In this edition: The OECD has invited public comments on scoping the future revision of Chapter IV and Chapter VII of the Transfer Pricing Guidelines; the IRS and Coca-Cola Company transfer pricing trial has concluded; the IRS released an updated template to be utilized by taxpayers when applying for an advance pricing agreement; the German Federal Fiscal Court ruled in favor of the taxpayer in a preliminary injunction case; the Italian Ministry of Economy and Finance provided additional guidance concerning the application of certain transfer pricing provisions; and the Australian Government published its 2018 Federal Budget.
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OECD Requests Public Comments on Scope of Future Changes to Guidance on Chapters IV and VII of the Transfer Pricing Guidelines
In a move to complete the overhaul of the original Transfer Pricing Guidelines, the OECD has invited public comments on scoping the future revision of Chapter IV (administrative approaches to avoiding and resolving transfer pricing disputes) and Chapter VII (special considerations for intra-group services).
Since the introduction of the original Transfer Pricing Guidelines by the OECD in 1995, there has been an intermittent program of revision. Chapters I to III were updated in 2010, when Chapter IX on Business Restructuring was also added, and chapters V, VI and VIII were overhauled in 2015 under the recent BEPS project.
Although Chapters IV and VII have incorporated limited revisions since the original 1995 edition of the Transfer Pricing Guidelines (the revision of the section of Chapter IV on safe harbors in 2013 and the addition of the section on a simplified approach to determine the arm’s length charges for low-value adding services to Chapter VII as part of the BEPS revisions), they remain largely unchanged since the 1995 Guidelines.
The OECD has indicated that additional work could be done to update the guidance in Chapter IV in relation to examination practices and to mechanisms to prevent and resolve tax disputes, and potentially to include guidance on risk assessment. The OECD published a Draft Handbook on Transfer Pricing Risk Assessment in April 2013 and sought comments at the time but this project has been in abeyance ever since.
Although comments are invited on safe harbors and arbitration, there are apparently no plans to revise the guidance in this respect. Topics on which views are particularly welcomed include aspects or mechanisms to minimize the risk of transfer pricing disputes that could be included as part of the guidance on transfer pricing compliance practices, how to minimize the risk of double taxation on corresponding and/or secondary adjustments, observations on improving the use of APAs and views on other mechanisms for administering transfer pricing or preventing or resolving transfer pricing disputes that could be included in Chapter IV.
The OECD has indicated that the future revision of Chapter VII could be focused on aligning the guidance with the chapters already revised under the BEPS Project, particularly Chapter I but also Chapters VI and VIII, as well as considering whether, and if so, how to incorporate the ongoing work on the use of profit split methods and financial transactions.
To inform the Chapter VII scoping exercise, views are invited on how the guidance could be revised or supplemented to address issues related to the practical implementation of the Guidelines in the context of intra-group services, thus increasing tax certainty for taxpayers and preventing double taxation. Some of the practical challenges identified include demonstrating the rendering or benefits of a service, distinguishing between services that benefit local affiliates or that result from group membership and identification of an appropriate allocation key for intra-group services.
Interested parties are invited to send their comments in Word format no later than June 20, 2018 to [email protected]. The OECD aims to finalize this scoping exercise by the end of 2018.
The invitation from the OECD to comments can be found in Chapter IV here and Chapter VII here.
The U.S. Tax Court Transfer Pricing Trial for Coca-Cola Wraps Up
The February edition of Transfer Pricing Times contains an article “IRS and Coca-Cola Getting Ready for Trial”, which outlined the transfer pricing issue at dispute, the transfer pricing methods applied by each of the IRS and Coca-Cola Company (“Coca-Cola”), as well as each party’s key arguments to support their respective positions. This article continues reviewing the case and summarizes the eight-week trial that was wrapped up in May 2018.
The case is Coca-Cola Co. v. Commissioner, T.C., No. 31183-15, which involves a $9.4 billion transfer pricing adjustment made by the IRS for the tax years 2007 to 2009, which would have yielded $3.3 billion in additional income tax for the company. The IRS applied a comparable profits method (“CPM”) by arguing that the foreign affiliated licensees are comparable in terms of functions and risks to independent bottlers that engage in packaging and distribution functions. Coca-Cola’s approach is based on a 10-50-50 method, under which each foreign affiliated licensee retains 10 percent of gross sales, with the residual operating profit, after adjustment, split 50-50 between the licensees and Coca-Cola. Coca-Cola’s argument derived from the position that licensees make substantial non-routine contributions to value through the development of the brand in their local markets through marketing and other investments. The difference between the IRS and taxpayer positions boiled down to a debate on the role played by each of the U.S. headquarters of Coca-Cola, the foreign affiliated licensees (also referred to as “Supply Points” or “Business Units” during the trial) and the independent bottlers.
