In this edition: the Organization for Economic Co-operation and Development (OECD) released two new discussion drafts, the Trump Administration issued Executive Order 13789, Japan's National Tax Agency issued the Transfer Pricing Guidebook, HMRC issued its annual report related to UK Diverted Profits Tax, and the Vietnam Ministry of Finance issued new transfer pricing rules following BEPS actions.
OECD Developments: Revised Discussion Drafts for Action 7 and Actions 8-10 of the BEPS Action Plan and Revised 2017 OECD Transfer Pricing Guidelines
On June 22, 2017, the Organization for Economic Co-operation and Development ("OECD") released two new discussion drafts regarding ongoing work related to the Base Erosion and Profit Shifting ("BEPS") Action Plan.
The first, the Discussion Draft on Additional Guidance on the Attribution of Profits to Permanent Establishments, provides additional draft guidance on the attribution of profits to permanent establishments ("PEs") related to Action 7, Preventing the Artificial Avoidance of Permanent Establishment Status, of the BEPS Action Plan. This discussion draft supersedes the 2016 discussion draft. The discussion draft provides additional guidance and examples for dependent agency PEs arising from Article 5(5) of the OECD Model Tax Convention, focusing on commissionaire and other related intermediary arrangements. In addition, the discussion draft provides an example intended to clarify the anti-fragmentation rule incorporated into article 5(4) of the OECD Model Tax Convention by Action 7. The anti-fragmentation rule is intended to prevent an exemption from PE status for MNEs that perform functions in the source country that in isolation might be viewed as preparatory or auxiliary in nature, but which might be instead considered to constitute complementary functions that are part of a cohesive business operation when considered together. Disappointingly, it is worth noting that the discussion draft lacks detailed guidance on the application of the Authorized OECD Approach ("AOA") as requested by commentators to the previous discussion draft of July 2016.
The second, the Discussion Draft on the Revised Guidance on Profit Splits, provides additional draft guidance and clarification with regards to profit splits as set out in Action Item 8-10, Aligning Transfer Pricing Outcomes with Value Creation, of the BEPS Action Plan as intended to be incorporated into the 2017 OECD Transfer Pricing Guidelines. The discussion draft topics include circumstances in which a profit split is likely the most appropriate method for evaluating the arm's length nature of a transaction, methods for determining the profits to be split, guidance for profits, and criteria for factors used to split profits. The discussion draft contains several examples with regards to the transaction profit split method, including examples for ascertaining when the profit split method is the most appropriate method, and examples depicting the appropriate profits to be split (i.e. anticipated or actual profits).
Relative to the discussion draft of July 2016, this latest draft is much clearer that the application of profit splits to actual profits will be driven by the allocation of economically significant risks in the accurately delineated transaction. The 2016 draft guidance had discussions around several types of circumstances, such as highly integrated businesses, that may create conditions where profit splits should be applied. The new draft guidance still discusses these circumstances, but makes it clear that they would only lead to the application of a profit split insofar as they create an environment of inseparable risks being borne by the parties to the transaction.
For both discussion drafts, interested parties are invited to send their comments to the OECD. Comments should be sent by September 15, 2017. The OECD intends to hold a public consultation on the discussion drafts in November 2017 at the OECD Conference Centre in Paris, France.
Additionally, the OECD released the 2017 edition of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations on July 10, 2017. The 2017 edition of the OECD Transfer Pricing Guidelines incorporates substantial revisions reflecting a consolidation of the changes resulting from the BEPS Project, in particular the 2015 BEPS Reports on Actions 8-10, Aligning Transfer Pricing Outcomes with Value Creation, and on Action 13, Transfer Pricing Documentation and Country-by-Country Reporting. These Reports provide revisions to the Guidelines in Chapters I, II, V, VI, VII and VIII, as well as Chapter IX. Additional changes to Chapter IV, safe harbors, reflect changes to that guidance from May 2013.
Further information on the discussion draft relating to Action 7 is available here.
Further information on the discussion draft relating to Actions 8-10 is available here.
Simplification Measures: Identifying and Reducing Tax Regulatory Burdens (Implementation of Executive Order 13789)
On April 21, 2017, the Trump Administration issued Executive Order 13789, which was designed to provide tax relief and simplified tax guidance by reducing the burden imposed on taxpayers by existing tax regulations. As part of this directive, the Secretary of the Treasury, in consultation with the Office of Management and Budget, was charged with reviewing all significant tax regulations issued on or after January 1, 2016, to identify all regulations that are considered to: (i) impose an undue financial burden on taxpayers; (ii) add undue complexity to the federal tax laws; or (iii) exceed the statutory authority of the IRS. As part of this Executive Order, Treasury must follow its review with a report, due no later than September 18, 2017, recommending specific actions to mitigate the burden imposed by regulations identified.
