different approach from the legal and
formalistic one could involve substantial practical and technical difficulties related
to the uncertainty of applying a uniform practice to the other similar
commissionaire arrangements. Therefore, based on this reasoning, the Norwegian
Supreme Court affirmed that Dell Ireland did not have any PE in Norway and,
consequently, no income should have been assessed.
In February 2014 in a case before the Indian High Court it was held that an
(indirect) Indian subsidiary of a US company was not a PE, notwithstanding the
close association between the US company and the Indian company, the division
of functions, the assets used and the risks assumed. The High Court held that a
consideration of these factors was not the appropriate test to determine whether
a PE was present. The Court considered the PE definition in the US-Indian double
tax convention and focused on the conditions necessary to fulfil these PE tests. As
the Indian Revenue was not able to prove the “right to use” test and having space
at “the disposal” of the company test were satisfied, no fixed PE was found to exist.
Similarly, in the absence of any evidence that employees of the Indian subsidiary
were under the control or supervision of the US parent and providing services on
behalf of the US company, or that the Indian employees were participating in
negotiations with customers, no service PE or agency PE were found to exist either.
Encompassing the brands Dixons, Currys and PC World, the Dixons Stores Group
(‘the Group’) included DSG International plc (‘the Parent’) and subsidiaries DSG
Retail Ltd (‘DSG’), Mastercare Coverplan Service Agreements Ltd (‘MCSAL’),
Mastercare Services and Distribution Ltd (‘MSDL’), and Dixons Insurance Services
Ltd (‘DISL’), the latter being the Group's captive insurance company which was
resident in the Isle of Man. While not licensed by the Isle of Man regulators to write
insurance in the UK, DISL was authorized to write reinsurance business. Under the
Income Tax (Exempt Insurance Companies) Act 1981, DISL was exempt from Isle of
Man Corporate Tax.
The second arrangement was established from April 1997, in response to the
increase in the rate of Insurance Premium Tax from 2.5% to 17.5% that was
announced in November 1996, and which would have reduced premium revenue
by 15%. In response to this the Group stopped offering insurance cover as part of
its extended warranties and started selling service contracts via a new 3rd party
company Appliance Serviceplan Ltd (‘ASL’), an Isle of Man company, with MCSAL
acting as its agent in the UK. As with the Cornhill period, the sales company
received a sales commission and passed on net premiums to an unconnected
third party company, now ASL. In this instance 100% of ASL's liability was
subsequently insured by DISL, which changed its regulatory status to allow it to
undertake insurance business with ASL. This effectively circumvented the IPT rate
hike as the insurance element of the structure no longer fell into the scope of UK
tax, with the counterparties to the insurance policy both being Isle of Man
companies.
HMRC contended that the terms of the arrangement did not sufficiently recognise
the advantage gained by DSG at the point of sale, and that DISL subsequently
gained more of an advantage than would have been available in the case of an
arm's length agreement. While DSG had no direct legal contractual relationship
with DISL, the interposition of a third party (Cornhill/ASL) into the overall transaction
did not preclude the application of ICTA88, S773(4), whereby the opportunity for
DISL to able to enter into such an attractive insurance arrangement amounted to
DSG providing a ‘business facility’ to DISL. Additionally, on analysing the series of
transactions as a whole, the Commissioners found that the arrangements were
effectively integrated by means of an ‘understanding’ between the Group and
Cornhill/ASL – although the series of contracts were not in themselves technically a
‘provision’ for the purposes of Schedule 28AA, the means by which they were
applied equated to a provision ‘as between’ DSG and DISL, and the arm's length
principle therefore applied to the advantage gained by any party.
The Commissioners ultimately found that DISL was entirely dependent on DSL for its
profits, which arose directly as a result of DSL's significant brand strength and ‘point
of sale advantage’, and a profit split was determined on an arm's length return on
capital for DISL, with DSL receiving the residual profits.
In this case the minority shareholders brought the case questioning the level of the
transfer prices.
This case focused on the transfer pricing system between Ford U.S. and Ford
Canada. The system is a product of the Canada-United States Auto Pact and,
more recently, the free trade agreements that created a single, integrated market
for vehicles made and sold in Canada and the United States. To a large extent,
the structure of the system is tax driven. Canadian and U.S. tax regimes require
entities that do not deal with each other at arm's length to attribute arm's length
transfer prices to their goods and services to prevent entities from artificially
allocating losses in the high-tax regime and profits in the low-cost regime. For Ford
U.S. and Ford Canada, the transfer pricing system is the mechanism utilised to
comply with the tax laws in the two countries.
