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ADIT
PAPER IIIF
Principles of Corporate and International Taxation
2014 EXAMINATIONS
178
INTRODUCTION
INTRODUCTION
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ADIT Paper IIIF TP examines Principles of Corporate and International Taxation
Secondary Jurisdiction Transfer Pricing option.
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Kees Van Raad
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INTRODUCTION
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.
1 September 2013.
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.
Additional material was provided by:
David Abrehart
Gareth Green
Paul Griffiths
Philip Howell
BDO
(Chapter 24)
(Chapters 12,13)
(Chapters 3,15,23)
(Chapters 2,16)
(Chapters 5,7)
II
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CONTENTS
CONTENTS
1
Fundamental Sources
Associated Enterprises
Functional Analysis
Entity Characterisation
10
Comparability Analysis: Aggregation and Use of Third Party nontransactional Data
11
12
13
14
15
16
Recharacterisation Issues
17
Permanent Establishments
18
19
20
Compliance Issues
21
22
23
24
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CONTENTS
Appendices
Appendix 1 Case Law
Appendix 2 EU Arbitration Convention European Union, http://eur-lex.europa.eu/
EUJTP Revised Code of Conduct for the effective implementation of the Arbitration
Convention European Union, http://eur-lex.europa.eu/
EUJTP Code of Conduct on transfer pricing documentation for associated
enterprises in the European Union (EU TPD) European Union, http://eurlex.europa.eu/
IV
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CHAPTER 1
FUNDAMENTAL SOURCES
In this chapter we will look at:
origins of Transfer Pricing;
the origin of the Arms Length Principle (ALP);
the ALP in the OECD Guidelines;
the ALP in the OECD Model Tax Convention;
application of the OECD Guidelines by states;
alternatives to the ALP.
1.1
Illustration 1
Entity 1
(Loss)
Production cost
Product
Entity 2
Profit
Sale
Revenue
To take a simple scenario where entity 1 produces a product and it is sold to an
external customer by entity 2, if there were no transfer price for the product, all of
the sales revenue would be in entity 2 and all of the production cost would be in
entity 1, so entity 1 would show a loss and entity 2 would show a profit margin of
100% (or perhaps a little lower if it has sales and marketing costs). Clearly, a transfer
price is needed, so that the accounts of both entities better reflect the economic
contribution that they have made.
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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 dealing with the strategic and managerial
aspects of transfer pricing.
1.2
Taxation context
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, over the last
century, given rise to specific tax legislation in relation to transfer pricing. This
manual relates to transfer pricing in its tax context, rather than the wider
management accounting sense.
Illustration 2
Entity 1
Country 1
Production
cost
Transfer price
amount will affect
profit split
Product
Entity 2
Country 2
Sales
Revenue
Product
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
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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.
In this taxation context, the term transfer pricing is inseparable from the concept of
the arm's length principle. 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 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. Perhaps the most notable country which rejects the arm's
length principle is Brazil, which sets its own rules about acceptable levels of profits
from intercompany transactions.
1.3
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.
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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 2012 edition
of the book International Transfer Pricing, published and written by
PricewaterhouseCoopers, contains reports on transfer pricing rules in 67 different
countries, plus a chapter covering Africa, in which the transfer pricing rules in a
further five countries are described at length and other countries, such as Malawi
and Zimbabwe, are reported to be considering introducing transfer pricing rules.
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.
1.4
1.5
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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 Guidelines. (Discussed further in
later chapters.) 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 has been provided in relation to comparability
analysis and this has now been split out from the old Chapter I and is dealt with in
the new Chapter III. Arguably, the new 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 Guidelines
since 1997. (Discussed further in a later chapter).
It is therefore important to be clear which version of the OECD Guidelines is
relevant for any particular analysis. The situation is not entirely clear. It could be
argued that the new Guidelines should be ignored except in cases where the year
under examination is later than 2010 and the new Guidelines have clearly been
adopted, for instance by specific reference in legislation or by renewing a double
taxation agreement without expressing any opt out from the new Guidelines.
However, the counter position would be that the 2010 Guidelines are simply a
more detailed elaboration on the original Guidelines, in which case the 2010
Guidelines are relevant even for years before 2010.
The OECD is currently working on a major new project aiming to resolve some of
the most controversial issues in transfer pricing, in relation to intangible assets. A
discussion draft of a proposed revised Chapter VI was issued in June 2012. This was
discussed by transfer pricing experts from Governments and private
representatives in November 2012. This is considered in more detail in a later
chapter.
In April 2013 a revised section on safe harbours in Chapter V was approved by the
committee on fiscal affairs. We will also look at this in a later chapter.
1.6
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transfer pricing adjustment should not be allowed, because the treaty generally
sets out to eliminate double taxation.
The article reads as follows:
Article 9
ASSOCIATED ENTERPRISES
1. Where
a.
b.
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.
2. Where a Contracting State includes in the profits of an enterprise of that State
and taxes accordingly profits on which an enterprise of the other Contracting
State has been charged to tax in that other State and the profits so included are
profits which would have accrued to the enterprise of the first-mentioned State if
the conditions made between the two enterprises had been those which would
have been made between independent enterprises, then that other State shall
make an appropriate adjustment to the amount of the tax charged therein on
those profits. In determining such adjustment, due regard shall be had to the other
provisions of this Convention and the competent authorities of the Contracting
States shall if necessary consult each other.
The wording is somewhat tortuous, but if it is read slowly the meaning is clear.
Broadly speaking, paragraph 1 authorises a country that is a signatory to the tax
treaty to increase the taxable profits of an enterprise. The conditions for it to do so
are that those profits have been understated as a result of making or imposing
non-arm's length conditions (which usually means prices that do not meet the
arm's length test) in its commercial or financial relations (which usually means
transactions) with another enterprise which is associated with the first enterprise.
It should be noted that it is generally accepted that Article 9 is intended to be
permissive; it allows Contracting States to apply the transfer pricing rules that form
part of their tax legislation. It is generally considered that, although not explicitly
stated in either the Model Tax Convention or the Commentary thereon, Article 9
does not create a stand-alone right for countries to make transfer pricing
adjustments that go beyond what is authorised by their own domestic rules. This is
because the basic purpose of a double taxation agreement is to relieve double
taxation; it would go way beyond this purpose if a double taxation agreement
imposed harsher tax treatment on a particular transaction between country A and
country B than would have applied if the same transaction had taken place
between country A and another country, with which country A has not concluded
a double taxation agreement.
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Article 7 effectively follows on from Article 5, which sets out the conditions under
which an enterprise of one Contracting State is deemed to have sufficient nexus
with the other Contracting State that it is taxable therein. Article 5 does this by
defining what constitutes a permanent establishment.
Article 7 sets out the consequences of having a permanent establishment and
defines the extent to which the business profits of an enterprise are taxable in a
Contracting State within which it has a permanent establishment. The wording is as
follows:
Article 7
BUSINESS PROFITS
1. Profits of an enterprise of a Contracting State shall be taxable only in that State
unless the enterprise carries on business in the other Contracting State through a
permanent establishment situated therein. If the enterprise carries on business as
aforesaid, the profits that are attributable to the permanent establishment in
accordance with the provisions of paragraph 2 may be taxed in that other State.
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.
3. Where, in accordance with paragraph 2, a Contracting State adjusts the profits
that are attributable to a permanent establishment of an enterprise of one of the
Contracting States and taxes accordingly profits of the enterprise that have been
charged to tax in the other State, the other State shall, to the extent necessary to
eliminate double taxation on these profits, make an appropriate adjustment to the
amount of the tax charged on those profits. In determining such adjustment, the
competent authorities of the Contracting States shall if necessary consult each
other.
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 2010 update to the OECD Model Tax Convention,
which was the culmination of a project that has, over several years, reviewed and
revised OECD policy in relation to the attribution of profits to permanent
establishments. This is explained in greater depth in a later chapter.
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 permanent establishment 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 permanent
establishment should be the profits that the permanent establishment 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 permanent establishment is an enterprise
separate and independent from the enterprise of which it is in fact a part. We then
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apply the arm's length principle in order to determine the appropriate transfer
pricing of any hypothetical transactions between the two hypothetical entities.
As will be explained in greater detail in a later chapter, the 2010 update of Article
7, together with the revised Commentary thereon, removes the previous
perceived ambiguity about whether the separate enterprise hypothesis should
override the fact that the permanent establishment is in fact just a part of a wider
enterprise. Therefore an arm's length amount of interest can, for instance, be
allocated to the permanent establishment to reflect an appropriate amount of
capital to reflect the functions of the permanent establishment.
Article 11 Interest
Article 11 of the OECD Model Tax Convention 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.
Paragraph 6 reads as follows:
6. Where, by reason of a special relationship between the payer and the
beneficial owner or between both of them and some other person, the amount of
the interest, having regard to the debt-claim for which it is paid, exceeds the
amount which would have been agreed upon by the payer and the beneficial
owner in the absence of such relationship, the provisions of this Article shall apply
only to the last-mentioned amount. In such case, the excess part of the payments
shall remain taxable according to the laws of each Contracting State, due regard
being had to the other provisions of this Convention.
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 Model Tax Convention limits the tax
to 10% of the interest, although many double taxation agreements that are based
on the Convention 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.
The effect is that a multinational enterprise can potentially be doubly penalised if it
is shown to have charged interest which exceeds an arm's length amount. First, it
can be denied a deduction for the excess interest, by virtue of Article 9; second, it
can suffer greater tax at source on the excess interest.
It will be noted that whereas Article 9 defines association in terms of direct or
indirect participation in management, control or capital of an enterprise, this
wording is not mirrored in Article 11, which uses the simple term special
relationship. This is because Article 11(6) is intended to apply more widely than
Article 9, for instance where the special relationship arises by way of family or
marriage ties between individuals or where there is any community of interests
see paragraph 34 of the Commentary to Article 11 between the lender and
borrower other than the loan relationship itself.
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Article 12 Royalties
Article 12, the royalties article of the OECD Model Tax Convention, 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.
Paragraph 4 reads as follows:
4. Where, by reason of a special relationship between the payer and the
beneficial owner or between both of them and some other person, the amount of
the royalties, having regard to the use, right or information for which they are paid,
exceeds the amount which would have been agreed upon by the payer and the
beneficial owner in the absence of such relationship, the provisions of this Article
shall apply only to the last-mentioned amount. In such case, the excess part of the
payments shall remain taxable according to the laws of each Contracting State,
due regard being had to the other provisions of this Convention.
1.7
Barter transactions;
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With legal entities that have reported losses in their tax returns for the two tax
years preceding the transaction.
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the OECD Model Tax Convention. The United Nations has not put forward any
alternative to the OECD Guidelines.
Membership is gradually expanding and Russia is currently engaged in discussions
to join the OECD. In addition, the OECD has enhanced agreements with Brazil,
China, India, Indonesia and South Africa. Representatives from those countries
participate in the OECD's deliberations about transfer pricing as observers.
As mentioned above the Guidelines are a guide to the member countries. A
survey by the OECD published in May 2012 looked at simplifications that countries
had added to the Guidelines in their domestic rules. The survey covered 41
countries and so included some non OECD members. Of the 41 countries surveyed
only 8 had not put in place some kind of simplification measure. Many of the
simplifications related to simplifications for small and medium sized enterprises
(SMEs) (some 21 countries including the UK, Ireland, Argentina, Mexico and China)
or small value transactions (some 15 countries including Germany, France, India
and the United States). Another common area for simplification was
documentation (some 37 countries including Australia, Germany, Turkey and
India). Almost half of those with simplification measures had safe harbours (16 out
of 33).
1.8
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European Union if it moves to a common tax base for member countries (or a
subset thereof).
1.9
1.10
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1.11
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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 Tax Conventions and the definition of Associated Enterprises;
SME practices and the Associated Enterprise definition
2.1
Introduction
As we saw in the previous chapter, Article 9 of the OECD Model Treaty 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 Treaties. 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
b.
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.
Article 9(1) of the 2011 UN Model Tax Convention is worded identically.
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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 is a body corporate resident in State A; B Limited is a body corporate
resident in State B. A Inc holds 100% of the voting shares in B Limited and no
person other than A Inc has an interest in the management, control or capital of B
Limited,
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 arms 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.
Enterprises
The Commentary on Article 9 does start with the following statement:
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.
Article 9 is phrased to apply to enterprises. This is in contrast to most of the rest of
the Model Tax Convention, which generally applies to residents. The phrase
enterprise is also used for Article 5, which deals with Permanent Establishments,
and Article 7, which deals with the Business Profits of Permanent Establishments.
The phrase enterprise is not defined in the body of the Model Tax Convention,
but is commonly thought of as analogous to business.
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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 arms length basis.
In practice, the distinction is of limited importance because it is relatively rare for
there to be a transfer pricing issue on transactions between persons at least one of
which is not a company. Many countries explicitly limit their domestic transfer
pricing legislation to transactions between companies, although this is not the
case in the UK, which phrases its transfer pricing legislation in terms of provisions
between persons.
2.3
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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. Ds 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.
ii.
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 Ltd, 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 arms 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 s.92 onwards. An
associated enterprise is defined analogously to Article 9(1) of the OECD Model
Tax Convention. 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.
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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.
The consequences of variation in state practice: corresponding adjustment
An important practical implication of the differences in state practices described
above is the possibility that a corresponding adjustment under the applicable
treaty equivalent of Article 9(2) of the Model Tax Convention might be denied if
the Contracting State that would otherwise be obliged to grant the adjustment
does not regard the two enterprises as associated but the other Contracting State
does.
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 arms 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 double tax convention includes an Article based on Article
9(2) of the OECD Model.
Where a Contracting State includes in the profits of an enterprise of that State
and taxes accordingly profits on which an enterprise of the other Contracting
State has been charged to tax in that other State and the profits so included are
profits which would have accrued to the enterprise of the first-mentioned State if
the conditions made between the two enterprises had been those which would
have been made between independent enterprises, then that other State shall
make an appropriate adjustment to the amount of the tax charged therein on
those profits. In determining such adjustment due regard shall be had to the other
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2.4
Conclusion
The concept of Associated Enterprises is important because it concerns the control
thresholds which bring into play domestic transfer pricing rules which often include
onerous documentation requirements and the risk of penalties for noncompliance. Whether or not two enterprises are associated with each other will , in
many cases, be uncontroversial in both contracting states. However, the lack of a
clear definition in the OECD Model and Commentaries has permitted a wide
variation in state practice which could give rise to double taxation in practice.
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CHAPTER 3
THE ARM'S LENGTH PRINCIPLE AND COMPARABILITY
In this chapter we are going to look at:
why the arms length principle is needed;
the OECD Guidelines and comparability;
the five comparability factors;
application of comparability analysis.
3.1
Introduction
The purpose of this chapter is to explore the arms length principle, and to
understand how it should be applied by taxpayers and tax authorities (namely,
through comparability analysis). The arms 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 arms
length from each other). However, the complexity of applying this in practice is at
the heart of all uncertainty and controversy within transfer pricing.
Therefore, this chapter will provide:
3.2
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of the UK 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 the United States,
where the corporate tax rate is currently 40%, the company would 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 UK, where a
corporate tax rate of 23% would be applied. With a high transfer price, little profit
would be earned in the United States and thus little tax would be paid at the
higher rate, minimising the groups overall tax liability.
Conversely, if the sales company were located in Ireland, with a corporate tax
rate of 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 Ireland, and less in the
UK, reducing the overall tax liability.
Illustration 1
Final sales price 500.
Cost of production 200
Transfer Price
400
300
UK Profit
23%
200
100
USA Profit
40%
100
Ireland Profit
12.5%
200
Total Profit
300
300
In each case the total profit is 300. However where the UK 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 Ireland most of the profits have been moved there.
Let us focus on sales in the USA. With a transfer price of 400 to the USA 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 Ireland the total tax
bill would become 23+80 = 105 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 the USA.
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 UK manufacturer selling to third party distributors in the United States and Ireland
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 counter parties. From a shortterm 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
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different transfer prices used in the calculation of taxable profits in each country
and the double taxation of group profits.
Such an outcome would undesirable on many levels. Ultimately it would lead to a
significant reduction in cross-border trade, impacting jobs and economic
prosperity. Such an outcome would be unpalatable for most governments. The
result is that compromise is required, and this comes in the form of the arms length
principle. 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 couldnt 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.
The OECD Guidelines 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 2010
Transfer Pricing Guidelines 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.
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. (See OECD 2010 Transfer Pricing Guidelines
Chapter I, B, 1.15).
As no alternative has yet been acknowledged, comparability analysis is in all
effects the only available test for determining whether two related parties are
transacting at arm's length.
Notwithstanding the opportunity for associated enterprises to manipulate prices, it
should not be assumed that prices will not be arms length. The OECD Guidelines
observe that, Associated enterprises in MNEs sometimes have a considerable
amount of autonomy and can often bargain with each other as though they were
independent enterprises. Enterprises respond to economic situations arising from
market conditions, in their relations with both third parties and associated
enterprises. (See OECD 2010 Transfer Pricing Guidelines Chapter I, A, 1.5).
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 arms 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
arms length outcome (we will look at this in a later chapter). Furthermore,
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commercial teams will generally have a good understanding of their own industry
and a reasonable idea of what constitutes arms length arrangements.
A further complication is that taxpayers will often enter into transactions and
arrangements that simply do not exist between unrelated parties.
Such transactions may not necessarily be motivated by tax avoidance but may
occur because in transacting business with each other, members of an MNE group
face different commercial circumstances than would independent enterprises.
Where independent enterprises seldom undertake transactions of the type
entered into by associated enterprises, the arms length principle is difficult to
apply because there is little or no direct evidence of what conditions would have
been established by independent enterprises. The mere fact that a transaction
may not be found between independent parties does not of itself mean that it is
not arms length. (See OECD 2010 Transfer Pricing Guidelines Chapter I, A, 1.11).
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.
For example, multinational groups may centralise certain ancillary activities to be
more efficient. These activities may include human resources, IT support and
finance. Although it is possible to find independent companies providing these
services, it is important to note that for the independent companies, these services
are core activities. As such, they will also need to perform their own sales activity
and commercial management and generally act in an entrepreneurial manner.
Where these activities are performed in the context of a related party service,
there is generally no such entrepreneurial element.
A further example is found in the context of business restructuring (discussed in
more detail in a later chapter). Companies may choose to centralise many of the
key economic activities and business risks, such that operations in local markets
may have a very limited role. For example, distributors may have only a very
specific role in sales management, and manage few risks. Such distributors are
unlikely to be found operating independently. Nevertheless, provided the structure
is not purely for the purpose of tax avoidance, the transaction should be
respected and the arms length principle should still apply. In such cases, more
thorough analysis would be required to evaluate the arms length price.
The natural corollary to this is to note that the arms length principle does not
require taxpayers to behave in arms length manner. It is simply the case that
pricing for transactions should be consistent with an arms length consideration.
For example, companies are not required to negotiate as independent parties
would, or limit access to commercial information.
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3.4
Functional analysis;
Contractual terms;
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
arms 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.
MNE based in Japan
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
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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.
You will see more detail on what a functional analysis looks like in a later chapter.
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.
In undertaking comparability analysis, third party data involving companies with
similar functional, risk and asset profiles to the tested party is required. In practice,
it is impossible to find companies with identical profiles. Therefore, broader analysis
of the industry and the company are required to determine which are the
significant determinants of profit for the company, and which are routine.
Contractual terms
Contractual terms and conditions should always be reviewed when using the CUP
method 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.
At a deeper level, the contractual arrangements may confer rights and
obligations on the parties that need to be reflected in the transfer pricing. For
example, the distributor may have exclusive rights to distribute the televisions within
the UK market and would therefore expect to pay a premium for such right. It may
also be obligated to undertake a certain level of advertising and promotion
activity that would need to be factored into the price. It may also contractually
bear or pass on some of the risks identified in the functional analysis. An
understanding of the contractual relationship between the parties is therefore
necessary to enable the identification of sufficiently comparable third party
relationships.
Economic circumstances
Economic circumstances relate to the broader context in which the transaction
takes place. There are many factors that are beyond the control of the related
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parties that would influence the arms length price for any given transaction. The
most obvious example is the state of the economy. If we consider the UK
distributor purchasing televisions against a backdrop of very low economic growth
and poor consumer confidence, this will have a significant impact on the demand
for televisions and other consumer products. This will impact the overall profitability
for the group, and level of profitability that the distributor might expect to make.
Another factor may be the degree of competition amongst customers. For the UK
distributor, there may be a large number of significant customers and a high
degree of competition at the retail level. 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
distributor.
In undertaking comparability analysis, it is therefore necessary to consider whether
the third parties face the same economic circumstances as the tested party, and
if so, whether those differences are material. Comparable data from different
markets, geographic or otherwise, should not automatically be excluded but do
require careful evaluation.
Business Strategies
The OECD Guidelines acknowledge that business strategies will play an important
role in determining the arms length price.
In practice, this is most commonly
considered in the context of market penetration. In the case of our example, 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 arms length price.
However, it should be cautioned that there should be consistency between the
business strategy and the functional analysis. If in the long term the UK distributor is
to be considered a low-risk distributor, with very little responsibility for managing
market risks in the UK, then it would not be expected to incur the costs of starting
up the UK business and establishing the brand. Under those circumstances, the
transfer price would need to be lowered to allow the UK distributor to earn
sufficient profit from a very early stage.
3.5
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CHAPTER 4
TRANSFER PRICING METHODS
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.
It is preferable to look at transfer pricing methods prior to setting up intragroup
transactions as it limits the risk of exposure in case of an audit.
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 Guidelines 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).
It is important to understand all the methods; however, it is even more important to
understand how to apply them and when they should be chosen.
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4.3
Functional profile (i.e. does the related party carry out the same functions to
deliver the service or product to the third party as to the related party?);
Risk profile (i.e. does the enterprise bear the same risk when dealing with both
the third and the related party?);
Cost base (i.e. does the enterprise bear more or less cost when interacting with
a related party?); and
Contractual terms (i.e. are there any differences between the third party and
related party contract? For example, payment terms, return policy,
cancellation terms, etc.).
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4.4
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Known
(X)
(X)
(X)
(X)
X
Selling price
Transport costs
Advertising
Other costs
Resale price margin*
Arm's length price
*This is a known.
The RPM is as the OECD Guidelines 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).
However, the latest business trends are showing an increasing number of large
MNEs setting up principal structures, where the sales entities act mainly as agents
to facilitate the sale or as limited risk distributors.
In cases where the sales entity does not take legal title to the goods or has a
reduced risk profile and is acting on behalf of a principal distributor the RPM model
is not the appropriate model and it is worth looking at other methods such as the
Transactional Net Margin Method (TNMM) instead.
Another consideration that should be made on the RPM, which transpires from the
OECD Guideline's description of the method, is that the gross margin applicable to
the distributor or wholesalers should include an arm's length return.
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 tax payer 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
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To use a similar example to the OECD Guidelines, 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 good; 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.
Furthermore, applying the cost plus method presents a number of difficulties in
relation to how cost is managed and what strategy drives spending and
investment patterns in a business as the OECD Guidelines highlight in the extract
below.
The cost plus method presents some difficulties in proper application,
particularly in the determination of costs. Although it is true that an enterprise
must cover its costs over a period of time to remain in business, those costs
may not be the determinant of the appropriate profit in a specific case for
any one year. While in many cases companies are driven by competition to
scale down prices by reference to the cost of creating the relevant goods or
providing the relevant service, there are other circumstances where there is
no discernible link between the level of costs incurred and a market price
(e.g. where a valuable discovery has been made and the owner has incurred
only small research costs in making it). (OECD 2010 Transfer Pricing Guidelines
Chapter II, 2.43)
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.
However, making adjustments to the cost base can make applying an
appropriate mark-up difficult as when looking for comparable transactions it might
not be as easy to identify the cost base in the comparable (especially if this is a
third party comparable). This issue is also encountered when applying the cost plus
method under a Transactional Net Margin Method (TNMM).
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(OCED
2010
Transfer
Pricing
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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 2010 Transfer Pricing Guidelines Chapter II, 2.76).
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 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.
The remaining return is consequently left to the associated enterprise controlling
the intangible asset; the return to the intangible asset is, in practice, a residual
category being the return left over after other functions have been appropriately
compensated at arm's length.
This implies 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. As stated above 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
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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.
Transactional Profit Split Method
The transactional 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 realise from engaging in the transaction or transactions. The
transactional profit split method first identifies the profits to be split for the
associated enterprises from the controlled transactions in which the
associated enterprises are engaged (the combined profits). References to
profits should be taken as applying equally to losses It then splits those
combined profits between the associated enterprises on an economically
valid basis that approximates the division of profits that would have been
anticipated and reflected in an agreement made at arm's length. (OECD
2010 Transfer Pricing Guidelines Chapter II, 2.108)
The wording in the OECD Guidelines introducing the Profit Split Method (PSM)
immediately touches on the main application for the PSM, which is dealing with
complex transactions where several parties contribute to generate overall value
(i.e. a product or a service). 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 highly integrated operations for which a one-sided method would
not be appropriate. A transactional profit split method may also be found to
be the most appropriate method in cases where both parties to a transaction
make unique and valuable contributions (e.g. contribute unique intangibles)
to the transaction, because in such a case independent parties might wish to
share the profits of the transaction in proportion to their respective
contributions and a two-sided method might be more appropriate in these
circumstances than a one-sided method. In addition, in the presence of
unique and valuable contributions, reliable comparables information might
be insufficient to apply another method. On the other hand, a transactional
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profit split method would ordinarily not be used in cases where one party to
the transaction performs only simple functions and does not make any
significant unique contribution (e.g. contract manufacturing or contract
service activities in relevant circumstances), as in such cases a transactional
profit split method typically would not be appropriate in view of the functional
analysis of that party. (OECD 2010 Transfer Pricing Guidelines Chapter II,
2.109)
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.
The globalisation trends and increasing competition require businesses to come up
with unique ways to sell their products and services and gain (plus keep) the
interest of new and existing customers.
Technical intellectual property, business and industry know-how and brands are
often becoming the main driving force for large businesses. With brands valued in
excess of tens of billions, ensuring that intellectual property is properly accounted
for when allocating profit is key.
One of the inherent properties of intangible is its uniqueness as businesses gain by
differentiating themselves from the competition. However, the unique nature of
intangible translates in more difficulties in finding comparable transactions when
pricing the intangible contribution for transfer pricing purposes.
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.
Before elucidating how the PSM and RPSM work with intangibles, it is important to
understand how the PSM and RPSM work in practice.
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.
Two main methods to split the profits amongst the associated enterprises can be
used:
Residual analysis.
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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.
If the relative value of the contributions can be calculated directly, then
determining the actual value of the contribution of each enterprise may not be
required. The combined profits from the controlled transactions should normally be
determined on the basis of operating profits. However, in some cases it might be
proper to divide gross profits first and subsequently subtract the expenses
attributable to each enterprise. Furthermore, when services are exchanged which
contribute to the overall value proposition, other methods can be used to
apportion the overall profit, such as the cost plus method.
If we compare contribution analysis to TNMM we see that TNMM depends on the
availability of external market data comparables to measure efficiently the value
of contribution of each of the related parties, while the contribution analysis can
still be carried out even when it is not possible to measure directly each party's
contribution to the overall profit base of the multinational group.
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 twostep 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
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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 OECD Guidelines 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.
Another way to allocate the residual profit is to look at the development
expenditures in recent years and identify a trend (i.e. if these costs have been
constant over time).
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 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.
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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
intragroup transaction own valuable intangible properties (e.g. technical IP,
patents, trademarks, and tradenames). 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.
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CHAPTER 5
FUNCTIONAL ANALYSIS
In this chapter we look at:
The goal of functional analysis;
An introduction to the analysis of functions, assets and risk;
Summarising the functional analysis;
Functional analysis and entity characterisation.
