Fri, Mar 31, 2017

Transfer Pricing Times: U.S. Tax Court Rules in Favor of Amazon in Latest Transfer Pricing Case

In this edition: U.S. tax court rules in favor of Amazon, U.S. tax reform and the effects on transfer pricing, OECD releases toolkit for identifying financial data in developing countries, UK releases guidance on cash pooling, Australia releases risk framework for centralized operating models and New Zealand releases consultation documents addressing potential transfer pricing changes.    

U.S. Tax Court Rules in Favor of Amazon in Latest Transfer Pricing Case
On March 23, 2017, the United States Tax Court issued its long-awaited opinion in the Amazon transfer pricing case (, Inc. v. Commissioner, 148 T.C. No. 8 (2017)). This case focused on buy-in and cost-sharing transaction payments made by a Luxembourg affiliate associated with Amazon's cost sharing arrangement covering its European operations in 2005 and 2006. Given the years at issue, this case was decided under the "old" cost sharing regulations (1.482-7A) which were substantially revised in 2009. This summary focuses only on determinations associated with the buy-in payment. The IRS had determined that the total buy-in payment should have totaled $3.5 billion, a large multiple of the $245 million total buy-in payment determined by Amazon.

With respect to the buy-in payment, the core issues in this case are very similar to those in the Veritas case (see Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009)), and many viewed this case as the IRS' attempt to re-litigate the findings in the Veritas case. In Veritas, the taxpayer had determined a buy-in payment based on the application of the Comparable Uncontrolled Transaction ("CUT") method using internal transactions, in combination with a royalty decay mechanism meant to reflect the shift in intangible ownership that occurred as a result of the cost sharing payments that were expected to be made by Veritas' Irish subsidiary. The IRS, on the other hand, had determined a buy-in payment based on a variant of the income method that became embedded in the cost sharing regulations in 2009. This method did not rely on CUTs to determine income attributable to the pre-existing intangibles, but rather identified that value based on discounted projected profits over an infinite period.

The Amazon case involved three buckets of intangibles (technology, trademarks and associated intangibles, and customer-based intangibles). The taxpayer‘s experts at Amazon had used CUT approaches with declining royalties for each of these buckets (and had used internal agreements for the technology and customer-based intangibles). The IRS' primary expert had used a discounted cash flow ("DCF") method to determine the value of the aggregate bundle of intangibles. This DCF approach shared many similar features to that employed by the IRS in Veritas. The similarities included an embedded assumption that the pre-existing intangibles had a perpetual life.

Amazon presented a great deal of information demonstrating that Amazon's European business was highly uncertain at the time of the buy-in and required constant innovation. Amazon also argued that its European affiliates made substantial contributions to the European business, and that longer-term projections included profits attributable to future (not pre-existing) intangibles. As a result, Amazon argued the approach taken by the IRS did not identify the value of pre-existing intangibles, as required by the regulations in place at the time, but rather treated the buy-in as being "akin to the sale" of a business – a line of argument that was successful in Veritas.

In the Amazon opinion, Judge Lauber writes, "One does not need a Ph.D. in economics to appreciate the essential similarity (between the approach applied by the Commission in Veritas vs. that applied in the Amazon case)." The court found, like it did in Veritas, that the IRS' approach was fatally flawed because it treated the buy-in transaction as being akin to the sale of the business and did not give appropriate consideration to the environment of rapid innovation; nor to the current and future contributions of Amazon’s European operations to the projected profits of that business.

Judge Lauber's opinion is clearly a huge win for Amazon, and a major setback for the IRS. However, taxpayers should take caution in interpreting this opinion too broadly. This is especially the case for newer cost sharing transactions given that the findings in this case were made under the cost sharing regulations in place prior to 2009. Revisions that occurred to the cost sharing regulations in that year, in combination with more recent revisions to other regulations (such as to Section 367 and to the aggregation guidance set forth in Section 482) make the repercussions of this case for later transactions unclear.

Further information on Judge Lauber's opinion is available here.

U.S. Tax Reform and the Effects on Transfer Pricing
As the legislative debate in Congress shifts from health care to tax reform, we at the TP Times are planning to provide our readers with content that tracks how tax reform may or may not impact the transfer pricing landscape. While it is impossible to predict what the outcome of this debate will be, our hope is to help our readers make sense of a vastly complex debate. For our first piece, we tackle the starting point of the debate in Congress: Speaker Paul Ryan's "Better Way" proposal.

In June 2016, the House Republicans unveiled a tax reform package in a whitepaper, "A Better Way, Our Vision for a Confident America" referred to as the "Blueprint". The “Blueprint” represents a paradigm shift from the current corporate tax system and is intended to encourage manufacturing (and thus investment) in the U.S., simplify the U.S. corporate tax rules, and eliminate the benefits of abusive cross-border transfer pricing while putting U.S.-headquartered companies in tax parity with their foreign competitors.