The transfer pricing system can impact on shareholders, such as the minority
shareholders of Ford Canada. If the system is unfairly skewed to assign losses to the
Canadian subsidiary, the subsidiary's minority shareholders will be deprived of their
fair share of Ford Canada's profits. The parent, Ford U.S., will not be injured since it
will offset the loss from its Canadian holdings through increased profits in its U.S.
operations. With minor exceptions, the taxing authorities in the two countries have
not faulted the Ford transfer pricing system.
The court concluded that a poor transfer pricing mechanism that had been
adopted amounted to oppression of the minority shareholders since it frustrated
their reasonable expectation that the company would operate to maximize
profits. This case is indicative of how transfer pricing can be a factor in a matter
that is essentially one of corporate governance.
The case related to the UK company holding the commercial rights to stage, host
and promote the Indian Grand Prix in 2011 through to 2013 at a location owned by
an Indian company. The existence of a PE was upheld as the court found that the
racing circuit constituted a fixed place from which a business/economic activity
was conducted. In addition, the various agreements between the Indian
company and the UK company (together with its affiliates) could not be looked at
in isolation. In the Court's view, the facts pointed to the conclusion that the UK
company had made its earnings in India through the racing circuit over which it
had complete control during the event. The duration of the event and the number
of days for which the UK company's personnel had access to the circuit would not
make any difference.
In July 2014 the ITAT (Indian tax tribunal) held that the LinkedIn profiles of the
employees of the GE group submitted by the tax authorities were admissible as
evidence in determining the existence of a PE in India. The tribunal's view was that
the LinkedIn profiles were not hearsay but were akin to admissions made by a
person; and they had considerable bearing on the subject matter of this appeal.
However, the taxpayer is free to rebut the information contained in their LinkedIn
profile by bringing on record contrary facts to dislodge the claims made.
1.17 General Electric Capital Canada Inc. v. The Queen (2009) TCC 563
This was a Canadian case where the Canadian tax authorities sought to deny the
deduction for payment of guarantee fees by GEC Canada to a US related party,
GEC US, during the tax years 1996-2000. In disallowing deduction of the guarantee
fees, the tax authorities had argued that the US guarantee conferred no
additional benefit to the Canadian taxpayer since the parent company would be
expected to support the subsidiary even in the absence of a formal guarantee.
However, the court found that there was real economic value to the guarantee
and reinstated the corresponding tax deductions.
The court case revolves around the fixing of the price paid by a Canadian
subsidiary (Glaxo Canada) of a pharmaceutical company to a related non-
resident company for Ranitidine (the main ingredient used for manufacturing a
branded prescription drug).
Glaxo Canada was paying a price over five times higher to buy the ranitidine from
the Glaxo Group than it would have paid to buy the ranitidine from generic
manufacturers.
However, Glaxo Canada was also obliged to acquire the main ingredient for the
drug (i.e. ranitidine) from a Glaxo approved source (i.e. Adechsa, a Swiss
subsidiary of the GSK Group).
The price paid by the Canadian subsidiary for the active ingredient was
significantly higher than the price paid by Canadian generic manufacturers.
The CRA reassessed Glaxo Canada by increasing its income on the basis that the
amount it had paid Adechsa for the purchase of ranitidine was “not reasonable in
the circumstances” within the meaning of the transfer pricing rules.
Glaxo Canada's position was that the price paid to Adechsa was reasonable in
the circumstances when viewed in consideration with the License Agreement and
its business to sell Zantac.
Glaxo Canada appealed the CRA's reassessment to the Tax Court of Canada
(TCC), which affirmed the CRA's adjustment of the transfer price on the basis of
the prices generic drug companies were charged for ranitidine. The TCC
Without the licensing agreement the Canadian subsidiaries would not have been
in a position to use the active ingredient patent and the Zantac trademark.
Therefore, the only way for Glaxo Canada to conduct business in Canada would
have been to enter the generic market where the cost of entry would have been
much higher.
The key question to be answered is whether the tax payer is to factor in all
circumstances in determining the arm's length price.
The CRA's position is that the appropriate analysis is what is the arm's length price
for the active ingredient and any other circumstances should be disregarded.
According to the CRA, it is not important whether the buyer wanted to acquire the
ranitidine for the generic market or the premium brand market.
In October 2012 the Supreme Court of Canada handed down a decision that
favoured Glaxo. In a unanimous decision, the Supreme Court disagreed with the
arguments put forward by the Canadian government, saying other factors, such
as licensing agreements, should be considered when determining a reasonable
arm's length price. But it declined Glaxo's request to actually decide whether the
price its Canadian subsidiary paid was fair, referring that question back to the Tax
Court of Canada.