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 2010 OECD Transfer Pricing Guidelines 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.
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.
5.2
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To help establish this there is guidance from the OECD in paragraph 1.38 on five
important comparability factors that should be considered:
Paragraph 1.36 refers to five factors that may be important when determining
comparability. As part of a comparison exercise, the examination of the five
comparability factors is by nature two-fold, i.e. it includes an examination of the
factors affecting the taxpayer's controlled transactions and an examination of the
factors affecting uncontrolled transactions.
We looked at these comparability factors in an earlier chapter. You will recall that
they may be summarised as:
Functional analysis
Contractual terms
Economic circumstances
Business strategies
The function (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.
Paragraph 1.42 of the OECD Guidelines summarises the importance of the
functional analysis and its impact on arm's length pricing:
1.42 In transactions between two independent enterprises, compensation usually
will reflect the functions that each enterprise performs (taking into account assets
used and risks assumed). Therefore, in determining whether controlled and
uncontrolled transactions or entities are comparable, a functional analysis is
necessary. This functional analysis seeks to identify and compare the economically
significant activities and responsibilities undertaken, assets used and risks assumed
by the parties to the transactions. For this purpose, it may be helpful to understand
the structure and organisation of the group and how they influence the context in
which the taxpayer operates. It will also be relevant to determine the legal rights
and obligations of the taxpayer in performing its functions.
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.
Whichever view is taken, the analysis of the economically significant functions,
assets and risks remains key.
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5.3
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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.
A functional analysis will often be performed by way of an interview with key
stakeholders in an enterprise. As a tool, the functional analysis interview is an
effective way to explore the full range of comparability factors.
The representation of the functional analysis in documentation is important. It
typically forms a core part of a transfer pricing report and can be the subject of
scrutiny by a tax authority or other interested party (for instance a minority
shareholder) many years after writing. As such, it needs to be a full explanation
that stands alone in a fashion that is not reliant on reference back to source or
detailed supplementary materials.
5.4
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.
Activity
HO Ltd
Parent Co
Functions
R&D management, review,
budget
R&D performance
Procurement
Production
Logistics and shipping
Marketing & business
development
Sales (inc customer contract)
After sales service
Insurance
Strategic management
Day-to-day management
Back office support
MO Ltd
Manufacturer
DO Ltd
Distributors
X
X
X
X
X
X
X
X
X
X
X
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Assets
Raw materials stock
Design intellectual property
Production equipment
Manufacturing know-how
Stock of finished goods
Trade mark and brand IP
Customer lists
IT support systems
Website
X
X
X
X
X
X
X
X
X
Risks
New product development
Warranty
Market
Foreign exchange
Stock
Regulatory
X
X
X
X
X
X
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.
We can contrast this to the following illustration.
Illustration 2
Here we have a functional analysis for the C Group.
Activity
CP Ltd
Parent Co
Functions
R&D management, review,
budget
R&D performance
Procurement
Production
Logistics and shipping
Marketing & business
development
Sales (inc customer contract)
After sales service
Insurance
Strategic management
Day-to-day management
Back office support
CM Ltd
Manufacturer
CD Ltd
Distributors
X
X
X
X
X
X
X
X
X
X
X
X
X
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Assets
Raw materials stock
Design intellectual property
Production equipment
Manufacturing know-how
Stock of finished goods
Trade mark and brand IP
Customer lists
IT support systems
Website
X
X
X
X
X
X
X
X
X
Risks
New product development
Warranty
Market
Foreign exchange
Stock
Regulatory
X
X
X
X
X
X
5.5
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CHAPTER 6
ANALYSIS OF FUNCTIONS, ASSETS AND RISK
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
This chapter focuses on the practical aspects of preparing a functional analysis,
from considering the audience for the functional analysis through to conducting
interviews and preparing and updating its documentation.
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.
6.2
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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.
The functional analysis interview team
For each functional analysis interview, it is advisable to have one person
responsible for conducting the interview and another person whose sole task is to
take notes of what the interviewee has said. It is very difficult to conduct an
interview and take adequate notes at the same time.
Ideally, in addition to the interviewee, it is helpful to have three participants:
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.
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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.
6.3
Is the busiest person in the room: if people are talking they probably should be
writing.
The interview
Conducting the interview
There is undoubtedly an art to conducting a good functional analysis interview but
as a rule, as indeed with most things, the more preparation that is done ahead of
the meeting the better the interview is likely to go.
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.
It is good practice to begin by explaining to the interviewee the purpose of the
interview, what types of transactions/issues are the highest priority and how the
information will be used. It is surprising how much more relaxed interviewees are
when they find out that the information will only be used in a document for tax
purposes. Keep in mind that the interviewee may be defensive: the questions they
are being asked are trying to get to the core of the business. They are in essence
being asked what they do, why it is important and how they add value. As such, it
never hurts to tell the interviewee that in the majority of cases the document that is
being prepared is unlikely to ever be read by anyone outside of the business's tax
department. Transfer pricing documentation, like insurance, is best when you
never have to use it.
It is good practice to start the functional analysis interview by asking the
interviewee to describe their current role, the team they work in, and their history
with the company. Open questions are key to getting the information needed,
such as can you please explain how or describe the process involved in.
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6.4
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introduces each function, risk and asset and then describe the entities to which
these apply under each relevant heading.
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.
Core Example: Otaki Group
Illustration 1
OTAKI CENTRAL
(New York)
Pricing, Logistics, Marketing
Design selection,
Trade marks
Stores
3rd PARTY
Contract
Manufacturers
(Asia)
OTAKI
Design
(Milan)
Develops designs
OTAKI
Manufacturing
(Philippines)
20% of products
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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.
Research and development (R&D)
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.
But in other industries, for instance making Champagne, a long established
process must be followed, and the importance of R&D is likely to be less than other
factors such as owning land in the right appellation (an asset).
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
Procurement is the acquisition of goods or services. Within a global group, this
function might be performed separately by many entities or, in some cases, by a
dedicated business whose sole function is to arrange procurement for members of
a group. By centralising procurement in this way a group may hope to produce
efficiencies and potentially economies of scale.
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may include setting the global marketing plan which subsidiaries can then adapt
to their own local market.
Intragroup services
Many multinational groups have services provided by one or more member to
others, often centralised and/or combined with head office roles. These services
may include back-office support such as human resources, recruitment, IT, and
financial reporting. It is important to consider how beneficial these are, and
whether they are unique or could be sourced from a third-party. This is especially
important for high value services such as marketing.
Financing
Some multinational companies may centralise expertise within an entity to provide
a financing or treasury management function for the group. Examples of this may
include providing capital to subsidiaries in the form of intercompany loans,
providing hedging of foreign exchange exposures, cash pooling, and sweep
accounts. It is important to identify whether the role of a finance entity is to
provide intragroup services, such as advice in respect of hedging, or whether it
enters into transactions and if so to what extent it is exposed to risk.
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) you speak to, you may be able to gain 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 type of assets to be included in a functional analysis is broad. As noted in
paragraph 1.44, the OECD Guidelines highlight the importance of considering
assets as part of the functional analysis:
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.
Both tangible and intangible assets should be considered. It is important to identify
assets at both ends of the transaction, making it clear which party owns the assets
(legally and economically) and which party uses the assets and how the owner is
compensated.
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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.
Trade and receivables
Does the company have a large amount of receivables when compared to
payables? If so what are the payment terms offered to related parties and third
parties? Is there a significant difference, and does this impact on the working
capital of the company under review? For example, if a distribution company
receives payment from third party customers after 60 days, but must pay for stock
purchased from related parties within 7 days, this may result in a cash flow issue.
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
There is increasing emphasis in transfer pricing on determining which party is
responsible for the development, enhancement, maintenance and protection of
intangibles. The functional analysis should clearly state which party is responsible
for these activities and which party is entitled to the rewards arising from the
intangibles.
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6.7
Risks
Risk has often been 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 revised OECD Chapter
IX guidance on business restructurings. 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.
When conducting functional analysis interviews, it can be helpful to ask what
would happen should a catastrophic disaster occur. In the Otaki Group example,
what would happen if it turned out that a third party contract manufacturer used
toxic chemicals in dying a batch of t-shirts that resulted in 50 customers being
hospitalised? How would this be different if it was Otaki Manufacturing that used
the toxic chemicals?
It is important to review any contracts that underpin the intercompany
transactions under review. It is surprising how often a company is not following the
terms of a contract, and may have unnecessarily borne costs or become liable for
risks that another group member is responsible for.
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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 down turn,
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
Regulatory risk arises when an industry is particularly subject to compliance with
government regulations. While this is a barrier to entry that can protect businesses
meeting the requirements, changes to these requirements creates risk that either
additional cost will be incurred or that new competition will be allowed into the
market. For example, assume that an energy sector construction company
entered into a contract to build a new refinery in an emerging market. The
contract is signed, and contains a clause that states that the refinery will meet
local emission laws. Half way through construction the developing nation reacts to
non-government pressure to improve its poor environmental record, and halves
the allowable emissions from all commercial sites including refineries.
As a consequence, the construction company will incur an addition 50m in
construction costs to install new scrubbers and other equipment to meet the
standards.
Contractual risk (or warranty/performance 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.
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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.
New product development risk
In many industries, continued success relies on the ongoing development of new
or improved products. Some examples of this may be the development of new
technology, improving an existing technology or a new design for an existing
product. New product development risk arises where the enterprise is primarily
responsible for successfully maintaining this development cycle. For instance,
Apple has been very successful in developing new products in recent years.
Products such as the iPad and iPhone have captured significant amounts of
market share at the expense of other companies, and in the case of the iPad
created a new market.
However, none of Apples competitors have developed a tablet computer to date
which has exceeded the sales volumes of the iPad. Developing new products can
be very risky, and many companies, such as Polaroid and Kodak, have failed
when their products have failed to keep pace with changes in the market when
consumers moved to digital, and mobile phone cameras.
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?
Foreign exchange risk
Foreign exchange risk arises where an enterprise is exposed to currency
fluctuations on contracts. The risk arises when expenses and revenue are
denominated in different currencies.
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Exchange rates can be quiet volatile and generally, unless the subject is a
financial company, the company's core competence will not be in financial
markets.
6.8
6.9
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Otaki
Central
Functions
Manufacturing
Design
Product selection
Sales & Distribution
Warehousing
Strategic
Management
Financing
Tangible Assets
Trade receivables
Inventory
Property
Plant / equipment
Intangible Assets
Trademark
Manufacturing
Intangibles
Marketing
Risks
Market
Credit
Inventory
Product selection
Contract
Staff
Key:
XXX
XX
X
Otaki
Design
Otaki
Manufacturing
Otaki Retail
X
XX
XXX
X
X
XX
X
X
X
X
X
X
X
X
X
XX
XXX
X
XXX
XX
X
XX
XXX
XX
X
Key
Important
Routine
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6.10
6.11
Conclusion
A good functional analysis will provide a succinct summary of the business'
functions, risks and assets, and the relative importance of these elements to the
business. Once the functional analysis has been established, the next step is to use
this information to characterise the business, which is considered in detail in a later
chapter.
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CHAPTER 7
RELATING FUNCTIONAL ANALYSIS TO SELECTION OF TP METHOD
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
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.
The functional analysis has the following aims:
To ensure that the functional and risk profile of the tested party is reflected in
the chosen comparable.
Chapter III of the OECD Guidelines 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.
3. Understanding the controlled transaction(s) under examination, based in
particular on a functional analysis, in order to choose the tested party (where
needed), the most appropriate transfer pricing method to the circumstances
of the case, the financial indicator that will be tested (in the case of a
transactional profit method), and to identify the significant comparability
factors that should be taken into account.
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7.2
Cost plus
Resale price
Profit split
The guidelines no longer contain a hierarchy for selection of the transfer pricing
method, however some countries continue to do so.
7.3
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to customers.
restructured to
majority of the
supported by
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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.
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 groups
facts and circumstances.
Maruti Suzuki India Limited v ACIT (2010)
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 TP
method will likewise be inappropriate.
7.4
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The transactions involve commodity type products, but only those in which
product differences are adjustable; and
7.5
Cost Plus
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 is often used in transactions involving a contract
manufacturer, a toll manufacturer or a low risk assembler which does not own
product intangibles and incurs little risk. The cost plus method is usually not a
suitable method to use in transactions involving a fully fledged manufacturer,
which owns valuable product intangibles as it is difficult to locate independent
manufacturers owning comparable product intangibles.
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 (i.e. cost plus based on transactional rather than transaction. See section
7.11 later in this chapter).
It is important to have good quality data and ensuring that the comparable
transactions are indeed comparable and a close match to the controlled
transaction.
7.6
Resale Price
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 a typical intercompany transaction involving a fullyfledged manufacturer
owning valuable patents or other intangible properties and affiliated sales
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companies which purchase and resell the products to unrelated customers, the
resale price method is a method to use in respect of the sales company if the CUP
method is not applicable and those sales companies do not own valuable
intangible properties.
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).
7.7
Profit Split
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.
7.8
7.9
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...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.
7.10
Contract manufacturer
Service provider
Distributor
Description
This is the entity containing
the decision makers,
taking the investment risks
(e.g. research, new
markets and innovation).
The group entrepreneur
can take several forms. For
example it can be a
manufacturer, the group
researcher or the group
product designer.
A contract manufacturer
produces goods under the
direction and using the
technology of the group
principal (usually by
reference to a contract).
Its risks are primarily limited
to its efficiency and ability
to retain the group
manufacturing contract. In
its most limited risk form it
will be a toll manufacturer
with the principal
supplying and retaining
ownership of all materials
A service provider supplies
services to other group
companies usually by
reference to a contract. Its
risks are primarily limited to
its efficiency and ability to
provide contracted
services at budgeted costs
A group distributor
distributes goods supplied
by its principal. It risk profile
can vary dependent on
the structure of the
operation.
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Pricing method
Residual profit after
rewarding the other
entities in the supply
chain for their functions.
CUP/Cost plus
method/Transactional
net margin method
CUP/Resale price
method/Transactional
net margin method
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7.11
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 (India) PvT. Limited v CIT (2012)
GAP International Sourcing provides procurement services for its group in India.
The Indian tax authorities sought to challenge the companys transfer pricing
policy of a mark up on value added expenses, preferring a commission of 5% of
the Free on Board price. The taypayers 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 Sellers expense to a specified point and no further.
LG Electronics India Pvt. Limited v ACIT (2013)
LG India manufactures and distributes LG Koreas products under license, for
which it paid a royalty. The Indian tax authorities successfully deemed LG Indias
marketing expenses to be excessive and something that should be recharged to
LG Korea with a mark up using the cost plus method at arms length given the
license arrangement and allocation of risk between the companies.
This
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effectively imputed another transaction for brand building which had not been
captured in the transfer pricing method. It also confirmed the acceptance of the
Bright line test, as there was no increase to taxpayer income or profits from the
additional marketing spending.
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.
7.12
Availability of comparables
For all transfer pricing methods access to information on comparables is necessary
and it may be that due to difficulty in getting access to reliable data on
comparables a different method is then chosen.
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).
Alternatively an industry analysis (publicly available or internally conducted by
the company) could be used to identify profit levels that can reasonably be
expected for various routine functions (e.g. production, services, distribution, etc.).
7.13
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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.
8.1
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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, lowrisk 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.
8.2
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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.
Fundamentally there is a direct correlation between the profit potential of a
company and the type of activity it conducts, the risks that it assumes and the
assets, especially intellectual property, that it owns. More complex entities possess
a higher degree of functionality, risks and assets, and so have the potential to
generate the greatest profit margins. On the other hand, increased functionality
and risk gives rise to the potential for much greater fluctuations in profitability,
including the possibility of financial losses. These more complex entities are more
entrepreneurial where they drive the key strategic and critical decisions for a
group and take on the associated risk. The right or wrong decisions in this regard
will have a direct impact on the financial performance of the group.
In some cases, multinational enterprises may seek to centralise key strategic or
high value functions and risks in a single entity to avoid duplication and simplify
management. Where implemented effectively, this further reduces the functions,
assets and risks of local activities in favour of those in the entrepreneur or
principal company.
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.
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8.3
Sales functions
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, researching
the market and facilitating logistics but not entering into customer contracts or
taking 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.
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8.4
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?
Manufacturing entities
Many groups outsource their manufacturing operations to third party contract
manufacturers, particularly in low cost territories such as China and Eastern Europe,
to enhance profit margins and to be price competitive. Groups may decide that it
is more effective to set up their own manufacturing subsidiary - for instance, to
have more control over the manufacturing process or to protect their intellectual
property.
A functional analysis can identify different types of manufacturing entity. Again,
some of the terms commonly given to the spectrum of manufacturing function
and the potential for profit (and profit volatility) associated with them are
illustrated below.
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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
A contract manufacturer is the first step up from a toll manufacturer. In addition to
owning plant and machinery and employing a skilled labour force, it will also own
the raw materials through the production process and have title to the end
product. However it will not own any of the design-related intellectual property
(despite having know-how relating to its production processes) and will usually
manufacture set volumes to order.
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.
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Licensed manufacturer
As with their equivalent distributors, a manufacturer may license (either explicitly or
in effect) design intellectual property from another group entity. This may be a
long term arrangement. The manufacturer will then have the responsibility to
exploit this effectively, potentially investing in developing intangibles used in the
production process. Again, there is a sliding scale of functionality. It may
undertake its own procurement or draw from a central group function, and it may
hold stocks of both raw materials, semi-finished and finished product. It is also
much more likely to carry local risk for under-utilisation of its production capacity.
Again, careful functional analysis is important to identify all the relevant
transaction types does it contract out procurement, for example? This will allow
an understanding of whether the licensed manufacturer remains the simpler entity
or whether the other assets and functions on which it relies including group
distributors are in fact themselves the simpler parties in respect of the transactions
involved.
Full risk manufacturer
Where a functional analysis shows a manufacturer assuming significant levels of
functions and risks in respect of its processes, similar to or greater than a licensed
distributor, then it should be considered to be full risk. This will include
management decisions on the use of production capacity and related risks such
as procurement and warranty issues, together with pricing of its output.
As a result, profit levels are expected to be more volatile as aspects such as
capacity and input raw materials cost are taken into account. This will need to be
reflected through the transfer pricing method either for the overall activities of the
manufacturer (if a profit-based method is used) or for component transactions
with other group entities. If the latter is used, consideration should again be given
to whether the full risk manufacturer remains the simpler party and the appropriate
focus of testing. Key questions for the functional analysis may include:
8.5
Who takes inventory risk for raw materials and finished goods?
Who takes procurement risk i.e. securing appropriate raw materials at the
right price?
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8.6
8.7
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choice of entity characterisation bias the way in which the functional analysis
review is undertaken and documented, whereas the functional analysis should
always come first and be used as the tool to drive entity classification.
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 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:
Consider the case of the latest smart phone purchased by a customer.
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)
Wholesales to
retail stores
Software/hardware/ brand
development company
Central services
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
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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.
In order to facilitate a global distribution network, groups will need a presence in
the major territories around the world where they expect to do business. They will
normally have an entity whose role is to wholesale the smart phones to retail stores
and to market the product in the local marketplace. This could be achieved
through a limited risk structure.
The above is a simple example. When implemented properly, it could result in a
tax efficient supply chain with supernormal profits associated with the group's
intellectual property accruing offshore. However, a group's lack of robustness in
the implementation process could undermine the effectiveness of the structure.
Typically this will be due to commercial and personnel issues.
For example, it could be difficult to operate a brand management company
offshore as brand people from a commercial perspective may wish to work in
places such as London, California, etc where there is a pool of talent and key
advertising agencies to develop campaigns. There are also personnel issues in that
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.
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CHAPTER 9
COMPARABILITY ANALYSIS: OECD PROPOSED PROCESS
In this chapter we look at the OECD guidance on how to perform a comparability analysis
including:
the process laid down in the OECD Transfer Pricing Guidelines;
choice of the tested party;
external comparables and sources of information;
selection of comparables;
comparability adjustments;
the Arms Length range;
timing issues;
compliance issues;
9.1
Introduction
This chapter follows closely Chapter III of the OECD 2010 Transfer Pricing
Guidelines. You may find it useful to highlight key parts of your copy of Guidelines
as you work through the chapter.
9.2
9.3
Functional analysis;
Contractual terms;
Business strategies.
Typical process
The 2010 Transfer Pricing Guidelines set out in Chapter III Section 41 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. The steps are as follows.
Step 1: Determination of years to be covered.
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b.
c.
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d.
e.
f.
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9.4
PARENT CO
COMPANY A
Manufacturer
Simple functions
Product 1
COMPANY B
Intangibles
Technical
specifications
Tested Party
Product 1 is manufactured using valuable intangibles owned by company B and
following technical specifications set by B. Company A performs only simple
functions, and does not make any valuable, unique contribution in relation to the
transaction. The tested party would most often be company A.
PARENT CO
COMPANY A
Manufacturer
Intangibles
Product 2
COMPANY B
Distributor
Simple functions
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.
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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.
9.5
9.6
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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
D.1.2 must still be met, and comparability adjustments may still be required as at
A.6. 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.
9.7
b.
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 to whether to reward owners by means of salary or dividend,
and it may be difficult to identify and separate out these factors.
d.
e.
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.
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9.8
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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;
c.
d.
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.
9.9
Comparability adjustments
Because the comparables identified are unlikely to match the controlled
transaction exactly, adjustments may be appropriate, depending upon the costs
and compliance burden that this would involve. This is Step 8 in the typical process.
Different types of comparability adjustments
Adjustments may be made to eliminate differences in accounting treatment
between the controlled and uncontrolled transactions, to exclude significant noncomparable transactions included within composite data for the uncontrolled
transactions, and to take account of differences between companies in capital,
functions, assets and risks. In practice these factors may also affect decisions as to
where to place a company within the range of arm's length results as discussed
below. For example, a transaction that exposes a company to higher than
average degree of risk may justify placing it in that part of the range which will
produce a higher profit.
Sometimes a working capital adjustment will be appropriate to reflect the fact
that where a company carries high levels of debtors and inventory the cost of
doing so may (theoretically at least) be reflected in the price it charges; similarly,
the benefit of a high level of creditors may be reflected in a reduced price.
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9.10
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risk may also be used to justify placing of the particular company in question at the
higher or lower end of the range.
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.
Selecting the most appropriate point in the range
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.
Extreme results: comparability considerations
Extreme results in one of the potential comparables may indicate a defect in
comparability, or exceptional conditions that only apply to an otherwise
comparable third party. While extreme results may be excluded on the ground
that they bring to light previously overlooked defects in comparability, they should
not be excluded merely because they are extreme.
In general, all relevant information should be used. There is no general principle
that loss-making comparables should either be included or excluded, because it is
the circumstances of a company taken as a whole that determine whether it is
comparable, rather than its financial result. The existence of a loss will, however,
normally trigger further investigation of whether the comparable is valid. It should
be excluded where the loss does not reflect normal business conditions, or where it
reflects a level of risk that does not exist in the controlled transaction. Similar factors
apply as regards abnormally large profits.
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.
9.11
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Timing of origin
Ideally, comparisons would be made with contemporaneous uncontrolled
transactions, which reflect the same economic circumstances. In practice,
however, that may not always be practical.
Databases of company accounts will always be out of date by a minimum period
of about one year, once allowance is made for the time taken to produce
accounts and then to incorporate them into the database. Sometimes it will be
helpful to consider a number of years together in order to detect any underlying
trends.
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.
Valuation highly uncertain at the outset and unpredictable events
Where valuation uncertainties existed at the time of the controlled transaction, it is
necessary to ask whether the uncertainty was so great that independent parties
would have incorporated a price adjustment mechanism in their agreement.
Similarly, where unpredictable events affecting the value occurred after the time
of the controlled transaction it is necessary to consider whether these were so
fundamental to the value that independent parties would have renegotiated the
transaction. In such cases an arm's length price should be determined on the basis
of the agreed price-adjustment mechanism or a hypothetical renegotiation, as
the case may be. In other cases it will not be appropriate to make calculations
using the benefit of hindsight that would not have been available to independent
parties.
Data from years following the year of the transaction
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.
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9.12
Compliance issues
Comparability analysis may impose a significant cost and compliance burden on
taxpayers. It is not necessary to conduct an exhaustive search for all possible
relevant sources of information, but simply to exercise judgement to determine
whether particular comparables are reliable.
It is good practice for taxpayers to set up processes to establish, monitor and
review their transfer prices, taking into account the size of the transactions, their
complexity, the level of risk involved and whether they take place in a stable or a
changing environment. Where transactions are small, simple, relatively risk-free
and conducted in stable circumstances it will be reasonable to devote less effort
to finding information on comparables, and perhaps not to perform a complete
comparability analysis every year. Practical issues with review procedures will be
looked at in a later chapter.
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CHAPTER 10
COMPARABILITY ANALYSIS: AGGREGATION AND USE OF THIRD
PARTY NON-TRANSACTIONAL DATA
In this chapter we will look at the practical aspects of implementing Comparability
Analyses including:
aggregation and unbundling;
set offs;
segmentation of comparable data;
sources of information and timing issues;
sources of third party non transactional data;
commercial databases;
comparability lessons from DSG Retail;
proprietary databases and secret comparables;
using databases;
other sources of information;
timing of information on comparable transactions.
10.1
Introduction
In this and the next chapter we will examine the practical aspects of implementing
the OECD 2010 Transfer Pricing Guidelines 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.
Comparability requires a comparison of the economically relevant conditions in a
controlled transaction with the conditions in an uncontrolled transaction.
To be comparable means that none of the differences (if any) between the
situations being compared could materially effect the condition being
examined in the methodology (e.g. price or margin), or that reasonably
accurate adjustments can be made to eliminate the effect of any such
difference (See OECD 2010 Transfer Pricing Guidelines, paragraph 1.33)
The 2010 OECD Guidelines contain considerably more extensive commentary
about comparability than did the 1995 Guidelines. The 2010 Guidelines do strike a
reasonable balance between setting a quality threshold for comparability
analyses and an acknowledgment of the limitations to what can cost-effectively
be achieved in practice. However, a concern is that tax authorities may seize on
the more detailed commentary, for example the nine-step typical process that
we looked at in the previous chapter, as a justification to require more extensive
analysis from taxpayers.
10.2
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In fact, the Article does not specifically refer to transactions but the OECD
Transfer Pricing Guidelines 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.
Examples of transactional and non-transactional data
Transactional data
Publicly available price information
(commodities exchanges)
Royalty rate for patent licence derived
from US SEC filings 10K
Interest rate and covenants for a loan
agreement derived from commercial
databases
Non-transactional data
Company-wide profitability data
derived from published financial
statements
Segmented profitability data derived
from published financial statements
Trade association data
Price lists
As we saw in the last chapter the OECD recognise that, in practice, it may be
unrealistic to evaluate each transaction separately. (See OECD 2010 Transfer
Pricing Guidelines Chapter 3 Section A.3.1 Paragraphs 3.9-3.12) The OECD cites the
following examples where aggregation of separate transactions might be
acceptable:
Portfolios of higher and lower margin goods or services with an arms length
return overall
Cash pooling
Debt factoring
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10.3
Set-offs
A set-off occurs if affiliate A provides goods or services to affiliate B and affiliate
B provides different goods or services to affiliate A. The Guidelines address
intentional set offs, where the taxpayer deliberately evaluates the overall
economic effect of both transactions. The Guidelines accept that intentional set
offs may be found at arm's length and hence may be acceptable for similar flows,
although not for overall balancing of different transaction types. (See OECD 2010
Transfer Pricing Guidelines Paragraphs 3.133.17)
As part of the comparability analysis, it is clearly desirable for taxpayers making
intentional set offs to gather evidence that similar transactions are found at arm's
length. There is a good deal of material available regarding package pricing in
some industries e.g. web hosting/ development, broadband/telephony.
