In this edition: Her Majesty's Revenue & Customs (HMRC) published the latest transfer pricing and diverted profits tax statistics, the IRS appeals the U.S. Tax Court's 2016 Medtronic's intangibles decision, The Inland Revenue Authority of Singapore (IRAS) published the second edition of the e-tax guide on country-by-country reporting, and the Vietnamese government published new transfer pricing regulations.
UK Publishes Latest Transfer Pricing and Diverted Profits Tax Statistics
On September 13, 2017, Her Majesty’s Revenue & Customs ("HMRC") published 'Transfer Pricing and Diverted Profits Tax Statistics, to 2016/17', and just as importantly, 'Diverted Profits Tax Yield: methodological note'.
According to HMRC, "in the years from 2011/12 to 2016/17, HMRC secured £5.914 billion of additional tax by challenging the transfer pricing arrangements of multinationals". This is said to include additional tax which was secured as a result of HMRC's investigations into arrangements within the scope of the Diverted Profits Tax ("DPT") legislation, where businesses have adjusted the transfer pricing on those arrangements during the investigation. The annual amount of additional tax secured from transfer pricing challenges is said to have approximately doubled from £853m in 2015/16 (12 months to March 31) to £1,618m in 2016/17.
Some of the noteworthy statistics released by the HMRC are discussed below:
- At 27.3 months, the average age of open transfer pricing enquiries was at its highest point for the six year run of figures provided, as was the average age of settled enquiries at 28.8 months. 50 percent of enquiries took longer than 29.4 months to settle in 2016/17, also the worst figure for the six year period. This is despite an increase to 82 full time equivalent staff in HMRC’s specialist transfer pricing group (there were also around 40 diverted profits tax specialists). This indicates that HMRC has been taking a significantly harder line in transfer pricing enquiries.
32 APA applications were made during the year, down from 47 in 2015/16 and 66 in 2014/15. The reason for this halving in applications is not discussed. Despite the halving in the number of applications, the number of applications turned down more than doubled from 2 in 2014/15 to 5 in 2016/15; again, the reasons for the same are not discussed. The number of APAs agreed during the year halved from 37 in 2014/15 to 19 in 2016/17.
Despite the marked decline in APA workload, the average time taken to reach agreement also doubled from 18 months in 2014/15 to 32.8 months in 2016/17, and 50 percent of APA applications took more than 34.7 months to resolve, more than twice as long as the figure of 15.6 months in 2014/15. These are strong indications of a remarkable hardening in HMRC’s approach to APAs, and a (presumably linked) reduction in their use by taxpayers.
Separate figures were published for financing APAs, known as 'Advance Thin Capitalization Agreements' or 'ATCAs'. The number of ATCAs agreed during the year declined fairly significantly from 213 in 2014/15 to 124 in 2016/17, and the number of agreements in force during the year fell from 577 to 479. The average time to reach agreement increased from 11.3 months to 14.9 months, and 50 percent of ATCAs took longer than 13.7 months, up from 10.5 months in 2014/15. These dispiriting statistics reflect a similar situation to the APA figures and overall, less willingness on the part of HMRC to give certainty to taxpayers about the future UK tax treatment of their international structures. One might hope that this position will be reconsidered in the context of Brexit.
Turning to the resolution of double taxation through the Mutual Agreement Procedure ("MAP") provided for in the UK's tax treaties, the number of cases resolved during the year fell significantly from 49 in 2015/16 to 36 in 2016/17. The average time to resolve cases worsened from 18.5 months in 2015/16 to 24.4 months in 2016/17. The reason for this is not discussed but presumably it might be linked to the general hardening in HMRC’s position indicated by the figures above, or to the increased complexity of transfer pricing matters following the publication of relevant BEPS project reports.
- Finally, the yield from the DPT increased from £31m in 2015/16 to £281m in 2016/17. The figure for 2016/17 is reported to include £138m amount raised from the first issue of DPT charging notices; the remaining £143m is said to be result of "behavioral change". This behavioral change component is in turn said to comprise two elements, namely the additional Corporation Tax ("CT") paid as a result of "HMRC intervention to ensure that profits earned in the UK are taxed in the UK", and where businesses have changed their structures or transfer pricing arrangements without an intervention from HMRC in order to avoid paying the DPT at a higher rate (25 percent) than CT (19 percent). As examples of this behavioral change, HMRC’s 'Diverted Profits Tax Yield: methodological note' suggests that "businesses may make transfer pricing adjustments, or restructure so that profits from the development or exploitation of Intellectual Property carried on in the UK are taxable in the UK". There is clearly a degree of guesswork about the extent of this change: HMRC notes that "additional CT from behavioral change linked to HMRC compliance activity is also monitored and scored when there is clear evidence that the behavioral change is related to the introduction of DPT. As a result, there is a high level of certainty around those elements of the yield. However, additional CT collected as a consequence of spontaneous behavioral change is not observed directly and has to be estimated."