On July 24, 2017, the IRS released Notice 2017-38 regarding its implementation of Executive Order 13789. In this initial report, the Treasury identified eight regulations that meet at least one of the first two criteria set forth by the Executive Order, but did not disclose any regulations considered to meet the third criterion. Of particular interest to taxpayers and transfer pricing practitioners, Treasury identified Final Regulations under Section 482 addressing aggregation principals and Section 367 on the Treatment of Certain Transfers of Property to Foreign Corporations, as well as Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness for further review. As part of Notice 2017-38, the Treasury has solicited public feedback, due August 7, 2017, on whether the identified regulations should be rescinded or modified, as well as how they could potentially be modified to reduce burden and complexity.
The identified regulations include Treasury Decision 9803, which contained substantive changes to U.S. Treasury Regulations §§ 1.367(a), 1.367(d), and 1.6038B–1(g) as well as changes to U.S. Treasury Regulation § 1.482-1(f). The Final Regulations under IRC 367 eliminated provisions exempting foreign goodwill and going concern from gain recognition, and removed the 20-year useful life limitation under section 367(d).
Also included in the identified regulations was Treasury Decision 9790, which contained the Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness ("385 Regulations"). As Treasury has not yet issued its follow-up report, there is uncertainty as to how these identified regulations will be evaluated and when any potential changes could be made. However, in the event that the 385 Regulations were to be significantly modified or even rescinded, it is important to note that the guidelines under IRS Internal Revenue Code (IRC) Section 385 will still stand. As such, multinational corporations with related party debt interests will still need to perform the same foundational analyses (i.e. debt capacity and repayment analyses) to withstand audit.
Japan: NTA Issued the Transfer Pricing Guidebook
On June 9, 2017, Japan's National Tax Agency ("NTA") published the Transfer Pricing Guidebook, Maintaining and Improving Voluntary Tax Compliance ("Transfer Pricing Guidebook"), with the purpose of providing more certainty and transparency with respect to the transfer pricing rules. In June 2016, the NTA also introduced the new documentation requirements as part of the tax reform conducted in response to the development of OECD's Base Erosion and Profit Shifting ("BEPS") project (Action 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting). The intention is to encourage taxpayers to voluntarily and proactively exercise transfer pricing compliance using the information provided in the Transfer Pricing Guidebook.
The Transfer Pricing Guidebook consists of the following three sections:
- NTA's Transfer Pricing Initiatives and Policies:
Effective as of July 1, 2017, the NTA has established an inquiry counter at each NTA office (total of 12 locations) to handle individual inquiries regarding cross-border transactions that are subject to contemporaneous documentation. A taxpayer can visit an inquiry counter and ask for guidance/advice on functional analysis, selection of the transfer pricing methods, selection of comparable transactions or allocation factors, determination of target profitability range, etc.
In addition to establishing the inquiry counter, the Transfer Pricing Guidebook indicates that an officer will visit a company, whose cross-border intercompany transactions are subject to documentation requirements, to check on progress of the local file preparation. The NTA officer will notify a company via a phone call prior to a visit. Such a visit will not create tax audits; however, a company may be subject to an audit later, even if it did not receive any advice/guidance from an officer during the visit.
- Key Points in the Application of Transfer Pricing Regulations:
Section II provides a discussion on the application of the transfer pricing rules based on the NTA's past audit experience and case studies from the advance pricing agreement ("APA") procedures. This section also describes 18 case studies where it compares perspectives from both the taxpayer and an inspector in each scenario, and provides a summary of considerations for taxpayers, especially with respect to areas that are likely to be questioned or clarified by the inspector.
- Contemporaneous Documentation Guide:
Section III provides two sample local files in order to demonstrate the overall picture and specify the items to be included in the local file. These are supplemental to the "Outline of the Revision of the Transfer Pricing Documentation" and "Examples for Preparing Documents Deemed Necessary to Calculate Arm's Length Price (Local File)" released by the NTA in June 2016.
The deadline for the first local file preparation in Japan is May 31, 2018 (or June 30, 2018 with extension) for companies' fiscal year ending March 31, 2018. A taxpayer is encouraged to effectively use the Transfer Pricing Guidebook to seek guidance and be ready for the local file preparation. However, if a taxpayer receives advice on a certain topic, the NTA inspector will most likely look for and/or follow-up if such advice was reflected in the local file. Hence, the taxpayer needs to be mindful as to what information to provide, and if it decides to provide the information, it is critical to provide the entire picture, including the data as well as the clear illustration and representation of the taxpayer's facts, so that it does not invite scrutiny from the NTA.