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Illustration 1
In this illustration we will look at the approach of the UK tax authorities to
aggregation. The Berg group of companies manufactures and distributes memory
chips for use in smartphones and tablets. The chips are manufactured by Berg
(Polska) sp. z.o.o in Poland and sold to Berg plc in the UK. Berg plc distributes the
chips to third party business customers in the UK and Europe. Berg S.A provides
consultancy services to computer manufacturers in South America.
BERG PLC
UK PARENT
BERG S.A.
Brazilian subsidiary
During the year ended 30 June 2013, 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.
10.4
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
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10.5
Illustration 2
Copland Machines, Inc. is a United States manufacturer of advanced construction
machinery. Its UK subsidiary, Copland Machines (UK) Limited, acts as the exclusive
distributor of the parent company's products in the UK. In Canada, Copland
Machines, Inc. distributes its product via an unrelated distributor, Delius Inc. An
unrelated UK company, Hindemith plc, is also identified which distributes similar
machinery manufactured by two other companies, both unaffiliated with
Copland, to third party customers in UK and Europe.
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.
Again using the UK as an example, HMRC guidance expresses the importance of
evaluating potential internal comparables. It cautions against the mechanical
dismissal of internal comparables merely because they are not identical to the
controlled transaction. Indeed, HMRC take the position that a taxpayer who
adopts a TNMM analysis but ignores a very clear internal comparable without
justification may be exposed to deliberate inaccuracy penalties. Many other tax
authorities also express a preference for internal comparables. To some extent, this
may still be supported by some of the wording from the 1995 Guidelines that has
been retained in the 2010 Guidelines. (See, for example, Paragraph 2.58 in the
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10.6
10.7
Commercial databases
Proprietary databases
Investment research
Commercial databases
Commercial databases, permitting search, filtering and analysis of company
information reported to national company registries and similar institutions, play a
major part of transfer pricing practice. The Guidelines note the practical benefits
that such databases may bring, but urge caution against potential misuse. In
particular, databases should not be the default option if reliable information is
available elsewhere, regard must be had to the extent and quality of the source
data, and the emphasis must be on quality over quantity.
Leading commercial databases include:
Name
Amadeus (Bureau van Dijk)
Orbis (Bureau van Dijk)
Oriana (Bureau van Dijk)
Thomson Reuters
Fundamentals
Thomson Reuters European
Comparables
Compustat (Standard &
Poor's)
ktMINE Royalty Rate Finder
Thomson Reuters Loan
Connector
Type
Company financial
statements
Company financial
statements
Company financial
statements
Company financial
statements
Company financial
statements
Company financial
statements
Intangible property SEC
filings
Loan pricing market
information
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Coverage
Europe
Global
Asia-Pacific
Global
Europe
North America
Global
Global (with US
emphasis)
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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
This will typically include filters for:
Geographical scope
Periods covered
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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
with a targeted search. As a simple example value-added reseller may yield
better results than distributor in the computer software industry.
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.
Bulk and subsequent stage rejections
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.
Among the financial ratios applied are:
Name
R&D Intensity
Days sales of
inventory
Profit per
employee
Formula
R&D expenditure/net
sales
(Inventory/cost of
sales) 365
Operating
profit/number of
employees
Use
A measure of relative importance of
R&D
A measure of how long it takes to
convert inventory to sales suitable
for assessing distribution activities
A measure of whether profit is
primarily driven by productivity or by
size of workforce
Qualitative evaluation
A detailed evaluation of financial statements, company websites, analysts' reports
and any other available information relating to the remaining comparables is key
to the assessment of their suitability.
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
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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.
10.8
DSG advanced a number of potential CUPs and a TNMM analysis. All were
rejected; a selection is summarised in the following table:
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Potential
comparable
offered
Orion
National Satellite
Services (NSS)
Office of Fair
Trading (OFT)
Report
Domestic &
General (D&G)
10.9
Description
1982 extended
warranty arrangement
between a large
electrical retailer and
a third party
An insurer acted as an
agent for NSS in selling
insurance contracts to
customers of NSS who
purchased or repaired
satellite equipment.
The insurance was sold
to customers at the
time of installation or
repair
A competition
authority report
containing
anonymised data on
extended warranty
commission rates
A third party provider
of domestic appliance
breakdown insurance.
A TNMM analysis was
advanced by
comparing the return
on capital achieved
by D&G with that
achieved by DISL
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controlled transactions where two tax authorities take a different view on timing of
comparable data.
At the time of writing, the OECD has issued draft proposed revisions to the
Guidelines in response to recognition that different approaches to timing of
information lead to further difficult issues such as respecting taxpayer initiated
year-end adjustments (true-ups) and the admissibility of post transaction date
information in assessing the validity of projections and adjustments. The draft
revisions indicate an increased emphasis that information should be as
contemporaneous with the transaction as possible and that information used in
price testing approaches must be related to the timing of the controlled
transaction, with comparability adjustments for economic changes if appropriate.
OECD Guidelines 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 draft UN Practical Manual on Transfer Pricing contains much the same wording
on timing issues as the OECD Guidelines. However, there is a greater acceptance
of the price testing approach stating that:
An ex post analysis is most commonly used method to test arm's length price
of international transactions.
Contemporaneous data which may be available to the taxpayer and tax
administration at the time of filing of the tax return or conducting ex post
analysis of transfer pricing studies can not be held as use of hindsight.
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CHAPTER 11
COMPARABILITY ADJUSTMENTS INCLUDING PRACTICAL ISSUES
In this chapter we will look at comparability adjustments, in particular, looking at:
adjustments for accounting items;
capital intensity
other adjustments
tax authority responses to comparability adjustments
the arms length range
compliance issues
safe harbours
frequency of review
11.1
Introduction
This chapter considers what reasonably accurate adjustments (See paragraph
3.47 OECD 2010 Transfer Pricing Guidelines) might be made to reduce the effect of
differences between economically relevant conditions in a controlled transaction
and the conditions in an uncontrolled transaction.
Comparability adjustments may be made to either the tested party or to the
potential comparable transaction/company. They may be made under any
transfer pricing method and may be particularly useful where there is an internal
comparable which can accurately inform the adjustments that need to be made
to the controlled transaction. They are also seen frequently in profit methods,
perhaps most commonly in the form of working capital adjustments.
The Guidelines emphasise that comparability adjustments need to be reliable,
objective, transparent and documented. They should not be applied
mechanically or used to create an impression of precision where they are in fact
unwarranted. (See paragraphs 3.50-3.54 OECD 2010 Transfer Pricing Guidelines)
11.2
Illustration 1
Stockhausen Ltd is a UK contract manufacturer, for its German parent of
communications systems for aeronautical applications. A transfer pricing study
identifies TNMM as the most appropriate pricing method with a Profit Level
Indicator (PLI) of Operating Margin (Operating profit/sales). One of the seven
potential comparables remaining after all bulk and second stage rejections is
Simpson Ltd, a UK manufacturer of communications systems for marine
applications.
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The financial results of both companies for the year ended 31 March 2013 is as
follows:
Stockhausen Ltd
Sales (S)
Cost of sales
Distribution costs
Administration costs
Exceptional costs
Earnings before interest and tax
= operating profit
Operating margin
(Tested party)
'000
2,750
(750)
2,000
(776)
(1,059)
_______
165
Potential
comparable
Simpson Ltd
'000
3,876
(1,121)
2,755
(855)
(1,530)
(311)
59
165/2,750 = 6%
59/3,876 = 1.5%
11.3
59
311
370
370/3,876 = 9.5%
Illustration 2
This is a simplified illustration of the type of working capital adjustment featured in
the OECD Guidelines. (See Annex to Chapter III.) The Guidelines are at pains to
stress that this form of adjustment is merely illustrative and this type of adjustment is
not binding on taxpayers or tax authorities.
In this illustration, the transfer pricing method is TNMM with a PLI of operating
margin, that is, Earnings before interest and tax/sales.
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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 party
million
Sales
Earnings before interest and tax (EBIT)
EBIT/sales (%)
600
6
1.00%
Comparative
company
million
800
24
3.00%
Working capital:
Trade debtors (receivables) (D)
Stock (Inventory) (S)
Trade creditors (C)
Working capital:
Working capital/sales
40
45
22
63
10.5%
80
90
27
143
17.8%
10.5%
17.8%
-7.3%
5%
-0.37%
3.00%0.37% = 2.63%
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.
11.4
Other adjustments
Less common forms of comparability adjustment include geographical risk and
economic volatility.
11.5
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11.6
Illustration 3
Schoenberg Scooters Limited carries out contract research and development in
the United Kingdom for its Austrian parent company. The group commissions a
transfer pricing study which is intended to corroborate the pricing policy adopted
of an operating margin of 5%.
Eleven companies are evaluated as potential comparables, as follows:
Comparable company
1
2
3
4
5
6
7
8
9
10
11
Operating margin
-17.0%
-0.5%
2.7%
3.9%
4.1%
4.4%
8.8%
9.0%
9.8%
13.4%
17.3%
On the basis that the median of the above data points is 4.4%, and the mean is
5.07%, 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 increase 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 2010 revision to the OECD Transfer Pricing Guidelines contains a statement, not
included in the 1995 version, to the effect statistical tools that take account of
measures of central tendency may usefully be applied to larger data sets where
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every effort has been made to ensure comparability or adjust for noncomparability. (See OECD 2010 Transfer Pricing Guidelines 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.
11.7
Compliance issues
This is a subject that we will look at in more detail in a later chapter.
The Guidelines 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.
Although the acknowledgment of potential compliance burden in the Guidelines
is welcome, it must be said that there is no specific guidance on practical
approaches, no doubt as reflection of reality that such soft law cannot achieve
consistency of approach among all OECD Member Country tax administrations.
However, the OECD has now placed a renewed emphasis on the need for
simplification measures as part of its review of the administrative aspects of transfer
pricing.
11.8
Safe harbours
The IBFD Online Glossary defines a safe harbour as:
An objective standard or measure, such as a range, percentage, or absolute
amount, which can be relied on by a taxpayer as an alternative to a rule
based on more subjective or judgmental factors or uncertain facts and
circumstances.
In the specific context of transfer pricing comparability analysis, a safe harbour
provides simplified compliance obligations, such as an acceptable arm's length
range, for transactions with limited mispricing risk. A consultative document issued
by the OECD in June 2012 (See proposed revision of the section on safe harbours
in Chapter IV of the OECD Transfer Pricing Guidelines, OECD Discussion Draft 6
June 2012) recorded a number of member country examples as at 1 January
2012, most commonly:
Safe harbour arm's length range for low value-adding intragroup services
Such safe harbours are certainly welcome, but they are all unilateral with widely
varying rules for similar transaction types.
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We will look in detail at the OECD approach to safe harbours in a later chapter. It
is sufficient to note here that in May 2013 following the consultation document
mentioned above a revised section E to Chapter IV of the guidelines was issued.
The revised guidelines 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
Kodaly Concepts Limited is the UK parent of a group of marketing and
communications consultants. It provides accounting, human resources and IT
support to its operational subsidiaries in Australia, Austria and Japan. The company
qualifies for the SME exemption from UK transfer pricing rules and has brought
forward trading losses. It identifies the direct and indirect costs of providing the
above services and charges them at a 12.5% mark-up.
The safe harbour position in the three subsidiary companies for low value adding
intragroup services is:
Australia
Austria
Japan
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.
11.9
Frequency of review
Another common practical issue is how often it is necessary to update the
comparability analysis. The Guidelines accept that it may not be necessary to
perform a detailed comparability analysis each year for simple transactions in a
stable environment. (See paragraph 3.82 of the OECD 2010 Transfer Pricing
Guidelines.) It is sometimes advocated that an annual sense check could be
used to ensure that previous comparability analysis has not been invalidated by a
significant change in the industry, market or economic environment, together with
a full review every three years. Again, country expectations differ here. The danger
is that incremental changes to the enterprise and its operating environment may
have a material cumulative effect.
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CHAPTER 12
SPECIFIC TRANSACTIONS: INTRA GROUP SERVICES
In this chapter we will look at what the OECD Transfer Pricing Guidelines say in respect to
services, in particular looking at the categorisation of services and charging for services.
12.1
Introduction
Almost all groups will have intra-group services of some kind. Often, the services
arise because it is more efficient and economic 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.
Other types of intra-group services are ones that will be apparent to the customers
of the business, such as one company carrying out warranty repairs of equipment
sold by a related company in another country, or one company carrying out sales
as agent of a related company.
This chapter primarily focuses on the main issues that arise in determining the arms
length price for services that have been rendered as part of an intra-group
transaction.
Some countries have specific legislation, regulations or guidelines on this, but in
most cases the only guidance is the OECD Transfer Pricing Guidelines. These
include a specific chapter, Chapter VII, dealing with intra-group services. This was
published in 1995 and has been unchanged since then.
In the analysis of transfer pricing for intra-group services, the OECD Guidelines
mainly concentrate on two issues. First of all, it is important to understand whether
a service has actually been rendered in the context of the intra-group transaction
under analysis.
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.
12.2
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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 arms length
principle.
Illustration 2
Company C, is a Singaporean company that has been subcontracted by its
parent company, D, to act as investment subadvisor on an investment fund which
invests in equities from the Pacific region. Company D is the investment manager
which has launched and marketed the fund to UK investors, and if company C
was not making decisions about which equities to buy and sell, company D would
clearly need to do this itself or subcontract the work to a third party. It clearly
receives a benefit from the activities carried out by company C for it, and so they
qualify as a service and a charge is justified (indeed necessary) under the arm's
length principle.
The OECD Guidelines make special mention (at paragraph 7.14) 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 Guidelines 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.
However, depending on the service, identifying whether there is a service might
not be as simple and requires understanding of how the service benefits the
related parties. The OECD Guidelines highlight several situations that may not be a
service to a group company because there is no benefit to that company:
Shareholder activities;
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Duplicative activities;
Incidental benefits.
The Guidelines also discuss whether on-call activities are a service. All of these
situations are discussed below.
The Guidelines 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
Some types of activity are performed by a company because of its ownership
interest in other companies, i.e. in its capacity as shareholder. Ordinarily such
activities do not provide an economically relevant value to the other group
members. They do not need the activity and would not be willing to pay for it if
they were independent. Such activities are referred to as shareholder activities.
The OECD guidelines provide the following examples of shareholder activities:
1.
2.
3.
Costs of raising funds for the acquisition of its participations (i.e. its subsidiaries).
The OECD Guidelines 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.
In order to determine whether these activities can be categorised as intra-group
services, we should carefully analyse whether they create any benefit. If the
activities are ones that the subsidiary would be likely to carry out itself if they were
not being done for it by its parent, they should probably be counted as a service,
notwithstanding that the parent is carrying out the activity partly because a
shareholder naturally wishes to manage and protect its investment.
The concept of shareholder activities was introduced in an OECD report published
in 1984, entitled Transfer Pricing and Multinational Enterprises Three Taxation
Issues. This superseded an earlier term, stewardship activities, which was referred to
in the 1979 OECD report, Transfer Pricing and Multinational Enterprises, which was a
forerunner of the OECD Transfer Pricing Guidelines (the first seven chapters of
which were published in 1995). The term stewardship activity was broader in nature
and included activities such as detailed planning services for particular operations,
emergency management and technical advice (troubleshooting), and in some
cases assistance in day-to-day management. The OECD Guidelines make it clear
that these activities are not within the definition of shareholder activities.
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Illustration 3
Company E is a listed Spanish company with a subsidiary in Argentina, company F.
The head office in Spain carries out a number of services for the benefit of itself
and its subsidiary. A transfer pricing analysis is carried out and the following
services are identified:
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.
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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 marketing it
becomes clear that there is strict delineation of marketing responsibilities between
the local marketing teams and the head office. The local marketing teams report
back to head office on a regular basis, so any wasteful duplication would be
spotted and eliminated. Accordingly, it is confirmed that there is in fact no
duplication and the marketing assistance is a valid service for which a charge
should be made.
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 knowhow 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. However, the head of
knowledge management in company J considers that the group system is inferior
and therefore decides to continue operating the existing system, setting up an
arrangement where the content of the local system is automatically added to the
group system in order to satisfy group policy.
Because of the partnership, decentralised ethos of law firms, he is able to resist
efforts to persuade him to save money by closing down the local system. 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 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. A charge would not
be appropriate for transfer pricing purposes.
Incidental benefits
There are some cases where an intra-group service performed by a group
member relates only to some of the group members but incidentally provides
benefits to other group members. When a MNE is looking to reorganise the group,
acquire a new company, or to terminate a division, these activities could possibly
constitute an intra-group service to the particular members of the group involved.
For instance, a member of the group might be the appropriate entity to acquire a
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new business in the same country and might therefore be charged for the costs of
acquiring the new business.
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 Guidelines 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.
Illustration 6
A multinational group has operations around the world and manufactures a
certain product line in three factories in Poland, Slovenia and the UK. 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. On an arm's length basis, they would
be unlikely to be willing to pay a competitor to close down its factory, indeed this
would probably be illegal under competition law. Nor would they be reassured
that they would pick up all of the production previously carried out by that
competitor. 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
Guidelines (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
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have if it were not part of the group. The Guidelines draw a distinction, however,
between benefits arising from passive association as opposed to active promotion
that positively enhances the profit-making potential of particular members of the
group. 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 case concerned a guarantee provided by GE Capital in the US to its
Canadian subsidiary, which had the result that the Canadian subsidiary was able
to borrow on the market at an interest rate considerably lower than if it had been
a stand-alone company. A guarantee fee was charged, equal to 1% of the
borrowings of the Canadian subsidiary. The Canadian tax authority argued that
although an explicit guarantee had been given, the arms 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. This argument is widely considered to be an attempt to widen the
application of the passive association concept.
GE Capital argued that any implicit guarantee arising from passive association
arises only from the shareholding relationship and the arms 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 arms length test would not allow a
charge for a benefit that would have arisen from the implicit guarantee. However,
it 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. An on call service is a service provided by a parent
company or a group service centre that ensures the complete availability of a
service for members of an MNE group. The question is whether the availability of
the service has to be considered an intra-group service itself (in addition to any
services that are actually performed) and therefore should be charged at arms
length.
In the OECD Guidelines 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
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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 Guidelines
suggest, is looking at the extent to which the service have 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.
12.3
cost allocations
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group and result in compliance cost that could be excessive in relation to the
activities themselves.
The OECD Guidelines 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 Guidelines 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 Guidelines state that if an indirect charge 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 Guidelines 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
Company L is the parent of a multinational group. It carries out human resources
and IT services on a centralised basis for the whole group. 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.
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Illustration 8
Company M is a Chinese company which manufactures consumer products. It
sells them in China and, through its overseas subsidiaries, in the rest of the world.
Although the subsidiaries carry out some of their own marketing, the head office in
China includes a marketing team which carries out marketing for the benefit of
the group as a whole, including carrying out promotion at international fairs and
arranging global marketing campaigns based around sponsorship of international
sports people and teams. 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). An appropriate allocation key
might be to split the costs in proportion to sales in each market. 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.
12.4
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CUP method
The Guidelines say that the CUP method is likely to be applied when the intragroup 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. There is no explicit statement that CUP is to be preferred, although
arguably the discussions regarding mark-ups (see below) implicitly mean that cost
plus is overridden in cases where it would imply a price higher than the market
value of the services (i.e., a CUP).
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
Refer back to the previous illustration involving company L. 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 would have to be investigated whether the pricing system would
produce a reliable split between the group companies. 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.
As company L is not in the business of supplying human resources services
externally, it would be unlikely to be possible to use the CUP method to charge for
the HR services.
Cost plus method
The OECD guidelines 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.
However, the use of a transfer pricing method is not conditional on establishing
that the same method would have been used had the transaction have been
carried out between arm's length parties. Moreover, if there is no reliable CUP
available which reaches an acceptable standard of comparability with the
controlled transaction, cost plus is, like it or not, generally the only other method
that can be used.
Regardless of the method used in determining an arms length price for intragroup services, it is important that the remuneration reflects the nature, functional
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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 were dealt with in depth in the new OECD Chapter IX,
published in 2010. 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. It is beyond the scope of the
current chapter of this manual to examine OECD Chapter IX, but 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 Guidelines do not explicitly state
a clear, unambiguous position on this, but paragraph 7.33 does observe that "in an
arms length transaction, an independent enterprise normally would seek to
charge for services in such a way as to generate profit, rather than merely
providing the services at cost". The paragraph then goes on to discuss
circumstances in which an independent enterprise may not realise a profit from
the performance of a service, so it is arguably implicit that a mark-up should be
added unless there are special circumstances to justify providing the services at
cost or even below cost.
One example of a special circumstance in which it might not be appropriate for
there to be a profit mark-up would be where the supplier of the services wishes to
offer the service so that a customer does not turn to the supplier's competitors to
obtain this particular service. This might give the competitor a chance to win the
contract to supply other services currently being rendered by the supplier to the
customer on a profitable basis. Another example would be to open up a new
relationship with a prospective customer. In practice, however, arguments that
such circumstances apply to intra-group services are often viewed sceptically by
tax authorities, because it is often the case that group companies do not have the
same freedom of choice regarding service providers as would be the case if they
were independent.
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). In this case, the
service should generate a profit for SP.
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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.
Until recently, it was an independent company and, in an attempt to move
upmarket, it entered into negotiations to supply services to company N, whose
fashion magazines are at the top end of the market and extremely prestigious.
Rather than simply become a customer, company N chose to purchase SP, seeing
a large potential to expand SP's business. In such a circumstance, there might be
an opportunity to argue that the kudos and credibility of being a supplier of these
services to the prestigious magazines published by company N would be so
attractive to SP that it might be willing to provide its services to N at cost or even at
less than cost if this were necessary to win the contract with N.
Another example given by the OECD Guidelines of where it might be
inappropriate to add a profit mark-up is where the market value of the intra-group
services is not greater than the costs incurred by the service provider. 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 Guidelines 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
Company Q is the UK parent company of a group that provides international
consultancy services. It acquires company R, a Mexican business providing local
consultancy services on a relatively small scale. Q has, over the last decade,
developed an extremely sophisticated computer system for planning, managing,
and tracking its consultancy projects and its policy is that all group companies
should use this. It 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.
However, when a transfer pricing analysis is performed in relation to this
transaction, the Mexican CEO explains that this system is far more sophisticated
than is justified by the needs of the current Mexican business. It is tailored to the
needs of other countries, particularly the US and UK, which often need to manage
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complex projects involving multiple inputs from many parts of the group and
involving many stages. 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 markup 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 USA takes a particularly pragmatic approach to the question of
mark-ups on certain services. It 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.
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Illustration 13
Company S delivers intra-group services to all of its affiliated entities (lets 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 5%, Company S will generate a
profit of 5 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 5 million. The charge
should be increased by 10 million, plus a 5% mark-up on this.
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.
A related issue is the question of whether a mark-up should be applied in cases
where the service provider is merely acting as an intermediary. On the face of it,
no mark-up should be applied to costs that are merely being passed on, and a
mark-up should only be made on the costs of performing the intermediary
services. An example would be advertising companies, which often acquire
advertising space on behalf of their clients. Arguably, if such a service is being
provided intra-group, the amounts disbursed to the providers of the media space
should not be marked up and the mark-up should only be applied to the costs of
negotiating and arranging the purchase of such space.
However, if the mark-up percentage is being set by reference to comparable
independent companies and those companies have flow-through costs reflected
in their cost base, then their cost base should be adjusted to strip out the flowthrough costs. This is not always possible, depending on the level of disclosure in
the accounts of the comparable independent companies, and so the only option
might be to include flow-through costs in the cost base of the in-house service
providing company.
12.5
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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.
Turning to methodologies, the report acknowledges a cost plus method as the
most commonly used. The report states that for low value services only a moderate
mark up will be 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;
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CHAPTER 13
SPECIFIC TRANSACTIONS: LOANS AND OTHER FINANCIAL
TRANSACTIONS
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.
13.1
Introduction
Intragroup transactions are generally regarded as falling into one of four
categories: sales of tangible goods, provision of services, licences to use intangible
property, and financial transactions. There are specific chapters in the OECD
Transfer Pricing Guidelines relating to services and intangible property, and
although there is no specific chapter on tangible goods, much of the first three
chapters of the Guidelines tends to be written in the context of setting a price for
tangible goods. In contrast, the OECD Guidelines have little specific to say about
loans and other financial transactions.
We will start by considering how to determine the arms length interest rate for a
loan and will then consider thin capitalisation, which relates to whether the
quantum of the amount lent meets the arms length test. We will then briefly
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
Association tests for loans
This chapter will not focus on the question of determining whether a loan is subject
to transfer pricing rules, because each country sets its own rules about determining
exactly how closely connected two enterprises must be before they are required
to meet the arms 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
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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).
As there is scope for these syndicates of shareholders to "act together" because
they jointly control the target business, these special rules provide that a financing
arrangement (a loan) made by a person, P, to another person, B, will be subject to
the UK transfer pricing rules if certain conditions are met. These conditions are that
P acted together with one or more other persons in relation to the financing
arrangement and P would be taken to control B if it were attributed with the rights
and powers of that other person or persons.
Determining the arms length interest rate
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. Therefore, in cases where an intragroup loan is subject to
transfer pricing rules, it is necessary to show that the interest rate meets the arms
length test. That is, the interest rate is no higher nor lower than it would have been
if the lender and borrower had not been related to one another.
In order to determine whether the interest rate meets the arms length test, it is
necessary to understand how interest rates are determined, commercially. Interest
rates always have two components. First, there should be a component of interest
to reflect the use of money. Even if there is no risk that the borrower might default
on the loan, the lender is still making the money available to the borrower and so
there is a minimum price for the use of the money. This is usually referred to as the
base rate. 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 has not necessarily been the case since the global financial crash
that began in 2007. 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 arms length
test to an intragroup interest rate should therefore be carried out by considering
the two components: the arms length base rate and the arms length margin.
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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.
If we take the second quarter of 2013 as an illustration, the central bank rates for
Pounds and Euros was 0.5% and for US dollars, 0.25%, because the US, UK and
Eurozone economies were in or close to recession and interest rates were being
held at historic record lows in the hope of stimulating economic growth. In
contrast, many emerging market economies were booming and their central
banks were using higher interest rates to dampen unsustainable growth and
control inflation. For instance, the Indian Central Bank rate for Rupees was 7.25% at
this time.
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
If an Argentinian company borrows a loan denominated in US dollars, the relevant
base rate is the base rate for US dollars. If there is a greater risk of default by an
Argentinian borrower than an otherwise equivalent US borrower, this should be
taken into account in the margin.
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.
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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.
Term of the loan
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.
It is therefore important to be absolutely clear whether the intragroup loan has a
fixed or floating rate and this should be matched when selecting the relevant
base rate. For instance, if the intragroup 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.
The date the loan was made
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.
Sources of this information include information providers such as Bloomberg and
the Financial Times and official websites such as the website of the relevant central
bank, finance ministry or tax authority.
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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.
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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
The macroeconomic conditions that should be considered include the following:
Market sentiment. As we have just seen over the last decade, commercial
lenders do change their views about the level of interest rate margin that they
expect/require for a given level of creditworthiness. During the credit boom
seen in Western economies in the years 2004-2007, banks were keen to lend
and interest rate margins fell. The subsequent crash saw the "animal spirits"
(Keynes 1936; collective optimism and pessimism) evaporate and banks
became extremely risk averse, so interest rate margins shot up. .
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,
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Board papers
It will be apparent from the preceding discussion that carrying out a transfer
pricing study in relation to an intragroup 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
As with any transfer pricing analysis, it will normally be necessary to obtain
comparability data to indicate what the interest rate margin would have been, on
an arms length basis, given the above comparability factors.
In some cases, the group might have loans to or from unrelated parties. Whether
or not these loans are comparable with the intragroup 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.