GAP International Sourcing provides procurement services for its group in India. The
Indian tax authorities sought to challenge the company’s transfer pricing policy of
a mark up on value added expenses, preferring a commission of 5% of the Free on
Board price. The taypayer’s position was upheld as the Tribunal found no evidence
of local intangibles that would move its transfer pricing method away from cost
plus and that any location savings would be passed on to customers by a third
party.
The Glaxo group recently settled a transfer pricing dispute in the US for $3.4 billion.
The magnitude of this settlement helps illustrate the scope of the problem in
valuing IP and exploiting it correctly without triggering potential tax avoidance.
Glaxo is headquartered in the United Kingdom and holds several subsidiaries in the
US. Glaxo's primary business is the development and manufacturing of
pharmaceutical drugs. Cross-border transactions of valuable pharmaceutical
drugs generating large profit margins have attracted the attention of revenue
authorities.
Glaxo's sales of drugs in the United States generated almost $30 billion in revenues
from 1989 to 1999. During this period, Glaxo paid about $1.3 billion in U.S. taxes.
Glaxo claimed that the United Kingdom had already taxed the MNE Group's
profits under dispute with the IRS, arguing that any reallocation by the United
States would result in double taxation of Glaxo.
The drug had been patented in the UK and hence, the US subsidiary was acting as
distributor for the US market. However, the IRS argued that the US subsidiary of
Glaxo overpaid its UK parent for the patent it held. The IRS also argued that
marketing efforts by the US subsidiary were the determining factor in the success of
Zantac. Also, as the US was the largest market for the drug, which was also
manufactured in the US, the economic ownership of the IP was challenged. The
IRS demanded about $8 billion in tax adjustments and penalties.
Glaxo tried to reach settlement with the IRS by referring the dispute to a
competent authority under the MAP procedure. The governmental discussions did
not reach common ground and the IRS took Glaxo to court to preserve evidence
in preparation for the anticipated trial.
In settling the Glaxo case, IRS Commissioner Mark Everson stated that transfer
pricing issues “are one of the most significant challenges” tax agencies face.
The Commission’s opening decision concludes that the 2006 APA may have given
a tax advantage to IKEA systems (BV). The opening decision includes the
statement that when applying the transactional net margin method (TNMM) the
2006 APA incorrectly may have considered IKEA Systems (BV) as the less complex
entity and therefore the tested party. Alternatively, even if Systems had been
correctly identified as the tested party, application of the TNMM appears to
contain certain methodological ’mistakes’.
In 2011, Inter IKEA changed the way it was structured. As part of this restructure
Inter IKEA Systems bought the intellectual property rights formerly held by I I
Holding, financing this by an intercompany loan from its parent company in
Liechtenstein.
The Dutch authorities issued an APA in 2011, which endorsed the price paid by
Inter Ikea Systems to acquire the intellectual property, including a price
adjustment clause. It also endorsed the interest to be paid to the parent company
in Liechtenstein and the deduction of these payments from Inter Ikea Systems'
taxable profits in the Netherlands. As a result of the interest payments, a large part
of Inter Ikea Systems' franchise profits after 2011 was shifted to its parent in
Liechtenstein.
The Commission believes that the 2011 APA may have granted an advantage to
Systems since it endorses a tax treatment that does not seem to reflect a reliable
approximation of a market-based outcome in line with the arm’s length principle,
when considering the price paid for the intellectual property aspects of the price
adjustment clause and the loan terms; in addition some aspects of the interest
payments may not comply with Dutch law.
The Japanese High Court considered the position of a US resident company which
sold automobile accessories over the internet. The US company had an apartment
in Japan, the address of which was listed on its internet site. The apartment was
used for packaging products, but also for inserting Japanese-language manuals in
the products and for receiving returns of defective goods. Subsequently, it hired a
warehouse in Japan. The Japanese tax authorities concluded that it had a
permanent establishment in Japan through the apartment complex and the
warehouse, and, in the absence of documentation of the profits, attributed profit
to the notional taxpayer formed by the permanent establishment on a
comparison with other similar enterprises. The taxpayer appealed arguing that it
had no permanent establishment in Japan by virtue of Article 5(4) of the US-Japan
tax treaty which was identical to the OECD Model.
A central issue in the appeal was whether the use of facilities for storage, display or
delivery in para (a) of the Article also needed to be 'preparatory or auxiliary'. This
was a matter of some discussion, and the Japanese court concluded that the
activities must be preparatory or auxiliary for the exemption to apply. There is a
contrary view that paras (a) to (d) are 'per se' preparatory and auxiliary, and that
only paras (e) and (f) require activities to be preparatory or auxiliary. The Court
also commented on the role of the OECD Commentaries, and of the 2012 OECD
Discussion Draft on Permanent Establishments in this context. In addition, the Court
discussed whether it was significant that Japanese-language manuals were
inserted in the products at the locations in Japan, and that the address of the
premises was listed on the website of the US business.
