Inside this edition: OECD Releases First BEPS Recommendations.
On September 16, 2014, the Centre for Tax Policy and Administration, part of the Organization for Economic Co-operation and Development (OECD), held a webcast to release its first round of recommendations under the Base Erosion and Profit Shifting (BEPS) Project. The release addressed seven areas of interest, or “action plans,” to which 44 countries (OECD, G20, plus Columbia and Latvia) “agreed [to] by consensus.” (The OECD’s BEPS action plan, which was released on July 19, 2013, calls for 15 major international tax reforms, 4 of which involve transfer pricing. (See Transfer Pricing Times, Volume X, Issue 8.))
The OECD delivered three reports that addressed Action Plans 1, 5, and 15:
Addressing the Tax Challenges of the Digital Economy (Action 1)
The report clearly indicates that it is not possible to “ring-fence” the digital economy from the rest of the economy, and any tax measures designed exclusively for that would be counterproductive. While the report did not introduce new measures related to the digital economy, it did identify key features and new business models that exacerbate BEPS risks. These BEPS risks will be addressed by other action items (CFC Rules -Action 3, Artificial Avoidance of PE -Action 7, and Transfer Pricing -Actions 8-10).Click here for the full release from the OECD.
Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance (Action 5)
The OECD emphasized that the work of the Forum on Harmful Tax Practices (FHTP) needs to be revamped with a focus on requiring substantial activity for all preferential regimes and with increased transparency. This interim progress report plans to update the FHTP’s work on substantial activity as it would apply to Intellectual Property (IP) regimes. Click here for the full release from the OECD.
Developing a Multilateral Instrument to Modify Bilateral Tax Treaties (Action 15)
The report centered on the feasibility of using multilateral instruments as a way to implement treaty-based measures. It was noted that based on precedents from various areas outside tax, a multilateral instrument is not only feasible but desirable to ensure the sustainability of the consensual framework to eliminate double taxation. The goal of the instrument is to expedite and streamline the implementation of the measures developed to address BEPS and to amend tax treaties. The report recommends that interested countries convene at an international conference in 2015 to develop the multilateral instrument. Click here for the full release from the OECD.
The OECD also delivered four instruments that addressed Action Plans 2, 6, 8, and 13:
Neutralizing the Effects of Hybrid Mismatch Arrangements (Action 2)
The guidance sets out recommendations for changes to domestic law and to the OECD Model Conventions to deal with hybrid mismatch arrangements. The recommendations aim to create clear, automatic, and comprehensive rules that neutralize tax mismatches without disturbing the commercial or regulatory consequences. The group has agreement on the scope of the report and the concept of linking rules. The next steps involve addressing the overall application of these rules and the eventual implementation. Click here for the full release from the OECD.
Preventing the Granting of Treaty Benefits in Inappropriate Circumstances (Action 6)
The OECD clearly states that treaties should avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including treaty shopping. The report details a number of specific treaty anti-abuse rules and clarifies the interaction between said rules and tax treaties. The report also provides tax policy considerations and recommendations for developing countries when entering into treaties. The next steps include coming to agreement on a minimum level of protection, which is thought to be the elimination of double taxation without creating “treaty shopping” opportunities. Click here for the full release from the OECD.
Transfer Pricing Aspects of Intangibles (Action 8)
Chapter 1 of the OECD Transfer Pricing Guidelines has been expanded to discuss the treatment of location savings and other local market features, assembled workforce, and corporate synergies. Additionally, a new Chapter 6 on transfer pricing for intangibles includes discussion of levels of comparability, transfer pricing methods to be used, and the use of valuation techniques. The guidance also highlighted areas marked as interim until 2015, which include: (i) ownership of intangibles; (ii) intangibles whose valuation is uncertain at the time of transaction; and (iii) the application of Profit Split methods. The guidance is provisional because of strong links between the section on returns derived from intangibles and action items 9 and 10, which also relate to transfer pricing and will be released in 2015. Click here for the full release from the OECD.
Transfer Pricing Documentation and Country-by-Country Reporting (Action 13)
This document provides guidance on the proposed three-tiered approach to global transfer pricing documentation, including: 1) a Master File – a high-level overview of the MNE group business; 2) a Local File – detailed information on specific group transactions for a country; and 3) a country-by-country (CbC) report – a matrix of specific data by jurisdiction to be used as a risk assessment tool. The CbC report would include the following items to be listed by jurisdiction: revenues, profit, income tax, capital and accumulated earnings, number of employees, tangible assets, main business by activity, and country of organization/incorporation. Though there is consensus on the content, there is substantial work to be done on how CbC will be implemented, with careful consideration of issues such as confidentiality, timeliness, consistency, and appropriateness of the CbC among the countries involved. Click here for the full release from the OECD.
The OECD made it clear that these recommendations may be impacted by decisions made on the remaining eight elements of the BEPS Action Plan, which are scheduled to be presented to the G20 for final approval in 2015.