Another possible approach is to use commercial databases of loan agreements to
try to find comparable loans between unrelated parties. In some cases, there may
be surveys available which contain information (often anonymised) about interest
rates, for instance within a certain industry.
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
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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.
A further possible approach is to express the creditworthiness of the borrower as a
credit rating. It would be extremely expensive to pay one of the credit rating
agencies to carry out a full credit rating, but a more cost-effective approach is to
use proprietary software packages made available by the credit rating agencies
which will provide an estimate of the credit rating. This estimate is based on an
algorithm which reflects the correlation between various financial figures and
ratios and actual credit ratings given by the agency. Various information sources,
such as Bloomberg, can then be used to determine the interest rate margin that
corresponds with a given credit rating.
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 onlends 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 arms 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 assetpoor. The arms 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.
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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. A Finnish company replaced its external borrowings, on which it was
paying interest of a little over 3%, with an internal loan from a Swedish member of
the 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
intragroup 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 first category
is the petrol retailers. The second category is the explorers in relatively benign
countries, such as the USA, where shale gas exploration is taking place. The third
category is the explorers in riskier countries, such as Libya. Analysis of each
category shows that although the creditworthiness of individual companies in the
category might vary a little, the arms length range of interest rate margins for
each of them has a degree of overlap, so a single interest rate margin can be
used for the whole category. Therefore, the group uses three interest rate margins.
13.3
Thin Capitalisation
Thin capitalisation (US spelling, capitalization) is a phrase used to describe a
situation where a borrower has an excessive amount of debt capital relative to its
equity capital.
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.
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Illustration 4
K9 is a company in the North American country of Columbiana. It carries on
business manufacturing dog food and dog care products in Columbiana and
selling these products in its home market and through distributors in other countries.
Most distributors are independent, but it distributes in the European country of
Albion through its subsidiary, K9 Albion. One of its competitors, Clean Paws, falls
upon hard times and K9 takes the opportunity to grow its business by acquiring
Clean Paws.
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.
In order to acquire Clean Paws Ockerland, K9 incorporates a wholly-owned
subsidiary in Ockerland which makes the acquisition. It lends $100 million to this
subsidiary and injects $50 million of share capital. Ockerland has a thin
capitalisation rule based on a fixed debt:equity threshold of 3:1. As K9 Ockerland
debt is equal to twice its equity, it is below this threshold and so it will not be
denied a deduction for interest on any of the loan. (Assume that the interest rate
meets the arms length test.)
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 arms length basis.
Albion operates a system whereby it is willing to negotiate in advance of
acquistions APAs in relation to thin capitalisation. K9 wishes to have certainty
about the deductibility of interest on the debt, so a thin capitalisation APA is
applied for. In support of the desired debt level, it submits a transfer pricing analysis
which identifies independent companies that are comparable to K9 Albion (taking
into account its investment in Clean Paws Albion) and demonstrates that they
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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 arms 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.
Considerable debate ensues, with K9 Albion presenting detailed cash flow
forecasts showing that it will be able to service the full amount of debt quite
comfortably. However, the Albion tax authorities raise concerns that the forecasts
might be overoptimistic and so they insist that they will not approve the full amount
of debt.
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 arms length level of debt
for K9 Albion must be at least $110 million, because the top-up loan of $10 million is
an arms length loan and is in addition to the intragroup 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.
Interaction with interest rates
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
Australia. Australia has 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 arms
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. The Australian Tax Office takes the
view, however, that in determining the appropriate interest rate the actual
amount of debt should be disregarded and the interest rate should be determined
on the basis of the rate that would have applied on an arms length basis if the
debt had been no higher than the arms length amount of debt. Other countries
may raise the same argument, but Australia has issued a formal ruling setting out
this policy.
Thin capitalisation on third-party loans
Different countries take different approaches to whether thin capitalisation rules
should apply in cases where the group company has borrowed from an
independent lender. On the face of it, the debt should, by definition, be arms
Reed Elsevier UK Ltd 2013
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length. However, there can be situations where the debt exceeds an arms length
amount, for instance where another group company has given a guarantee to
the lender, without which the lender would not have been willing to lend as much
as it has lent. A variation on this would be a back-to-back loan, where a group
company has lent money to the bank and then the bank has lent a similar amount
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 in 13.5 regarding guarantee fees.
Definitions of debt, equity and interest cover
Whether applying a fixed threshold or the arms 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?
Similarly, it is important to be clear about the definition of interest cover. It is usually
based around dividing profits or cash flow by interest, but should the profits be EBIT
or EBITDA? Or should it be free cash flow? And should the interest be the gross
interest expense or should it be net of interest income?
13.4
Interest-free loans
An issue that arises from time to time is that a group wishes to make an interest-free
intragroup loan. For instance, the group might prefer not to label an injection of
capital as being equity, for instance due to regulatory restrictions or exchange
controls.
On the face of it, an interest-free loan would not be acceptable under the arms
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. For
instance, 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.
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13.5
Guarantee fees
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 arms 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
being paid. If the guarantee relates to an intragroup loan, it may be necessary to
do another analysis to determine the arms length interest rate taking into account
the support from the guarantor.
As discussed in the preceding chapter regarding intragroup services, it may also
be necessary to exclude the portion of the benefit that would have arisen from a
passive guarantee. This is because of a legal decision involving the Canadian
subsidiary of GE Capital. It is clearly stated in the OECD Guidelines that where a
benefit is derived by a group company from mere passive association with the rest
of the group, this does not justify any fee being charged for this benefit. The
Guidelines give an example where it is perceived that there is an implicit
guarantee by the group and therefore a group company is able to borrow at
lower interest rates than it might if it were a stand-alone company. They make
clear, however, that where the benefit is brought about by specific action by
another group company, such as giving an explicit guarantee, this is a service for
which a fee should be expected.
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 other
words, the Canadian judgement says that the benefit of the explicit guarantee
should not be determined by comparing 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.
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 stand-alone
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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 stand-alone 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 UK
company, as the UK rules allow for a guarantor to be treated as if were the
borrower in respect of disallowed interest.
However, an alternative approach would be that the borrower should be entitled
to a deduction for the interest on the extra debt that it was only able to borrow
because of the guarantee, provided it can be shown that a similar guarantee
would have been available on an arms length basis. If so, then determining the
benefit to the borrower would be more complicated, because part of the benefit
is being able to borrow more than it could otherwise have borrowed.
BEPS action plan and interest deductions
In the BEPS (Base Erosion and Profit Shifting) action plan released in July 2013,
interest deductions and other financial payments are targeted as an area that
needs a coordinated approach (Action 4). The work will look at financial and
performance guarantees, derivatives, captive and other insurance arrangements.
The work is to be coordinated with that on hybrids and CFC rules. The action plan
states that the aim is to develop changes to the transfer pricing guidelines by
December 2015.
13.6
Captive Insurance
A number of multinational groups have implemented self-insurance arrangements
under which the group decides that it will no longer obtain external insurance for
certain risks.
Insurance companies work on the basis that although it is difficult to forecast
whether any individual insured party will suffer a loss, statistical analysis allows the
insurance company to anticipate the average loss of a portfolio of similar risks with
much greater certainty. The insurance company therefore sets an insurance
premium that reflects the average likely loss per insured party, plus running costs,
plus a profit margin for the insurance company. The benefit for the insured party is
that they are exchanging the risk of the full loss for the certainty of paying a much
smaller amount as an insurance premium. However, if a (non-insurance) group has
a wide range of group members which each have the same risks, then the group
can also benefit from this portfolio effect.
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
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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 intragroup 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 arms 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 arms length level of
premium was far lower than the actual premiums paid.
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13.7
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CHAPTER 14
SPECIFIC TRANSACTIONS: INTANGIBLE PROPERTY
In this chapter we will look at transfer pricing in relation to Intangible Property (IP), in
particular:
the life cycle of intangibles;
development of IP;
OECD Guidelines and Cost Contribution Agreements (CCA);
case law and cost sharing arrangements;
exploiting IP Principal Structure v Licensing Out;
valuation of IP;
case law on valuation of IP;
OECD latest developments.
14.1
Introduction
The term intangible property includes rights to use industrial assets such as
patents, trademarks, trade names, designs or models. It also includes literary
and artistic property rights, and intellectual property such as know-how and
trade secrets. (OECD 2010 Transfer Pricing Guidelines Chapter VI, 6.2).
Intangible property (IP) has been at the centre of several debates and court
cases in recent years. The increasing attention of tax authorities on IP is mainly due
to IP 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 IP to
achieve the required competitive advantage.
As a result, ensuring that intra-group transactions involving IP are thoroughly
planned and priced is key in minimising the risk of tax adjustments and penalties in
case of non-arm's length results.
Among the transfer pricing transactions of MNE Groups, IP transfer prices are the
most significant and susceptible to manipulation. This is a result of IP's high value
and mobility and the complexity of IP-related issues. IP carries high value because
it often produces or has the potential to boost profitability as it provides the MNE
with a competitive advantage. Given that IP is an intangible asset without physical
presence, it is easily transferable from one country to another. IP-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 IP 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 IP. In other situations, to increase deductions in a
higher-tax country, the MNE Group might impose higher transfer prices on a
related MNE operating in a lower-tax country. This shift is made possible by service
charges, royalties paid to the owner or licensor of the IP, or through cost-sharing
arrangements.
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14.2
14.3
Development of IP
As noted above IP is a moveable asset that provides opportunities for tax planning
right from the start. There are two main ways that IP can be developed - via
contract R&D agreements or via cost sharing agreements.
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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 IP 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
Contract R&D
services
IP Users
CONTRACT
R&D PROVIDER
R&D
Costs
Benefits
COMPANY A
14.4
COMPANY B
COMPANY C
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share of the cost is commensurate with their share of the benefits (see paragraph
8.13 of the OECD 2010 Transfer Pricing Guidelines).
In deciding whether the arrangements are arm's length the earlier chapters of the
OECD 2010 Transfer Pricing Guidelines will be in point that is to say factors such as
the contractual terms, economic circumstances and how risks are shared.
The OECD provide guidance on determining whether the allocation of costs to
each participant is arms length, suggesting that one solution could be allocation
keys (see section C4 of Chapter VIII of the OECD 2010 Transfer Pricing Guidelines).
The OECD guidance also recognises the problem of estimating benefits that will
arise in the future and suggests this might be dealt with via a balancing payment
at a later date (see section C5 of Chapter VIII of the OECD 2010 Transfer Pricing
Guidelines).
Section D2 of Chapter 8 to the OECD 2010 Transfer Pricing Guidelines deals with
the issue of disregarding part or all of the terms of a cost contribution agreement.
This is a subject that we will look at in the chapter on recharacterisation issues but it
should be noted that this issue can also arise in relation to contract R&D services.
Buy in and buy out payments will need to be in line with the arm's length principle.
In broad terms the main areas in Chapter VIII are:
1.
2.
3.
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14.5
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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.
14.6
14.7
Valuation of IP
The valuation of IP is difficult to carry out without an element of subjectivity and is
often subject to scrutiny by the auditors and tax authorities. The economic value of
IP is primarily determined by the economic and legal environment in which the IP is
created and exploited, the market demand for the IP and the existence or
absence of close substitutes.
Valuation experts usually identify assumptions in establishing value such as
expected future earnings estimates, the rate of the average cost of capital, and
other factors including the discount rate. The valuation of IP is also affected by its
tax treatment.
IP value can often fluctuate in value depending on the market, competitors, etc.
The fluctuation occurs not only over time, but at any one time depending upon
the key assumptions of the inherent risks associated with the IP. These risks can
include liability concerns or the possibility that competitors will create new and
better products.
Thus, the OECD 2010 Transfer Policy Guidelines recognise that it is often difficult to
attribute a distinct value to each piece of IP on an ongoing basis.
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The valuation of IP 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.
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C1, C2.Cn = The forecast cash flows in each of the time periods from time 1
to time n (the explicit forecast period)
TV = Terminal Value (the value at the end of the explicit forecast period)
WACC = E/V * Re + D/V * Rd * (1 Ct)
Re = cost of equity
Rd = cost of debt
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V=E+D
The formulae above show how complex using the DCF method to set the transfer
price is and the number of variables implies that all valuations are subject to
sensitivity. The more information the MNE can provide, the more precise the
valuation can be; however, it is always advisable to run sensitivity analysis on the
main variables (i.e. WACC, growth rate for terminal value, etc.).
It is often useful to run two methods in parallel to ensure that the results are
comparable and increase accuracy.
Due to the complexity in valuing IP and determining where IP is created (or where
it should generate profits) tax authorities have been focusing more on assessing
the transfer pricing for large MNEs holding valuable IP.
14.8
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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 IP especially in relation to research activities within Group
(economic ownership versus legal ownership).
There is an argument that just as IP law merged with international trade law to form
international IP law, it is now time to consider merging transfer pricing regulation for
IP with international IP law 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 IP law is to promote
the development of IP, particularly with respect to patents for new inventions.
Some would say international transfer pricing regulation should consider all of
these policy goals. It is possible for both the international IP legal system and
governmental tax regimes to adopt these fundamental goals while simultaneously
creating a more effective legal system regulating the transfer pricing of IP.
The fast growth in transfer pricing legislation and regulations represents crossborder 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.
Through transfer pricing regulations governments are attempting to limit tax
avoidance by MNE Groups engaged in transfer pricing manipulation. However,
effective and fair transfer pricing regulations must allow MNEs to use valuation
approaches as appropriate transfer pricing methods for IP. Clearer rules on
valuation of IP will translate in fewer grey areas, which can translate in
challenges by the tax authorities and large tax adjustments.
14.9
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In November 2012 meetings were held in Paris by the OECD to discuss the
comments received on the June 2012 draft. Those attending (approximately 100)
voiced concern about the broad definition of intangibles and the focus on
abusive behaviour. It was suggested that discussion on those entitled to returns
from intangibles should focus on risk bearing.
For
information
on
the
feedback
go
to
the
OECD
website
http://www.oecd.org/ ctp/transferpricing/ publiccommentsreceivedonthediscussiondraftonthetransferpricingaspects
ofintangibles.htm
In July 2013 the BEPS (Base Erosion and Profit Shifting) action plan was released by
the OECD. It is a detailed plan with 15 actions. Action 8 deals with the prevention
of BEPS via the movement of intangibles within a group.
Action 8 is as follows:
Develop rules to prevent BEPS by moving intangibles among group members. This
will involve: (i) adopting a broad and clearly delineated definition of intangibles;
(ii) ensuring that profits associated with the transfer and use of intangibles are
appropriately allocated in accordance with (rather than divorced from) value
creation; (iii) developing transfer pricing rules or special measures for transfers of
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CHAPTER 15
SPECIFIC TRANSACTIONS: BUSINESS RESTRUCTURING
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
Chapter IX of the OECD 2010 Transfer Pricing Guidelines on the transfer pricing
aspects of business restructuring attempts to deal with the growing trend of large
groups undergoing structural changes.
In an economic environment where globalisation has become the norm and
stronger competition has forced many big players out of business, looking at how
a business can function more efficiently, reducing cost and maximising profitability
potential are key to the survival of the business itself. In many cases, when a group
undergoes a structural change it often leads to centralisation of functions and risks.
Through selection of location of these centralised activities, many multinational
groups seek to maximise the tax benefits of restructuring as well.
Business restructuring is often a necessity; however, when looking at restructuring
groups also try to maximise profitability potential by looking at cost and tax
efficiencies. This is a concern for tax authorities, who are concerned that the
restructuring may be wholly or predominantly for tax purposes, and who are
therefore keen to protect their tax base from erosion through abusive planning.
Following business restructuring activities, operating companies will typically earn
lower profits than pre-restructuring, with related party transactions with a central
entity in a low-tax jurisdiction being the mechanism by which those profits are
reduced. Therefore, understanding the transfer pricing implications of business
restructuring is critical.
This chapter addresses the following issues:
15.2
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15.3
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:
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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.
15.4
The principles that are established earlier in the OECD Guidelines regarding the
treatment of related party transactions apply equally to business restructuring: This
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chapter starts from the premise that the arms length principle and these
Guidelines do not and should not apply differently to restructurings or postrestructuring transactions than to transactions that were structured as such from
the beginning. (See OECD 2010 Transfer Pricing Guidelines Chapter IX, 9.9)
Nevertheless, it is feature of business restructuring that they often include structures
and constructs not typically seen between independent parties, creating
substantial complexity. Furthermore, the amounts of tax at stake are often
substantial. These factors therefore explain the specific consideration given to
business restructuring within the OECD Guidelines.
Risk
In transfer pricing, the concept of risk is an important one, especially when dealing
with added value functions and transfer pricing models. Along with functions and
assets, they are one of the key economic drivers of value within a business. In
broad terms, entities bearing more risk would expect to earn higher profits, albeit
with a higher variability in the returns earned.
Although risks are important in relation to any related party transaction, there is an
increased focus on risk when it comes to business restructuring. This is because
many business restructurings rely on the transfer of risk from operating company to
Principal to justify the transfer of profit. For example, LRDs, as their name suggests,
rely on the idea that risks relating to the sales process are transferred to the
Principal. These may be specific risks such as inventory obsolescence risk or
warranty risk, or more nebulous risks such as market risk. The same principles apply
to other structures, with key risks transferred to the Principal under a contract
manufacturing or contract R&D model.
For tax authorities seeking to evaluate the arms length price under a restructured
model, it is important to understand whether the purported allocation of risk
between parties is correct. The starting point for evaluating this is to consider the
contractual allocations. As with transactions under normal circumstances, 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 division of risk (and the returns for risk).
The first consideration is to whether the division of risk is consistent with what is seen
at arms length. If independent parties engaging in comparable uncontrolled
transactions have a similar division of risk, then arguably the risk allocation is
defensible. However, one of the features of business restructurings is that they
often take a form not seen between unrelated parties. This does not mean in itself
that the allocation of risk is not arms length, but just that further analysis is required.
One of the key issues to consider is whether the party that supposedly bears a risk
has control over that risk. To exercise control, a party should be able to
demonstrate that it makes the key decisions necessary to manage that risk. A
simple example might be in relation to inventory risk. If inventory risk is allocated to
a Principal, it would be expected that the Principal would make the key decisions
around management of that risk. For example, it might make decisions about
inventory holding levels, and when to write off stock. If those decisions were made
by the distributor, it may be necessary to reconsider the allocation of risk.
A further issue to consider is whether an entity actually has the capacity to bear
the risk that it has been allocated. This would mean that a Principal should have a
balance sheet that is strong enough to bear the risks allocated. If it did not, this
would cast significant doubt over whether those risks would be allocated to that
party at arms length.
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A third consideration is whether the risks that have been transferred are
proportionate to the value that has been transferred during the restructuring. For
example, consider a fully-fledged distributor that typically earns 8% to 12%
operating margins before restructuring, but is converted to an LRD earning 2%
operating margin after restructuring. The risks transferred to the Principal to justify
this reduction in return might be inventory risk, warranty risk and credit risk.
However, upon closer examination of historical performance, it is identified that
average inventory obsolescence is 1% of revenue, warranty risk is less than 0.5% of
revenue and there is no history of bad debt write offs. Under those circumstances,
it could be challenged whether the drop in profit truly reflects the value
associated with the risk transferred. This would lead tax authorities to question
whether the post-restructuring transfer pricing leaves sufficient profit for the LRD, or
indeed whether something else of value has been transferred to the Principal
during the restructuring that might give rise to broader tax considerations.
The OECD Guidelines also raise the fundamental challenge about whether a
transfer pricing method can create a low-risk environment. It has been argued in
the past that a contract manufacturer earning a cost plus return is by definition
low risk, because it will earn a low guaranteed return.
The Guidelines
acknowledge that the pricing mechanism cannot be ignored in evaluating risk,
since the mechanism may legitimately insulate one party from risk in a way that is
seen at arms length. Nevertheless, the basic principle should be to choose the
method that best applies given the circumstances. As the Guidelines note:
...it is the low (or high) risk nature of a business that will determine the selection of
the most appropriate transfer pricing method, and not the contrary. (See OECD
2010 Transfer Pricing Guidelines Chapter IX, 9.46)
Arms length consideration for the restructuring itself
The OECD Guidelines 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.
Complexities arise where there is a business restructuring resulting in a significant
shift in the profit profile of entities restructured but no obvious transfer of assets.
Consideration needs to be given as to how the arms length principle would apply,
by challenging whether the restructured entity operating on a standalone basis
would be prepared to accept the restructuring without need for additional
payment.
The first step of this process is to understand the nature of the restructuring.
Specifically, 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.
Furthermore, it is also important to understand the business rationale for
restructuring. Understanding where the expected benefits should arise will inform
the likelihood of whether the restructuring would have been accepted at arms
length.
Having undertaken this analysis, consideration should then be given to the options
realistically available to the restructured party. By evaluating the restructured
entity as if it were operating independently from the rest of the group, it should be
evaluated 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,
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if it can be established that the restructured entity had material profit potential
that it has given up, then at arms 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.
The OECD Guidelines also address whether it is necessary for the restructured party
to be indemnified against restructuring costs (such as plant closure and
redundancy costs). 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 arms 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.
Post restructuring Transfer Pricing
As a guiding principle, the determination of arms length transfer prices following a
business restructuring should be no different to any other related party
transactions. Nevertheless, the OECD Guidelines acknowledge that there are
certain features of a business restructuring that create specific challenges.
One issue is that comparability analysis may be harder to apply. 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 arms 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.
A further difference for the application of transfer pricing models to business
restructuring is the interaction with the restructuring itself. Although it is discussed
at length whether payment is required to compensate for foregone profit
potential, it is important to consider whether the same outcome can be achieved
through post-restructuring pricing. It may be the case that parties would agree to
forego an upfront payment in return for a more beneficial transfer price. As such,
the arrangements would need to be considered holistically to determine whether
they comply with the arms length standard.
The OECD Guidelines also consider the concept of location savings. In many
cases, business restructurings result in the shift of labour-intensive activity from highcost countries to low-cost ones to create efficiencies within the business. However,
it has become an increasing trend for tax authorities in those low-cost territories to
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assert that a proportion of those cost savings should be shared with the new
operations creating the savings.
The Guidelines 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 arms 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.
Recognition of actual transactions
The fourth part of the business restructurings chapter focuses on whether tax
authorities, in challenging and adjusting transfer prices, should recognise the
transactions as structured by the taxpayer. The Guidelines reinforce the point that
taxpayers are free to organise their business operations as they see fit.
Nevertheless, they also recognise that tax authorities have the right to determine
the tax consequences of the structure in place.
In general, tax authorities should only disregard the structure of the transaction in
exceptional circumstances: where the economic circumstances of the transaction
differs from the form, or where independent parties would not have structured
their transactions in such a way and the arms length price cannot reliably be
determined (ie. the same circumstances where a tax authority could disregard a
transaction that would apply to all transactions, not just business restructuring.)
Whilst the first circumstance is relatively straightforward to apply, based on a robust
functional analysis, the second is more challenging.
It has already been
established that transactions following business restructuring frequently differ from
those structured between independent parties. Nevertheless, if an appropriate
transfer price, taking into account all factors of comparability analysis, can be
identified, then the transaction should be recognised as structured. This would
apply even if the tax authority doubted the commercial rationale for the
arrangements.
Even if the tax authority were to disregard the transactions as structured by the
taxpayer, the alternative characterisation used for taxation would nevertheless
need to recognise certain commercial realities. For example, if the restructuring
involved the closing of manufacturing activities, any recharacterisation would
need to recognise that such functions no longer exist in a country. Likewise, if
property (tangible or intangible) were legally transferred between parties, the
recharacterised post-restructuring transactions could not disregard this. We will
look at these issues in more detail in the next chapter.
15.5
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given to both the underlying tax legislation in a country, and the relief
provided by any relevant double tax agreements (DTAs). The variation that
exists in both legislation and DTAs means that a structure rolled out identically
in a number of countries may have a different PE analysis in each
15.6
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 seek to recharacterise
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. In 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,
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.
From a business perspective, restructuring seen as a whole may constitute a
commercially sound business decision, focusing on optimisation, removing
duplication and reducing costs. However, tax authorities may see it as a taxable
transfer of intellectual property rights as well as a significant part of the business.
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 Guidelines and would actually
follow the OECD paper 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
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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 intragroup agreement and strong proof of commercial
rationale driving the transformation are essential in reducing the risk of potential
tax audits and consequent adjustments.
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CHAPTER 16
RECHARACTERISATION ISSUES
In this chapter we are going to look examine the circumstances in which a tax authority
may seek to disregard or recharacterise a transaction between associated enterprises.
16.1
Introduction
Recharacterisation refers to the extent to which a tax authority may, for tax
purposes, set aside the contractual terms of a transaction entered into by the
parties. This setting aside may take two forms:
The arms 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 recharacterisation 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.
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16.2
while the form and substance of the transaction are the same, the
arrangements made in relation to the transaction, viewed in their totality, differ
from those which would have been adopted by independent enterprises
behaving in a commercially rational manner and the actual structure
practically impedes the tax administration from determining an appropriate
transfer price.
Paragraph 1.66 explains that, in both circumstances above, the totality of the
terms of the controlled transaction would not have been found at arms length
and therefore tax authorities are to include in the profits of an enterprise any profits
which would have accrued to it, but for these conditions which differ from those
which would be made between independent enterprises. (OECD Model Tax
Convention, Article 9.1).
Paragraph 1.65 provides an example of each type of exceptional circumstance.
The example given for the first type is an interest bearing loan to an associated
enterprise in circumstances where, at arms length, it might be more appropriate
to characterise the investment as a subscription of equity capital. The example
given for the second type is a transfer under a long-term contract, for a lump sum,
to an associated enterprise of the benefit of intellectual property rights arising from
future research. It is suggested that a more rational characterisation might be
an on-going contract research agreement.
Illustration 1
As an illustration of differing tax authority approaches to the debt/equity example
referred to above, consider the position for the Zeta group of companies:
Zeta Holdings Ltd (resident in
Cayman Islands)
Zeta (UK) Limited (resident in UK)
The UK and Spanish subsidiaries are established with nominal equity capital of
1/1 respectively. They are both financed by Zeta Holdings Ltd by way of loans of
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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 arms 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 to be recharacterised as share capital and the
interest payable to be recharacterised as dividends.
In Spain, the thin capitalisation rule of 3:1 debt:equity applies. Because this is
breached, a tax deduction will be denied to Zeta Espana SRL for the interest
charged. Moreover, the interest is classified as a dividend and withholding tax is
applied accordingly.
Factors to be considered
Against what criteria can it be assessed whether or not arrangements made in
relation to the transaction, viewed in their totality, differ from those which would
have been adopted by independent enterprises behaving in a commercially
rational manner?
Options realistically available
The OECD Guidelines note, at Paragraph 1.34, 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 recharacterisation, 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 arms length might have chosen? If so, that option may provide
a means of recharacterising the actual transaction undertaken. (Andrewa Bullen,
in a doctoral thesis examining recharacterisation issues argues that there are five
reasons why the options realistically available concept is relevant in a
recharacterisation context)
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
Guidelines do not seek to answer such questions. 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
arms length have chosen a clearly more attractive option.
Risk
When looking at the question of recharacterisation the allocation of risk is
important. The OECD Guidelines pay special attention to the allocation of risks,
underlying contractual terms as well as the capabilities and responsibilities to
manage those under Paragraphs 1.47 to 1.49, as expanded in the Business
Restructurings Chapter at Paragraphs 9.22 to 9.43. Emphasis is placed on whether
the parties conform to the purported allocation of risks and whether the party to
which the greater risk is allocated has the capacity to control it. In this context,
control does not mean day to day management but the ability to strategically
assess the risk.
Business restructuring aspects
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
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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.
Centralisation is often pursued by large MNEs not as way to achieve tax
advantages, but in the pursuit of cost efficiencies, better control and as a way to
stand against the competition.