The Swedish Administrative Court of Appeal considered the issue of a physical PE.
The Court determined that a foreign company which regularly conducted
business from the same place in Sweden had a PE there. The case concerned a
German company that developed and sold software for tyre inflation pressure
systems. The company annually performed tests in winter conditions in Sweden,
and the test results were then used for software development in Germany. The
annual testing period ranged from three to four months, but the company was
only on the ground for a few weeks at a time.
The Court decided that the company regularly conducted business from the same
place in Sweden; and that the activities that it undertook, i.e. the testing, could
not be considered to be of a preparatory or auxiliary nature. Therefore, the
company was considered to have a fixed place of business in Sweden through
which part of the company's core business was conducted. Consequently, it was
determined that there was a PE in Sweden.
1.24 KHO:2010:73
In this 1992 case a purported lease with reciprocal put/call options was
recharacterised as a secured loan. This was not a transfer pricing case as such
because the parties to the transaction were not associated enterprises. However,
it serves as a contextual reminder of the need to consider all possible legal tools at
the disposal of the tax authority which might ultimately result in the disregard or
recharacterisation of a transaction. In the Kwiat case, the appellant taxpayers
leased shelving equipment to another party. There was a put option permitting the
taxpayers to sell the equipment at a projected profit to the taxpayers.
The Tax Court held that the rights and responsibilities of ownership of the shelving
had passed to the purported lessee: the lease was in substance a sale and the
taxpayer was denied tax depreciation in respect of the assets in question.
This case looks at thin capitalisation rules and compatibility with EU law. The case
involved payment of interest from a German company to a non resident (Dutch)
grandparent company. Thin cap rules applied to limit the deduction in the
German company where the company was thinly capitalised and the loan was
not on arm's length terms. However these rules only applied where the interest was
paid to a non resident (and certain non-CT paying domestic entities), interest
payments to other German companies were not caught by the rules. The ECJ held
that such rules were contrary to the freedom of establishment, as they
discriminated against shareholder companies based in other EU States. However,
the tax authorities put forward various justifications. The tax avoidance justification
did not work, as the rules were too broadly drafted and did not target wholly
artificial arrangements.
Maruti Suzuki India Limited (“Maruti”) manufactures passenger cars and spare
parts in India. Suzuki Motor Corporation, Japan (“Suzuki”) holds majority shares in
Maruti. The trade mark/logo “M” is the registered trade mark of Maruti. In 1992
Suzuki entered into an agreement under which Suzuki agreed to grant a license to
Maruti for manufacturing and sale of specified models of cars. Under the said
agreement, Maruti was obligated to use the trade mark “Maruti Suzuki” on all the
products and parts manufactured pursuant to this agreement. Further, since 1993,
Maruti replaced the logo “M”, logo of Maruti by “S”, logo of Suzuki on the front of
the cars manufactured and sold by it. At the same time it started using the
“Maruti” mark along with the word “Suzuki” on the rear side of the vehicles.
Maruti made payments to Suzuki for the use of their brand. The Indian tax
authorities said that Maruti should receive payments for using the Suzuki brand as
they were effectively giving the Maruti brand to Suzuki. The Maruti brand was
stronger than the Suzuki Brand in India at the time. Secondly the authorities said
that as Suzuki were penetrating the Indian market by “piggybacking” on to the
Maruti brand, they thought that Maruti should receive something like a royalty fee
as a result. Thirdly it also held that the advertisement expenses incurred by Maruti
had gone to benefit Suzuki.
Maruti contended that at no time had there been a transfer of the Maruti brand to
Suzuki. Suzuki did not have a right to use the trademark, and the trademark could
be transferred only by a written instrument of assignment.
Further, Maruti asserted that it had received a large benefit from Suzuki while
Suzuki had received no benefit, and that because it had a right to use the Suzuki
trademark in the future, Maruti received the benefit of its advertising.
The case talks a lot about the approach taken by the government official, the TPO
(transfer pricing officer). The court found that the the TPO can reject the price
computed by the assessment person only if he finds that the data used by the
assessment person is unreliable, incorrect or inappropriate or he finds evidence,
which discredits the data used and/or the methodology applied by the
assessment person; further the Transfer Pricing Officer (TPO)/Assessing officer (AO)
is obliged to give the assessment person an opportunity to produce evidence in
support of the arm's length price and before making adjustments, he is obliged to
convey to the assessment person the grounds on which the adjustment is
proposed to be made and give the assessment person an opportunity to
controvert the grounds on which the adjustment is proposed.
