Inside this Edition: OECD Addresses base Erosion and Profit Sharing; Global Transfer Pricing Developments; and Interest Deductibility Around the World.
On February 12, 2013, the Organization for Economic Cooperation and Development (“OECD”) released its report Addressing Base Erosion and Profit Shifting (“BEPS”), as commissioned by the Group of Twenty Finance Ministers and Central Bank Governors commonly known as the G-20. This report discusses the ways in which interactions between different countries’ tax systems yield opportunities for multinational enterprises (“MNEs”) to substantially reduce or even eliminate taxation on a substantial portion of their profits in a manner that is inconsistent with the objectives of these tax systems. In other words, the recognition of profit can be disconnected from the locus of “real economic activity.” Gaps in the tax regimes that permit BEPS arise because the tax systems of many countries are based on outdated ideas about how businesses operate and drive value. The report also presents information that at least suggests that MNEs seem to be exploiting these gaps, and discusses the creation of a comprehensive action plan by the OECD that will help countries address BEPS issues. Given the breadth of causes of BEPS and the required coordination to address them, the BEPS project is a very ambitious undertaking by the OECD and will likely have far reaching effects.
According to the report, BEPS opportunities come from a variety of sources, one of which is transfer pricing. The paper places a particular focus on BEPS opportunities created through risk shifting arrangements and intangible movements. As intangibles have played an increasingly important role, and as technology has allowed MNEs to run integrated businesses that are spread across the globe, tax regimes have failed to keep up, resulting in significant BEPS issues. With respect to the transfer pricing issues identified, the fundamental questions relate to determining when taxpayers’ risk allocations (and intangible movements) should and should not be respected, and in particular, what level of economic substance should be required in order for those allocations to be respected. This theme was echoed in the OECD draft intangibles guidance released last year, which concluded that the only parties entitled to intangible related returns would be those that were actually involved in (rather than merely funding) the most critical aspects of intangible creation and management.
The OECD’s BEPS paper and intangible guidance clearly indicates that substance is likely to play an increasingly important role in defining the limits of the arm’s length standard. To date, the U.S. transfer pricing regulations have largely given deference to the way that taxpayers have chosen to structure their transactions, stating that as long as a transaction has economic substance, the IRS should respect it rather than forcing a characterization of the transaction to match “arm’s length behaviors.” In contrast to the US transfer pricing regulations, the language in the BEPS report and the OECD draft intangibles guidance seem a good deal more restrictive on these points, casting doubt on whether arrangements that are deemed to be “artificial” will be respected under future guidance and advice coming from the OECD.
In addition to transfer pricing, the report also identifies numerous other sources of BEPS opportunities, including (but not limited to): (i) tax jurisdiction gaps created by an increasingly digital economy, (ii) mismatched entity and instrument classification across different tax systems, and (iii) insufficient anti-avoidance measures. The report stresses that all of the sources of BEPS need to be addressed on a comprehensive and coordinated basis. To this end, the OECD will be developing an initial comprehensive action plan to present to the Committee on Fiscal Affairs in June of this year. This initial plan will (i) identify actions that need to be undertaken to address BEPS; (ii) set deadlines to implement these actions; and, (iii) identify resources and methods necessary to execute these actions. Components of this initial plan will also include proposals to develop tools to address each of the BEPS “pressure areas” on a coordinated basis.
It is clear that the efforts that will be undertaken as part of the BEPS focus (some of which, like the draft intangible guidance, are already underway), along with other developments (e.g., the United Nation’s efforts to provide transfer pricing guidance), have the potential to fundamentally change critical components of transfer pricing, as well as broader international tax regulation and administration worldwide. As such, it will be important to keep abreast of these developments.
Global Transfer Pricing Developments
Highlighted below are a few recent developments in the continuing evolution of national transfer pricing regulatory regimes.
Canada Releases 2012 Annual APA Program Statistics1
In January 2013, the Canada Revenue Agency (“CRA”) released its annual report on Canada’s APA program, covering the fiscal year ended March 31, 2012 (“FY 2012”). We highlight several key findings from that report below.
- Increase in number of pre-file meetings conducted – Over the course of FY 2012, the CRA had 34 applicants to the APA program. This marks the most pre-filing meetings since FY 2008.