Further information on the HMRC's report on Transfer Pricing and Diverted Profits Tax Statistics, to 2016/17, is available here. For 'Diverted Profits Tax Yield: methodological note', click here.
IRS Appeals U.S. Tax Court's 2016 Medtronic's Intangibles Decision
The U.S. Tax Court decision in the case of Medtronic, Inc. v. Commissioner of Internal Revenue1 has been contested by the Internal Revenue Service ("IRS") before the U.S. Court of Appeals for the Eighth Circuit. The IRS's key argument in the appeals filing pertains to the selection of Comparable Uncontrolled Transaction ("CUT") method without having regard to the stringent comparability standards prescribed under the 482 Treasury regulations.
In its decision released on June 9, 2016, the U.S. Tax Court rejected the IRS's use of the Comparable Profits Method ("CPM") to determine the arm's length royalty rate paid by Medtronic Puerto Rico Operations Co. ("Medtronic P.R.") for use of intangibles including technical information and patents for undertaking manufacturing of devices and leads used in the medical devices space. The Tax Court selected the CUT method instead, which was also the method that the taxpayer put forth. The Court did, however, make alterations and adjustments to the implementation of that method.
Although the Tax Court ruled taxpayer's analysis as "unconvincing and vague", it agreed to the selection of a 1992 cross-license agreement between Medtronic U.S. and one of its competitors, Pacesetter Inc. (the "Pacesetter agreement") as an appropriate CUT. Pursuant to the Pacesetter agreement, the parties agreed to grant the "non-exclusive" license to use each other's patents for devices and leads to settle several pending lawsuits involving patents, anti-trust and employment issues.
The Tax Court made comparability adjustments to account for the difference in profit potential and product differences between the two agreements as well as the fact that Medtronic P.R. had access to taxpayer's knowhow. These adjustments caused the unadjusted royalty rate from the agreement (7 percent) to increase to 44 percent for the cardiac pulse generators and neurological stimulators (i.e., the devices) manufactured by Medtronic P.R. under the Tax Court's opinion, while the royalty rate for leads was set at 22 percent, half of the royalty rate for devices.
In the Petitioner brief filed on June 21, 2017,2 the IRS has alleged that the adjustments made by the Tax Court are inadequate, arguing that the licensing agreement used by the Tax Court in its application of the CUT method is not comparable to the intercompany license being analyzed in the case. Specifically, the IRS argues that the royalty rate from the Pacesetter agreement is not commensurate with the income attributable to the intangibles in the intercompany license. It also identifies certain characteristics that it believes disqualifies this agreement as an appropriate comparable, including:
- The Pacesetter agreement is a litigation settlement and not a license entered into in the ordinary course of business. Additionally, the Pacesetter agreement involved contractual terms that were not present in licenses between Medtronic and its related parties. Specifically, the IRS has contested that the Tax Court ignored the $75 million lump-sum payment which the IRS argues formed a substantial portion of the consideration under the Pacesetter agreement.
The Pacesetter agreement included a cross-license that allowed Medtronic U.S. to use the Pacesetter's patents. Relying upon the tax ruling in case of Seagate, 3 the IRS has submitted that agreements requiring "advance payments" are not comparable to one without that feature. Further, the royalty in case of a cross-charge is typically lower than one-way license arrangements was also alluded to by the IRS;
The Pacesetter agreement only covers patents for cardiac products while the intercompany license covered all technical intangibles including trade secrets, know-how, and technical design expertise for both cardiac and neurological products. Specifically, the Pacesetter agreement did not provide the licensee with any ability to exploit the licensed intangibles; and
- A mismatch of functions performed by the licensee, given that in the IRS's view Pacesetter engaged in manufacturing, sales, research and development and clinical functions, while Medtronic P.R. only engaged in manufacturing finished.
The IRS has claimed that given the number, magnitude and nature of adjustments required to consider the Pacesetter agreement an appropriate CUT undermines the reliability of the Tax Court's analysis and therefore necessitates the need to re-evaluate CPM as the best method.
1Medtronic Inc. and Consolidated Subsidiaries, Petitioner v. Commissioner of Internal Revenue Service, Respondent. Docket No. 6944-11. Filed June 9, 2016.
2Medtronic Inc., & Consolidated subsidiaries, Appellee v. Commissioner of Internal Revenue, Appellant on Appeal from the Decision of the United States Tax Court. Brief for the Appellant. No. 17-1866. Filed July 21, 2017.