In considering payments made for using the S logo on the products the court
stated that it is important to consider whether the use of the trademark was
discretionary or mandatory. All factors of the agreement needed to be taken in to
account including the value of marketing intangibles.
In June 2016 the US Tax Court ruled in favour of the taxpayer in Medtronic Inc. &
Consolidated Subsidiaries v. Commissioner (T.C. Memo. 2016-112)
The IRS contented that the royalties payable from a Puerto Rico affiliate to
Medtronic, Inc should be increased. by $US1.4 billion. The Tax Court rejected the
IRS's proposed transfer pricing method as arbitrary, capricious, and unreasonable.
The court instead accepted Medtronic’s use of the Comparable Uncontrolled
Transaction (CUT method) but made adjustments to take account of differences
between the licenses and the comparable transaction relied on by Medtronic.
The IRS argued that the Puerto Rico company was merely an assembler which only
had a minor role in design manufacturing and development. The court disagreed;
they found that the company in Puerto Rico was involved in every step of the
manufacturing process and that the functions it performed were critical to overall
profitability of the group. It was found that product quality was a critical factor. An
interesting point is that the court found that a license could add to the assets of
the licensee. The rights under the license can become an intangible asset for the
licensee.
The taxpayer, a company incorporated under the Indian Companies Act, is the
wholly owned subsidiary of IKOS Systems Inc., a company incorporated in USA and
engaged in the business of software development and also rendering marketing
systems services to the parent company. The taxpayer filed its return of income for
the year under consideration on October 31, 2002 declaring total income at INR
3,99,080/- for the F.A.2001-02. The income disclosed included profit from export of
computer software to its parent company for which deduction was claimed.
The taxpayer selected TNMM as the most appropriate TP method. The Indian
authorities stated that the amount for export of software development services
was not arm’s length; they were happy with the amounts for export of marketing
support services.
The taxpayer searched public databases as required by law and carried out
quantative analysis narrowing the selection to 16 companies. As the NCP (Profit
Margins) of above companies as per average arithmetic mean was 13.41%
against 11.07% earned by the taxpayer in the relevant assessment years, it was
claimed that taxpayer carried out international transactions at arm's length.
The Indian authorities (TPO) raised objections to the comparables chosen and the
years looked at as comparables.
The Delhi branch of the Indian tribunal system rejected the adjustments that the
TPO tried to make to the figures submitted by the tax payer.
Commentators have noted that by ignoring high profit and high loss making
companies in the comparable set, the Tribunal's observation on the arm's length
range is commensurate with use of an inter-quartile range as prevalent in other
jurisdictions.
In this case the IRS contract auditor applied a CPM analysis comparing profit-to-
cost ratio of Microsoft with the profit-to-cost ratio of businesses chosen as
comparables. However, the auditor aggregated both controlled and uncontrolled
transactions of Microsoft. Columbia Judge found that there was no justification for
such aggregation which rendered the analysis “arbitrary, capricious and
unreasonable.”
NSC was engaged in the manufacture of a variety of electronic products for use
by consumers, industry, and Government. Those products included IC's, discrete
devices, hybrid circuits, electronic displays, module components, calculators,
digital watches, and other similar products.
During the late 1970s, the management of NSC decided that NSC needed to
enter the large-die market in order to continue growing. Large amounts were
spent on R&D.
The Asian subsidiaries were responsible for packaging some of the products.
Several of the Asian subsidiaries held dies (used in the packaging) and finished
goods inventory. The Indian Subsidiaries financed inventories, held by them, of the
dies and sometimes of the finished goods. In addition, the Asian subsidiaries bore
the cost of shipping finished devices. On the whole, the Asian subsidiaries had
successful digital and linear lines and were efficient cost-competitive packagers.
The Asian subsidiaries increased the efficiency of the packaging through process
improvements, which, among other things, improved output per operator.
Like most organisations that produce a large number of individual products using
processes that are both complex and relatively standardised, NSC used a
standard cost system for product costing. It assigned a specified cost to each
material component and labour operation that was required to complete each
stage in the production process. A standard amount of manufacturing overhead
costs was also applied.
The total standard cost was computed as the sum of the material, labour, and
overhead costs when the product was completed. “Overhead” costs were those
indirect costs that were most directly identifiable with the manufacturing activities
and were allocated to production on a unit-by-unit basis. Indirect costs that were
related to manufacturing activities, but not identifiable with specific units of
production, were classified as “manufacturing period” expenses. The balance of
indirect costs were commonly classified as nonmanufacturing period expenses,
engineering, R&D, selling, and general and administrative expenses. Any
difference that was identified as a result of comparing the standard cost of
producing a specific quantity of a product with the actual cost of producing that
quantity was called a variance. Variances had two potential causes: either the
standard cost was not accurate or production process irregularities resulted in
changed actual costs of production. To determine which was the cause required
a detailed investigation.