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, which
try to re-characterise the limited risk distributor as a full risk distributor, when it
appears that the local entity is indeed taking on more risk and functions than the
main distributor.
Another classic example is in relation to contract R&D arrangements, where an
enterprise pays a related party for the development of IP, which is then exploited
by the paying enterprise. Tax authorities often argue that the R&D company might
be acting on its own behalf and the IP being created resides locally and does not
belong to the enterprise paying for the R&D expenses. It is important to ensure that
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.).
Commercial evidence is also very important when assessing the nature of a
transaction or facing a recharacterisation challenge by a tax authority.
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 9.161 to 9.194 in Chapter IX of the Guidelines address the issue of
recharacterisation 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 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.
MNE groups implement business models that may be rarely, if ever, found at
arms length. That does not automatically make them irrational.
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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
Company A in Country A: Head
Office and valuable brand owner
Contract manufacturing
company in Country B
Post-reorganisation
Company A in
Country A: Head
Office
Transfer of
brand
Contract
manufacturing
company in Country
B
Distribution company
in Country C
Company Z in Country
Z: valuable brand
owner No staff
No risk-bearing
capacity
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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 blatant 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.
Base Erosion and Profit Shifting (BEPS) Action Plan
In July 2013, the OECD published its wide-ranging Action Plan to combat a number
of international tax planning strategies used by MNEs and to modernise longstanding tax rules which are considered not to have kept pace with globalisation,
technology and the growing role of intangibles and services.
Three of the 15 action points are concerned with transfer pricing outcomes
relating, respectively, to intangibles, risks and capital, and other high-risk
transactions . It should be noted that one of these action points is to:
develop rules to prevent BEPS by engaging in transactions which would not, or
would only very rarely, occur between third parties. This will involve rules..to
clarify the circumstances in which transactions can be recharacterised
The OECD has set the relevant working party a deadline of September 2015 to
generate proposed changes to the Transfer Pricing Guidelines.
Many commentators are heralding the BEPS work as a turning point, and although
the 2015 deadline is rather ambitious, given all the other workstreams of this
project, it might be expected that tax authorities will gain confidence in mounting
recharacterisation arguments even in advance of agreed changes to the
Guidelines.
16.3
Country examples
recharacterisation
of
case
law
and
other
guidance
on
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
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enterprises. Relevant developments in Canada, the United States and the United
Kingdom are considered below.
Canada
A recent court case in Canada (which at the time of writing has yet to be
resolved) illustrates how controversial and difficult recharacterisation and
adjustments can be especially when in relation to intangible property. The case is
The Queen v. GlaxoSmithKline Inc. (This is a case we look at in other parts of this
manual as it covers many issues).
This case highlights two main issues:
How the OECD Guidelines 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 nonresident 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.
Glaxo Canada paid a royalty to its UK parent company (and IP owner) to
manufacture and sell the branded drug Zantac in the Canadian market. Glaxo
Canada's rights under the intragroup agreement allowed the Canadian entity to
manufacture, use and sell various Glaxo Group products (including Zantac), make
use of other trademarks owned by the Glaxo Group, gain access to new Glaxo
Group products and receive technical support.
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
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.
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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.
Glaxo Canada replied that it is not uncommon in Canada for enterprises to
purchase goods that clearly have an intangible property component (e.g. Nike).
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 views the transaction as a separate item and not in the context of the
larger picture. The lack of clear guidance in the legislation leaves room for
interpretation.
The Supreme Court of Canada has now upheld Glaxo Canadas 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 Guidelines
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 intragroup 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
recharacterise 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 recharacterisation 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
Reed Elsevier UK Ltd 2013
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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 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.
United Kingdom
There are no UK case law decisions which address recharacterisation in a transfer
pricing context.
HM Revenue & Customs guidance in the International Manual (INTM 440200)
summarises the OECD guidelines and concludes:
It is important to note that this is a very difficult area and it would be necessary to
ascertain all the facts and circumstances of a case, together with any evidence
that such arrangements would not have existed between third parties, before
concluding that a provision should be set aside. Any evidence of the provision and
the price that would have existed would also have to be considered. In all such
instances, consult the Transfer Pricing Team at CTIAA Business International.
INTM 441070, which addresses commissionaire structures in a UK context, suggests
that HMRC might seek to set aside such structures if the facts show that they would
not have been adopted at arms length.
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CHAPTER 17
PERMANENT ESTABLISHMENTS
In this chapter we will look at the OECD guidance on transfer pricing in relation to
Permanent Establishments including:
identification of a PE;
further developments on PEs;
double taxation relief;
case law.
17.1
17.2
Identification of a PE
The first source of reference on the taxation of PE's is the OECD Model Tax
Convention and its commentary.
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
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countries. The OECD Model Tax Convention 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 Tax Convention 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.
In the OECD Model Tax Convention there are two types of PE which are defined in
Article 5. These are the fixed (premises) PE and the dependent agent PE. In
addition some Double Tax treaties have extra clauses relating to PE's e.g.
identification of service PE's.
Of course the articles in the OECD Model Tax Convention are 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.
It should also be noted that the UN has also produced a Model Tax Convention
that is used by developing nations when negotiating tax treaties. The UN Model is
designed to aid developing states to tax a larger part of the overseas investor's
income than the other two Models. In particular the UN convention recognises
services PEs without a fixed base (discussed later).
There is also a model tax convention produced by the USA that in general reflects
the OECD Model Tax Convention articles relevant to PEs.
Fixed PE
Reproduced below are paragraphs 1 to 4 of Article 5 of the OECD Model Tax
Convention (in italics). Underneath the paragraphs there are the key issues raised
in the commentary on the article:
1.
2.
a place of management;
b.
a branch;
c.
an office;
d.
a factory;
e.
a workshop, and
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4.
the use of facilities solely for the purpose of storage, display or delivery of
goods or merchandise belonging to the enterprise;
b.
c.
d.
e.
f.
For a place of business to constitute a PE the enterprise using it must carry on its
business wholly or partly through it. A PE begins to exist as soon as the enterprise
commences to carry on its business through a fixed place of business. In general
the common feature of the activities that are treated as exceptions are
preparatory or auxiliary activities.
In summary a fixed PE exists where a company is resident in country 1 and carries
out its business or part of its business using fixed premises in country 2 as defined in
Article 5. The consequence is the company is then taxable in country 2 on the
profits attributable to that business. How to attribute profits is considered in the next
chapter.
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Dependent agent PE
Paragraphs 5 to 7 of Article 5 of the Model Taxation Convention are reproduced
below (in italics) as again this (or its actual treaty equivalent) is the starting point of
any analysis. Underneath the paragraphs there are the key issues raised in the
commentary on the article.
5.
6.
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7.
Service PE
In certain international tax treaties there is also provision to tax a service PE. A
company tax resident in country 1 is deemed to have a Service PE if the
employees / personnel of that company render services in country 2 for a period
exceeding that specified in the specific Tax Treaty. It may not be necessary to
have fixed premises in country 2. As a consequence the company will be taxed by
country 2 on the profits attributable to the services performed in country 2.
Service PE's are not within the OECD Model Tax Convention. They are however
discussed in some detail in the commentary. The background is that some
countries consider that profits from services performed in a given state should be
taxable in that state. This is based on the policy principles relating to taxation of
business profits.
With a service business, a company may not require a fixed place of business to
transact high levels of business. Some countries look to impose taxation on these
services in the country where the services are received under their domestic law
even in the absence of a PE.
17.3
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Does paragraph 6 apply only to agents who do not conclude contracts in the
name of their principal?
17.4
17.5
Case Law
Phillip Morris Case
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).
Facts
The facts of the case were as follows:
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.
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Decision
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.
Zimmer Case
Facts
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.
Decision
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.
Key points arising from the case
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 re-characterised by the tax authorities as a contractual arrangement
of a different nature.
A commissionaire agreement can grant sufficient flexibility to the commissionaire
for carrying out its daily activities without constituting a PE of its principal.
The decision is based on legal principles and does not look at what is actually
happening in the business and how it actually operates.
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CHAPTER 18
ATTRIBUTION OF PROFITS TO PEs
In this chapter we will look at the attribution of profits to a PE in particular:
the functionally separate approach;
former Article 7 of the OECD Model Tax Treaty;
new Article 7 of the Model Tax Treaty;
summary of main changes in new Article 7;
implementing the revised Article 7: the two step approach to profit attribution;
practical application of the transfer pricing process;
special considerations for dependent agent PEs;
E-commerce and PEs;
rejection of force of attraction principle;
attribution of profit in excess of the total profit of the enterprise;
comparison of the Article 7 OECD approach to Article 9.
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 Tax Convention. The
convention 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 of the convention.
In these articles the convention distinguishes between the attribution of profits to a
PE and transfer pricing between separate entities by including different articles for
each of these situations:
Where
a)
b)
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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.
2.
18.2
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General application
The first section is covered in detail in this chapter. For the other sections this
chapter looks at salient points but does not go into the depth of analysis
contained in the OECD Report.
The latest pricing methodology is dealt with in Article 7 of the OECD Model Tax
Convention. The authorised (recommended) OECD approach to profit attribution
is that 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.
The PE is hypothesised as a functionally separate and independent enterprise in
order to calculate the profits of the PE under Article 7. The arm's length principle is
then applied to this hypothesis. As this is a fiction the OECD approach is not to
directly apply the guidance given in the OECD 2010 Transfer Pricing Guidelines but
apply by analogy.
Of course this is only a model convention and the recent changes to Article 7
have not yet been implemented into 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 new Article 7 is considered in greater detail below.
There is also the ancillary point as to whether the commentary contained in the
latest Model Tax Convention can be applied to interpret previous Model Tax
Conventions. 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 Model Convention 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
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18.3
2.
3.
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18.4
4.
5.
6.
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.
2.
For the purposes of this Article and Article [23 A] [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 method of calculation of the profits that are attributable to a PE is
contained in paragraph 2. The paragraph also makes it clear that the method
of calculation applies to dealings between the PE and the enterprise. (A
dealing is the Article 7 equivalent of a transaction.)
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The PE is treated as a separate enterprise that will deal at arms length (as
defined in Article 9 of the Model Tax Convention). 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.
Where the PE transacts with an associated enterprise the price should be at
arms length and if adjusted by a tax authority it can be subject to an
application for a corresponding adjustment under paragraph 2 of Article 9 of
the Model Tax Convention.
The separate and independent enterprise concept does not extend to Article
11 of the Convention as this does not apply to a payment within a company.
(Article 11 is the Interest article within the Model Tax Convention 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 Tax Convention (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.
Recognition is required together with arm's length pricing of the dealings
where one part of the enterprise performs functions for the benefit of the PE
(e.g. through the provision of assistance in day-to-day management). The tax
deduction is not limited to the amount of the expenses.
One of the issues relating to taxation of PEs is the deductibility of expenses.
Expenses can fall into two categories:
Article 7 of the OECD Model Tax Convention 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 new Article 7 and the old version is to
remove from the article the right of the permanent establishment 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 old Article
limited the deduction for expenses to the actual amount rather than the arms
length amount. In respect of general and administrative expenses this limited
the expenses charged to the cost of those services.
The new wording contained in paragraph 2 of Article 7 requires an arms
length charge for the provision of services (referred to as dealings) i.e. the
charge is not limited to cost, for example a charge can be made on a cost
plus basis.
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The commentary to the both the new and old 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).
3.
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.
As already outlined in order to further interpret Article 7, relevant guidance is
contained in the OECD Report.
18.5
It clarifies and extends the situations where arm's length remuneration for
internal service dealings is required. Previously internal charges for services
were limited to cost. It is now clarified that these should be calculated on an
arms length basis.
Where other activities are undertaken by the PE, profits can be attributed to a
purchasing function. (paragraph 5 of old Article 7 removed)
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18.6
The removal from the article the right of the permanent establishment to
deduct executive and general administrative expenses even if not incurred
in the country where the PE is established.
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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 have introduced the concept of significant people functions i.e. the
entities 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.
The OECD Report refers to paragraph 1.52 of the OECD 2010 Transfer Pricing
Guideline. 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 available 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.
PE's can also economically own acquired intangible property. To establish
ownership it is necessary to look at the role of the significant people functions. In
particular decision making, evaluating the management of risk, decision making
on acquisition, decisions on development work and use of the intangible will be
key.
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.
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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 attribution of capital based on the assets and risks attributed to the PE.
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Step 2 applies the five comparability factors contained in the OECD Guidelines.
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.
18.7
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Contract manufacturer
Service provider
Distributor
Description
This is the entity containing
the decision makers, taking
the investment risks (e.g.
research, new markets and
innovation). The group
entrepreneur can take
several forms. For example it
can be a manufacturer, the
group researcher or the
group product designer.
A contract manufacturer
produces goods under the
direction and using the
technology of the group
principal (usually by
reference to a contract). Its
risks are primarily limited to its
efficiency and ability to
retain the group
manufacturing contract. In its
most limited risk form it will be
a toll manufacturer with the
principal supplying and
retaining ownership of all
materials
A service provider supplies
services to other group
companies usually by
reference to a contract. Its
risks are primarily limited to its
efficiency and ability to
provide contracted services
at budgeted costs.
A group distributor distributes
goods supplied by its
principal. It risk profile can
vary dependent on the
structure of the operation.
Pricing method
Residual profit after
rewarding the other
entities in the supply
chain for their
functions.
CUP/Cost plus
method/ Transactional
net margin method
CUP/Cost plus
method/ Transactional
net margin method
CUP/Resale minus
method/ Transactional
net margin method
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 five comparability factors
contained in the OECD Guidelines (which we have looked at in earlier chapters).
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18.8
18.9
web site hosting arrangements typically do not result in a PE for the enterprise
that carries on business through the hosted web site;
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Paragraph 1.64 of the OECD Guidelines states that In other than exceptional
cases, the tax administration should not disregard the actual transactions or
substitute other transactions for them. Nevertheless in the same section (OECD
2010 Transfer Pricing Guidelines paragraphs 1.65 and 1.66) there are examples of
transactions where under Article 9 of the OECD Model Tax Convention a tax
administration can adjust the conditions of an intra-group agreement to those
conditions an independent party would have adopted behaving in a
commercially rational manner, where the arrangements are made between
group companies. In particular this can apply where transactions have been
structured by the taxpayer to avoid or minimise tax.
The OECD give a lot of weight to legal contracts, however the question has to be
asked re how far group contractual relationships can be relied on. What would
appear surely more important is the conduct of the two group companies rather
than a legal arrangement that would hardly ever be enforced or in many cases
respected by two associated companies.
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CHAPTER 19
PE: ATTRIBUTION OF PROFITS TO FINANCIAL INSTITUTIONS &
FINANCIAL INSTRUMENTS
In this chapter we are going to look at the guidelines relating to attribution of profits to PEs
of financial institutions and companies trading in financial instruments including:
attribution of profits for branches of financial institutions;
practical functional analysis for a traditional banking business;
PEs of enterprises carrying on global trading of financial instruments;
practical functional analysis for global trading of financial instruments.
19.1
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.
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The attribution of capital based on the assets and risks attributed to the PE.
The attribution of capital to a PE involved in a banking business is a key step in
the process of attributing profit to that PE. It determines the amount of capital
that the bank PE is allocated under the authorised OECD approach and the
appropriate treatment of Tier 1 and Tier 2 capital under the tax rules of the PE's
jurisdiction. As a PE of a bank, like any other type of PE, it should have sufficient
capital to support the functions it undertakes, the assets it uses and the risks it
assumes. Capital is looked at as free capital and other capital.
The attribution of free capital is a two stage process:
Stage 1
The first stage is to measure the risk of the PE. One possibility is to use a
regulatory based approach to measuring the risks attributable to a PE. One
example of a regulatory based approach would be to risk-weight the assets
by reference to the internationally accepted regulatory standards determined
by the Basel Committee (currently Basel III).
Stage 2
The next step is to determine how much free capital is needed to support
those risks identified in stage 1. This attribution has to follows the arm's length
principle. The two OECD approaches to capital attribution are:
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Step Two
Step Two is the pricing on an arm's length basis of recognised dealings:
19.2
Selecting and applying by analogy to the guidance in the Guidelines the most
appropriate method to the circumstances of the case to arrive at an arm's
length compensation for the dealings between the PE and the rest of the
enterprise, taking into account the functions performed by and the assets and
risks attributed to the PE.
Examples of functions
Cultivating potential clients, creating
client relationships and inducing clients
to start negotiating offers of business;
Negotiating the contractual terms with
the client, deciding whether or not to
advance monies and, if so, on what
terms, evaluating the credit, currency
and market risks related to the
transaction, establishing the
creditworthiness of the client and the
overall credit exposure of the bank to the
client, deciding what levels of credit,
currency and market risk to accept,
pricing the loan, considering whether
collateral or credit enhancement is
needed and committing the bank (and
its capital) to the loan and its associated
risks, etc.;
Raising funds and capital, taking
deposits, raising funds on the most
advantageous terms, making the funds
available;
Checking draft contracts and
completing the contract formalities,
resolving any outstanding legal issues,
checking any collateral offered, signing
the contract, recording the financial
asset in the books and disbursing the loan
proceeds.
Sale/Trading
Trading/Treasury
Sales/support
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Examples of functions
Monitoring risk
Managing risks
Sales trading
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Interest rate
Currency risk
Assets employed
Fixed assets/intangibles
Capital
19.3
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The OECD Report defines global trading as executing customers' orders in financial
products in markets around the world and/or around the clock. The examples
given include under writing and distributing products on a world-wide basis, acting
as a market-maker in physical securities (i.e. the traditional bond and equity
markets) and in derivative instruments, acting as a broker for client transactions on
stock and commodities exchanges around the world, and developing new
products to meet the needs of the financial institution's clients, for example credit
derivatives.
The income earned by the financial institution from these activities may consist of
interest and dividends received with respect to the stock it holds as a marketmaker for physical securities, trading gains from sales of that inventory, income
from derivatives, fee income from structuring transactions, gains from dealing in
liabilities, income from stock-lending and repo transactions, and brokers' fees from
exchange transactions executed for clients.
19.4
Practical functional
instruments
analysis
for
global
trading
of
financial
The approach for transfer pricing very closely follows that for banks discussed
above. In particular the report recognises the following functions, assets and risks:
Sales and marketing functions
Assets used
Risks
Capital
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CHAPTER 20
COMPLIANCE ISSUES
In this chapter we are going to look at compliance issues, in particular:
why documentation is important;
the OECD Guidelines on transfer pricing compliance;
domestic law approaches to transfer pricing compliance;
unilateral or multilateral documentation;
non documentation considerations;
BEPS action plan and documentation;;
safe harbours.
20.1
Introduction
In simple terms, compliance in the context of transfer pricing is predominantly
achieved by taxpayers through transacting with related parties on an arm's length
basis. If companies can achieve this, then the most significant costs of noncompliance (being penalties and double taxation) are substantially mitigated.
However, it is not sufficient for taxpayers to transact on an arm's length basis; they
must also be able to demonstrate that this is the case. This chapter explains the
steps that taxpayers must go through to demonstrate compliance with transfer
pricing regulations. It also addresses some of the broader compliance
requirements of taxpayers as a result of transacting across borders.
Compliance with transfer pricing regulations comprises a number of aspects, with
the importance of each varying across different countries. These include:
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.
20.2
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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.
For the taxpayers, preparation of transfer pricing documentation should be more
than simply about meeting a compliance requirement. Through the preparation of
documentation, taxpayers are able to proactively manage their transfer pricing
risk. Documentation provides a platform for the taxpayer to present its case.
Clearly any analysis needs to be factually accurate and economically sound.
Nevertheless, through the preparation of robust documentation, the taxpayer has
the opportunity to present the facts in the most favourable light and to a large
extent, determine the criterion through which transfer prices are evaluated.
Provided the taxpayer has made a reasonable attempt to follow OECD principles
in determining the choice of method and the means of application, it can be very
difficult for tax authorities to successfully apply a radically different framework. The
preparation of adequate transfer pricing documentation is often sufficient to
discharge the burden of proof regarding the arm's length nature of prices (where
this rests with the taxpayer), and put the onus back on the tax authority to
demonstrate that the arm's length standard has not been met.
Furthermore, the very process through which taxpayers prepare documentation
can help in the identification and management of transfer pricing risk.
Documentation can require the collection of considerable amounts of facts and
data regarding the nature of cross-border dealings. As a process, it can therefore
provide some discipline to tax risk management in the area of transfer pricing,
allowing the tax function within a multinational company to identify early those
countries or transactions with significant risk and devote resources accordingly.
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Guidelines is not to create additional burden for taxpayers above what is already
created by tax administration rules. Instead it seeks to provide balanced guidance
for both tax administrations and taxpayers as to what would be reasonable and
helpful in achieving the ultimate objective of determining the arm's length price
for related party transactions. The chapter is split in two parts; the first part provides
guidance on documentation rules and procedures, addressing behavioural issues
from both parties, whilst the second part provides more explicit guidance as to
what would be useful to include in a transfer pricing documentation study.
Rules and Procedures
From the perspective of the taxpayer, there is an acknowledgement that some
work will be required on their part in order to demonstrate that transfer prices meet
the arm's length standard. Taxpayers are advised to give consideration to what
transfer pricing arrangements are appropriate before pricing is established
through the application of principles established in earlier chapters of the OECD
Guidelines. 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.
In this regard, taxpayers should accept that it may be necessary to prepare
written documents that would not otherwise be required in the absence of tax
considerations. However, it is also clear that the taxpayers should not be expected
to incur disproportionately high costs relative to the complexity. For example,
taxpayers should not have to undertake an exhaustive search for CUPs if there is a
reasonable case for believing that such CUPs do not exist. Notwithstanding this,
taxpayers should recognise that tax authorities will need to make assessment on
the arm's length nature of transactions based on information presented by the
taxpayer, however incomplete that information is. See paragraph 5.6 of the OECD
Guidelines.
Furthermore, there should be an acknowledgement that the greater the
complexity of the issues, the more significance will be attached to the
documentation. Therefore, the taxpayer should take responsibility to ensure
adequate document retention and voluntary disclosure of information, in order to
help to improve the persuasiveness of analysis.
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. Tax authorities are discouraged from imposing
contemporaneous filing requirements for when pricing is set by taxpayers, or
indeed when a tax return filed. Instead they should be reasonable in requesting
documentation to be provided in timely manner upon request.
Furthermore, tax authorities should be reasonable in the type of information they
request from taxpayers in documentation. Requests for documents that became
available only after the transaction was entered into should be limited to avoid
the use of hindsight. Instead, tax authorities should have regard for what the
taxpayer would have reasonably had available at the time of the transaction.
They should take care not to ask for what is not in the possession or control of the
taxpayer. This includes acknowledgement that it may be difficult to identify data
from foreign affiliates, particularly where such information is in practice not
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Business Restructuring
Further guidance on compliance is provided in relation to business restructuring. In
terms of direct reference to compliance matters, the OECD Guidelines simply
observes that processes established by a taxpayer around compliance should
take into account complexity of the transactions; where business restructuring is
undertaken it can result in significant changes to risk allocation and risk profile
(implying more detailed analysis on the part of the taxpayer would be
appropriate). In a broader terms, the OECD identifies a range of issues thrown up
by business restructuring, including changes to functional and risk profile, change
in profit profile, transferring of value in the context of options realistically available
and profit potential, and post-restructuring transfer pricing, all of which are
discussed elsewhere in this manual. However, there are obvious consequences for
taxpayers in relation to compliance. There will clearly be a higher risk of challenge
from tax authorities, and the necessity to provide evidence of business change will
be that much greater. This will include factual (details of changes to functional
and risk profiles), commercial (rationale for business change), and analytical
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20.4
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 tax payers meet the defined criteria. We look at
these in more detail below.
Many countries use the OECD Guidelines 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.
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20.5
20.6
Non-Documentation Considerations
Transfer pricing compliance issues extend beyond the realms of documentation,
even if that is often the focus of consideration. Throughout the lifecycle of related
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party transactions, there are a number of areas where compliance issues need to
be addressed. Even if the driver behind these issues is not corporate tax, the tax
practitioner still needs awareness of what needs to be done.
Before the transaction
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 Guidelines,
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.
However, in practice this approach is not followed by all jurisdictions. In certain
territories, it is required to have a legal agreement in place before deductions will
be given in relation to intercompany charges. Predominantly, this relates to royalty
payments for use of intellectual property, and fees paid for related party services.
Indeed, royalty payments may require pre-approval by tax or finance authorities
and be subject to strict limits.
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.
Executing the transaction
Where a related party transaction is entered into, due consideration should be
given to accounting requirements. Transactions should be recorded appropriately
and records maintained to support the statutory accounts, with appropriate
remittance. In some cases, taxpayers may choose to offset transaction flows in
opposite directions. This concept of intentional offsetting is acceptable under
OECD principles, although care needs to be taken to evaluate the arm's length
nature of each side of the series of transactions, and recording the basis for
believing that the set off is reasonable. Furthermore, consideration needs to be
given to secondary tax implications from offsetting transactions (such as indirect
tax or withholding tax).
Appropriate invoicing is also important, particularly where transactions involve the
provision of related party services. In some countries, tax deductions will not be
given for related party service charges unless supported by an invoice giving an
adequate description of the services provided. Other countries may require the
basis for calculating the charge to be included with the invoice.
Where intercompany transactions relate to services, royalty payments or interest,
consideration needs to be given to withholding tax obligations. Taxpayers should
be aware not only of the rate that is payable, but also the timing of the
obligations. In some territories, the timing will be determined by when payment is
actually made, but in others, it will be determined with reference to when the
service is provided (or interest or royalty becomes payable), which may well be at
an earlier date. Furthermore, where withholding tax rates are reduced under a
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double tax treaty, taxpayers should ensure they understand whether this reduction
is automatically applied, or whether a further process needs to be followed in
order to benefit from the treaty rate.
After the transaction
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.
20.7
20.8
Safe harbours
In May 2013 a revised section E to chapter IV of the 2010 OECD Transfer Pricing
Guidelines was approved by the OECD.
The revised section E changes the stance on safe harbours. Paragraph 4.94
acknowledges that the original guidelines were generally negative towards the
use of safe harbours. Up to May 2013, the Guidelines 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.
The revised Guidelines state that safe harbours will be most appropriate when
directed at low risk transactions and/or taxpayers (see paragraph 4.96 revised
section E).
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The revised Guidelines recognise that safe harbours can be a benefit to tax
administrations as well as taxpayers.
Paragraph 4.100 of the revised section E contains the following definition:
A safe harbour in a transfer pricing regime is a provision that applies to a defined
category of taxpayers or transactions and that relieves eligible taxpayers from
certain obligations otherwise imposed by a countrys general transfer pricing rules
A safe harbour substitutes simpler obligations for those under the general transfer
pricing regime. Such a provision could, for example, allow taxpayers to establish
transfer prices in a specific way, e.g. by applying a simplified transfer pricing
approach provided by the tax administration. Alternatively, a safe harbour could
exempt a defined category of taxpayers or transactions from the application of all
or part of the general transfer pricing rules. Often, eligible taxpayers complying
with the safe harbour provision will be relieved from burdensome compliance
obligations, including some or all associated transfer pricing documentation
requirements.
So we can see that a safe harbour can take many forms.
Certain forms of safe harbour are not covered by the discussion in the revised
section E; these include administrative simplifications and exemption from certain
documentation requirements, APAs and thin capitalisation rules. (See paragraph
4.101 revised section E)
The Guidelines set out a discussion on the pros and cons of safe harbours covering
the same points as in the previous Guidelines. No new advantages or
disadvantages have been added, however the discussion is now more positive,
with suggestions of how bilateral or multilateral safe harbours could help reduce
the problem areas.
