In this edition: the U.S. tax court's conclusion on the cancellation of Eaton Corporation's advance pricing agreements, the Organization for Economic Co-operation and Development (OECD) is due to publish its first substantive guidance on transfer pricing for financial transactions by the end of 2017, Chevron withdrawing its appeal to the High Court, Asia Pacific developments, and the upcoming Duff & Phelps IP Value Summit.
U.S. Tax Court's Conclusion on the Cancellation of Eaton's APAs
On July 26, 2017, the U.S. tax court issued a memorandum, Eaton Corporation and Subsidiaries vs. Commissioner of Internal Revenue, T.C. Memo 2017-147, concluding that the cancellation by the IRS of advance pricing agreements ("APAs") was abuse of discretion.
Eaton Corporation ("Eaton") and the Internal Revenue Service ("IRS") entered into two unilateral APAs covering Eaton's tax years from 2001 through 2005 ("APA I") and 2006 through 2010 ("APA II"). On December 16, 2011, the IRS notified Eaton that APA I and APA II would be cancelled effective January 1, 2005 and January 2006, respectively, indicating in its letter that "These cancellations are based on numerous grounds, including the failure of a critical assumption, misrepresentation, mistake as to a material fact, failure to state a material fact, failure to file a timely annual report, or lack of good faith compliance with the terms and conditions of the APA."
As a result of cancelling APA I and APA II, the IRS determined that, under IRC section 482, transfer pricing adjustments were necessary and that, if IRC section 482 adjustments were not sustained, it had determined that Eaton transferred intangible property and such value transferred is taxable under IRC section 367(d) for tax year 2006.
In response, Eaton filed a petition with the tax court, arguing that it did not omit or misrepresent any material. Eaton contended that the errors are related to data and computations and did not affect the validity of the transfer pricing method and that the data and computational errors were corrected on its amended tax returns.
The U.S. tax court concluded that data and computational errors Eaton made were immaterial and not deliberate, and did not fit the APA revenue procedures' definition of "material." Further, the U.S. tax court stated that "an APA is a binding agreement and it should be cancelled only according to the terms of the revenue procedures and should not be cancelled because of a desire to change the underlying methodology that would result in a significantly different profit split." Based on these reasons, the U.S. tax court indicated that the cancellation of the APAs was arbitrary and unreasonable; and hence accordingly concluded that it was abuse of discretion for the IRS to cancel APAs.
Finally, the U.S. tax court considered and rejected the IRS's alternative position stating that "the IRS did not specifically identify any intangible or explain the exact value of any intangibles" and the court "could not conclude that intangibles were transferred that should be subject to IRC section 367(d)."
This ruling should help mitigate concerns within the taxpayer community that APAs might not provide the certainty that is a driving purpose for obtaining an APA.
OECD Set to Publish First Draft of Its Guidance on Transfer Pricing for Financial Transactions
The Organization for Economic Co-operation and Development ("OECD") is due to publish its first substantive guidance on transfer pricing for financial transactions by the end of 2017; and a first draft for public comments is now expected in October. It is an attempt to achieve a measure of consensus and address highly technical issues about which high profile court cases have reached differing conclusions, where national law and guidance is at odds, and where international conventions do not exist.
To some extent, the project team appears to have made their task harder by setting themselves two quite separate objectives: to provide practical guidance on simple loan pricing and cash pooling on the one hand, and to provide guidance for tax administrations on addressing potentially abusive financing arrangements. Financial transactions can involve a wide range of arrangements such as back-to-back loans, extended credit, interest-free loans, cash pooling, financial guarantees, performance guarantees, and the provision of collateral and captive insurance/reinsurance. Within each of these types of transactions there are sub-issues, and there are also issues such as 'implicit group support' which cut across all categories of financial transactions. These cross-transaction issues are the ones with which international courts have been struggling for years, reaching quite different conclusions.
The project is taking place against the backdrop of OECD- and EU-led actions against the use of hybrid instruments and entities, as well the perceived abuse of treaty networks by taxpayers in order to achieve BEPS through related party financing arrangements. For example, popular 'Benelux' country arrangements often involved financing from a low tax jurisdiction using hybrid instruments such as convertible preferred equity certificates or profit participating loans, along with hybrid entities such as 'check-the-box' companies. These structures benefited from tax rulings which provide for taxation of a small, mechanically-calculated interest spread and consequently a grant treaty benefits, which eliminated withholding tax on those interest payments. In December 2016, at the prompting of the European Commission, Luxembourg issued a tax circular (LIR No. 56/1-56bis/1) which brought the calculation of taxable interest more into line with the arm’s length principle. Other European jurisdictions seem to be following suit (for example Cyprus, which made a similar announcement on July 21 this year).
The environment and practice of financial transfer pricing is therefore changing even as the OECD's project attempts to describe and address it. Given this background, and the lack of consensus among revenue authorities and the breadth of potential topics, it may be challenging for the OECD to make meaningful progress this year on anything like the full range of topics envisaged. In fact, it is already looking as if this may develop, like the decade of work that resulted in the 2010 OECD report on the attribution of profits to permanent establishments, into a very long-term process.
Chevron Australia withdraws Appeal to the High Court
On August 18, 2017, it was reported that Chevron Australia Holdings Pty. Ltd. has withdrawn its appeal to the High Court over the ATO's assessment of $340 million in tax, interest and penalties for interest payments on a $2.5 billion intercompany loan received in 2003, after reaching a settlement with the ATO.
As reported in the Transfer Pricing Times, the company lost an appeal to the full Federal Court in April this year on April 28, 2017. The withdrawal of the appeal to the High Court means that the Full Federal Court’s decision is now final.