For financial and tax reporting purposes, NSC treated as sales (1) the transfer of
semiconductor dies in wafer form and associated materials to the Asian
subsidiaries (outbound sales) and (2) the transfer of assembled devices from the
Asian subsidiaries back to sales and marketing affiliates in the United States
(inbound sales) or to affiliates in third countries.
The issue presented to the Court was whether the transfer prices that were
charged between NSC and its Asian subsidiaries met the arm's length standard of
section 482.NSC claimed to have proven that the determinations made by the IRS
were unacceptable and to have presented comparable transactions between
unrelated parties and industry data which proved that its transfer prices satisfied
the arm's length standard.
The IRS claimed that NSC had not presented comparable uncontrolled prices to
prove that its transfer pricing system should be upheld.
Before trial, NSC filed a memorandum requesting that the burden of proof be
shifted to the IRS with regard to certain allegations in the IRS's amendments to
answer, pertaining to methods of allocation based on outbound sales prices,
because they were beyond the scope of the notices of deficiency.
Both sides called on expert witnesses who gave detailed calculations and
explanations of how the transfer price should be calculated.
The court ruled that because evidence presented by each side demonstrated
that the notices were unreasonable, the determinations in the notices were
arbitrary, capricious, or unreasonable.
The court allowed some amendments to the transfer price; however the majority
of the location savings were allowed to remain in Asia.
One of the best known cases on PEs heard before a European Tax court is the
Phillip Morris case heard by the Italian Supreme Court (L Ministry of Finance (Tax
Office) v Phillip Morris GMBH Corte Suprema di Cassazione 7682/02 25th May 2002).
Phillip Morris GMBH, a company tax resident in Germany, received royalties from
the Italian Tobacco Administration for a license to produce and sell tobacco
products using the Phillip Morris trademark. The execution of the agreement was
supervised by Interba SPA, a group company resident in Italy. The company
performed agency and promotional activities for Phillip Morris in duty free zones. Its
other main activity was the manufacture and distribution of cigarette filters.
The Italian tax authorities argued that Interba Spa was a PE of the group as it
participated in the royalty agreement negotiations as well as other group business
activities with no remuneration. Accordingly the royalty income should be
allocated to a PE of Phillip Morris Gmbh. They also argued that the Italian
subsidiary had been formed to avoid a PE.
The Italian Supreme court found a PE existed. The activity could not be considered
auxiliary for the purposes of Article 5 of the German/Italian tax treaty (similar
provisions are contained in the model tax treaty). It was found that participating in
contract negotiations can be construed as an authority to conclude contracts. A
PE will also be established where a principal entrusts some of its business operations
to a subsidiary.
This case looked at the transfer pricing analysis conducted by the taxpayer, such
as selection of tested party, aggregation of transactions, selection of overseas
comparables, etc. The Tribunal also made comments on the disclosure norms in
the accountant's report and the inadequate disclosures made by the taxpayer.
The case involved transactions with some 17 AEs in various countries including
Malaysia, Africa, Brazil, Germany and Ireland. The transactions included sale of
products and payments for technical knowhow. The company looked for
The Indian tax authorities questioned the company's return on two issues:
1. The determination of the arm's length price (ALP) was not referred by the
Assessing Officer (AO) to the Transfer Pricing Officer (TPO) as required by the
law; and
2. TNMM was used as the most appropriate method and the PLI of the AEs were
tested instead of the PLI of the taxpayer.
On the second point Ranbaxy contended that the AEs were the less complex
party and as a result it was correct that they be the tested party. The tribunal
disagreed as reliable data on the AEs was not made available to allow
benchmark analysis to be undertaken.
The tribunal also stated that it was not correct to aggregate the 17 AEs and treat
them as one tested party. The tribunal agreed that the least complex part should
be the tested party but stated that if comparable data was available relating to
the other party, in this case the Indian tax payer Ranbaxy, then that should be
used. Note that in India there is publicly available data on pharmaceutical
companies and the tribunal thought this should be used in preference to foreign
data.
The tribunal also commentated that the OECD Guidelines should not be referred
to on a selective basis as this would be against the spirit of the Guidelines.
The case is notable for being the first decision in a court room on a substantive
transfer pricing issue under Australian law.
This case involved the judges in looking at the testimony of expert witnesses who
do not agree with each other.
The Australian Tax Office (ATO) questioned the transfer pricing methodology used
by the company.
The court disagreed with the evidence put forward by the ATO criticising a number
of “presumptions” made by a number of the expert economists. The court thought
the economists were too US-focused in their approach and as a result they did not
provide analysis that specifically addressed Australia's transfer pricing provisions.