Further information on the Transfer Pricing Guidebook (in Japanese) is available here.
UK Diverted Profits Tax Starts to Bite
The UK Diverted Profits Tax ("DPT") was introduced by Finance Act 2015 and applies to accounting periods beginning on or after April 1, 2015. Recently, HMRC has issued its annual report which gives taxpayers a view into the administration of this tax in the periods after it was enacted.
The DPT is not a corporate income tax; therefore, the Mutual Agreement Procedure article of tax treaties cannot be invoked in order to seek a corresponding income adjustment in the other jurisdiction. The tax is applied at a rate of 25%, compared to the corporation tax rate of 19%, and interest will be payable on this amount for the period beginning six months after the end of the accounting period to which the charge relates until the day the notice imposing the charge to tax is issued. An HMRC officer, having given the company a "preliminary notice", and considered the company's representations, may determine that a "charging notice" should be issued to the company. Only 30 days are permitted to make a representation and another 30 days for the issuance of a charging notice. The company must then pay the tax within a further 30 days, a notably aggressive aspect of the tax, reflecting the intention that it should steer behavior away from the practices which it is designed to address. In particular, a cashflow disadvantage is imposed as well as additional tax, putting pressure on taxpayers to help resolve DPT matters quickly (and to the benefit of HMRC).
The DPT applies to larger entities or transactions which lack economic substance, or where economic activity is carried on in the UK, but a non-UK company avoids a UK taxable presence through arrangements designed to avoid or reduce UK Corporation Tax (unlike the transfer pricing SME exemption, the DPT SME exemption applies whether or not the UK has a tax treaty with the other jurisdictions involved). In both situations, tax may be assessed on the basis of a "relevant alternative provision", defined as "the alternative provision which it is just and reasonable to assume would have been made or imposed as between the relevant company and one or more companies connected with that company...had tax...on income not been a relevant consideration....” Clearly, an element of subjectivity is therefore involved, creating uncertainty for taxpayers. Taxpayers' representations could therefore relate to a) whether the relevant avoidance has occurred, b) the quantum of the avoidance compared to an appropriate counterfactual, or c) both. A second area of subjectivity relates to the decision to invoke the DPT; anecdotal evidence suggests that this may happen when HMRC is not satisfied with the progress of a transfer pricing enquiry, and/or where the taxpayer or its industry has been the focus of public campaigning against aggressive tax avoidance.
In its Annual Report and Accounts for the period 2016-17, HMRC noted that charging notices were issued for the first time, and raised $182.1 million. HMRC noted that the tax had been introduced in order to encourage businesses to change their arrangements and pay Corporation Tax in line with their economic activities; in this respect, it estimated that the DPT regime has also driven behavioral change in companies that has led to an additional $188.7 million of Corporation Tax being raised in the period. It was noted that the Diverted Profits Board had met twelve times, considered eleven proposals (by taxpayers) to resolve DPT issues, referred two of these for further work and sent the other nine on to the Commissioners. These figures indicate that the Board is unlikely to be swayed by the taxpayer’s representations and is much more likely to start a process which may lead to litigation. This in turn may suggest that taxpayers' representations relate more to the question of whether the relevant avoidance has occurred than to the issue of how much tax has been avoided.
Individual companies known to be affected include:
Diageo Plc, which announced on May 10, 2017 that it had received notice of an assessment of $141.2 million, but does not believe that it falls within the scope of the DPT and is making no provision for additional tax; and
Glencore Plc, which announced on July 10, 2017 that it planned to appeal the High Court's decision of June 29, 2017 to deny it permission to apply for judicial review of an assessment of $28.1 million. (However, the appeal was denied, only because HMRC had reopened discussions with the company).
Diageo and Glencore account for the great bulk of DPT assessed and both are challenging their assessments – the true picture of tax collected in the first year as a result of the DPT has yet to be determined. However, the amount of additional tax that has been paid because of the deterrence effect of the DPT is also unclear, and may be much larger than the official figure.
Vietnam: Release of New Transfer Pricing Rules Following BEPS Actions
On June 22, 2017, the Ministry of Finance issued Circular 41/2017/TT-BTC ("Circular 41/2017") to provide further guidance on the application of Decree No. 20/2017/ND-CP ("Decree 20/2017"), which was issued earlier on February 24, 2017. Circular 41/2017 is made to be retroactively effective from May 1, 2017.