The "Blueprint" proposes to alter the U.S. corporate tax in five major ways, namely:

  • The corporate tax rate would be reduced from 35.0 percent to 20.0 percent;
  • Businesses will be able to fully and immediately write off capital investments, eliminating depreciation expense;
  • U.S. tax will be determined on a "territorial" system vs. the current "worldwide" tax regime;
  • Businesses will no longer be able to deduct interest as a business expense; and
  • The corporate tax would be "border adjusted."

These changes convert the U.S. corporate income tax into what is called a "destination-based cash flow tax" (referred to as a "DBCFT"). 
There are four basic rules for calculating U.S. taxable income under a DBCFT, which are as follows:

  1. Revenues associated with U.S. sales are included in taxable income;
  2. Revenues from non-U.S. sales are excluded from taxable income;
  3. Costs of U.S. inputs are deductible from taxable income; and
  4. Costs of non-U.S. inputs are not deductible from taxable income. 

The combination of these four rules makes the revenue from sales to non-U.S. residents exempt from taxation and the cost of goods purchased from non-U.S. residents non-deductible. As a result, some have argued that the DBCFT system might cause transfer pricing to become irrelevant from a U.S. perspective.

We believe that transfer pricing will continue to be important for any multinational corporation with U.S. operations for a number of reasons:
Multinational corporations will still be incentivized to minimize their effective tax rate, and given the IRS' resulting indifference to intercompany cross-border pricing, foreign taxing authorities will likely be even more interested in transfer pricing, especially for transactions involving the U.S. as the DBCFT provides another opportunity to accomplish this goal.

  1. While the application of the DBCFT is relatively straightforward for tangible property transactions (i.e., the place of consumption for tangible property is very clear), its application to services transactions and intellectual property licenses may be more complicated (i.e., the consumer of services and IP is more difficult to ascertain). Transfer pricing will be helpful when addressing those complications.
  2. The DBCFT, coupled with the reduction of the U.S. corporate tax rate, may spark new transfer pricing planning opportunities. In the past, companies have been incentivized to use transfer pricing to shift profits outside the U.S. to lower tax jurisdictions. Various aspects of the "Blueprint" may flip this on its head and incentivize companies to use transfer pricing to do just the opposite—particularly for flows that will generate favorable tax treatment in the U.S. For example, a multinational corporation with operations in the U.S. may be inclined to minimize the U.S.-outbound payments to foreign affiliates for import products and maximize the U.S.-inbound payments from foreign affiliates for export products in order to reduce the taxes paid in those higher tax jurisdictions outside the U.S.

Further information on The Blueprint is available here.

OECD Releases Toolkit for Identifying Financial Data in Developing Countries
The Organization for Economic Co-operation and Development ("OECD"), in conjunction with the International Monetary Fund, United Nations, and World Bank Group, developed a toolkit to address difficulties typically faced by developing countries in accessing financial data for transfer pricing analyses.

A key issue raised by developing countries is the scarcity of the financial data necessary to carry out a comparability analysis. Such issues can affect both taxpayers and tax administrations. In many developing countries, challenges of obtaining information are not limited to specific, highly complex transactions: they may exist even for simple transactions. For many resource-rich developing countries, a lack of data on the pricing of certain commodities is a particular concern. Additionally, the cost of commercially available databases is not a viable option for developing countries looking to perform comparability analyses.

The draft toolkit:

  • Reiterates the importance of accurately delineating the transaction in accordance with the revised Chapter I guidance that was issued in the final report for Action Items 8 through 10 from the BEPS project.
  • Outlines a typical comparables search process that aims to identify potential comparables using a commercial database. When there are significant differences between the controlled transaction under review and the comparables, the toolkit provides guidance on comparability adjustments to help reduce the effects of these differences including working capital adjustments, accounting adjustments, and country specific risk adjustments.
  • Proposes the use of safe harbors by tax administrations to reduce the need to find a comparables set in every case. Safe harbor measures are proposed both for an appropriate transfer pricing method and set financial ratios by type of transaction, as well as processes which when applied would meet the requirements of transfer pricing rules.

There is recognition that further work needs to be completed to alleviate the difficulties around comparables, including: increasing data availability via international databases, support for access to commercial databases, and effective use of existing data.

Further information on the draft toolkit is available here.

UK Releases Guidance on Cash Pooling
Her Majesty’s Revenue & Customs ("HMRC") recently issued guidance regarding the transfer pricing aspects of cash pooling arrangements ("HMRC Guidance"), taking into account the revised guidance arising from the OECD's base erosion and profit shifting ("BEPS") project.

The HMRC Guidance acknowledges that, given the variety of legal and contractual arrangements in place, the facts and circumstances associated with different cash pooling arrangements may vary considerably, and therefore it is difficult to provide a prescriptive approach that fits all circumstances. The guidance notes that documentation should be in place to support the interest rates applied within the pool, the remuneration to the cash pool header, and the allocation of benefits to cash pool participants.

The new HMRC Guidance highlights the need to consider the economic "substance" of the arrangements as well as their legal form. 