- Increase in fiscal year-end inventory of active cases – The CRA accepted 17 new cases in FY 2012. With the completion of ten APAs, and the withdrawal of one application, the APA program reported a closing inventory of 102 in FY 2012 (up from 96 in the previous year).
- Slight decrease in number of APA cases accepted – There were 17 cases accepted for FY 2012 compared to 20 new cases in FY 2011.
- Majority of APAs filed continue to be bilateral or multilateral – As of FY 2012, over 90 percent of cases currently in process involved taxpayers seeking a bilateral or multilateral APA.
- Decrease in average time to conclude a bilateral APA (from acceptance into the program to completion) – The average time to conclude a bilateral APA was 44 months in FY 2012. This is down from the average 50.3 months previously reported for FY 2011.
- Shift of cases from the transfer of tangible goods – Approximately one-half of total APA cases in process involve the transfer of tangible property, while cases involving intangible property and intra-group services represented 31 percent and 22 percent of cases, respectively. This marks a shift away from tangible property cases compared to the prior year’s report.
- New countries Involved – For the first time in the program’s history, bilateral APAs were initiated with Ireland and Singapore.
The CRA continues to focus on conducting comprehensive due diligence before accepting a taxpayer into the program in order to continue to move towards shorter average processing times and pare down its inventory of active cases.
Peru Amends Transfer Pricing Rules
Effective January 1, 2013, Peru issued a decree (DS No. 258-2012-EF) that amends its current income tax regulations (i.e., the Reglamento de la Ley del Impuesto a la Renta) in a continued effort by the taxing authorities to clarify previous changes to the country’s transfer pricing rules. We highlight the key changes of this decree which impact transfer pricing below.
- Clarification to transactions subject to transfer pricing rules – The rules clarify that transfer pricing rules are applicable to (i) all transactions between international and domestic related parties; and, (ii) all transactions with entities located in “tax haven” jurisdictions.
- Use of multiple year averages – To better understand the facts behind the determination of the transfer price, the amended rules allow for the consideration of information related to both the tested party and the comparables corresponding to two or more years before or after the transaction under review.
- Currency adjustment required for application of the CUP method only – The rules clarify that transactions selected as comparable that are made in a different currency will only require an adjustment if the CUP method is used for analysis. A currency conversion adjustment is not required for any other transfer pricing method.
- Use of full range applicable in certain CUP applications – The rules retain the use of the interquartile range to establish the arm’s length nature of an intercompany transaction. However, in certain circumstances where there is a high degree of comparability, the full range may be used to evaluate the results of a CUP analysis.
- APA program has been established, but specific procedures are still pending – Under Peru’s transfer pricing rules, APAs may be unilateral or multilateral. In addition, before a taxpayer submits an application for an APA, they may meet with the taxing authorities to determine whether or not an APA is feasible. The specifics of these meetings and the requirements of maintaining an accepted APA are still pending.
Other initiatives of DS No. 258-2012-EF include clarification concerning whether an internal transaction may be considered comparable to the transaction under review, and under what circumstances certain transfer pricing methods may be used. This decree comes in an effort to lend greater clarity and guidance to Peru’s transfer pricing rules.
Greece Announces New Tax Law
The Greece taxing authorities published tax Law 4110 / 2013 (“Greek TP Law”) in the Government Gazette on January 23, 2013. The highlights of Law 4110 / 2013 are as follows:
- Broader definition of the meaning of affiliated enterprises – The definition of “affiliated enterprises” has been extended to include cases where even the possibility of influence (rather than necessitating outright control / dependence) on one of the enterprises exists. The Greek TP Law is also applicable to loan agreements, transfer of shares, participation percentages in civil law society / joint ventures, and real estate.
- Extended obligation for documentation – The Greek TP Law requires that taxpayers retain a copy of their transfer pricing documentation for five years after the end of the calendar year during which the tax return is submitted. This period of time may be even longer depending on whether or not the taxpayer is involved in an audit. In addition, taxpayers are required to update their documentation in the event there is a change in the market conditions that would affect the facts / data contained in the original documentation.
- Specific deadlines for drafting of documentation / electronic submission – The Greek TP Law requires that documentation be prepared within 50 days from the end of the accounting period. The taxpayer is also required to submit a table summarizing relevant transfer pricing information to the Greek tax authorities during this timeframe. One exception is made for December 31, 2012, for which the deadline is extended to May 10, 2013.
