As often happens, the end-of-year holiday period included a flurry of releases on transfer pricing regulatory issues, most having to do with the Organization of Economic Development and Cooperation’s (OECD) Base Erosion and Profit Shifting (BEPS) Project.
This edition of the Transfer Pricing Times reflects the heightened activity surrounding this initiative.
Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines
On December 19, 2014, the OECD released the “Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines (Including Risk, Recharacterization, and Special Measures).” This draft provides measures to assure that transfer pricing outcomes are in line with value creation, a central aspect of the OECD’s BEPS initiative. Specifically, the discussion draft deals with work in relation to BEPS Action items 8, 9 and 10.
The draft is structured in two parts, with Part I (“Guidance for Applying the Arm’s Length Principle”) revising Chapter I, Section D of the OECD Transfer Pricing Guidelines (Guidelines), and Part II (“Potential Special Measures”) setting out options for special measures to assure that transfer pricing outcomes are in line with value creation after the changes in Part I have been implemented.
Part I’s proposed revisions to Section D of Chapter 1 of the Guidelines generally provide guidance for applying the arm’s-length principle and determining the economically relevant characteristics or comparability factors of a controlled transaction. The revisions address:
- Accurately delineating the actual transactions between related parties based on the contractual arrangements and the conduct of the parties;
- Specifying the associated risks and the allocation of risk to risk management; and
- Allowing for the non-recognition of transactions if they lack the fundamental attributes of arrangements between unrelated parties.
Part I of the discussion draft is structured such that new and modified paragraphs are added to the existing guidance to form an updated Part D; it concludes with five examples.
Part II of the discussion draft outlines options for potential special measures that could be put in place where BEPS risks may remain even after adoption and implementation of the Part I revisions and other BEPS Action items. These residual risks are identified as mainly relating to information asymmetries between taxpayers and tax administrations and the relative ease with which Multinational Enterprise (MNE) groups can allocate capital to minimally functional entities in low tax jurisdictions. The five special measures, which the draft acknowledges may deviate from the arm’s-length principle, include:
- Measures to address hard-to-value intangibles;
- Circumstances in which asset-rich companies depend on another group company to generate a return from a particular asset;
- Thick capitalization;
- Minimal function entities; and
- Ensuring appropriate taxation of excess returns.
The measures described in Part II have a close interaction with other BEPS Action items, including strengthening CFC rules (Action 3) and interest deductions (Action 4).
The OECD is accepting written comments on the draft until February 6, 2015, and a public consultation will be held on March 19 and 20, 2015. For additional information, see the complete discussion draft available here.
OECD Discussion Draft on Profit Splits Poses Questions on Implementation
As part of BEPS Action 10, the OECD also released a “Discussion Draft on the Use of Profit Splits in the Context of Global Value Chains.” The discussion draft does not reach many conclusions, but rather poses questions, mostly through examples, of when and how the profit split method can be best applied.
MNE groups with related-party value chains often utilize profit splits when multiple legal entities make key contributions to an integrated business. The discussion draft, however, begins by emphasizing that the existence of a global value chain within an MNE does not itself indicate the need to employ a profit split analysis. In fact, the draft argues such structures actually segregate functions and risks such that one-sided analyses, such as a Transactional Net Margin Method (TNMM), often become more reliable, not less. In contrast, for circumstances such as intercompany global supply chain systems, profit split methods best apply when the key functions and risks of different actors become interdependent, or synergies or other integrated benefits are intended.
Action 10 acknowledges the difficulty of interpreting the current OECD language that states profit splits may apply when two or more parties provide “unique and valuable contributions” to a common venture. The draft points to the OECD’s recently issued 2014 “Guidance on the Transfer Pricing Aspects of Intangibles,” which defines “unique and valuable contributions” as those constituting a competitive advantage for the business, and those which make finding reliable comparables difficult. The comment on comparables is perhaps most useful for practitioners, as a lack of adequate comparables is a finding that can be demonstrated and supported by data, whereas proving contributions to competitive advantage is more difficult. The draft provides an example of a distributor that provides value-added customer services which create a distinct competitive advantage. The fact pattern is a common one, so clarity on this example from OECD will be useful.