The new transfer pricing regulations in Vietnam, Decree 20/2017 and Circular 41/2017, were introduced under pressure for more stringent control requirements to combat transfer pricing and loss of tax revenue in the state budget. In addition, the Decree 20/2017 is also a response to Base Erosion and Profit Shifting ("BEPS") developments at the OECD level as well as in Asian jurisdictions including India, China and Singapore.
The new transfer pricing regulations specify that a taxpayer with related party transactions will be comply with new annual contemporaneous documentation and three-tiered documentation including:
- Transfer pricing forms (Form No. 01), to be submitted together with the annual corporate income tax (CIT) return;
The Master file (with summarized content in Form 02);
The Local file (with summarized content in Form 03); and
- The Country-by-country (CbC) report (Form 04).
The transfer pricing documentation must be in Vietnamese language, completed before the filing deadline of the Transfer Pricing Form and submitted within 15 days from written request.
The new transfer pricing Decree introduced key safe harbors for taxpayers with respect to the filing and documentation, and the transfer pricing Circular provides further guidance on these:
- Exemption from filing Form 01: if the taxpayer only has transactions with local related parties who have the same tax rate and are not subject to any tax holiday;
- Exemption from transfer pricing documentation: if the taxpayer meets one of the following conditions:
- Total annual revenue less than $2.2 million and total related party transaction values less than $1.3 million; or
- An APA signed with local authority; or
- Total annual revenue does not exceed $9 million, no related party intangibles transactions, and meets the operating profit margin threshold of 5% for distributors, 10% for manufacturers or 15% for toll manufacturers. For those taxpayers who have mixed or complex key functions, segmented financial data is required to enjoy this safe harbor.
Key developments introduced by the new transfer pricing regulations worth highlighting:
Loan interest cap
Decree 20/2017 cap the total loan interest of taxpayer at 20% of net earnings before interest, tax and depreciation (EBITDA). In a recent seminar, the General Department of Taxation in Vietnam ("GDT") has confirmed that the cap is applied for both inter-group loans and independent loans. This has triggered challenges for those taxpayers in industries such as real estate or retail, and those who are suffering losses.
Restriction on management fees and royalties
Decree 20/2017 has a very strict attitude towards management service. These restrictions apply to services:
- Provided only for serving the interests of or creating value for other related parties;
Serving the interests of shareholders of related parties;
Which several related parties provide with respect to one type of service,
Which do not bring any added value for the taxpayer; and
- For which the benefit received by the taxpayer is due to it being a member of the group.
Based on tax authorities' explanation, the payments for those services/regional shared costs will be the targets of future transfer pricing audits and challenges. In fact, payments for several of these services have been monitored by auditors in the previous transfer pricing audit; however, now they have a clear legal basis to disallow these payments for tax purposes, without reviewing any calculation or cost sharing basis of the charges.
Following similar trends, those royalties which are paid for trademarks, technology, etc., which could not be proven to bring any economic benefit to the taxpayers, will also be challenged. Tax authorities have taken further steps on this by challenging the marketing and sales expenses which local taxpayers have incurred in promoting and developing or any other part of DEMPE functions with regards to the brand and/or technology.
Voluntary self-transfer pricing adjustment
Tax authorities' guidance on the new transfer pricing regulations also include the encouragement of "voluntary" transfer pricing adjustments at year-end. Though it has been introduced in the previous annual transfer pricing form (Form No. 03-7), which is now replaced by Form No. 01, the self-adjustment has not been so common. The lack of key guidance on what is supposed to be an "accepted" profit margin/price to make self-transfer pricing adjustments, leaves taxpayers no guarantee that they would be safe from any future transfer pricing audit adjustments.
Further, the new transfer pricing regulations highlight the requirement of a self-adjustment and stress that not making self-adjustments after completing a benchmarking study would be subject to deemed profit rate provided by tax authorities from their "secret database", and an additional penalty. However, again, there is no clear guidance or guarantee given.
Applicable period of the new regulations
One of the key concerns for Vietnamese entities are which financial periods will be subject to the new transfer pricing regulations. This triggers confusion and creates challenges because in the latest draft of Circular 41, it seems that the guidance will be applied from fiscal year-ended December 31, 2017. The lack of clear guidance leaves those companies who have fiscal year-ended March 31, 2017, June 30, 2017 or September 30, 2017, no other choice but to strive to meet the new requirements before their filing deadlines.
It is expected that the Ministry of Finance will provide further guidance on the relief of loan interest cap upon the increased complaints and confusion of taxpayers. Until then, taxpayers in Vietnam having related party transactions, especially Foreign Direct Invested companies, have several things to prepare for and sort out to arrange for a greater level of transfer pricing scrutiny by the tax authorities.
Further information on Decree 20 and Circular 41 (in Vietnamese) are available here and here.