The full news release by the OECD can be found here, while OECD’s Explanatory Statement of the seven deliverables can be found here. The full recording of the webcast can also be found here.
France Releases New Transfer Pricing Disclosure Requirements
France’s tax authority, the Direction Générale des Finances Publiques, released the final version of its new transfer pricing disclosure requirements on September 16, 2014. The return (which consists of three spreadsheet-type forms) must be submitted annually and equates to abridged transfer pricing documentation (in addition to the comprehensive documentation requirements the country introduced in 2010 for large multinationals).
In terms of content, the return requirements are not purely domestic and will allow France to build a reasonable picture of the key intragroup transfer pricing flows of the multinational group, by country. Moreover, in today’s age of BEPS and information exchange, it would be a mistake to believe that this information will remain in France. When preparing the return, groups should therefore assess the possible implications of this for non-French group entities.
These new measures apply to French legal entities* with either sales revenues or gross assets of at least €400 million ($540 million) in their own right, and also to French legal entities of any size controlled by foreign entities which themselves meet the €400 million threshold. French legal entities with a December 31, 2013 fiscal year-end must file the return by November20, 2014of this year.
Additional details and recommendations will be provided in our next issue.
*for these purposes ‘legal entity’ also includes a French permanent establishment of an overseas entity’.
Transfer Pricing Case Review: Update on Significant Litigation in Transfer Pricing
The Internal Revenue Service (IRS) continues to focus audit efforts on the intercompany use of Intellectual Property, as confirmed by a review of the current litigation environment. Below is an update on significant ongoing transfer pricing cases.
Medtronic Inc. v Comr.:The Medtronic Inc. v. Comr. case is set for trial in late 2014 or early 2015. The medical device manufacturer, Medtronic, originally filed suit in March 2011 against a proposed upward income adjustment of over $2 billion for the 2005 - 2006 tax years. This proposed adjustment included a $1.2 billion transfer pricing adjustment related to licensing and manufacturing of cardiac and neurological devices by an affiliate in Puerto Rico. In a motion filed August 14, 2014, the IRS argued that the intercompany licensing agreements did not shift product liability, and further that the transaction lacks economic substance. On August 20, 2104, the U.S. Tax Court denied the IRS’s motions to depose more than a dozen former and current executives at Medtronic. Instead, the IRS will have access to just two high-ranking former executives in Medtronic’s neurological division.
In a joint status update, the IRS and Medtronic agreed to focus efforts on resolving the transfer pricing issues and put a temporary hold on a dispute related to the disallowance of a $793.6 million dividends-received deduction for the 2006 tax year.
Amazon.com Inc. v. Comr.:In a case filed December 28, 2012, Amazon is challenging a $2 billion adjustment and the resulting $234 million tax assessment under a cost sharing arrangement in which IP was transferred to a subsidiary in Luxembourg. The trial is scheduled to begin November 3, 2014.
3M Co. v. Comr.:3M Co. filed a challenge to a $37.9 million income adjustment related to the payment of royalties by a Brazilian subsidiary. The IRS claims underpayment of royalties for the use of patents and trademarks by the Brazilian subsidiary, but 3M maintains that local Brazil law prohibited them from paying higher royalties. The 3M Co. v. Comr. case was originally scheduled for a September trial but the court granted a continuance on July 25, 2014.
Caterpillar Inc. v. Comr.:On August 12, 2014, Caterpillar and the IRS settled a transfer pricing dispute related to royalty payments the IRS claimed to be owed from certain European affiliates. The originally-challenged assessment involved $82.5 million of income adjustment. Caterpillar agreed to pay an additional $3.35 million in taxes related to the disputed royalty payments – less than half of the underpaid taxes originally claimed by the IRS.
Vanguard Whistleblower Case
Further on the litigation front, a former employee of Vanguard Group Inc. (VGI), the mutual fund giant, has filed a whistleblower lawsuit in New York Supreme Court charging that Vanguard has for nearly 40 years sheltered significant income from federal and state taxation through its transfer pricing practices. Parallel complaints were also filed with the Securities and Exchange Commission (SEC) as well as the IRS.
The Vanguard group of companies has a unique structure in that VGI, the management company providing services to the Vanguard family of mutual funds, is owned by those funds. More commonly in the mutual fund industry, the management company and the funds that it services are unrelated. The suit alleges that VGI violated Internal Revenue Code §482 (as well as certain state statutes) by providing its services to the funds at cost, i.e., without a profit element.
Vanguard’s ownership structure raises interesting issues in defining arm’s length behavior among the relevant parties. In most transfer pricing analyses, arm’s length pricing comes down to a question of market compensation for functions performed and risks borne. It remains to be seen whether the mutual ownership arrangement employed by VGI and the Vanguard funds, along with the SEC exemptive order underwhich it was set up, justifies at-cost pricing for services that might conventionally be expected to command premium remuneration.