• that arm's length prices be determined for each separate year under
consideration, rather than a multiple-year average.
Following the case the ATO released as a statement that in their view Roche is
confined to “to the facts of the case” and that “all things considered [Roche] is
seen as having limited significance for the administration of transfer pricing laws
generally”
The Supreme Court of Spain came to a controversial decision, in that the subsidiary
of a non-Spanish company was considered to be the overseas company’s PE. The
Supreme Court confirmed, on appeal, the existence of a Spanish PE of Roche
Vitamins Europe, as a result of the activities carried on by the Spanish subsidiary. In
particular, the Court considered that the Spanish subsidiary operated as a
dependent agent of the Swiss entity, as it carried on, under two contracts, the
activity which could have been done directly through a fixed place of business
(being the sale and distribution of the goods produced).
The Australian company had used the comparable uncontrolled price using the
pricing of transactions between the suppliers and their arm's length customers. The
company incurred losses, in part due to commercial issues (including a low level of
sales per salesperson, competition in the Australian market, excessive stock levels,
and poor management) and partly due to a strategy to penetrate the Australian
market.
The Australian Taxation Office argued that the transactional net margin method
should be used, where a 'benchmark operating profit' should be determined with
reference to the operating profits achieved by other 'functionally comparable'
distributors.
The Federal Court accepted the company's pricing, and held that it could not be
concluded that the prices were artificially inflated.
1.38 SNF (Australia) Pty Ltd v Commissioner of Taxation (Full Federal Court
Decision) (2011) FCAFC 74
The Full Court concluded that SNF Australia was not required to quantify and
provide evidence to establish the correct arm’s length price, only that the
Commissioner’s assessments were excessive. This departs from the previous
decision in WR Carpenter Holdings Pty Ltd v Commissioner of Taxation [2007]
FCAFC 103, where the Court interpreted the domestic law as seeming to require
“the applicant to prove the actual amount of the arm’s length consideration”. The
Full Court decision in SNF Australia makes it clear that proving that amount is not
required.
This decision concerns tax rulings which validate advance pricing arrangements
(“APAs”).
The IRS challenged this saying that Sunpac was a “machine shop” or a “contract
manufacturer”.
The Court determined that Sunpac was not, in fact, a contract manufacturer
because it operated under a licence from the parent company.
Sundstrand argued that Sunpac should retain any location savings because the
licence agreement gave it a “monopolistic position” with respect to CSD spare
parts. This monopolistic position would, Sundstrand argued, have led Sunpac to
price in a way that caused all the location savings to remain in Sunpac. The Court
agreed with this argument. The court accepted that Sunpac has market power as
a result of the IP it owned.
In the case of Bausch & Lomb (B&L), B&L, a manufacturer of contact lenses,
developed and patented the spin cast method for manufacturing soft contact
lenses, which enabled production costs of approximately $1.50 per lens, while
alternative methods used by competitors cost at least $3.00 per lens. B&L
subsequently licensed the technology to wholly-owned Irish subsidiary B&L Ireland.
B&L Ireland manufactured the lenses at a cost of approximately $1.50 per lens and
then sold them to B&L for $7.50 per lens. The TP price was challenged by the IRS.
The IRS contended that the Irish company was a contract manufacturer because
sale of its total production was assured. Because it did not bear the risks of an
independent manufacturer, B&L Ireland is only entitled to cost plus a comparable
contract manufacturer mark-up.
The court found that CUP was the correct method. This was partly because B&L
Ireland was not contractually bound to sell the lenses it produced to B&L.
Therefore, it bore the risks of an independent producer, and it was entitled to the
market prices commanded by analogous independent producers. If B&L
committed to purchase the entire production, it would need to be compensated
for taking on that additional risk in the form of a discounted unit price.
Some writers have criticised this decision as the cost savings had been developed
in the US via development of the technology.
This ECJ case considered the UK thin cap rules and held that whilst they were a
restriction on the freedom of establishment, such rules would be acceptable so
long as: they were aimed at purely artificial arrangements (identified using
objective and verifiable elements); they allowed taxpayers to produce evidence
of commercial justification for the transaction; and any disallowance only applied
to the interest which exceeded the arm's length amount.
Unilever UK manufactured various products for Unilever Kenya. The transfer pricing
documentation included the following based on the capital used for production
of the goods:
• The price will not be less than full variable cost + 10% profit mark up plus actual
transport costs.
The Kenyan Tax Authorities tried to impose a CUP. Unilever said that there was no
CUP pointing out the functional differences between Unilever Kenya and third
parties that it sold to.