3Seagate Tech., Inc. v. Commissioner, 102 T.C. 149, 278-280 (1994) Pg. 37 of Brief for the Appellant.
Singapore – Updated Guidance on Country-by-Country Reporting
The Inland Revenue Authority of Singapore ("IRAS") published on July 11, 2017 the second edition of the e-tax guide on Country-by-Country ("CbC") reporting ("Updated Guidance on CbC Reporting"), which came after the first edition published on October 10, 2016 with more clarifications on how taxpayer should comply with the requirements to complete CbC Report.
A CbC Report of the MNE group will include information on the group's global allocation of the income and taxes paid in different jurisdictions and other financial data. CbC Reports submitted to IRAS will be provided to tax authorities of jurisdictions with which Singapore has qualifying competent authority agreements for the automatic exchange of CbC information. CbC Reports may be used by Singapore and other tax authorities in evaluating transfer pricing risks and other BEPS related risks.
On June 21, 2017, Singapore signed the Multilateral Competent Authority Agreement on the exchange of CbC Reports ("MCAA CbCR"). The signing of the MCAA CbCR will enable Singapore to efficiently establish a wide network of exchange relationships for the automatic exchange of CbC Reports.
The same as its first edition, the Updated Guidance on CbC Reporting is applicable to an MNE group which meets all of the following conditions:
- The ultimate parent entity of the MNE group is tax resident in Singapore;
Consolidated group revenue for the MNE group in the preceding financial year is at least S$1,125 million; and
- The MNE group has subsidiaries or operations in at least one foreign jurisdiction.
CbC report must be submitted based on the format specified in Paragraph 5 of the Updated Guidance on CbC Reporting. The Reporting Entities are expected to have processes in place to collate and prepare the required data in accordance with the prevailing CbCR XML Schema. Data submitted to IRAS in any other format will not be accepted.
As compared to the first edition, the key updates brought by the Updated Guidance on CbC Reporting are a few more FAQs providing more guidance on the Filing Requirement, Completing the Template and Clarification of Terms used in the Template.
Further information on the Updated CbC Reporting guideline is available here.
Vietnam – New Thin Capitalization Regime for Transfer Pricing Audits for Vietnam Tax to Meet Up Tax Collection Target
Transfer pricing became a key enforcement and investigation/audit for tax collection in Vietnam. On September 15, 2017, Prime Minister Nguyen Xuan Phuc highlighted the theme of the 24th APEC Small and Medium Enterprises Ministerial Meeting, and added that, "Vietnam hopes to receive cooperation from other APEC member economies to enhance the capacity of the tax system to encourage business production, fair competition, and prevent transfer pricing and tax evasion of some foreign investors."4
In addition to the current ongoing and aggressive transfer pricing audits, Vietnamese government have published the new transfer pricing regulations effective from May 1, 2017, which consists of Decree No. 20/2017/ND-CP ("Decree 20") and Circular 41/2017/TT-BTC ("Circular 41/2017"). The new transfer pricing regulations cover several key issues which respond to Base Erosion and Profit Shifting ("BEPS") developments at the OECD level as well as in Asian jurisdictions including India, China and Singapore, including the new thin capitalization regime.
Among these, following BEPS Action No.4, Decree 20 caps the total allowable loan interest of the taxpayer at 20 percent 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 deductibility of interest expense could be applied for both intra-group loans and independent loans. This has triggered challenges for taxpayers in industries such as real estate or retail, and those who are suffering losses.
In order to tackle transfer pricing issues and meet the tax collection targets, the Ministry of Finance ("MoF") announced proposals to strengthen the new thin capitalization regime under Decree 20 by setting industry-specific debt-to-equity ratios. In particular, the current proposal sets additional requirements in the corporate income tax laws, that no tax deduction for interest expense for the loans debt-to-equity ratio exceeds five-to-one (5:1) for manufacturing companies, four-to-one (4:1) for other sectors, and twelve-to-one (12:1) for banking industry. The draft laws are expected to be presented to the National Assembly for adoption in year 2018, with changes to take effect in year 2019. We noted that the thin capitalization proposal was raised by MoF in revising Income Tax Law back in April 2013 but was not approved. However, according to the MoF, recent transfer pricing audits have witnessed several companies in Vietnam were under loss positions and thus do not pay any tax due to having significant loan interest from inter-company loans. Many of those are long-term loans from parent company since local company's establishment. These loans are normally extended every year with the principal adding up with yearly over-due payment, which further increase the loan interest expense.
Further information on the draft Law revising several tax laws in Vietnam is available here (in Vietnamese language).
Decree 20/2017/NĐ-CP is available here (in Vietnamese language).