Fri, May 23, 2014

Transfer Pricing Times: Volume XI, Issue 5

In this Edition, OECD Holds Public Consultation on Transfer Pricing Documentation and CbC Reporting.  

On May 19, 2014 the OECD held a public consultation on transfer pricing documentation and country-by-country (CbC) reporting in Paris. The consultation relates to Action 13 of the BEPS Action Plan released on July 19, 2013, which calls for a review of the existing transfer pricing documentation rules and the development of a template for CbC reporting of income, taxes and economic activity for tax administrations. As part of this process, the OECD published a discussion draft in January 2014 that contained revised guidance on transfer pricing documentation and CbC reporting, and invited public comments. The written comments were discussed by Working Party No. 6 of the Committee on Fiscal Affairs at its March 2014 meeting and certain commenters were invited to speak in Pairs. The consultation focused primarily on the proposed Masterfile and CbC reporting template, with topics ranging from content of the documents to confidentiality. The filing method was a contentious point, with some parties asserting each local affiliate of a multinational company should provide the proposed master file and template directly with their local taxing authorities. However, several business groups contend that the most secure and reliable process requires the parent company to file only with its home jurisdiction. The home tax authority would then have the responsibility to distribute, through information exchange provisions in its tax treaties, the information requested by foreign jurisdictions. The consultation was broadcast live online and the full recording can be found here:


ATO’s Draft Guidance under New Transfer Pricing Laws Confirms Increased Taxpayer Burden in Self-Assessing and Documenting Transfer Pricing Positions

On April 16, 2014, the Australian Taxation Office (ATO) issued draft guidance1 in relation to the application of its recently-enacted revised transfer pricing legislation2 (“subdivision 815”). The draft guidance:

  • confirms the requirement for taxpayers to self-assess their transfer pricing positions, including determining and documenting whether arm’s-length conditions exist in their controlled transactions, by specific reference to and consideration of the “recharacterization” provisions of sections 815-130 and 815-140;
  • confirms the requirement for contemporaneous transfer pricing documentation (at the time of lodging tax returns) in order for taxpayers to assert a “reasonably arguable position” (RAP), which can impact on the rate at which penalties would be applied, in the event of a transfer pricing adjustment; and
  • sets out a framework for detailed transfer pricing documentation. This includes explicit requirements to document and demonstrate:

Regarding “recharacterisation”: There is considerable uncertainty, specifically related to how it will be applied by the ATO. Under subdivision 815, taxpayers are required to self-assess their transfer pricing positions, including considering whether or how the basic rule or any of three exceptions set out in the legislation4 do or do not apply. This potentially imposes a significant additional compliance burden on taxpayers. Also, the structure and/or mechanics of certain controlled transactions that heretofore have been ‘routinely accepted’ should perhaps be considered more closely. Further, internal uncontrolled transactions may give rise to particularly challenging issues for Australian taxpayers.

That said, the draft guidance provides some assurance that the Commissioner will not engage in widespread recharacterization of transactions, by stating that, in most cases, the arm’s-length conditions will be based on the actual commercial or financial relations (“the basic rule”) between the parties.

The draft guidance provides clear links to the OECD Guidelines. However, it is notable that in discussing the various exceptions to the basic rule, the draft guidance indicates a considerably broader scope for potential recharacterization than that expressed in the OECD Guidelines.

In regards to transfer pricing documentation: under subdivision 815, there continues to be no mandatory requirement to prepare transfer pricing documentation in Australia, although the general statutory record-keeping provisions for businesses must be complied with. However, under the new legislation5, if the taxpayer has not prepared contemporaneous documentation that meets certain requirements, the taxpayer will then lose the ability to rely on a reasonably arguable position (RAP) for reduction in penalty rates in the event of a transfer pricing adjustment.

The documentation must:

  • be prepared contemporaneously with filing of the income tax return;
  • explain the way that the transfer pricing self-assessment provisions apply or do not apply; and
  • explain how the transfer pricing outcomes best achieve consistency with the OECD Guidelines. This includes a requirement to address the more extensive coverage of comparability now set out in the OECD Guidelines, and a thorough analysis of the selection and rejection of transfer pricing methods.

The new legislation imposes a significantly higher burden on taxpayers in requiring self-assessment for transfer pricing positions and in introducing contemporaneous documentation requirements for penalty remission purposes. The draft guidance provides some assistance for taxpayers, but increases rather than alleviates that additional burden. Thus, Australian taxpayers that rely on international / offshore transfer pricing documentation should review and, where appropriate, revise and expand such documentation to specifically address the Australian documentation expectations.

Whilst the current ATO guidance is in draft form (with comments due by May 30, 2014), it is expected that the final form of the guidance may not differ materially. Once final guidance is issued, it will apply to income tax years commencing on or after June 29, 2013. Thus, for many Australian companies with June 30 year ends, this guidance applies for the current financial period ending June 30, 2014.