Action 10 also addresses situations in which a profit split method seems quite appropriate, but the circumstances make it difficult to apply. First, the OECD refers to “multisided business models,” whereby distinct and separate functions come together to form a unique product. Here they use an example of an internet company where a single product generates advertising revenue but is built from the contributions of legacy technology, promotion within jurisdictions, and aggregation of user data, among other contributions. The firm’s single product is built from significantly disparate activities.
The OECD also acknowledges the difficulty of applying profit split methods when risks are contractually shared, but functions are distinct and routine, suggesting if not for the risk borne, a one-sided method such as a TNMM might be best. The draft does not provide an indication of where the OECD will stand on these situations, but rather poses questions for public comment.
The OECD’s draft acknowledges the realities of applying a profit split method, in particular the need for reliable benchmarks and metrics for allocating residual profits. Interestingly, the OECD proposes that the profit split method could provide an alternative method for when operations are too specific to be reliably benchmarked individually. For example, if two sales and distribution entities exist within a larger value chain, a profit benchmark for sales and distribution on a combined basis might provide a pooled profit benchmark, which could then be split between the two operations. Finally, the OECD addresses which metrics are best to use, and when they might lead to unreasonable conclusions. With analysts often turning to functional metrics – whether headcount, surveys, value-added matrices, etc. – how can risk bearing best be incorporated into the calculation? Are there situations where a system loss should be treated differently than a system profit? These practical considerations are welcome additions to the OECD’s narrative on profit splits, as practitioners and taxpayers have to move beyond the theory to reach and support their conclusions.
Overall, the OECD’s Article 10 discussion of profit splits does not provide much indication of where the OECD will end up on these issues, or how much specific guidance will be created, but it indicates that the OECD is aware of the practical issues. Profit splits are inherently subjective, both in terms of when the method is needed and how exactly it should be applied. The public comments (due February 6, 2015) will hopefully solidify examples and other OECD support that taxpayers and practitioners can rely on.
For more information, the complete draft is available here.
Action to Make Dispute Resolution Mechanisms More Effective
On December 18, 2014, a discussion draft on BEPS Action 14 covering dispute resolution was also released by the OECD. This discussion draft acknowledges that Action 14 “is a unique opportunity to make a difference in this area and to overcome traditional obstacles; however there is no clear consensus that moving towards a universal mandatory binding mutual agreement procedure (MAP) arbitration process is the answer.” Instead the draft suggests that “complementary solutions” that are both practical and measurable should be sought.
As a first step, the current discussion draft identifies obstacles that prevent countries from resolving disputes through the MAP and to propose possible measures to address these obstacles. The draft frames the issues in the context of the following four principles:
- Treaty obligations related to MAPs are implemented in good faith;
- Administrative processes promote the prevention and resolution of treaty related disputes;
- MAP is accessible for eligible taxpayers; and
- Cases are resolved once in MAP.
The discussion draft suggests that these obstacles should be reviewed in the broader context of the redesign of the MAP program, which includes:
- Political commitments to effectively eliminate taxation not in accordance with the OECD Model Convention;
- New measures to improve access to MAP and improved procedures within MAP; and
- A monitoring mechanism to check for proper implementation.
The OECD solicited comments on the discussion draft, which were due on January 16, 2015. A public consultation was expected to be held on January 25, 2015. For more detail, click here.
BEPS Workshop with Developing Countries
Officials from fifteen developing countries engaged in a workshop on December 10 - 11, 2014, in order to discuss increased engagement in the BEPS project. The participants included representatives from Albania, Azerbaijan, Bangladesh, Croatia, Georgia, Jamaica, Kenya, Morocco, Nigeria, Peru, Philippines, Senegal, South Africa, Tunisia, and Vietnam, along with the African Tax Administration Forum.