The HMRC Guidance highlights areas that tax authorities may consider when reviewing the transfer pricing policies applied to such arrangements, including:

  • How cash pool participants should be compensated for deposits and charged for borrowings, including when these balances are, in practice, long term in nature;
  • Whether the benefits of the cash pooling arrangement are appropriately allocated to participants based on an analysis of their respective functions, risks, and assets;
  • The compensation to long term cash pool depositors in the broader context of the operations (i.e., functional profile, acquisitive nature, debt profile etc.); and
  • Whether the entity administering the cash pool is appropriately remunerated for the functions performed and risks borne associated with its role.

It is important to note that the HMRC Guidance does not outline specific rules on setting interest rates for cash pooling arrangements or for allocating any benefits of the cash pool to participants. Rather, it underscores important considerations in conducting transfer pricing analyses of cash pooling arrangements, and highlights areas of sensitivity in a tax authority's review.

Companies with established cash pooling arrangements, or those considering such arrangements, should take measures to ensure that they have adequate transfer pricing documentation in place to support their arrangements.

Further information on the new HMRC guidance is available here.

Australia Releases Risk Framework for Centralized Operating Models
In January 2017, the Australian Taxation Office ("ATO") issued a Practical Compliance Guideline ("Guideline") which lays out its compliance approach to transfer pricing issues related to centralized operating models. The Guideline is designed to assist taxpayers manage transfer pricing compliance risk and costs associated with centralized models or hubs. Typical centralized functions include procurement, marketing, sales and distribution; however, the Guideline is not limited to these functions.

The Guideline is in effect from January 1, 2017 and applies to existing and newly created hubs. In this regard, the Guideline is to be used to: assess the transfer pricing risk of a hub in accordance with the ATO's risk framework; provide documentation and disclosure guidance depending on the risk profile of a hub; and lay out options available to taxpayers to work with the ATO to mitigate related transfer pricing risk.

With respect to the risk assessment, the ATO will issue specific schedules for the different types of centralized models/hubs. In order to assess risk, taxpayers will be able compare the transfer pricing outcomes of their hub structure against the ATO risk benchmarks provided in their respective schedule. If a taxpayer's risk outcome is outside of a low risk category, the ATO provides a list of questions which are indicative of the issues that the ATO will consider when further reviewing the hub arrangement. The questions are aimed to better understand economic substance (from a functional and risk perspective) as well as the commercial purpose of a centralized hub

Australian taxpayers with centralized operating models should review the risk assessment framework. Depending on the outcome, appropriate transfer pricing documentation should be maintained in light of the ATO's specific expectations and guidance.

Further information on the ATO's Guideline is available here.

New Zealand Releases Consultation Documents Addressing Potential Transfer Pricing Changes
On March 3, 2017, New Zealand's Inland Revenue Department ("IRD") released consultation papers addressing the following:

  1. Transfer pricing ("TP") and permanent establishments ("PEs") avoidance;
  2. Interest deductibility rules; and
  3. Implementing the multilateral instrument ("MLI") to align New Zealand's tax treaties with OECD BEPS recommendations.

The TP and PE avoidance discussion document proposes to strengthen New Zealand's ("NZ") TP rules, prevent the abuse of tax treaties, and limit the ability to artificially avoid PE status. The proposals will align NZ legislation with the OECD's BEPS-revised guidelines and, to some extent, with Australia’s rules. In addition, the proposals will shift the burden of proof for transfer pricing positions to the taxpayer at every stage of inquiry. This change reflects the difficulties encountered by the IRD under current law in audits.

The proposed thin capitalization change would limit the deductible interest on related party loans from a non-resident to a New Zealand borrower, also reflecting issues experienced by the IRD in disputes involving ratings notching for determination of arm's length interest rates for intercompany debt and the IRD's application of this concept. The discussion document proposes to limit the interest rate to the rate of the borrower’s ultimate parent company on senior unsecured indebtedness, plus "some margin", essentially reflecting notching to the parent or group level irrespective of the commercial issues and market differences the NZ borrower may face. This proposed change could be regarded as provocative, and inconsistent with seminal international case law and OECD BEPS Action 4 changes.

The proposed guidance aligns NZ's TP rules with the 'economic substance' provisions of the OECD Guidelines, as revised by BEPS Actions 8-10, and would introduce more detailed guidance on recharacterization into NZ's TP legislation. It is worth noting, however, that recharacterization under the proposed guidance is not necessarily limited to "exceptional cases". This ability to recharacterize transactions potentially goes beyond that envisioned under the OECD Guidelines, and risk transference in controlled transactions and/or atypical transaction structures may trigger recharacterization. This provision could be subject to abuse by overzealous auditors who may seek to recharacterize transactions in a manner that does not reflect the actual substance of the transaction.

Further information on the IRD's consultation documents is available here

Valuation Advisory Services

Our valuation experts provide valuation services for financial reporting, tax, investment and risk management purposes.

Tax Services

Built upon the foundation of its renowned valuation business, Kroll's Tax Service practice follows a detailed and responsive approach to capturing value for clients.

Transfer Pricing

Kroll's team of internationally recognized transfer pricing advisors provide the technical expertise and industry experience necessary to ensure understandable, implementable and supportable results.

Valuation Services

When companies require an objective and independent assessment of value, they look to Kroll.