For additional detail, full text of the draft guidance is available here.


China Comments on the UN’s Transfer Pricing Manual

On January 16, 2014, the United Nations (UN) published a letter requesting comments on the UN Transfer Pricing Manual (UN TP Manual) regarding intra-group services and management fees. The State Administration of Taxation (SAT) of the People’s Republic of China submitted a response in late March outlining its perspective and providing recommendations to be included in the next update of the UN TP Manual.

The comments confirmed the SAT’s position that service fees between related parties must comply with the arm’s-length principle. In its response letter SAT explains that if a parent company benefits more than its subsidiary for certain strategic management activities, the subsidiary should not be charged for such services. Additionally, SAT states that it requires the taxpayer to consider whether the services received from the subsidiary are necessary given the functions of the subsidiary and imply that if a subsidiary is paying a royalty to a parent company, it should not be paying an additional management fee. SAT goes on to offer its opinion on the OECD Transfer Pricing Guidelines, pointing out the OECD’s definition of stewardship is too narrow.

The SAT recommends the next UN TP Manual address relevant requirements in relation to transfer pricing documentation contained in the OECD Action Plan on Base Erosion and Profit Shifting and to require parent companies to disclose specific information on their global intra-group services in the Master File. The SAT also recommends the UN to provide additional guidance on differentiating royalties from technical service fees. 

For further detail, see China’s comments available here.


Dealing with Pass-Through Costs in Transfer Pricing

Pass-through costs are external third-party costs that an entity incurs on behalf of a related affiliate or third-party customer in connection with its business activities. Because these costs are already incurred at market rates, they are typically “passed through” to affiliates or customers at cost (i.e. the amount originally charged by the external third party) and can be disclosed in annual reports depending on their materiality. Examples of third-party pass-through costs that companies charge through to their customers include costs incurred by advertising agencies to obtain advertising space on behalf of their customers and payments by pharmaceutical companies to third-party clinical research organizations.

When evaluating the arm’s-length pricing for controlled services transactions under the application of the comparable profits method (“CPM”), the treatment of pass-through costs may have a significant impact on the transfer pricing calculation. For instance, in CPM analyses that apply a cost-based profit level indicator (“PLI”) such as a mark-up on total operating costs, pass-through costs are often removed from the revenues and expenses of the tested party as well as from the revenues and expenses of the comparable companies to avoid distortions of profitability. While the Internal Revenue Service (IRS) generally agrees with these adjustments, Section 482 of the U.S. Internal Revenue Code and its corresponding regulations (the U.S. transfer pricing regulations) state that the facts and circumstances specific to the transaction under review should be considered before determining the correct treatment of pass-through costs.6 

Examples included within the U.S. transfer pricing regulations generally provide that under a CPM, only “value-added” costs should be included in the cost base when calculating a cost-based PLI. Often times, this applies to situations where the service provider is acting as an agent or intermediary in the provision of services. Take the example of third-party advertising space rental costs incurred by an advertising agency on behalf of its affiliates.7 Assume it is determined from the functional analysis that the advertising agency acts merely as an intermediary facilitating the advertisement placements offered by third parties. The advertising agency does not offer the advertising space and its value-added functions (e.g., consulting, developing advertisement strategy) are captured in other functional costs. Under the US transfer pricing regulations, the latter value-added costs would be included in the cost base on which the mark-up is applied.8 The advertisement rental costs may be treated separately as an internal comparable uncontrolled service price and charged at cost to the affiliates.9  Adjustments would need to be applied consistently across the financial results of the tested party and comparable companies to ensure reliable comparisons. Note that adjustments for pass-through costs are generally more difficult to reliably apply to the financial statements of non-U.S. based comparable companies due to lack of financial disclosures.

A September 2012 survey conducted at Bloomberg BNA’s Transfer Pricing forum (BNA survey) examined the treatment of pass-through costs by practitioners in 23 countries. Practitioners from 19 of the countries surveyed commented that their local country jurisdictions are likely to accept the removal of pass-through costs in the PLI calculation.10 11

While it is common to see adjustments applied to remove pass-through costs from the marked-up cost base, examples provided in the U.S. transfer pricing regulations illustrate certain circumstances where it may be appropriate to include third party pass-through costs in the cost base. Some common arguments for the inclusion of pass-through in the mark-up cost base are provided below:

  • Comparable companies do not separately report third-party pass-through versus value-added costs. Since adjustments cannot be reliably made to remove the pass-through costs from the comparable companies’ financial statements, an operating profit over total cost is a more appropriate PLI for determining the arm’s-length return.12
  • The cost-based PLI for comparable companies using database-produced results implicitly include pass-through costs. Removal of these costs would require judgments based on the review of annual reports, if available, and the adjusted PLI would deviate from the results produced by the database.13
  • It would be reasonable to include pass-through costs in the cost base of the tested party when calculating an arm’s-length return in circumstances where it is determined that similar third party pass-through costs are included in the mark-up cost base of comparable companies.14
  • In instances where the third-party costs are related to functions vital to the services being provided and it is determined that comparable companies performing similar services are also required to incur similar costs, there may be a basis for calculating an arm’s-length return (e.g. a mark-up on cost) on these third-party costs.15

As discussed in this article, it is common to see adjustments applied to remove third party pass-through costs from the calculation of cost-based PLIs. However, there are certain instances that warrant inclusion of these costs in the PLI calculation. Before determining the treatment of pass-through costs in a transfer pricing analysis, it is important to thoroughly consider the facts and circumstances surrounding the transaction, and the local requirements and views of the affected tax jurisdictions.


Internal Revenue Service Rulings on Stock-Based Compensation Measurement

On March 28, 2014, the IRS released an additional ruling on determining the amount of stock-based compensation (SBC) to be included as intangible development costs (IDCs) in a cost sharing arrangement (CSA). Similar to the previous rulings, this letter consents to a taxpayer’s request to change from the default spread-at-exercise method to the elective fair value method when measuring the amount of SBC. The spread-at-exercise is the spread between the stock option exercise price and the fair market value at the time the SBC is exercised. The use of this amount is the default method according to the U.S. cost sharing regulations. The U.S. cost sharing regulations also permit the use of the fair value method of measuring SBC in accordance with the Statement of Financial Accounting Standards No. 123. The letter further addresses that any change in SBC measurement method is only permitted prospectively for the following year with the consent of the Internal Revenue Service (IRS) Commissioner.

For additional information, full text of the IRS’ letter containing the rulings is available here.


A Practical Guide to U.S. Transfer Pricing Published

Transfer pricing is one of the hottest topics in international tax today. Transfer pricing rules are an inescapable part of doing business internationally, and the third edition of Practical Guide to U.S. Transfer Pricing published by LexisNexis provides an in-depth analysis of the US rules. This book is designed to help multinationals cope with the US transfer pricing rules and procedures, taking into account the international norms established by the Organization for Economic Cooperation and Development (OECD). It is also designed for use by tax administrators, both US and foreign, as well as tax professionals, corporate executives, and their non-tax advisors, within the US and abroad.

To access to the complimentary chapter “Documented Self-Compliance and Transfer Pricing Penalties”, which covers a detailed overview of Section 6662 penalties, the four requirements of self-compliance, documentation strategies, and new perspectives on documentation in light of the IRS’ recently released Audit Roadmap and the OECD’s publications on country-by-country reporting, contact us.


1.TR 2014/D3 Draft Taxation Ruling Income tax: transfer pricing - the application of section 813-130 of the Income Tax Assessment Act 1997; TR 2014/D4 Draft Taxation Ruling Income tax: transfer pricing - documentation requirements, as required under section 284-255 of Schedule 1 to the Taxation Administration Act 1953; Practice Statement Law Administration PS LA 3672 Administration of transfer pricing penalties for income years commencing on or after June 29, 2013; and PS LA 3673 Guidance for transfer pricing documentation.
2.Subdivisions 815-B to –E of the Income Tax Assessment Act 1997, as introduced by the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013. These subdivisions replace the earlier amendments of subdivision 815-A and the domestic transfer pricing legislation contained in Division 13 of the ITAA 1936. These new provisions apply for financial years commencing July 1, 2013 or later. Subdivision 815-B applies to entities and forms the focus of this commentary.

3.OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations July 2010, (“the OECD Guidelines”).
4.Subdivision 815-130 (for entities).
5.Sections 284-250 and 255 of Schedule 1 to the Tax Administration Act 1953, as introduced by the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013.
6.Treas. Reg. §1.482-9(l)(5). Example 20 and 21.
7.The reader should also reference case ITA No. 712/Del/2010L DCIT v. Cheil Communications India Private Ltd.
8.Treas. Reg. §1.482-9(l)(5). Example 21.
9.For a similar example related to clinical trial pass through costs, see example 20 provided in Treas. Reg. 1.482-9(l)(5).
10.The countries include: Argentina, Australia, France, Germany, Hong Kong, India, Ireland, Israel, Italy, Mexico, New Zealand, Poland, Portugal, Russia, South Korea, Spain, Switzerland, the United Kingdom, and the United States
11.Bell, Kevin. “Bloomberg BNA Transfer Pricing Forum: Examines Treatment of Pass-Through Costs”. October 29, 2012. Available  here  :
14.Treas. Reg. §1.482-9(l)(5). Example 20.
15.Treas. Reg. §1.482-9(l)(5). Example 21.

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