The trial started on March 5, 2018, which lasted eight weeks (with a two-week extension after the originally scheduled six-week trial), and wrapped up on May 11, 2018.
In the first segment of the trial, fact witnesses, who were (former) executives at various positions within Coca-Cola or with the bottlers, were called to provide their testimony. The testimony and cross-examinations largely focused on the following areas: (1) the interactions among the entities; (2) the decision-making and approval protocols for marketing and R&D projects; (3) local marketing and advertising activities and the involvement of these entities; (4) trademark management; and (5) business plans and concentrate pricing arrangements made between the foreign affiliated licensees/Supply Points/Business Units and the bottlers.
In the second segment of the trial, expert witnesses presented their testimonies. The IRS and Coca-Cola called for experts in the field of marketing to present their analysis of Coca-Cola’s marketing intangibles, with a particular focus on the role of the global brand vs. localized marketing campaigns. In addition, transfer pricing experts from both sides testified on their expert reports, providing their opinions on Coca-Cola’s business model and arguments for why their respectively selected transfer pricing method is most reliable.
In addition to the information presented to the court in these two segments, there were also discussions about the relevance of a 1996 royalty closing agreement entered between Coca-Cola and the IRS, which established the “10-50-50 method” and of certain historical factual discussions and analysis the company had prepared in association with the pursuit of an APA with Japan in 2001.1
The originally scheduled six-week trial was extended to eight weeks and concluded on May 11, 2018. Opening briefs are due on October 19, 2018 and the simultaneous reply briefs will be due on February 15, 2019. Duff & Phelps will continue to monitor this case and will alert our readers when significant developments occur.
IRS Releases Updated Advanced Pricing Agreement Template
On May 11, 2018, the U.S. Internal Revenue Service (“IRS”) released an updated template to be utilized by taxpayers when applying for an advance pricing agreement (“APA”) under Rev. Proc. 2015-41. This new options-based template is meant to lessen burdens on taxpayers in the program and to provide additional guidance to taxpayers when drafting and applying for an APA.
In September 2017, the IRS released a proposed version of the template and invited comments from taxpayers and practitioners. Based on the comments received, the IRS made the following changes prior to releasing the final APA template:
- Addition of a de minimis exception for intercompany payables to be excluded from calculation of indebtedness under Code Section 956 so long as the intercompany payable is satisfied within 90 days of the close of the APA tax year, in which the intercompany payable is established;
- Reiteration of the IRS’ relatively expansive definition of the term “Tested Party” in Section 4 of Appendix A to lessen any confusion around the term’s intended meaning; and
- Removal of Section 7 of Appendix A, which “addressed whether a covered method should be re-applied to take into account certain adjustments between an APA-covered entity and a non-APA-covered entity, and any results competent authority resolution, that would affect the testing of financial results under the covered method.”
The IRS recommends that taxpayers with pending APA requests contact their IRS Advance Pricing and Mutual Agreement Program team leader for guidance in updating their submission, if necessary.
The IRS’s announcement of the new APA template, as well as instructions for requesting the template and associated materials, can be found on its website here.
German Federal Fiscal Court Determines Interest on Tax Arrears Excessive
On April 25, 2018, the German Federal Fiscal Court (“BFH”), Germany's highest tax court, ruled in favor of the taxpayer in a preliminary injunction case (BUNDESFINANZHOF Beschluss vom 25.4.2018, IX B 21/18). In this case, the taxpayer had argued that the six percent per annum interest rate, which the German tax authorities charge on tax arrears, is excessive. The original rate of six percent per annum was based upon the assumption that a taxpayer that pays tax at a later date has an advantage (in the form of its cash flow) over taxpayers that pay their taxes on time, thus violating the principle of equal treatment in German law. This rate has been challenged and upheld several times prior to this ruling. For example, a few months earlier, a different panel of the BFH ruled against the taxpayer and did not find the six percent interest rate to be unconstitutional (BUNDESFINANZHOF Urteil vom 9.11.2017, III R 10/16).
However, in the most recent opinion of the BFH, the interest rate of six percent may be too high, particularly in times of low interest rates, when the currently applied interest rate of six percent has the effect of an unjustified surcharge on the tax assessment. Furthermore, there are serious doubts as to whether the interest rate is in line with the rule of law principle of Article 20 of the German Constitution (“Grundgesetz”).