The advantages of safe harbours are identified as
Provision of certainty
Use of safe harbours may mean that the arms length principle is not adhered
to
Unilateral adoption of safe harbours may increase the risk of double taxation
or double non taxation
There may be issues of equity and uniformity where apparantly similar tax
payers are not able to use the safe harbours because of the criteria.
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The Guidelines 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.
20.9
Summary
The approach taken by taxpayers to transfer pricing compliance is influenced by
many factors. At its heart is the core assertion in the OECD Guidelines that transfer
pricing is not an exact science. The natural corollary to this is that it is impossible to
be prescriptive in matters of compliance because so much comes down to
matters of judgement. 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 Guidelines, as well as local country
guidance, provides some direction as to what might be appropriate, but not
certainty. As such, approach to transfer pricing compliance is fundamental part of
the strategic approach to global tax risk management for many companies.
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CHAPTER 21
AVOIDING DOUBLE TAXATION AND DISPUTE RESOLUTION I
In this chapter we look at:
transfer pricing audits
corresponding adjustments
secondary adjustments
Article 25 of the OECD Model Tax Treaty (MAP)
arbitration in double tax treaties
the EU arbitration convention
21.1
Introduction
Despite the OECD 2010 Transfer Pricing Guidelines and the arm's length principle
being accepted by the majority of countries, tax authorities often seek to apply
the methodology in the OECD Guidelines differently. These differences can often
leave MNEs in the middle seeking to avoid double taxation as a result of the
differences in interpretation.
Double taxation can be either juridical or economic in nature. 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 Guidelines Chapter IV covers avoiding and resolving dispute resolution.
It is noted however, that in some circumstances taxpayers may accept a certain
amount of economic double taxation because it is more costly to defend an audit
than accept the additional tax. Furthermore, where a tax authority introduces
administrative simplification procedures, such as safe harbours, in order to access
the safe harbour and consequently reduce the compliance burden, the taxpayer
may accept an element of double taxation.
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:
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21.2
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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;
21.3
Corresponding Adjustments
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
Tax Convention. (See OECD 2010 Transfer Pricing Guidelines 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.
Article 9(2) of the current OECD Model Tax Convention 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 Tax Convention (July 2010) Article 9(2))
Corresponding adjustments mitigate double taxation in cases where one tax
authority increases a company's taxable profits (i.e, by making a primary
adjustment) as a result of applying the arm's length principle to transactions
involving a related party in a second tax jurisdiction. The corresponding
adjustment in such a case would constitute a downward adjustment (a decrease
in profits) to the tax liability of the related party, made by the tax authority of the
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second jurisdiction, so that the allocation of profits between the two jurisdictions is
consistent with the primary adjustment and double taxation is avoided.
The commentary to the OECD Model Tax Treaty notes that the adjustment is not
automatic and is therefore subject to the agreement of the other tax authority.
(See Commentary on OECD Model Tax Convention (July 2010) Article 9,
paragraph 7.) In practice, tax authorities consider requests for corresponding
adjustments under mutual agreement procedures (MAP) included in the relevant
double tax treaty (DTT), in order to address the economic double taxation caused
by a transfer pricing adjustment.
DTTs 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.
Article 9 does not specify the method by which a corresponding adjustment
should be made and therefore the method used is left to the discretion of the
relevant tax authorities. 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 Tax
Convention (July 2010) Article 9, paragraph 7.) A corresponding adjustment can
be made in two ways: by recalculating the profits subject to tax in the second
territory that is party to the transaction (ie, making the corresponding adjustment in
the tax return) or by granting the associated party in the second territory tax relief
against its own tax paid for the additional tax arising from the primary adjustment.
(See commentary on OECD Model Tax Convention (July 2010) Article 9 paragraph
7.)
Once a tax authority has agreed to make a corresponding adjustment, timing
needs to be considered as the corresponding adjustment may either be passed in
the year during which the original transaction took place or an alternative year
such as the year in which the primary adjustment was determined. This issue is not
addressed by the OECD Model Tax Convention. (See commentary on OECD
Model Tax Convention (July 2010) Article 9, paragraph 10.) The former approach is
generally preferred as it achieves a matching of income and expenses and more
accurately reflects the economic position as it would have been if the controlled
transaction had been at arm's length. (See commentary on OECD Model Tax
Convention (July 2010) Article 9, paragraph 10.) Timing issues may also raise a
question as to whether a party to the transaction is entitled to interest on the
portion of the overpaid tax.
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 Tax
Convention (July 2010) Article 9 paragraph 10.)
21.4
Secondary Adjustments
Primary adjustments and their corresponding adjustments change the allocation
of taxable profits of MNEs for tax purposes as they result in the adjustment of tax
computations, where necessary, to reflect the position that would have existed
had the related party transaction taken place at arm's length. Unless these
adjustments in the tax computations are matched by payments between the
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affected parties, the economic circumstances of the parties will be distorted. This
distortion can have a significant and continuing impact on capital structure and
more generally on profit potential, and thus on future tax liabilities. To address this
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 redetermined 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. (OECD 2010 Transfer Pricing Guidelines paragraph 4.66). 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 2010 Transfer Pricing Guidelines paragraph 4.68).
The OECD Model Tax Convention does not address the topic of secondary
adjustments. (Commentary on OECD Model Tax Convention (July 2010) Article 9
paragraph 8). Secondary adjustments are however, discussed in the OECD
Guidelines although many countries do not actually require or recognise them.
(OECD 2010 Transfer Pricing Guidelines paragraphs 4.66-4.76).
The UK does not require secondary adjustments although the UK will consider
corresponding adjustments for secondary adjustments required by other
jurisdictions on their own merits. (SP1/11 paragraph 54).
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. (OECD 2010 Transfer Pricing
Guidelines paragraph 4.68). This example, taken from the OECD Guidelines,
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. (OECD 2010 Transfer Pricing Guidelines
Paragraph 4.67).
Tax Authority A could alternatively treat the additional profits as being a dividend
in which case withholding tax may apply.
Secondary adjustments are not a common occurrence. A questionnaire was
circulated to all member states by the European Union Joint Transfer Pricing Forum
in June 2011 to discuss secondary transfer pricing adjustments. Of the 27 member
states that responded to the questionnaire, only nine had legislation in place that
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Illustration 1
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 intercompany 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 S
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. 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
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In practice it is used where double taxation has arisen in areas for which it is the
specific purpose of the Convention to avoid double taxation (OECD Model Tax
Convention (July 2010), commentary to Article 25, paragraph 9).
Common scenarios of double taxation where MAP is required include:
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;
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Administration of MAP
MAP can be entered into either at the request of the taxpayer or the request of
the tax authorities.
i.
ii.
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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 arms 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.
In summary 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 also provides an alternative to MAP and
tax treaty arbitration, in dealing with the elimination of double taxation related to
adjustments of associated enterprise profits, and this is discussed further in the
sections below.
21.6
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The above time line is taken from the Commentary on OECD Model Tax
Convention (July 2010) Annex Sample Mutual Agreement on Arbitration: 2. Time
for submission of the case to Arbitration, Commentary Article 25(5).
21.7
EU Arbitration Convention
The EU Arbitration Convention, the convention on the elimination of double
taxation in connection with the adjustment of profits of associated enterprises
(90/436/EEC), was introduced in 1995 as a mechanism by which double taxation
arising from transfer pricing adjustments for transactions between two EU member
states would be eliminated. It should apply to all transactions although some
jurisdictions, such as Bulgaria and Italy, do not accept that it covers financial
transactions.
An application for relief under the EU Arbitration Convention should be made
within three years of the notification of the adjustment that is likely to lead to
double taxation. (See (90/436/EEC), Article 6 paragraph 1). 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.).
Article 4 of the EU Arbitration Convention includes similar wording to Article 9 of the
OECD Model Tax Convention. The conclusion reached under the EU Arbitration
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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;
ii.
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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.
Base Erosion and Profit Shifting (BEPS) action plan and MAP
Action 14 of the BEPS action plan released by the OECD in July 2013 looks at
making dispute mechanisms more effective. The aim of Action 14 is 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 target date to make changes to the OECD model DTC is September 2015.
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CHAPTER 22
AVOIDING DOUBLE TAXATION AND DISPUTE RESOLUTION II
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.
22.1
Introduction
An advance pricing arrangement (APA) is an administrative approach to avoiding
transfer pricing disputes from arising by agreeing in advance the criteria for
applying the arm's length principle to transactions. It is a procedural arrangement
between parties that differs from classic tax ruling procedures as it is more fact
specific. (See OECD 2010 Transfer Pricing Guidelines Annex to Chapter IV
paragraph 3). Agreeing an APA allows taxpayers to gain certainty over their tax
affairs from a transfer pricing perspective. The OECD Guidelines include
commentary on APAs in chapter IV, together with an annex to chapter IV,
adopted in 1999, 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 2010 Transfer Pricing Guidelines
paragraph 4.143).
22.2
What is an APA?
An APA is defined in the OECD Guidelines as an agreement between a taxpayer,
one or more associated enterprises and one or more tax administrations, to
determine in advance an appropriate set of criteria that satisfies all parties, and
can be used to determine arm's length transfer pricing for the transactions
covered by the APA over the duration of the agreement. (See OECD 2010 Transfer
Pricing Guidelines paragraph 4.123). An APA can be unilateral, bilateral or
multilateral, although tax administrations, where they allow APAs, generally prefer
bilateral or multilateral APAs. (See OECD 2010 Transfer Pricing Guidelines
paragraph 4.130).
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). When a taxpayer makes an
application for a unilateral APA it is recommended that, where a suitable treaty is
in place, the tax authority informs the competent authority of the other territory
and invites them to participate in a bilateral APA. (See OECD 2010 Transfer Pricing
Guidelines paragraph 4.129).
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.
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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 OECD 2010 Transfer Pricing Guidelines Annex
Chapter IV paragraphs 74-85).
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Unlike the UK, 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).
The IRS issues a quarterly report on the APA program. The report issued for 31
December 2011 showed that during that quarter 12 APA matters were completed
including one withdrawal, two unilateral APAs and nine bilateral APAs. As at 31
December 2011 the IRS had 445 APA matters open.
China
China began using APAs on a trial basis in the late 1990s however, the first bilateral
APA was not agreed until 2005. In 2010, the China Advance Transfer Pricing Annual
Report was issued covering APA arrangements from 2005 to 2009. This was
updated in 2012 to cover 2010. During this period, China had agreed 45 unilateral
APAs and 16 bilateral APAs of which eight were agreed in 2010. The number of
applications for APAs in China is expected to increase, especially the number
related to finance or intangible assets or services.
The State Administration of Taxation (SAT) has offered multiple reports giving
guidance on the APA process. The current guidance regarding the APA process
and procedures is provided in Articles 46 through 63 of Guoshuifa (2009) No. 2.
Access to the APA program is limited to the largest taxpayers, as an applicant's
annual related-party transactions must exceed RMB 40m. In the 2010 APA Annual
Report the SAT also states that during the term of the APA, if the enterprise's
overall profit level stays below the median most of the time, where an arm's length
range is used, the tax authority may no longer accept an application for renewal
of an APA.
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 Guidelines and as with the UK, prefiling 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.
In the case that an APA is not followed through to completion, a new chapter
protection of taxpayers' rights on confidentiality was introduced in 2010, whereby
non-factual information about the enterprise cannot be used in future tax
investigations of the transactions covered by the proposed APA. This should
encourage taxpayers to access the program.
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.
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.
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Under the APA provisions (Sections 92CC and 92CD of the Income Tax Act, 1961)
applicable from 1 July 2012 access to the APA program will be available to all
taxpayers falling within the ambit of Indian transfer pricing legislation as no
threshold limit is currently prescribed.
The central board of direct taxes has announced APA officers will be based in
Delhi, Mumbai and Bangalore. The APA team is initially a nine member team with
two officers each in Mumbai and Bangalore and five officers in Delhi. These
officers will report into a central commissioner of income tax designated as the
APA Director, who will be based in Delhi. Bilateral APAs will have to be approved
through the office of the competent authority.
As the APA regime is newly introduced there is still uncertainty surrounding the
Indian APA scheme and thus far, only a basic framework has been provided in the
2012 Budget. It is also anticipated that the minimum fee level for the APA
application would be approximately INR 1 million (ie US$ 20,000) and would
increase in proportion with the value of the international transactions. Also the way
the basic rules read, provisions for rollback of the APA do not seem to be
available. The finer details of the APA regime such as the time frame, detailed
procedure, fees or whether APAs will be bilateral or unilateral are yet to be
released and thus taxpayers cannot yet access the APA route until the detailed
rules and forms are prescribed.
UK
In the UK, HMRC define an APA as a written agreement between a business and
the Commissioners of HMRC, which determines a method for resolving transfer
pricing issues in advance of a tax return being made. (See Statement of Practice
2/2010 paragraph 1). HMRC have published guidance on how they interpret APA
legislation and its practical application in Statement of Practice 2/2010 (the
contents of which are repeated in the HMRC International Tax Manual).
HMRC have operated an APA programme since 1999 (Statement of Practice
2/2010 paragraph 50) and so now have considerable experience of working on
and negotiating APAs. The APA program is open to UK taxpayers, including a nonresident 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
Guidelines 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. (OECD 2010
Transfer Pricing Guidelines paragraph 4.158)
Even though transactions where both parties are within the UK have been subject
to transfer pricing legislation since April 2004, they are not generally included in
APAs, apart from a few exceptions such as oil-related ring fenced trades.
(Statement of Practice 2/2010 paragraph 16).
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 Tax
Convention. 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.
Statement of Practice 2/2010 gives guidance on this process in the UK. HMRC
recommend that any enterprise that is considering entering into the APA process
should first express their interest and informally discuss their transfer pricing issues
with HMRC. (Statement of Practice 2/2010 paragraph 18). The information that
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2009/10
32
3
2
20
56
20.3
16.5
2010/11
49
1
2
35
67
22.7
14.0
2011/12
32
0
1
32
66
16.9
10.7
An applicant can withdraw from the APA application process at any time before
a final agreement is achieved. However, if an agreement cannot be achieved, a
formal statement recording the reasons for this will be prepared.
A taxpayer will be required to send an annual report with their annual tax return to
their normal tax office. (Statement of Practice 2/2010 paragraph 42). The required
contents will be agreed as part of the APA process. HMRC have stated that a
renewal application should be made not later than six months before expiry of its
existing term. (Statement of Practice 2/2010 paragraph 48).
The UK also has advance thin capitalisation agreements (ATCA) which are a form
of unilateral APA. Other than ATCAs, the UK previously favoured bilateral APAs
although there has been a softening of this attitude in the latest Statement of
Practice.
An ATCA is a unilateral APA, which is governed by the APA legislation in the UK,
although the ATCA application process is subject to separate guidance and is
separately administered. Guidance on the ATCA process is included in Statement
of Practice 01/12, which is supplemented by the Revenue & Customs Brief 01/09.
Further guidance has been issued in the HMRC Manuals. (HMRC Manual
INTM573000 onwards).
An ATCA is a process designed to help resolve financial transfer pricing issues.
(Statement of Practice 01/12 paragraph 11). It can be used to agree in advance
whether or not HMRC considers that a company is thinly capitalised and what
transfer pricing adjustments are required to affect an arm's length result.
The process for entering into an ATCA with HMRC is similar to that of other APAs
described above, although a taxpayer is more likely to make the first approach to
HMRC by way of a formal written application than as an expression of interest. In
this sense, HMRC's permission is not required to make an ATCA application.
22.4
Conclusion
As we discussed at the beginning of the chapters on double taxation taxpayers
will need to consider the various ways in which the risk of double taxation can be
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CHAPTER 23
ROLE OF STRATEGIC & MANAGERIAL TRANSFER PRICING
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.
23.1
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:
23.2
Public affairs
Business decisions
Management incentives
Customs Duties
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jurisdictions. However, its impact was clear; the brand reputation of each of the
parties under scrutiny was tainted. Indeed the response was such that Starbucks
even volunteered to pay additional tax in the UK, whilst not seeking relief for
those payments with the Netherlands (the counterparty to its transactions).
In many ways, the companies identified by the Public Accounts Committee could
consider themselves unlucky. There are many other multinational groups with
similar transfer pricing arrangements. Indeed, following on from this, a number of
other companies, including Apple and Rolls Royce, came under the public
spotlight for the amount of taxes paid.
Nevertheless, the consequences of this shift are likely to be felt by all taxpayers. 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. It has driven the OECD to indicate it will consider
significant changes to the way it approaches Base Erosion and Profit Shifting
(where transfer pricing is considered along with more structured tax planning
techniques), whilst governments, including the UK, are considering 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 boardlevel 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.
23.3
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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. Consider a number of examples of decisions that
a company might face:
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.
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those returns through tax risk management. Transfer pricing should not be driving
key business decisions. Nevertheless, it is a significant factor to be considered.
PART FINISHED PRODUCT
ENTITY A
Part finished
product
ENTITY B
Finished product &
Marketing
Transfer Price
23.4
Illustration 1
Contract manufacturer
Take the case of a simple contract manufacturing operation, producing products
solely on behalf of a Principal company.
Contract
manufacturer
Product
Payment
Principal
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Whilst this may create more profit for the manufacturer, this is reduces overall
profitability for the group.
It may be that transfer prices are based on budgeted costs.
In such
circumstances, the manufacturer could strive to operate more efficiently in order
to lower actual cost compared to budget. However, such efforts would only
temporarily increase profits as the new efficiencies would be factored into prices in
the following budget cycle.
The natural conclusion is therefore that plant management shouldnt be
incentivised on profitability, but instead be measured on performance against
factors that they can control, such as quality and efficiency. These factors would
contribute to the groups overall profitability. This is generally straightforward
where a plant is initially set up as a contract manufacturer. However, where a
plant is converted to contract manufacturer as part of a business restructuring, this
can cause conflict. Under such circumstances, the role/responsibility of the
manufacturer is reduced and as such the scope of responsibility for the
management of the manufacturer is reduced (with potential impact to salary and
business), creating potential conflict.
Illustration 2
Fully-fledged manufacturer
Consider now the case of a fully-fledged manufacturer selling direct to distributors.
Fully-fledged
manufacturer
Product
Payment
(Price A)
Related Party
Distributor (Country A)
Payment
(Price B)
Related Party
Distributor (Country
B)
Payment
(Price C)
Third Party Distributor
(Country C)
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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
Now lets consider the impact of a procurement company
Third Party Supplier
Material
Payment
(Price A)
Fully-fledged
Manufacturer
Material
Payment (Price C)
Payment
(Price B)
Related Party
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 is sources from the Supplier. Given its size, it is able
to negotiate Price A as the price for the Material.
Now assume that the group establishes Procurement Company to strategically
manage purchasing and leverage from the groups global spend. Although the
fully fledged manufacturer in this case is the largest manufacturer in the group, by
combining its requirements with those of other manufacturing sites, it is able to
negotiate a slightly lower price (Price B).
The Procurement Company then purchases the materials 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 the 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.
Such a scenario creates a conflict. If the management of the fully fledged
manufacturer in question are seeking to maximise their own profit, they will
negotiate their own supply at Price A. However, if their requirements are removed
from the spend managed by the Procurement Company, then the Procurement
Company will not be able to negotiate as good a price, and as a result overall
group profit will reduce.
Split of Management and Statutory Accounts
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 two operate with two sets of transfer
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prices one for statutory reporting purposes and the other 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 preferred internal transfer price is generally a function of the tax-admissible
price and the corporate income tax rates that apply in the jurisdictions the firms
divisions operates in.
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 timeconsuming and burdensome to run two sets of accounts. It adds complexity to
the management of the business that may be difficult to justify.
Secondly, and arguably more importantly, a transfer pricing framework should
reflect the economic reality of a business. If there is a need for a set of
management accounts that significantly diverges from the statutory accounts, it is
a strong indication that the pricing method used for the statutory accounts is not
arms length.
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.
Therefore, caution should be exercised before using separate management and
statutory accounts. In some cases, it is unavoidable. However the very existence
of separate management accounts and incentivisation structures can create
significant risk to the transfer pricing framework.
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23.5
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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.
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CHAPTER 24
LATEST DEVELOPMENTS IN TRANSFER PRICING
In this chapter we look at some of the latest developments in transfer pricing including:
transfer pricing in the news;
the OECD report on Base Erosion and Profit Shifting (BEPS)
Timing issues
OECD work on intangibles
exchange of information article 26
UN transfer pricing manual
OECD draft handbook on transfer pricing risk assessment.
24.1
The Starbucks group had an agreement with the Dutch authorities that
allowed it to pay a very low tax rate on its operation there. Reports indicate
that a licensing fee of 4.7% (formerly 6%) of sales was routed through the
Dutch roasting operation.
Starbucks's Swiss coffee trading unit charged group companies a 20% mark-up
on coffee beans. The Lausanne-based unit apparently bought 428 million
pounds of coffee beans for an average $2.38 per pound in 2011, suggesting a
total coffee bill of over $1 billion and income of more than $ 200 million for the
Swiss unit, which employs 30 people.
Google operated its European business out of Republic of Ireland using its
12.5% corporation tax rate. The Google Irish company was paying a fee to a
separate Dutch company within the Group.
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Similarly in France there has been press comment on the transfer pricing practises
and the use of low tax jurisdictions of Google, Amazon and Facebook.
In October 2012 the U.S. Senate Permanent Subcommittee investigated the
shifting of profits to low tax jurisdictions by US based multi-nationals.
Case studies of offshore tax avoidance schemes by Microsoft and HewlettPackard featured at the subcommittee hearing. The hearing concluded with a
statement by Senator Levin, in which he referred to multinationals' transfer pricing
arrangements as gimmicks, dubious transactions, and legal fictions.
The release of this information has created a perception that tax planning
(including transfer pricing) is reducing countries tax bases by moving profits to low
tax jurisdictions. In response to this in Europe the G20 finance ministers have asked
the OECD to look at the current international tax rules and make
recommendations to ensure multinational groups pay a fair amount of tax in the
countries in which they operate their businesses.
On 12 February 2013 OECD published a report entitled Addressing Base Erosion
and Profit Shifting (BEPS) which was targeted at addressing the problem of multinational groups using current international tax rules to ensure profits are
predominantly taxed in low tax jurisdictions and not in the countries where the
group sells its products or services. See below for more detail.
The OECD report was reviewed at a meeting of G20 Finance Ministers in Moscow
on 15-16 February 2013. Subsequently a letter from George Osborne, Pierre
Moscovici and Wolfgang Schuble was published in Financial Times on 16
February 2013 entitled We are determined that Multinationals will not avoid tax.
The letter states the following:
It found that the practices that some multinational enterprises use to reduce
their tax liabilities have become more aggressive over the past decade. Some
multinationals are exploiting the transfer pricing or treaty rules to shift profits to
places with no or low taxation, allowing them to pay as little as 5 per cent in
corporate taxes while smaller businesses are paying up to 30 per cent.
The letter goes on to say it will address this by setting up three working groups.
These are as follows:
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24.2
transfer pricing;
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The current relevant projects of the OECD will be accelerated. These are on
the following topics:
Finally, the OECD have issued a report on Timing Differences relating to Transfer
Pricing which is discussed below.
24.3
Timing Issues
Introduction
The issue of price checking versus price testing has been examined by the OECD
together with the choice of comparables in a recent report which is discussed
below. The following section examines the existing practises relating to the timing
of pricing and of choice of comparables.
Price checking versus price setting
In the 2010 OECD Guidelines one of the unresolved issues is whether tax payers
can rely on a price setting methodology or whether they should test the outcomes
of the methodology.
This issue is discussed in the 2010 OECD Guidelines paragraphs 3.67 to 3.70. The
price setting approach looks at information available at the date prices are set
using updated historical data (the price setting approach). The alternative is to
test the prices at a later date usually as part of the tax return process (the price
testing approach).
The 2010 OECD Guidelines fail to conclude on which the preferred method is and
recognises that tax authorities can take different approaches. However other
sections of the Guidelines appear to take a position on this issue. (In paragraph
9.44 the 2010 OECD Guidelines recognise that companies set prices using one
method but then another method can be used to test the outcome of the price
setting mechanism.)
True-ups
A second timing issue is the use of true-ups made by companies to ensure the
results achieved are adjusted to an arms length result. US taxpayers may make
upward or downward price adjustments in a tax return in order to get the transfer
prices right. However although year-end adjustments are accepted on an
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administrative level by most EU member states, no legal right exists to make them.
Sometimes the acceptance of setting or testing will be determined by the most
favourable result for the taxing authority.
As recognised in the Guidelines, in practise one transfer pricing policy is often used
for Price Setting when the inter-company transaction is entered into. However,
because of the lack of available third party comparable data, a separate transfer
pricing method is applied to carry out the price checking to ensure compliance
with the arm's length principle. One example of this is where prices are set using an
estimated gross margin (the resale price method) and then tested using the
transactional net margin method.
In 2011 the European Joint Transfer Pricing Forum issued a questionnaire to
member states tax administrations on their treatment of transfer pricing
adjustments. 8 member states had guidance on compensating adjustments. 1
intended to introduce guidance. The responses can be found at
http://ec.europa.eu/taxation_customs/resources/documents/taxation/company_
tax/transfer_pricing/forum/jtpf/2013/jtpf_019_rev1_2011_en.pdf
Use of Hindsight
A third timing issue is that the OECD Guidelines currently state that tax authorities
should not use the benefit of hindsight especially when valuation issues are
involved (paragraph 3.74). One unresolved issue is whether the valuation of a
transaction was so uncertain or fundamental changes occurred that, in a third
party arrangement, there would have been a renegotiation of the contractual
terms relating to the transaction. No specific answer is given on this issue other
than the tax authorities should not use the benefit of hindsight. This contrasts with
the approach taken by the US tax authorities (discussed below) where they can
apply the commensurate with income rule i.e. effectively hindsight can be used to
check whether a valuation was arm's length.
Report on Timing Issues Relating to Transfer Pricing (Revisions to existing
Paragraphs 3.67 to 3.70)
This draft report was released by the OECD on 6th June 2012. It can be
downloaded at http://www.oecd.org/tax/transfer-pricing/50519380.pdf
The OECD have identified the following issues resulting from the two different
approaches to pricing (setting versus testing):
The valuation of intangibles where the value is uncertain at the date the
transaction (see paragraphs 6.28 to 6.35 of the Guidelines). Specifically,
whether tax administrations should be permitted to assume the existence of a
renegotiation, price adjustment clause, milestone payment, or other risk
sharing mechanism within an agreement (other than under paragraph 1.65
recharacterisation of transactions which is discussed below).
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24.4
Patents
Group synergies
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A few tax authorities still argue that legal ownership is key and should be
followed regardless of who has paid. This appears more and more out of step
with international practise on transfer pricing.
Revised Guidelines
In the revised Guidelines the following factors should be considered in deciding
which companies in a group are entitled to the intangible related returns:
whether the functions performed, the assets used, the risks assumed, and the
costs incurred by members of the group in developing, enhancing,
maintaining and protecting intangibles are in alignment with the allocation of
entitlement to intangible related returns in the relevant registrations and
contracts;
The new draft Guidelines go on to set out the following tests for a company to be
entitled to the intangible return. The company should be responsible for the
following:
Incurring and controlling the risks and costs related to developing and
enhancing the intangible; and,
Incurring and controlling risks and costs associated with maintaining and
protecting its entitlement to intangible related returns.
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The inference is that it will be necessary to identify where employees perform the
key functions, relating to the important day-to-day decision making and significant
high value contributions. This is quite a radical change and if adopted could
impact groups where intangibles are held in specialised companies. Here the
group will have to check the substance of those operations e.g. the staff of those
companies have the seniority, capability and authority to undertake the required
activities.
Distributor intangibles
The proposed revised Guidelines discuss marketing intangibles and the entitlement
to a share of the return from those intangibles. The proposed test is what an
independent distributor would obtain in comparable circumstances.