While the Chevron case principally dealt with the application of the ‘old’ transfer pricing rules in Division 13, the principles arising from the case are likely to apply to financing arrangements subject to the ‘new’ transfer pricing rules in Subdivision 815-B.
The outcome is a significant win for the ATO and strengthens its position in pursuing other related party financing arrangements. The Hon. Kelly O’Dwyer MP, the Minister for Revenue and Financial Services, said in a press release last week that “The ATO’s initial estimates are that the Chevron decision will bring in more than $10 billion dollars of additional revenue over the next ten years in relation to transfer pricing of related party financing alone.”
The ATO’s continued assault on cross-border financing arrangements is expected to continue through the expected release of the following guidance:
- a. Draft Taxation Determination on outbound/inbound interest free loans (Expected release date - September 27, 2017): this will address the ATO’s views on circumstances in which interest free loans will be considered to be an equity contribution.
- b. Draft Taxation Determination on transfer pricing rules and debt/equity tests (Expected release date - September 27, 2017): this will address the ATO’s view on how the transfer pricing rules in Subdivision 815-B interact with the debt-equity tests in Division 974.
- c. Practical Compliance Guideline on the thin capitalization arm’s length debt test (Expected release date - TBD): this will set forth a tax integrity risk framework for purposes of applying the arm’s length debt test under the thin capitalization rules.
The Draft Practical Compliance Guideline on cross-border related party financing arrangements, released in draft on May 16, 2017 (for detailed comments, see our May issue of Transfer Pricing Times), is also expected to be released in final on September 27, 2017.
Further information will be shared on the above guidance once it is released.
Other Asia Pacific Developments
Malaysia – Updates to Transfer Pricing Guidelines 2012
The Malaysian Inland Revenue Board ("MIRB") recently announced new updates and changes to the Transfer Pricing Guidelines 2012 ("TPG 2012"), which became effective from July 15, 2017. The key takeaways from the updated version of the TPG 2012 are summarized below:
Chapter II – The arm's length principle [UPDATED]
Chapter VIII – Intangibles [UPDATED]
Introduction of DEMPE ("Development, Enhancement, Maintenance, Protection or Exploitation") concept to analyze transactions involving intangibles.
Valuation techniques in addition to the currently accepted CUP method and profit split method to estimate the arm’s-length price for the transfer of intangibles.
Chapter X – Commodity transactions [NEW]
- Chapter XI – Documentation [UPDATED]
Penalties waived if transfer pricing documentation is submitted within 30 days upon request and is prepared in compliance with the requirements of the Guidelines.
Taxpayers that are obliged to prepare the Country-by-Country Report to prepare the Master File and submit it together with the TPD when requested by MIRB.
Further information on the Updated TPG 2012 is available here.
New Zealand Government Locks in Path for Legislative Reforms
In August 2017, the New Zealand government released three Cabinet Papers addressing key proposals for New Zealand's implementation of certain OECD BEPS actions:
The Cabinet Papers press forward with proposed reforms included in the government's initial 'Discussion Drafts' released in late 2016 and early 2017. The passage of legislation is expected to be completed by June 30, 2018, with most changes taking effect for income years commencing after July 1, 2018.
Key aspects of the revised proposals include:
- A 'restricted transfer pricing rule' requiring inbound controlled loans to be priced under a presumption of financial support to the New Zealand borrower (notching to the parent/group level), with disregard of non-commercial terms and conditions. These rules would include an administrative 'safe harbor' interest rate cap.
Various revisions to the thin capitalization rules, including: (i) revising the thin capitalization ratio computation to have reference to assets, net of non-interest bearing liabilities; (ii) restricting asset valuation approaches; (iii) introducing certain de minimus provisions; and (iv) limiting taxpayers' interest deductions to the existing 60 percent safe harbor debt ratio where the New Zealand borrower is held by a group of non-resident owners acting together.
A reduction in the breadth of proposed permanent establishment ("PE") rules (compared to the prior Discussion Draft) to specifically target arrangements designed to avoid a PE, where the PE exists in substance.
Shifting the burden of proof onto taxpayers, extending the statutory time bar for transfer pricing from 4 to 7 years, and the introduction of reconstruction provisions aligned with the revised OECD Guidelines.
Non-adoption of a diverted profits tax, and no requirement for MNCs to pay disputed tax upfront. Most other administrative measures have been retained.
- Adoption of OECD-recommended approach to hybrid mismatches, with modifications, such as an exemption for local companies with foreign branches, and delayed application dates for some limited partnerships and trust structures.
Further discussion of the proposed reforms is available in our March 2017 issue here.
Duff & Phelps IP Value Summit
The Duff & Phelps transfer pricing team will once again present on current topics in Intellectual Property valuation-related issues at the fourth annual Duff & Phelps IP Value Summit, taking place October 16-17, 2017 in Half Moon Bay, California.
Transfer pricing focused sessions will include a taxpayer-driven panel on life under BEPS, a discussion of recent transfer pricing cases (such as Amazon and Apple), and implications for IP valuations related to OECD guidance on profit splits and hard to value intangibles.
Discussion topics are likely to include:
- Tax planning ideas and necessities considering BEPS Action Item 2 and increased transparency under country by country disclosures;
Issues and best practices with respect to the three-tiered transfer pricing documentation platform under Action Item 13 and the revised 2017 OECD Guidelines;
Current audit experiences including views on the effectiveness of advance pricing agreements and MAP as settlement procedures, usefulness of the MLII, and other current controversy issues.;
Opportunities and challenges for taxpayers bearing in mind increased scrutiny on active management of related investments and risks and its impact on economic ownership and control of intangibles; and
- Issues around consistency in cost sharing regulations, definition of intangible development costs, and application of valuation principles to valuations (e.g., assumptions on economic life).
Further information on the IP Value Summit is available here.