While the ruling is good news for taxpayers, there is still a case pending (1 BvR 2237/14, 1 BvR 2422/17) at the federal constitutional court (“BVerfG”) which will rule over the question of whether the six percent interest rate is unconstitutional. The court aims to issue a judgment on this matter before the end of this year.
In the meantime, companies facing interest charges from the German tax authorities due to an income adjustment may consider appealing against these charges. This would keep the cases open until the BVerfG judgement is issued, allowing taxpayers to benefit from a potentially favorable outcome of the pending court case.
New Decree Provides Updated Guidelines Concerning Italian Transfer Pricing Provisions
On May 14, 2018, The Italian Ministry of Economy and Finance provided additional guidance concerning the application of certain transfer pricing provisions, as codified under article 110, paragraph 7, of the Italian Income Tax Code. This code had previously been amended in 2017 as a result of changes made to the OECD Guidelines during the BEPS initiative.
The amendments to the Italian Income Tax Code are generally in line with the OECD Guidelines and it appears that the transfer pricing regulations in Italy are now more in alignment with the OECD Guidelines than they have been in the past. Key provisions of the most recent decree on this matter include:
- Confirmation of the Italian tax administration’s approach that requires verifying both the legal and economic control prior to applying the transfer pricing regulations (i.e., determination of related party status).
- Adoption of “comparability” standards that are consistent with the OECD Guidelines.
- Adoption of a “best method” standard, rather than a reliance on a hierarchy of methods.
- Provisions holding that tax inspectors should not disregard the transfer pricing method that the taxpayer applied where taxpayer complied with the Italian regulations and selected a reasonable transfer pricing method. In these circumstances, inspectors should rather verify (and potentially challenge) the correct application of this method.
- Introduction of safe harbors for “low value-adding services” in which a simplified approach can be adopted. This approach allows for a five percent mark-up on total costs related to the provision of services for which are considered supportive/administrative in nature (similar to the low-margin services provision in the OECD Guidelines).
With the changes to the Italian Income Tax Code, taxpayers operating in Italy would do well to examine their current transfer pricing support to ensure they are fully in compliance with the new guidelines in the Italian Income Tax Code.
Australian Government Releases 2018-2019 Budget Measures Pertaining to Multinational Tax Integrity
The Australian Government published its 2018 Federal Budget on May 8, 2018. The Australian Government proposed the following measures that may impact multinational companies and non-resident investors:
Expanding the Definition of Significant Global Entities
Effective from July 1, 2018, the definition of ‘Significant Global Entity’ will be expanded to include large multinational businesses that are ultimately owned by private companies, trusts and partnerships, or investment entities (e.g. real estate funds and private equity funds). This will ensure that these businesses are subject to the application of tax integrity rules such as the Diverted Profits Tax, Multinational Anti-Avoidance Law, and-Country-by-Country reporting obligations.
Ensuring Taxation of Digital Businesses
In an effort to ensure digital businesses pay an appropriate level of Australian taxes, the government proposed extending the Goods and Services Tax (“GST”) to be assessed on transactions made through offshore sellers starting July 1, 2019. This is in addition to previously enacted measures to apply GST to digital products and services imported by Australian consumers after July 1, 2017. The Government has also indicated that in the coming weeks it will be releasing a discussion paper on options for taxing digital businesses in Australia.
Tightening Australia’s Thin Capitalization Rules
The Government will limit the amount of interest deductions multinational entities can claim in Australia under the thin capitalization rules. In particular, entities will now be required to rely on asset values reported on their financial statements for debt capacity analysis. Also, foreign controlled Australian consolidated groups and multiple-entry consolidated groups that control a foreign entity will now be treated as both inward and outward investors under the thin capitalization rules. This will ensure that these taxpayers will not be eligible for tests that were only intended to apply to outward investors. These changes will apply for tax years commencing on or after July 1, 2019.
Tightening Stapled Structure Concessions for Foreign Investors
The Government announced it is releasing measures to address the perceived tax integrity risks posed by “stapled structures”. The Government will no longer allow foreign investors to convert active trading income of an operating company taxed at 30 percent into passive income (e.g. rent) of a managed investment trust (“MIT”) that was taxed concessionally at 15 percent or less. The Government released draft legislation for remarks by independent tax experts and the business community. The draft legislation includes the imposition of a 30 percent MIT withholding tax on distributions to non-resident investors. There is an exclusion for cross-staple rental payments that are funded by third-party rent. Examples of these structures include student accommodation and manufactured home-estate staples. Hotel staples however will be impacted by these new measures as they generate income from third parties through license fees instead of rental income. These changes will apply from July 1, 2019 with a transitional period of at least seven years for leases that existed before March 27, 2018.