The workshop sought to address the balance between attracting investments from multinational enterprises and ensuring compliance with BEPS, as well as ways that developing countries could benefit from increased engagement in the BEPS project. The specific discussions that took place at the workshop included:
- Agreement on the need to reform international tax rules as soon as possible;
- The means by which developing countries could participate in reform discussions and become effectively engaged;
- The creation of five regional networks of tax administration and tax policy officials, in cooperation with international and regional tax organizations; and
The need for additional practical guidance on the implementation of the BEPS project. For more information, click here.
OECD Released International VAT/GST Guidelines
On December 18, 2014, the OECD released draft guidelines regarding the value-added tax (VAT) and the goods and services tax (GST) entitled “International VAT/GST Guidelines” (the VAT/GST Guidelines) and accompanying provisions to support the application of the Guidelines (Supporting provisions).
The VAT/GST Guidelines and Supporting provisions provide additional detail on the collection of VAT and GST in B2C (business-to-consumer) and B2B (business-to-business) transactions, which was initially presented in BEPS Action item 1 regarding the digital economy as a pressing issue that needs to be addressed. The VAT/GST Guidelines ultimately recommend that non-resident suppliers of services and intangibles be required to register and remit VAT/GST based on the jurisdiction of taxation, and countries should implement a simplified registration and compliance regime to aid this process. It also provides examples of the main features of a simplified approach for non-resident supplier registration that balances the need to safeguard revenue and the need to simplify collection frameworks.
The Supporting provisions offer mechanisms to address issues of double taxation/non-taxation, disputes regarding taxation, and evasion or avoidance. These provisions include improving the existing forms of mutual cooperation and communication among tax administrations as well as providing taxpayer services that should aim to provide clear guidance on domestic VAT rules and points of contact with taxing authorities for businesses and consumers.
For additional information, please click here.
European IP Regimes – UK Patent Box Moves Ahead of the Pack (to the Top of the Class)
Having been referred to the EU Commission by Germany in respect to its Patent Box regime, the UK announced on November 11, 2014, that the two countries have buried the hatchet.
The UK is modifying its regime to ensure that it is fully compliant with all EU and G20/OECD (e.g., BEPS) requirements by adopting the Modified Nexus Approach (MNA) (requiring tax benefits to be connected directly to R&D expenditures, thereby ensuring the existence of substantial economic activity) proposed by the OECD. Germany and the UK jointly will present detailed technical proposals (e.g., qualification of expenditures, grandfathering and tracking qualifying R&D expenditure, etc.) for approval to both the OECD and the G20.
Meanwhile, since June 2013, the EU Commission has been investigating the IP regimes of 10 Member States (i.e. Belgium, Cyprus, France, Hungary, Luxembourg, Malta, the Netherlands, Portugal, Spain, and the UK) and it is now fully anticipated that the UK will be removed from this list and that other regimes amongst the remaining nine will be modified to fall in line with the OECD-approved MNA.
As a footnote, technical details regarding Ireland’s new ‘Knowledge Development Box,, announced in October last year, have yet to emerge, but it is fully expected that they too will be MNA-compliant.
Singapore Issues Second Edition of its Transfer Pricing Guidelines
On January 6, 2015, the Internal Revenue Authority of Singapore (IRAS) issued a second edition of its Transfer Pricing Guidelines (TP Guidelines).
The second edition updates and consolidates the four prior IRAS e-Tax guides covering: (i) guidelines, (ii) consultations, (iii) advanced pricing agreements (APAs), and, (iv) related party loans and services. The TP Guidelines also include two new sections, which cover IRAS’ position on (i) adjustments and (ii) attribution of profit to a permanent establishment (PE). IRAS also provides further detail and guidance on topics covering TP documentation.
The TP Guidelines were issued in advance of the OECD completing its work on all the relevant BEPS deliverables. Although Singapore is not an OECD member country, multinational enterprises with Singapore related party transactions will be impacted by the BEPS project deliverables. Therefore, taxpayers will need to monitor and identify any gaps that may arise as the OECD BEPS deliverables are completed and certain countries around the world adopt BEPS-related rules and practices.