1.43 VERITAS Software Corp., 133 TC No. 14,Dec. 58,016 (Dec. 10, 2009)
This was a US case looking at “buy in” costs for a cost contribution arrangement.
The IRS argued that what had taken place was akin to a sale or spinoff of Veritas
operations hence the sum to be paid should be valued on this basis.
Based on the licensing agreement, Veritas Software granted Veritas Ireland the
right to use certain “covered intangibles,” as well as the right to use Veritas
Software's trademarks, trade names, and service marks. In exchange for the rights
granted by licensing agreement, Veritas Ireland agreed to pay royalties, as well as
a “prepayment amount.”
In 2000 Veritas Ireland made a $166 million “lump sum buy-in payment” to Veritas
Software. This amount was later adjusted downward to $118 million. At issue, from
a tax perspective, is whether the buy-in payment was “arm's length.”
The court rejected the IRS approach agreeing with Veritas that the amount to be
paid should be based on comparable uncontrolled royalties payable over the life
of the agreement. Further the court said that the IRS determination was arbitrary,
capricious, and altogether unreasonable.
In noting the comparability, the court also pointed out the following:
(1) Veritas Ireland and the OEMs undertook similar activities and employed similar
resources in conjunction with such activities, (2) there were no significant
differences in contractual terms, (3) the parties to the controlled and uncontrolled
transactions bore similar market risks and other risks, and (4) there were no
significant differences in property or services provided,
therefore, the court was happy that the unbundled OEM agreements were
sufficiently comparable to the transaction they were looking at thus giving the
result that comparable uncontrolled transaction method (CUT) (as set down in the
US regulations) was the best method to determine the appropriate buy-in price.
The buy-in payment charged met the arm's length standard and the IRS's
contention was rejected.
Xilinx and XI entered into a Cost and Risk Sharing Agreement (“the Agreement”),
which provided that all right, title and interest in new technology developed by
either Xilinx or XI would be jointly owned. Under the Agreement, each party was
required to pay a percentage of the total R&D costs in proportion to the
anticipated benefits to each from the new technology that was expected to be
created. Specifically, the Agreement required the parties to share:
1. direct costs, defined as costs directly related to the R&D of new technology,
including, but not limited to, salaries, bonuses and other payroll costs and
benefits;
The IRS contended that ESOs issued to its employees involved in or supporting R&D
activities were costs that should have been shared between Xilinx and XI under
the Agreement.
The relevant sections of the US tax code apply the arm's length standard, the latter
stating: “… the standard to be applied in every case is that of a taxpayer dealing
at arm's length with an uncontrolled taxpayer.” (italics added)
Contrast that regulation with the regulation dealing with cost sharing agreements
which provides that participants in a cost sharing arrangement are to allocate all
costs of developing the intangible.
The parties agreed (and the Tax Court found as a fact) that unrelated persons
entering into a cost sharing arrangement would not include the cost of employee
stock options as a “cost.” Since the arm's length principle would require related
parties to only share costs that unrelated parties would share, that principle
dictates that ESOs should not be included as a shared cost.
Zimmer SAS, a former distributor in France for Zimmer Ltd products, was converted
in 1995 into a commissionaire. The French tax authorities then assessed Zimmer Ltd
to French corporate income tax for the years 1995 and 1996 on the grounds that it
had a PE, contending that the UK Company carried out a business through a
dependent agent (i.e., the French company Zimmer SAS) under Art. 4(5) of the
France-UK tax treaty.
The Paris Administrative Court of Appeal decided in February 2007 that the French
commissionaire of the UK principal constituted a French PE of that company.
Zimmer Ltd appealed against this decision before the French Supreme
Administrative.
The Supreme Court made its decision on a pure legal analysis of the provisions of
the French Commercial Code, according to which a French commissionaire has
no legal authority to conclude a contract in the name of its principal.
The Supreme Court referred to Article 94 of the former Commercial Code (L 132-1
of the new Code) which states that a commissionaire acts in its own name on
behalf of its principal. Contracts concluded by a commissionaire, even on behalf
of its principal, cannot directly bind the principal to the co-contracting parties of
the commissionaire. The Court concluded that a commissionaire cannot create a
PE simply as a result of the commission agreement with the principal.
However, that there may be exceptions to this rule, such as where the terms of the
commission agreement or other aspects of the instructions demonstrate that,
despite the qualification of the contract given by parties, the principal is bound by
contracts entered into by the commissionaire with third parties.
• Where the wording of the commissionaire agreement follows the legal nature
of a commissionaire, in accordance with French civil and commercial
regulations, it cannot be recharacterised by the tax authorities as a
contractual arrangement of a different nature.
• The decision is based on legal principles and does not look at what is actually
happening in the business and how it actually operates.