Pricing
Comparability analysis
The draft makes the following points on comparability analysis for intangibles:
There should be a two sided analysis for transactions involving the use or
transfer of intangibles.
Exclusivity
Geographic scope
Useful life
Stage of development
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24.5
24.6
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Chapter 1 Introduction
Chapter 5 Comparability
Chapter 6 Methods
Chapter 7 Documentation
Chapter 8 Audits
Appendix II Documentation
It is not possible to summarise every chapter here. Instead specific themes have
been identified that are pointing towards global trends in transfer pricing.
Chapter 5: Control over risk
The UN manuals have adopted the approach to risk that OECD in its report on
Intangibles and previous reports on restructuring has 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 manual states that in any transfer pricing study it is necessary to identify risk
and which party bears the risk. Tax authorities have to check that the allocation of
risk within group contracts reflects the actual allocation of risk. This contractual
allocation should be arms length. The concept of control over risk is also
introduced to determine an arms 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.
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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 and
refers to the relative bargaining position of the group is offered as one solution to
how to do this split.
China and India contributions to the UN manual: Location savings
China has also contributed a section Location specific advantages together with
examples.
It defines location savings as the net cost savings derived by a multinational group
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
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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.
In addition India also provides the following Location Specific Advantages (LSAs) in
addition to location savings: highly specialised skilled manpower and knowledge,
access and proximity to growing local/regional market, large customer base with
increased spending capacity, superior information network, superior distribution
network, incentives and market premium.
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.
India contributions to the UN manual: Market intangibles
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 (2013). 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.
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The report is some 40 pages long and is split into 5 key areas.
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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.
1.1
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1.2
1.3
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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.
Despite DSG maintaining that remuneration of the relevant parties could be
warranted as arm's length by providing a number of external comparables to the
pricing of the transaction, the Commissioners found that these prices were
inappropriate and it was not possible to make reasonably accurate adjustments
to the benchmarked prices such that they were directly comparable with the
tested transaction. Inadequacies found in the presented comparables revolved
around a number of areas, including DSG's dominance in the UK marketplace, the
relative complexity of the contractual arrangements, the wide variations in claim
rates across the product lines in question, and the significance of the gross retail
price that could be charged for the warranty, relative to which the retailer's
commission is generally expressed as a percentage.
The Commissioners subsequently determined that, in the absence of suitable
comparables, adjustments to DSG's profit for the relevant periods could only
reliably be made using a profit-split methodology. Application of this method was
specifically warranted by the relative bargaining power of the parties, with
particular note being made of the renegotiation of the arrangement during the
Cornhill period, when in 1993 Cornhill increased the commission paid to CISL, whilst
not requiring or seeking any equivalent renegotiation of the ceding commission
paid to it by DISL. Following on from this case, the concept of relative bargaining
power now forms an important element of HMRC's operational guidelines for TP
enquiries. On this basis, particular care needs to be taken when considering
pricing of transactions, as well as identification of potential comparable
unconnected 3rd parties for comparability, to the extent that a tested party may
have a particularly strong or weak bargaining power when undertaking a
transaction at arm's length rather than with a connected 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.
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1.4
1.5
1.6
General Electric Capital Canada Inc. v. The Queen (2009) DTC 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.
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1.7
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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.
1.8
1.9
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1.10
KHO:2010:73
A Finnish company replaced its external borrowings, on which it was paying
interest of a little over 3%, with an internal loan from a Swedish member of the
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.
1.11
1.12
1.13
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1.14
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1.15
1.16
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1.17
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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.
With regards to the expert witnesses the court said:
Because proper income allocations cannot be determined from the
transaction evidence presented by the parties, we must look to opinions of
their experts. As we have frequently stated, we are not bound by the opinion
of any expert witness. We may accept an expert's opinion or we may reject
testimony that is contrary to our own judgment. See, e.g., Estate of Hall v.
Commissioner, 92T.C. 312, 338 (1989). Further, We are not restricted to
choosing the opinion of one expert over another, but may extract relevant
findings from each in drawing our own conclusions. Bausch & Lomb, Inc. v.
Commissioner, 92 T.C. 525, 597(1989), affd. 933 F.2d 1084 (2d Cir. 1991).
The court allowed some amendments to the transfer price; however the majority
of the location savings were allowed to remain in Asia.
1.18
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1.19
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
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the other party, in this case the Indian tax payer Ranbaxy, then that should be
used. Note that in India there is publically 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.
1.20
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
1.21
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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.
1.22
1.23
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.
Veritas Software, which is in the business of developing, manufacturing, marketing,
and selling software products, went through several corporate changes a few
years back; mostly notably, it was purchased by Symantec Corp. on July 2, 2005.
Prior to that, on November 3, 1999, Veritas Software assigned all its existing sales
agreements with its European-based sales subsidiaries to a new corporation
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Veritas Ireland. In addition, on the same date, Veritas Software and Veritas Ireland
entered into a research and development agreement, as well as a technology
license agreement.
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.
Veritas used agreements between Veritas Software and certain original
equipment manufacturers (OEMs) as comparables. The IRS contended that the
OEM agreements involve substantially different intangibles. But the court
disagreed: it concluded that, collectively, the more than 90 unbundled OEM
agreements the parties stipulated were sufficiently comparable to the controlled
transaction.
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.
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Waterloo that the phrase business facility is a commercial not a legal term,
andthat where a commercial term is used in legislation, the test of ordinary
business might require an aggregation of transactions which transcended their
juristic individuality. HMRC's stated position is now that it does not matter that
business facilities had been given and received, by way of a complex provision,
rather than being sold and bought, by way of a straightforward transaction.
Therefore there is no need to specifically identify a transaction between the
parent and the subsidiary, the relevant share scheme merely needs to provide a
defined, valuable and quantifiable benefit to the subsidiary employing the
relevant employees.
Secondly, Waterloo gave some guidance on the complex and frequently
contentious area of tax treatment and allocation of employee share option costs.
HMRC now considers that a facility is being provided no matter how the
arrangements are set up for administering and delivering a Group employee share
plan, and transfer pricing rules will subsequently apply under Waterloo, that
facility should be priced accordingly, with the provider receiving or imputing
receipts that reflect the full value of the facility it is providing. Detailed
commentary based in part on the Waterloo findings now form part of HMRC's
guidance on the pricing of share plans under IFRS accounting rules that apply to
accounting periods commencing on or after 1 January 2005.
1.25
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;
2.
3.
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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.
Therefore, as stated above, there is a risk that the existing US cost-sharing
regulations, which require stock-based compensation to be included in the pool of
costs to be shared between the parties, are not in line with the arm's length
standard as set out by the OECD Guidelines.
1.26
Zimmer case
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.
Key points arising from the case:
Where the wording of the commissionaire agreement follows the legal nature
of a commissionaire, in accordance with French civil and commercial
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The decision is based on legal principles and does not look at what is actually
happening in the business and how it actually operates.
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APPENDIX 2
CONVENTION on the elimination of double taxation in connection with the
adjustment of profits of associated enterprises (90/436/EEC)
THE HIGH CONTRACTING PARTIES TO THE TREATY ESTABLISHING THE EUROPEAN
ECONOMIC COMMUNITY,
DESIRING to give effect to Article 220 of that Treaty, by virtue of which they have
undertaken to enter into negotiations with one another with a view to securing for
the benefit of their nationals the elimination of double taxation,
CONSIDERING the importance attached to the elimination of double taxation in
connection with the adjustment of profits of associated enterprises,
HAVE DECIDED to conclude this Convention, and to this end have designated as
their Plenipotentiaries:
HIS MAJESTY THE KING OF THE BELGIANS:
Philippe de SCHOUTHEETE de TERVARENT,
Ambassador Extraordinary and Plenipotentiary;
HER MAJESTY THE QUEEN OF DENMARK:
Niels HELVEG PETERSEN,
Minister for Economic Affairs;
THE PRESIDENT OF THE FEDERAL REPUBLIC OF GERMANY:
Theo WAIGEL,
Federal Minister for Finance;
Juergen TRUMPF,
Ambassador Extraordinary and Plenipotentiary;
THE PRESIDENT OF THE HELLENIC REPUBLIC:
Ioannis PALAIOKRASSAS,
Minister for Finance;
HIS MAJESTY THE KING OF SPAIN:
Carlos SOLCHAGA CATALN,
Minister for Economic Affairs and Finance;
THE PRESIDENT OF THE FRENCH REPUBLIC:
Jean VIDAL,
Ambassador Extraordinary and Plenipotentiary;
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3. Paragraph 1 shall also apply where any of the enterprises concerned have
made losses rather than profits.
Article 2
1. This Convention shall apply to taxes on income.
2. The existing taxes to which this Convention shall apply are, in particular the
following:
a. in Belguim:
b. in Denmark:
selskabsskat,
kommunale indkomstskat,
amtskommunal indkomstskat,
saerlig indkomstskat,
kirkeskat,
udbytteskat,
renteskat,
royaltyskat,
frigoerelsesafgift;
Einkommensteuer,
Koerperschaftsteuer,
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d. in Greece:
e. in Spain:
f. in France:
g. in Ireland:
Income Tax,
Corporation Tax;
h. in Italy:
i. in Luxembourg:
j. in the Netherlands
inkomstenbelasting,
vennootschapsbelasting;
k. in Portugal:
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Income Tax,
Corporation Tax.
3. The Convention shall also apply to any identical or similar taxes which are
imposed after the date of signature thereof in addition to, or in place of existing
taxes. The competent authorities of the Contracting States shall inform each other
of any changes made in the respective domestic laws.
CHAPTER II GENERAL PROVISIONS
Section I Definitions
Article 3
1. For the purposes of this Convention: competent authority shall mean:
in Belgium:
De Minister van Financin or an authorized representative,
Le Ministre des Finances or an authorized representative,
in Denmark:
Skatteministeren or an authorized representative,
in Greece:
O Ypoyrgos ton Oikonomikon or an authorized representative,
in Spain:
El Ministro de Economa y Hacienda or an authorized representative,
in France:
Le Ministre charg du budget or an authorized representative,
in Ireland:
The Revenue Commissioners or an authorized representative,
in Italy:
Il Ministro delle Finanze or an authorized representative,
in Luxembourg:
Le Ministre des Finances or an authorized representative,
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in the Netherlands:
De Minister van Financin or an authorized representative,
in Portugal:
O Ministro das Finanas or an authorized representative,
2. Any term not defined in this Convention shall, unless the context otherwise
requires, have the meaning which it has under the double taxation convention
between the States concerned.
Section II
Principles applying to the adjustment of profits of associated enterprises and to the
attribution of profits to permanent establishments
Article 4
The following principles shall be observed in the application of this Convention:
1.
Where:
a.
b.
2.
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Article 5
Where a Contracting State intends to adjust the profits of an enterprise in
accordance with the principles set out in Article 4, it shall inform the enterprise of
the intended action in due time and give it the opportunity to inform the other
enterprise so as to give that other enterprise the opportunity to inform in turn the
other Contracting State.
However, the Contracting State providing such information shall not be prevented
from making the proposed adjustment.
If after such information has been given the two enterprises and the other
Contracting State agree to the adjustment, Articles 6 and 7 shall not apply.
Section III Mutual agreement and arbitration procedure
Article 6
1. Where an enterprise considers that, in any case to which this Convention
applies, the principles set out in Article 4 have not been observed, it may,
irrespective of the remedies provided by the domestic law of the Contracting
States concerned, present its case to the competent authority of the Contracting
State of which it is an enterprise or in which its permanent establishment is situated.
The case must be presented within three years of the first notification of the action
which results or is likely to result in double taxation within the meaning of Article 1.
The enterprise shall at the same time notify the competent authority if other
Contracting States may be concerned in the case. The competent authority shall
then without delay notify the competent authorities of those other Contracting
States.
2. If the complaint appears to it to be well-founded and if it is not itself able to
arrive at a satisfactory solution, the competent authority shall endeavour to resolve
the case by mutual agreement with the competent authority of any other
Contracting State concerned, with a view to the elimination of double taxation on
the basis of the principles set out in Article 4. Any mutual agreement reached shall
be implemented irrespective of any time limits prescribed by the domestic laws of
the Contracting States concerned.
Article 7
1. If the competent authorities concerned fail to reach an agreement that
eliminates the double taxation referred to in Article 6 within two years of the date
on which the case was first submitted to one of the competent authorities in
accordance with Article 6 (1), they shall set up an advisory commission charged
with delivering its opinion on the elimination of the double taxation in question.
Enterprises may have recourse to the remedies available to them under the
domestic law of the Contracting States concerned; however, where the case has
so been submitted to a court or tribunal, the term of two years referred to in the
first subparagraph shall be computed from the date on which the judgment of the
final court of appeal was given.
2. The submission of the case to the advisory commission shall not prevent a
Contracting State from initiating or continuing judicial proceedings or proceedings
for administrative penalties in relation to the same matters.
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3. Where the domestic law of a Contracting State does not permit the competent
authorities of that State to derogate from the decisions of their judicial bodies,
paragraph 1 shall not apply unless the associated enterprise of that State has
allowed the time provided for appeal to expire, or has withdrawn any such appeal
before a decision has been delivered. This provision shall not affect the appeal if
and in so far as it relates to matters other than those referred to in Article 6.
4. The competent authorities may by mutual agreement and with the agreement
of the associated enterprises concerned waive the time limits referred to in
paragraph 1.
5. In so far as the provisions of paragraphs 1 to 4 are not applied, the rights of each
of the associated enterprises, as laid down in Article 6, shall be unaffected.
Article 8
1. The competent authority of a Contracting State shall not be obliged to initiate
the mutual agreement procedure or to set up the advisory commission referred to
in Article 7 where legal or administrative proceedings have resulted in a final ruling
that by actions giving rise to an adjustment of transfers of profits under Article 4
one of the enterprises concerned is liable to a serious penalty.
2. Where judicial or administrative proceedings, initiated with a view to a ruling
that by actions giving rise to an adjustment of profits under Article 4 one of the
enterprises concerned was liable to a serious penalty, are being conducted
simultaneously with any of the proceedings referred to in Articles 6 and 7, the
competent authorities may stay the latter proceedings until the judicial or
administrative proceedings have been concluded.
Article 9
1. The advisory commission referred to in Article 7 (1) shall consist of, in addition to
its Chairman:
where that person has, or has had, a large holding in or is or has been an
employee of or adviser to one or each of the associated enterprises,
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where that person does not offer a sufficient guarantee of objectivity for the
settlement of the case or cases to be decided.
4. The list of independent persons of standing shall consist of all the independent
persons nominated by the Contracting States. For this purpose each Contracting
State shall nominate five persons and shall inform the Secretary-General of the
Council of the European Communities thereof.
Such persons must be nationals of a Contracting State and resident within the
territory to which this Convention applies. They must be competent and
independent.
The Contracting States may make alterations to the list referred to in the first
subparagraph; they shall inform the Secretary-General of the Council of the
European Communities thereof without delay.
5. The representatives and independent persons of standing appointed in
accordance with paragraph 1 shall elect a Chairman from among those persons
of standing on the list referred to in paragraph 4, without prejudice to the right of
each competent authority concerned to object to the appointment of the person
of standing thus chosen in one of the situations referred to in paragraph 3.
The Chairman must possess the qualifications required for appointment to the
highest judicial offices in his country or be a jurisconsult of recognized
competence.
6. The members of the advisory commission shall keep secret all matters which
they learn as a result of the proceedings. The Contracting States shall adopt
appropriate provisions to penalize any breach of secrecy obligations. They shall,
without delay inform the Commission of the European Communities of the
measures taken. The Commission of the European Comunities shall inform the
other Contracting States.
7. The Contracting States shall take all necessary steps to ensure that the advisory
commission meets without delay once cases are referred to it.
Article 10
1. For the purposes of the procedure referred to in Article 7, the associated
enterprises concerned may provide any information, evidence or documents
which seem to them likely to be of use to the advisory commission in reaching a
decision. The enterprises and the competent authorities of the Contracting States
concerned shall give effect to any request made by the advisory commission to
provide information, evidence or documents. However, the competent authorities
of any such Contracting State shall not be under any obligation:
a.
to carry out administrative measures at variance with its domestic law or its
normal administrative practice;
b.
to supply information which is not obtainable under its domestic law or in its
normal administrative practice;
or
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the profits are included in the computation of taxable profits in one State only;
or
b.
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Article 17
This Convention will be ratified by the Contracting States. The instruments of
ratification will be deposited at the office of the Secretary-General of the Council
of the European Communities.
Article 18
This Convention shall enter into force on the first day of the third month following
that in which the instrument of ratification is deposited by the last signatory State to
take that step. The Convention shall apply to proceedings referred to in Article 6
(1) which are initiated after its entry into force.
Article 19
The Secretary-General of the Council of the European Communities shall inform
the Contracting States of:
a.
b.
c.
Article 20
This Convention is concluded for a period of five years. Six months before the
expiry of that period, the Contracting
States will meet to decide on the extension of this Convention and any other
relevant measure.
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Article 21
Each Contracting State may, at any time, ask for a revision of this Convention. In
that event, a conference to revise the Convention will be convened by the
President of the Council of the European Communities.
Article 22
This Convention, drawn up in a single original in the Danish, Dutch, English, French,
German, Greek, Irish, Italian, Portuguese and Spanish languages, all 10 texts being
equally authentic, shall be deposited in the archives of the General Secretariat of
the Council of the European Communities. The Secretary-General shall transmit a
certified copy to the Government of each Signatory State.
FINAL ACT
THE PLENIPOTENTIARIES OF THE HIGH CONTRACTING PARTIES,
meeting at Brussels, on the twenty-third day of July nineteen hundred and ninety,
for the signature of the Convention on the elimination of double taxation in
connection with the adjustment of profits of associated enterprises,
have, on the occasion of signing the said Convention:
a.
b.
taken note of the following unilateral Declarations attached to this Final Act:
na
daoine
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lmh
leis
an
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In fede di che, i sottoscritti hanno apposto le loro firme in calce al presente atto
finale.
Ten blijke waarvan de ondergetekenden hun handtekening onder deze Slotakte
hebben gesteld.
Em f do que os abaixo assinados apuseram as suas assinaturas no final do
presente Acto Final.
Hecho en Bruselas, el veintitrs de julio de mil novecientos noventa.
Udfaerdiget i Bruxelles, den treogtyvende juli nitten hundrede og halvfems.
Geschehen zu Bruessel am dreiundzwanzigsten Juli neunzehnhundertneunzig.
iEgine stis Vryxelles, stis eikosi treis Ioylioy chilia enniakosia eneninta.
Done at Brussels on the twenty-third day of July in the year one thousand nine
hundred and ninety.
Fait Bruxelles, le vingt-trois juillet mil neuf cent quatre-vingt-dix.
Arna dhanamh sa Bhruisil, an tr l fichead de Iil, mle naoi gcad ncha.
Fatto a Bruxelles, add ventitr luglio millenovecentonovanta.
Gedaan te Brussel, de drientwintigste juli negentienhonderd negentig.
Feito em Bruxelas, em vinte e trs de Julho de mil novecentos e noventa.
Pour Sa Majest le Roi des Belges
Voor Zijne Majesteit de Koning der Belgen
For Hendes Majestaet Danmarks Dronning
Fuer den Praesidenten der Bundesrepublik Deutschland
Gia ton Proedro tis Ellinikis Dimokratias
Por Su Majestad el Rey de Espaa
Pour le prsident de la Rpublique franaise
For the President of Ireland
Thar ceann Uachtarn na hireann
Per il presidente della Repubblica italiana
Pour Son Altesse Royale le Grand-Duc de Luxembourg
Voor Hare Majesteit de Koningin der Nederlanden
Pelo Presidente da Repblica Portuguesa
For Her Majesty the Queen of the United Kingdom of Great Britain and Northern
Ireland
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JOINT DECLARATIONS
Declaration on Article 4 (1)
The provisions of Article 4 (1) shall cover both cases where a transaction is carried
out directly between two legally distinct enterprises as well as cases where a
transaction is carried out between one of the enterprises and the permanent
establishment of the other enterprise situated in a third country.
Declaration on Article 9 (6)
The Member States shall be entirely free as regards the nature and scope of the
appropriate provisions they adopt for penalizing any breach of secrecy
obligations.
Declaration on Article 13
Where, in one or more of the Contracting States concerned, the decisions
regarding the taxation giving rise to the procedures referred to in Articles 6 and 7
have been altered after the procedure referred to in Article 6 has been
concluded or after the decision referred to in Article 12 has been taken and where
double taxation within the meaning of Article 1 results, account being taken of the
application of the outcome of that procedure or that decision, Articles 6 and 7
shall apply.
UNILATERAL DECLARATIONS
Declaration on Article 7
France and the United Kingdom declare that they will apply Article 7 (3).
Individual Declarations of the Contracting States on Article 8
Belgium
The term serious penalty means a criminal or administrative penalty in cases:
either of a common law offence committed with the aim of tax evasion,
Denmark
The concept of serious penalty means a penalty for the intentional infringement
of provisions of the Criminal Law or of special legislation in cases which cannot be
regulated by administrative means.
Cases of infringement of provisions of tax law may, as a general rule, be regulated
by administrative means where it is considered that the infringement will not entail
a punishment greater than a fine.
Germany
An infringement of the tax laws punishable by a serious penalty is constituted by
any infringement of the tax laws penalized by detention, criminal or administrative
fines.
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Greece
Under Greek legislation governing taxation, an undertaking is liable to severe
penalties:
1.
2.
3.
if it fails to supply the taxation details laid down in the Code on Taxation Data;
4.
5.
if it fails to keep accurately the books and records required by the Code on
Taxation Data, in so far as that inaccuracy has been noted in the course of a
regular check, the findings of which have been confirmed either by
administrative resolution of the discrepancy or because the period allowed for
an appeal has expired or as a result of a definitive decision by an
administrative tribunal, provided that during the management period
checked the discrepancy between gross income and the income declared is
more than twenty per cent (20 %) and in any case not less than one million (1
000 000) Greek drachmas;
6.
if it fails to observe the obligation to keep books and records as laid down in
the relevant provisions of the Code on Taxation Data;
7.
if it issues false or fictitious - or itself falsifies - invoices for the sale of goods or the
supply of services or any other taxation details as referred to in case 3 above.
A taxation document is regarded as false if it has been perforated or stamped
in any way without the proper authentication having been entered in the
relevant books of the competent tax authority, in so far as failure to make such
an entry has occurred in the knowledge that such authentication is required
for the taxation document. A taxation document is also regarded as false if
the content and other details of the original or the copy differ from those
which are recorded on the counterfoil of that document.
A taxation document is regarded as fictitious if it has been issued for a
transaction or part of a transaction, transfer or any other reason not recorded
in the total or for a transaction carried out by persons different from those
recorded in the taxation document;
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if it is aware of the intention of the action taken and collaborates in any way in
the production of false taxation documents or is aware that the documents
are false or fictitious and collaborates in any way in their issue or accepts the
false, fictitious or falsified taxation documents with the intention of concealing
material relevant to taxation.
Spain
The term serious penalties includes administrative penalties for serious tax
infringements, as well as criminal penalties for offences committed with respect to
the taxation authorities.
France
The term serious penalties includes criminal penalties and tax penalties such as
penalties for failure to make a tax return after receiving a summons, for lack of
good faith, for fraudulent practices, for opposition to tax inspection, for secret
payments or distribution, or for abuse of rights.
Ireland
Serious penalties shall include penalties for:
a.
b.
c.
d.
e.
f.
g.
The legislative provisions governing these offences, as at 3 July 1990, are as follows:
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Luxembourg
Luxembourg considers to be a serious penalty what the other Contracting State
considers to be so for the purposes of Article 8.
Netherlands
The term serious penalty means a penalty imposed by a judge for any action,
committed intentionally, which is mentioned in Article 68 of the General Law on
taxation.
Portugal
The terms serious penalties include criminal penalties as well as the further tax
penalties applicable to infringements committed with intent to defraud or in which
the fine applicable is of an amount exceeding 1 000 000 (one million) Portuguese
escudos.
United Kingdom
The United Kingdom will interpret the term serious penalty as comprising criminal
sanctions and administrative sanctions in respect of the fraudulent or negligent
delivery of incorrect accounts, claims or returns for tax purposes.
Declaration by the Federal Republic of Germany on Article 16
The Government of the Federal Republic of Germany reserves the right to declare,
when lodging its instrument of ratification that the Convention also applies to Land
of Berlin.
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II
(Information)
COUNCIL
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
(2009/C 322/01)
THE COUNCIL OF THE EUROPEAN UNION AND THE REPRESENTATIVES OF THE GOVERNMENTS OF THE MEMBER
STATES, MEETING WITHIN THE COUNCIL,
HAVING REGARD to the Convention of 23 July 1990 on the elimination of double taxation in connection
with the adjustment of profits of associated enterprises (the Arbitration Convention),
ACKNOWLEDGING the need both for Member States, as Contracting States to the Arbitration Convention,
and for taxpayers to have more detailed rules to implement efficiently the Arbitration Convention,
NOTING the Commission Communication of 14 September 2009 on the work of the EU Joint Transfer
Pricing Forum (JTPF) in the period March 2007 to March 2009, based on the reports of the JTPF on
penalties and transfer pricing, and on the interpretation of some provisions of the Arbitration Convention,
EMPHASISING that this Code of Conduct is a political commitment and does not affect the Member States'
rights and obligations or the respective spheres of competence of the Member States and the European
Union resulting from the Treaty on European Union and the Treaty on the Functioning of the European
Union,
ACKNOWLEDGING that the implementation of this Code of Conduct should not hamper solutions at a more
global level,
Without prejudice to the respective spheres of competence of the Member States and the European Union,
this revised Code of Conduct concerns the implementation of the Arbitration Convention and certain
related issues concerning mutual agreement procedures under double taxation treaties between Member
States.
1. Scope of the Arbitration Convention
1.1. EU triangular transfer pricing cases
(a) For the purpose of this Code of Conduct, a EU triangular case is a case where, in the first stage of the
Arbitration Convention procedure, two EU competent authorities cannot fully resolve any double
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taxation arising in a transfer pricing case when applying the arm's length principle because an associated
enterprise situated in (an)other Member State(s) and identified by both EU competent authorities
(evidence based on a comparability analysis including a functional analysis and other related factual
elements) had a significant influence in contributing to a non-arm's length result in a chain of relevant
transactions or commercial/financial relations and is recognised as such by the taxpayer suffering the
double taxation and having requested the application of the provisions of the Arbitration Convention.
(b) The scope of the Arbitration Convention includes all EU transactions involved in triangular cases among
Member States.
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2. Admissibility of a case
On the basis of Article 18 of the Arbitration Convention, Member States are recommended to consider that
a case is covered by the Arbitration Convention when the request is presented in due time after the date of
entry into force of accession by new Member States to the Arbitration Convention, even if the adjustment
applies to earlier fiscal years.
3. Serious penalties
As Article 8(1) provides for flexibility in refusing to give access to the Arbitration Convention due to the
imposition of a serious penalty, and considering the practical experience acquired since 1995, Member
States are recommended to clarify or revise their unilateral declarations in the Annex to the Arbitration
Convention in order to better reflect that a serious penalty should only be applied in exceptional cases like
fraud.
4. The starting point of the three-year period (deadline for submitting the request according to
Article 6(1) of the Arbitration Convention)
The date of the first tax assessment notice or equivalent which results or is likely to result in double
taxation within the meaning of Article 1 of the Arbitration Convention, e.g. due to a transfer pricing
adjustment (1), is considered as the starting point for the three-year period.
As far as transfer pricing cases are concerned, Member States are recommended to apply this definition also
to the determination of the three-year period as provided for in Article 25.1 of the OECD Model Tax
Convention on Income and on Capital and implemented in the double taxation treaties between Member
States.