- Exemption from documentation – In addition to the documentation exemption granted to foreign commercial / industrial companies incorporated in Greece (Law 89 / 1967), the Greek TP Law also grants exemptions to companies whose total intercompany transactions do not exceed either (i) €100,000, where gross revenues for all affiliated enterprises do not exceed €5,000,000; or (ii) €200,000, where gross revenues for the accounting period for all affiliated entities exceeds € 5,000,000.
- Rationalization of transfer pricing penalties – Penalties for typical violations have been reduced and are considered to be much more rational compared to the previous regime. Specifically, the 20 percent fine on the amount of transactions that were not documented has been eliminated by the Greek TP Law. Further details for other penalty provisions can be found under Law 4110 / 2013.
- Introduction of APA program – The Greek TP Law introduces the option for companies to apply for an APA. APA applications should be made to the General Directorate of Tax Audits and Collection of Public Revenue of the Ministry of Finance. The initial APA will last no longer than two years, with an option to renew for an additional four years.
The Greek TP Law will apply to all Greek companies and permanent establishments for accounting periods beginning on or after January 1, 2012, while the APA program will be available beginning January 1, 2014. Further clarification and guidance is expected to come from the Ministry of Finance in the coming months. However, the primary challenges facing Greek taxpayers will be finding the resources and information necessary to comply with the new documentation requirements.
Interest Deductibility Around the World
With the growing volume and visibility of loan transactions between related parties, tax deductibility of the resulting interest payments is a source of increasing concern for affected taxpayers. Tax authorities in various countries have challenged these payments, often on the assertion that the transaction in question is more akin to the provision of equity rather than bona fide debt. This assertion can at times be abetted by country-specific thin-capitalization (“thin cap”) rules, which refer to a maximum allowable ratio of debt to equity for tax purposes, and related provisions. While thin cap rules can evaluate a taxpayer’s overall tax structure, they are often aimed at limiting tax deductions for interest payments to related parties. Further, there is hardly any conformity in the relevant regulations and practices from country to country.
- United States – Does not have thin cap guidelines per se; however, earning stripping rules can come into play with respect to indebtedness of U.S. companies to foreign related parties. Generally, a debt-to-equity ratio of 1.5/1.0 may be a trigger point.
- France – Has a thin cap threshold of 1.5/1.0, generally applicable to interest paid by French taxpayers to related parties, or to third-parties when covered by a related-party guarantee.
- United Kingdom – Has no formal thin cap rules. Tax authorities suggest that each case should be examined individually, perhaps with reference to average ratios for the particular industry. In addition, consideration should be given as to how a third-party lender would evaluate a specific loan and the borrower’s ability to service it.
- Germany – Has replaced its thin cap guidelines with an overall limitation on interest deductions, breach of which could lead to withholding taxes and double taxation.
- Australia – Maximum indebtedness rules vary by type of company or investor and are applied to total debt, not just that with related parties. Taxpayers with low interest deductions are exempt.
- Belgium – Does not have general thin cap rules, but there are specific requirements for certain situations. For example, a 1.0/1.0 debt-to-equity ratio applies for financing obtained from some direct shareholders or from directors.
- Luxembourg – Similar to Belgium, Luxembourg does not have thin cap regulations. In practice, however, the tax authorities may apply a debt-to-equity ratio of 85/15 in some case.
- The Netherlands – Applies a thin cap ratio of 3.0/1.0 to the total debt of Dutch taxpayers. However, only interest deductions for payments to related parties are disallowed under these rules. However, any disallowed interest is not re-characterized as equity.
- Spain – Similar to the Netherlands, Spain also has a 3.0/1.0 ratio, but this is not applicable when payment is going to an entity in the European Union.
- Latin America – Some Latin American countries, such as Mexico and Argentina, have instituted thin cap rules. Some relief possible in Mexico under an Advanced Pricing Agreement.
The lack of consistency in thin cap and related rules around the world, not to mention differing practices among tax authorities in applying them, certainly does not make it any easier for taxpayers to predict how various forms of intercompany financing will be treated. The consequences can vary from re-pricing of a loan to disallowed interest deductions (and perhaps re-characterization as dividends), with all the resultant tax consequences.
1. More information on Canada’s APA Process and 2012 Statistics are available at: http://www.cra-arc.gc.ca/tx/nnrsdnts/cmp/p_rprt12-eng.pdf