5. The starting point of the two-year period (Article 7(1) of the Arbitration Convention)
(a) For the purpose of Article 7(1) of the Arbitration Convention, a case will be regarded as having been
submitted according to Article 6(1) when the taxpayer provides the following:
(i) identification (such as name, address, tax identification number) of the enterprise of the Member
State that presents its request and of the other parties to the relevant transactions;
(ii) details of the relevant facts and circumstances of the case (including details of the relations
between the enterprise and the other parties to the relevant transactions);
(iii) identification of the tax periods concerned;
(iv) copies of the tax assessment notices, tax audit report or equivalent leading to the alleged double
taxation;
(v) details of any appeals and litigation procedures initiated by the enterprise or the other parties to
the relevant transactions and any court decisions concerning the case;
(vi) an explanation by the enterprise of why it considers that the principles set out in Article 4 of the
Arbitration Convention have not been observed;
(vii) an undertaking that the enterprise shall respond as completely and quickly as possible to all
reasonable and appropriate requests made by a competent authority and have documentation at
the disposal of the competent authorities; and
(1) Reservation: The tax authority Member from Italy considers the date of the first tax assessment notice or equivalent
reflecting a transfer pricing adjustment which results or is likely to result in double taxation within the meaning of
Article 1 as the starting point of the three-year period, since the application of the existing Arbitration Convention
should be limited to those cases where there is a transfer pricing adjustment.
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(viii) any specific additional information requested by the competent authority within two months upon
receipt of the taxpayer's request.
(b) The two-year period starts on the latest of the following dates:
(i) the date of the tax assessment notice, i.e. a final decision of the tax administration on the additional
income, or equivalent;
(ii) the date on which the competent authority receives the request and the minimum information as
stated under point (a).
6. Mutual agreement procedures under the Arbitration Convention
6.1. General provisions
(a) The arm's length principle will be applied, as advocated by the OECD, without regard to the immediate
tax consequences for any particular Member State.
(b) Cases will be resolved as quickly as possible having regard to the complexity of the issues in the
particular case in question.
(c) Any appropriate means for reaching a mutual agreement as expeditiously as possible, including face-toface meetings, will be considered. Where appropriate, the enterprise will be invited to make a presen
tation to its competent authority.
(d) Taking into account the provisions of this Code of Conduct, a mutual agreement should be reached
within two years of the date on which the case was first submitted to one of the competent authorities
in accordance with point 5(b) of this Code of Conduct. However, it is recognised that in some situations
(e.g. imminent resolution of the case or particularly complex transactions, or triangular cases), it may be
appropriate to apply Article 7(4) of the Arbitration Convention (providing for time limits to be
extended) to agree a short extension.
(e) The mutual agreement procedure should not impose any inappropriate or excessive compliance costs on
the person requesting it, or on any other person involved in the case.
6.2. EU triangular transfer pricing cases
(a) As soon as the competent authorities of the Member States have agreed that the case under discussion is
to be considered a EU triangular case, they should immediately invite the other EU competent
authority(ies) to take part in the proceedings and discussions as (an) observer(s) or as (an) active
stakeholder(s) and decide together which is their favoured approach. Accordingly, all information
should be shared with the other EU competent authority(ies) through for example exchanges of
information. The other competent authority(ies) should be invited to acknowledge the actual or
possible involvement of their taxpayer(s).
(b) One of the following approaches may be adopted by the competent authorities involved to resolve
double taxation arising from EU triangular cases under the Arbitration Convention:
(i) the competent authorities can decide to take a multilateral approach (immediate and full partici
pation of all the competent authorities concerned); or
(ii) the competent authorities can decide to start a bilateral procedure, whereby the two parties to the
bilateral procedure are the competent authorities that identified (based on a comparability analysis
including a functional analysis and other related factual elements) the associated enterprise situated
in another Member State that had a significant influence in contributing to a non-arm's length result
in the chain of relevant transactions or commercial/financial relations, and should invite the other
EU competent authority(ies) to participate as (an) observer(s) in the mutual agreement procedure
discussions; or
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(iii) the competent authorities can decide to start more than one bilateral procedure in parallel and
should invite the other EU competent authority(ies) to participate as (an) observer(s) in the
respective mutual agreement procedure discussions.
Member States are recommended to apply a multilateral procedure to resolve such double taxation cases.
However this should always be agreed by all the competent authorities, based on the specific facts and
circumstances of the case. If a multilateral approach is not possible and a two or more parallel bilateral
procedures are started, all relevant competent authorities should be involved in the first stage of the
Arbitration Convention procedure either as Contracting States in the initial Arbitration Convention
application or as observers.
(c) The status of observer may change to that of stakeholder depending on the development of the
discussions and evidence presented. If the other competent authority(ies) want(s) to participate in the
second stage (arbitration), it (they) has (have) to become (a) stakeholder(s).
The fact that the other EU competent authority(ies) remain(s) throughout as (a) party(ies) to the
discussions as (an) observer(s) only has no consequences for the application of the provisions of the
Arbitration Convention (e.g. timing issues and procedural issues).
Participation as (an) observer(s) does not bind the other competent authority(ies) to the final outcome of
the Arbitration Convention procedure.
In the procedure, any exchange of information must comply with the normal legal and administrative
requirements and procedures.
(d) The taxpayer(s) should, as soon as possible, inform the tax administration(s) involved that (an)other
party(ies), in (an)other Member State(s), could be involved in the case. That notification should be
followed in a timely manner by the presentation of all relevant facts and supporting documentation.
Such an approach will not only lead to quicker resolution but also guard against the failure to resolve
double taxation issues due to differing procedural deadlines in the Member States.
6.3. Practical functioning and transparency
(a) In order to minimise costs and delays caused by translation, the mutual agreement procedure, in
particular the exchange of position papers, should be conducted in a common working language, or
in a manner having the same effect, if the competent authorities can reach agreement on a bilateral (or
multilateral) basis.
(b) The enterprise requesting the mutual agreement procedure will be kept informed by the competent
authority to which it made the request of all significant developments that affect it during the course of
the procedure.
(c) The confidentiality of information relating to any person that is protected under a bilateral tax
convention or under the law of a Member State will be ensured.
(d) The competent authority will acknowledge receipt of a taxpayer's request to initiate a mutual agreement
procedure within one month from the receipt of the request and at the same time inform the competent
authority(ies) of the other Member State(s) involved in the case attaching a copy of the taxpayer's
request.
(e) 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 upon receipt of the request, to provide it with the specific additional
information it needs.
(f) Member States undertake that the competent authority will respond to the enterprise making the request
in one of the following forms:
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(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;
(ii) if the request appears to the competent authority to be well-founded and it can itself arrive at a
satisfactory solution, it will inform the enterprise accordingly and make as quickly as possible such
adjustments or allow such reliefs as are justified;
(iii) if the request appears to the competent authority to be well-founded but it is not itself able to arrive
at a satisfactory solution, it will inform the enterprise that it will endeavour to resolve the case by
mutual agreement with the competent authority of any other Member State concerned.
(g) If a competent authority considers a case to be well-founded, it should initiate a mutual agreement
procedure by informing the competent authority(ies) of the other Member State(s) of its decision and
attach a copy of the information as specified under point 5(a) of this Code of Conduct. At the same time
it will inform the person invoking the Arbitration Convention that it has initiated the mutual agreement
procedure. 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.
(ii) its view of the merits of the case, e.g. why it believes that double taxation has occurred or is likely
to occur;
(iii) how the case might be resolved with a view to the elimination of double taxation together with a
full explanation of the proposal.
(b) The position paper will contain a full justification of the assessment or adjustment and will be accom
panied by basic documentation supporting the competent authority's position and a list of all other
documents used for the adjustment.
(c) The position paper will be sent to the competent authority(ies) of the other Member State(s) involved in
the case as quickly as possible taking account of the complexity of the particular case and no later than
four months from the latest of the following dates:
(i) the date of the tax assessment notice, i.e. final decision of the tax administration on the additional
income, or equivalent;
(ii) the date on which the competent authority receives the request and the minimum information as
stated under point 5(a).
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(d) Member States undertake that, where a competent authority of a country in which no tax assessment or
equivalent has been made, or is not intended to be made, which results, or is likely to result, in double
taxation within the meaning of Article 1 of the Arbitration Convention, e.g. due to a transfer pricing
adjustment, receives a position paper from another competent authority, it will respond as quickly as
possible taking account of the complexity of the particular case and no later than six months after
receipt of the position paper.
(e) The response should take one of the following two forms:
(i) if the competent authority believes that double taxation has occurred, or is likely to occur, and
agrees with the remedy proposed in the position paper, it will inform the other competent
authority(ies) accordingly and make such adjustments or allow such relief as quickly as possible;
(ii) if the competent authority does not believe that double taxation has occurred, or is likely to occur,
or does not agree with the remedy proposed in the position paper, it will send a responding position
paper to the other competent authority(ies) setting out its reasons and proposing an indicative time
scale for dealing with the case taking into account its complexity. The proposal will include,
whenever appropriate, a date for a face-to-face meeting, which should take place no later than
18 months from the latest of the following dates:
(aa) the date of the tax assessment notice, i.e. final decision of the tax administration on the
additional income, or equivalent;
(bb) the date on which the competent authority receives the request and the minimum information
as stated under point 5(a).
(f) Member States will further undertake any appropriate steps to speed up all procedures wherever
possible. In this respect, Member States should envisage to organise regularly, and at least once a
year, face-to-face-meetings between their competent authorities to discuss pending mutual agreement
procedures (provided that the number of cases justifies such regular meetings).
6.5. Double taxation treaties between Member States
As far as transfer pricing cases are concerned, Member States are recommended to apply the provisions of
points 1, 2 and 3 also to mutual agreement procedures initiated in accordance with Article 25(1) of the
OECD Model Convention on Income and on Capital, implemented in the double taxation treaties between
Member States.
7. Proceedings during the second phase of the Arbitration Convention
7.1. List of independent persons
(a) Member States commit themselves to inform without any further delay the Secretary-General of the
Council of the names of the five independent persons of standing, eligible to become a member of the
advisory commission as referred to in Article 7(1) of the Arbitration Convention and inform, under the
same conditions, of any alteration of the list.
(b) When transmitting the names of their independent persons of standing to the Secretary-General of the
Council, Member States will join a curriculum vitae of those persons, which should, among other things,
describe their legal, tax and especially transfer pricing experience.
(c) Member States may also indicate on their list those independent persons of standing who fulfil the
requirements to be elected as Chairman.
(d) The Secretary General of the Council will address every year a request to Member States to confirm the
names of their independent persons of standing or give the names of their replacements.
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(e) The aggregate list of all independent persons of standing will be published on the Council's website.
(f) Independent persons of standing do not have to be nationals of or resident in the nominating State, but
do have to be nationals of a Member State and resident within the territory to which the Arbitration
Convention applies.
(g) Competent authorities are recommended to draw up an agreed declaration of acceptance and a
statement of independence for the particular case, to be signed by the selected independent persons
of standing.
7.2. Establishment of the advisory commission
(a) Unless otherwise agreed between the Member States concerned, the Member State that issued the first
tax assessment notice, i.e. final decision of the tax administration on the additional income, or equivalent
which results, or is likely to result, in double taxation within the meaning of Article 1 of the Arbitration
Convention, takes the initiative for the establishment of the advisory commission and arranges for its
meetings, in agreement with the other Member State(s).
(b) Competent authorities should establish the advisory commission no later than six months following
expiry of the period referred to in Article 7 of the Arbitration Convention. Where one competent
authority does not do this, another competent authority involved is entitled to take the initiative.
(c) The advisory commission will normally consist of two independent persons of standing in addition to
its Chairman and the representatives of the competent authorities. For triangular cases, where an
advisory commission is to be set up under the multilateral approach, Member States will have regard
to the requirements of Article 11(2) of the Arbitration Convention, introducing as necessary additional
rules of procedure, to ensure that the advisory commission, including its Chairman, is able to adopt its
opinion by a simple majority of its members.
(d) The advisory commission will be assisted by a secretariat for which the facilities will be provided by the
Member State that initiated the establishment of the advisory commission unless otherwise agreed by the
Member States concerned. For reasons of independence, this secretariat will function under the super
vision of the Chairman of the advisory commission. Members of the secretariat will be bound by the
secrecy provisions as stated in Article 9(6) of the Arbitration Convention.
(e) The place where the advisory commission meets and the place where its opinion is to be delivered may
be determined in advance by the competent authorities of the Member States concerned.
(f) Member States will provide the advisory commission before its first meeting, with all relevant docu
mentation and information and in particular all documents, reports, correspondence and conclusions
used during the mutual agreement procedure.
7.3. Functioning of the advisory commission
(a) A case is considered to be referred to the advisory commission on the date when the Chairman confirms
that its members have received all relevant documentation and information as specified in point 7.2(f).
(b) The proceedings of the advisory commission will be conducted in the official language or languages of
the Member States involved, unless the competent authorities decide otherwise by mutual agreement,
taking into account the wishes of the advisory commission.
(c) The advisory commission may request from the party from which a statement or document emanates to
arrange for a translation into the language or languages in which the proceedings are conducted.
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(d) Whilst respecting Article 10 of the Arbitration Convention, the advisory commission may request
Member States and in particular the Member State that issued the first tax assessment notice, i.e.
final decision of the tax administration on the additional income, or equivalent, which resulted, or
may result, in double taxation within the meaning of Article 1 of the Arbitration Convention, to appear
before the advisory commission.
(e) The costs of the advisory commission procedure, which will be shared equally by the Member States
concerned, will be the administrative costs of the advisory commission and the fees and expenses of the
independent persons of standing.
(f) Unless the competent authorities of the Member States concerned agree otherwise:
(i) the reimbursement of the expenses of the independent persons of standing will be limited to the
reimbursement usual for high ranking civil servants of the Member State which has taken the
initiative to establish the advisory commission;
(ii) the fees of the independent persons of standing will be fixed at EUR 1 000 per person per meeting
day of the advisory commission, and the Chairman will receive a fee higher by 10 % than that of the
other independent persons of standing.
(g) Actual payment of the costs of the advisory commission procedure will be made by the Member State
which has taken the initiative to establish the advisory commission, unless the competent authorities of
the Member States concerned decide otherwise.
7.4. Opinion of the advisory commission
Member States would expect the opinion to contain:
(a) the names of the members of the advisory commission;
(b) the request; the request contains:
(i) the names and addresses of the enterprises involved;
(ii) the competent authorities involved;
(iii) a description of the facts and circumstances of the dispute;
(iv) a clear statement of what is claimed;
(c) a short summary of the proceedings;
(d) the arguments and methods on which the decision in the opinion is based;
(e) the opinion;
(f) the place where the opinion is delivered;
(g) the date on which the opinion is delivered;
(h) the signatures of the members of the advisory commission.
The decision of the competent authorities and the opinion of the advisory commission will be
communicated as follows:
(i) Once the decision has been taken, the competent authority to which the case was presented will send a
copy of the decision of the competent authorities and the opinion of the advisory commission to each
of the enterprises involved.
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(ii) The competent authorities of the Member States can agree that the decision and the opinion may be
published in full. They can also agree to publish the decision and the opinion without mentioning the
names of the enterprises involved and with deletion of any further details that might disclose the
identity of the enterprises involved. In both cases, the enterprises' consent is required and prior to any
publication the enterprises involved must have communicated in writing to the competent authority to
which the case was presented that they do not have objections to publication of the decision and the
opinion.
(iii) The opinion of the advisory commission will be drafted in three (or more in the case of triangular
cases) original copies, one to be sent to each competent authority of the Member States involved and
one to be transmitted to the Secretariat-General of the Council for archiving. If there is agreement on
the publication of the opinion, the latter will be rendered public in the original language(s) on the
website of the Commission.
8. Tax collection and interest charges during cross-border dispute resolution procedures
(a) Member States are recommended to take all necessary measures to ensure that the suspension of tax
collection during cross-border dispute resolution procedures under the Arbitration Convention can be
obtained by enterprises engaged in such procedures under the same conditions as those engaged in a
domestic appeals or litigation procedure although these measures may imply legislative changes in some
Member States. It would be appropriate for Member States to extend these measures to the cross-border
dispute resolution procedures under double taxation treaties between Member States.
(b) Considering that, during mutual agreement procedure negotiations, a taxpayer should not be adversely
affected by the existence of different approaches to interest charges and refunds during the time it takes
to complete the mutual agreement procedure, Member States are recommended to apply one of the
following approaches:
(i) tax to be released for collection and repaid without attracting any interest; or
(ii) tax to be released for collection and repaid with interest; or
(iii) each case to be dealt with on its merits in terms of charging or repaying interest (possibly during
the mutual agreement procedure).
9. Accession of new Member States to the Arbitration Convention
Member States will endeavour to sign and ratify the conventions on accession of new Member States to the
Arbitration Convention as soon as possible and in any event no later than two years after their accession to
the EU.
10. Final provisions
In order to ensure the even and effective application of this Code of Conduct, Member States are invited to
report to the Commission on its practical functioning every two years. On the basis of these reports, the
Commission intends to report to the Council and may propose a review of the provisions of this Code of
Conduct.
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(Information)
COUNCIL
Resolution of the Council and of the representatives of the governments of the Member States,
meeting within the Council, of 27 June 2006 on a code of conduct on transfer pricing documentation for associated enterprises in the European Union (EU TPD)
(2006/C 176/01)
THE COUNCIL OF THE EUROPEAN UNION AND THE REPRESENTATIVES OF THE GOVERNMENTS OF THE MEMBER STATES, MEETING
WITHIN THE COUNCIL,
Considering that transfer pricing documentation in the European Union needs to be viewed in the framework of the OECD
Transfer Pricing Guidelines,
Considering that standardised and partially centralised documentation should be implemented flexibly and should recognise the particular circumstances of the business concerned,
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Emphasising that the Code of Conduct is a political commitment and does not affect the Member States' rights and obligations or the respective spheres of competence of the Member
States and the Community resulting from the Treaty establishing the European Community,
Acknowledging that the implementation of the Code of
Conduct contained in this Resolution should not hamper solutions at a more global level,
HEREBY AGREE TO THE FOLLOWING CODE OF CONDUCT:
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(b) not request documentation that has no bearing on transactions under review;
1. Member States will accept standardised and partially centralised transfer pricing documentation for associated enterprises in the European Union (EU TPD), as set out in the
Annex, and consider it as a basic set of information for the
assessment of a multinational enterprise group's transfer
prices.
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TO THE CODE OF CONDUCT ON TRANSFER PRICING DOCUMENTATION FOR ASSOCIATED ENTERPRISES IN THE EUROPEAN UNION (EU TPD)
SECTION 1
CONTENT OF THE EU TPD
1. A multinational enterprise (MNE) group's standardised and consistent EU TPD consists of two main parts:
(i) one set of documentation containing common standardised information relevant for all EU group members (the
masterfile), and
(ii) several sets of standardised documentation each containing country-specific information (country-specific documentation).
The EU TPD should contain enough details to allow the tax administration to make a risk assessment for case selection purposes or at the beginning of a tax audit, ask relevant and precise questions regarding the MNE's transfer
pricing and assess the transfer prices of the inter-company transactions. Subject to paragraph 31, the company would
produce one single file for each Member State concerned, i.e. one common masterfile to be used in all Member States
concerned and a different set of country-specific documentation for each Member State.
2. Each of the items of the EU TPD listed below should be completed, taking into account the complexity of the enterprise and the transactions. As far as possible, information should be used that is already in existence within the
group (e.g. for management purposes). However, an MNE might be required to produce documentation for this
purpose that otherwise would not have been in existence.
3. The EU TPD covers all group entities resident in the EU including controlled transactions between enterprises resident
outside the EU and group entities resident in the EU.
4. The masterfile
4.1. The masterfile should follow the economic reality of the business and provide a blueprint of the MNE group and
its transfer pricing system that would be relevant and available to all EU Member States concerned.
4.2. The masterfile should contain the following items:
(a) a general description of the business and business strategy, including changes in the business strategy compared
to the previous tax year;
(b) a general description of the MNE group's organisational, legal and operational structure (including an organisation chart, a list of group members and a description of the participation of the parent company in the subsidiaries);
(c) the general identification of the associated enterprises engaged in controlled transactions involving enterprises
in the EU;
(d) a general description of the controlled transactions involving associated enterprises in the EU, i.e. a general
description of:
(i) flows of transactions (tangible and intangible assets, services, financial),
(ii) invoice flows, and
(iii) amounts of transaction flows;
(e) a general description of functions performed, risks assumed and a description of changes in functions and risks
compared to the previous tax year, e.g. change from a fully fledged distributor to a commissionaire;
(f) the ownership of intangibles (patents, trademarks, brand names, know-how, etc.) and royalties paid or received;
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(g) the MNE group's inter-company transfer pricing policy or a description of the group's transfer pricing system
that explains the arm's length nature of the company's transfer prices;
(h) a list of cost contribution agreements, Advance Pricing Agreements and rulings covering transfer pricing
aspects as far as group members in the EU are affected; and
(i) an undertaking by each domestic taxpayer to provide supplementary information upon request and within a
reasonable time frame in accordance with national rules.
5. Country-specific documentation
5.1. The content of the country-specific documentation supplements the masterfile. Together the two constitute the
documentation file for the relevant EU Member State. The country-specific documentation would be available to
those tax administrations with a legitimate interest in the appropriate tax treatment of the transactions covered by
the documentation.
5.2. Country-specific documentation should contain, in addition to the content of the masterfile, the following items:
(a) a detailed description of the business and business strategy, including changes in the business strategy compared
to the previous tax year;
(b) information, i.e. description and explanation, on country-specific controlled transactions, including:
(i) flows of transactions (tangible and intangible assets, services, financial),
(ii) invoice flows, and
(iii) amounts of transaction flows;
(c) a comparability analysis, i.e.:
(i) characteristics of property and services,
(ii) functional analysis (functions performed, assets used, risks assumed),
(iii) contractual terms,
(iv) economic circumstances, and
(v) specific business strategies;
(d) an explanation of the selection and application of the transfer pricing method(s), i.e. why a specific transfer
pricing method was selected and how it was applied;
(e) relevant information on internal and/or external comparables if available; and
(f) a description of the implementation and application of the group's inter-company transfer pricing policy.
6.
An MNE should have the possibility of including items in the masterfile instead of the country-specific documentation, keeping, however, the same level of detail as in the country-specific documentation. The country-specific
documentation should be prepared in a language prescribed by the Member State concerned, even if the MNE has
opted to keep the country-specific documentation in the masterfile.
7.
Any country-specific information and documents that relate to a controlled transaction involving one or more
Member States must be contained either in the country-specific documentation of all the Member States concerned
or in the common masterfile.
8.
MNEs should be allowed to prepare the country-specific documentation in one set of documentation (containing
information about all businesses in that country) or in separate files for each business or group of activities in that
country.
9.
The country-specific documentation should be prepared in a language prescribed by the Member State concerned.
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10. Use of the EU TPD is optional for MNE groups. However, an MNE group should not arbitrarily opt in and out of
the EU Transfer Pricing Documentation approach for its documentation purposes but should apply the EU TPD in a
way that is consistent throughout the EU and from year to year.
11. An MNE group that opts for the EU TPD should generally apply this approach collectively to all associated enterprises engaged in controlled transactions involving enterprises in the EU to which transfer pricing rules apply.
Subject to paragraph 31, an MNE group opting for the EU TPD would, therefore, need to keep the documentation
specified in Section 1 in respect of all its enterprises in the Member State concerned, including permanent establishments.
12. Where an MNE group has opted for the EU TPD for a given fiscal year, each member of the MNE group should
inform its tax administration accordingly.
13. MNEs should undertake to prepare the masterfile in time to comply with any legitimate request originating from
one of the tax administrations involved.
14. The taxpayer in a given Member State should make its EU TPD available, upon request by a tax administration,
within a reasonable time depending on the complexity of the transactions.
15. The taxpayer responsible for making documentation available to the tax administration is the taxpayer that would
be required to make the tax return and that would be liable to a penalty if adequate documentation were not made
available. This is the case even if the documentation is prepared and stored by one enterprise within a group on
behalf of another. The decision of an MNE group to apply the EU TPD implies a commitment towards all associated
enterprises in the EU to make the masterfile and the respective country-specific documentation available to its
national tax administration.
16. Where in its tax return, a taxpayer makes an adjustment to its accounts profit resulting from the application of the
arm's length principle, documentation demonstrating how the adjustment was calculated should be available.
17. The aggregation of transactions must be applied consistently, be transparent to the tax administration and be in
accordance with paragraph 1.42 of the OECD Transfer Pricing Guidelines (which allow aggregation of transactions
that are so closely linked or continuous that they cannot be evaluated adequately on a separate basis). These rules
should be applied in a reasonable manner, taking into account in particular the number and complexity of the
transactions.
SECTION 3
18. 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.
19. The period for providing additional information and documents upon specific request referred to in paragraph 18
should be determined on a case-by-case basis taking into account the amount and detail of the information and
documents requested. Depending on specific local regulations, the timing should give the taxpayer a reasonable
time (which can vary depending on the complexity of the transaction) to prepare the additional information.
20. Taxpayers avoid cooperation-related penalties where they have agreed to adopt the EU TPD approach and provide,
upon specific request or during a tax audit, in a reasonable manner and within a reasonable time, additional information and documents going beyond the EU TPD referred to in paragraph 18.
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21. Taxpayers should be required to submit their EU TPD, i.e. the masterfile and the country-specific documentation, to
the tax administration only at the beginning of a tax audit or upon specific request.
22. Where a Member State requires a taxpayer to submit information about transfer pricing with its tax return, that
information should be no more than a short questionnaire or an appropriate risk assessment form.
23. It may not always be necessary for documents to be translated into a local language. In order to minimise costs and
delays caused by translation, Member States should accept documents in a foreign language as far as possible. As far
as the EU Transfer Pricing Documentation is concerned, tax administrations should be prepared to accept the
masterfile in a commonly understood language in the Member States concerned. Translations of the masterfile
should be made available only if strictly necessary and upon specific request.
24. Member States should not oblige taxpayers to retain documentation beyond a reasonable period consistent with the
requirements of the domestic laws where the taxpayer is liable to tax regardless of where the documentation, or any
part of it, is situated.
25. Member States should evaluate domestic or non-domestic comparables with respect to the specific facts and circumstances of the case. For example, comparables found in pan-European databases should not be rejected automatically. The use of non-domestic comparables by itself should not subject the taxpayer to penalties for non-compliance.
SECTION 4
GENERAL APPLICATION RULES AND REQUIREMENTS APPLICABLE TO MNEs AND MEMBER STATES
26. Where documentation produced for one period remains relevant for subsequent periods and continues to provide
evidence of arm's length pricing, it may be appropriate for the documentation for subsequent periods to refer to
earlier documentation rather than to repeat it.
27. Documentation does not need to replicate the documentation that might be found in negotiations between enterprises acting at arm's length (for example, in agreeing to a borrowing facility or a large contract) as long as it
includes adequate information to assess whether arm's length pricing has been applied.
28. The sort of documentation that needs to be produced by an enterprise that is a subsidiary enterprise in a group
may be different from that needed to be produced by a parent company, i.e. a subsidiary company would not need
to produce information about all of the cross-border relationships and transactions between associated enterprises
within the MNE group but only about relationships and transactions relevant to the subsidiary in question.
29. 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.
30. The way that documentation is stored whether on paper, in electronic form or in any other way should be at
the discretion of the taxpayer, provided that it can be made available to the tax administration in a reasonable way.
31. In well justified cases, e.g. where an MNE group has a decentralised organisational, legal or operational structure or
consists of several large divisions with completely different product lines and transfer pricing policies or no intercompany transactions, and in the case of a recently acquired enterprise, an MNE group should be allowed to
produce more than one masterfile or to exempt specific group members from the EU TPD.
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