Transfer Pricing Times: Volume X, Issue 4
Inside this edition of the Duff & Phelps Transfer Pricing Times:
Seeing through the Clouds: Transfer Pricing Considerations for Cloud Computing
Transfer Pricing Disputes Resolution Alternatives
More Global Transfer Pricing Developments
Over the past several years, there has been a persistent shift by companies to more efficient management of their IT resources through the practice of cloud computing. The use of cloud computing allows companies to share a pool of configurable computing resources (e.g., networks, servers, storage, applications, and services) that require minimal management effort / service provider interaction.1 Although this shift has led to significant cost savings, it has also given rise to numerous transfer pricing and international tax issues that must be effectively managed in order for companies to recognize the full benefits of moving to the cloud. We highlight some of these issues below.
Characterization of Transactions
Although the US Transfer Pricing Regulations do not provide specific guidance related to cloud computing resources, direction can be taken from Section 1.861-18 of the US Treasury Regulations, which provide rules for classifying transactions related to computer programs for purposes of establishing income source rules under Section 1.482. Specifically, the Regulations mention the following four categories of transactions:2
- A transfer of a copyright right in the computer program;
- A transfer of a copy of the computer program (a copyrighted article);
- The provision of services for the development or modification of the computer program; and,
- The provision of know-how relating to computer programming techniques.
Depending on the nature of the transaction and rights transferred, therefore, a transaction may be characterized as a sale, license, lease, or service. 3 This is based upon whether the transaction would involve the transfer of a copyright right or copyright article. Specifically, one of the following four rights would need to be transferred in order for the transaction to be categorized as a copyright right:4
- The right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease, or lending;
- The right to prepare derivative computer programs based upon the copyrighted computer program;
- The right to make a public performance of the computer program; or,
- The right to publicly display the computer program.
Any transaction that involves the transfer of “all substantial rights” enumerated above would be treated as a transfer of a copyright right and characterized as a sale, whereas a transfer of “less than all substantial rights” would also be considered a transfer of a copyright right but consequently treated as a license generating royalty income. 5 By contrast, transactions involving the transfer of the “benefits and burdens of ownership” would be considered a transfer of a copyright article and rightly characterized as a sale. Transactions that do not constitute a sale / exchange (characterized by insufficient benefits and burdens of ownership of the copyrighted article being transferred) would be treated as a lease generating rental income. 6 How the transaction is characterized will subsequently affect which section 1.861 sourcing rules will apply.
Since cloud computing does not involve actual transfers of software (either downloaded or copied) or fit the characterization of any of the other aforementioned rights, it can be argued that cloud computing transactions fall outside the scope of Section 1.861-18. In this case, the transaction could likely be characterized as a service, whereas it would likely be characterized as either a sale, license, or lease prior to joining the Cloud and thereby subject to section 1.861 sourcing rules.
Thus, one of the key considerations when deploying cloud computing is to consider whether or not operating in the cloud changes the nature of the transaction. Not only will this affect the applicable income sourcing rules, but a change in characterization could also affect the appropriate transfer pricing methodology used to test the transaction, as discussed below.
Applicable Transfer Pricing Methodologies
The characterization of transactions is important from a transfer pricing perspective as it leads to the determination of the best method 7 for evaluating their arm’s length nature. For instance, transfers of copyright rights would necessarily be analyzed under one of the four transfer pricing methods for intangible property (i.e., CUT, CPM, Profit Split, or Unspecified Methods). On the other hand, in the instance of a copyright article transfer, the transaction would more appropriately be evaluated under one of the six transfer pricing methods for tangible property (i.e., CUP, Resale Price, Cost Plus, CPM, Profit Split, or Unspecified Methods). The use of cloud computing, however, eliminates the actual transfer of rights or ownership and opens up the possibility that the transaction will be characterized as a service rather than a sale, license, or lease (i.e., falls outside the scope of the §1.861-18 characterizations). This means that it could be evaluated under the transfer pricing rules for services, including potentially the Services Cost Method (“SCM”) for US transfer pricing purposes if the relevant criteria are met (allowing the transaction to be charged out at cost).Given the rapid rate of technological innovation over the last several years, it is becoming increasingly important that companies understand the transfer pricing and international tax implications of cloud computing in order to fully reap the advantages of converged IT infrastructure and shared services without undue tax inefficiency and exposure.
Transfer Pricing Disputes Resolution Alternatives
The proliferation of international tax disputes around the world is fueled by a variety of factors, increasingly including transfer pricing. Taxing authorities see transfer pricing as a way to protect their tax base, while multinational enterprises seek to optimize the efficiency of their tax payments in the relevant jurisdictions. The juxtaposition of these divergent goals often gives rise to conflict, further exacerbated by the current economic environment. Governments around the globe are engaging in fiscal consolidation, with a focus on transfer pricing as a source of tax revenue. To this end, they are implementing structural changes and dedicating additional resources for transfer pricing enforcement. Multinationals should therefore be aware of alternative dispute resolution (“ADR”) tools available to them in case of a challenge to their policies.
We highlight the primary ADR tools available to companies for transfer pricing disputes below.
Advance Pricing Agreement (“APA”) Program
The APA Program is designed to resolve actual or prospective transfer pricing disputes using a binding contract between the taxpayer and the tax authority pursuant to which the parties agree to the relevant facts of the transaction(s), the appropriate transfer pricing method(s), the expected result(s) of applying the selected transfer pricing method(s) to the transaction(s), and the term of the agreement. APAs may be unilateral, bilateral, or multilateral.
· Potential reduction in compliance costs
· More certainty in tax matters
· Greater predictability in financial reporting
· Ability to negotiate disputes during the APA process
· Possibility of “roll back” provisions of an APA to open years
· Requires substantial time investment by both taxpayers and taxing authorities
· Up-front costs can be significant for taxpayers
Compliance Assurance Process (“CAP”) Program
The CAP Program is a voluntary program that focuses on issue identification and cooperative interaction between taxpayers and the IRS to resolve issues as they arise during the tax year prior to the filing of returns. This program requires a contemporaneous exchange of information related to a taxpayer’s proposed return positions and its completed events and transactions that may affect federal tax liability.
· Ability for taxpayers to better manage tax reserves / create more precise financial statements
· Earlier identification of emerging issues
· More efficient use of resources by shortening the overall examination cycle
· Potential to avoid the need for amended tax returns
· Greater transparency into taxpayer operations and financial information for the IRS
· Limited acceptance into the program due to the demand and rigor of the annual process
· Lack of certainty – Nothing is certain until the audit window is passed, as no binding agreement / document is issued on an annual basis
The Office of Appeals is an independent office within the IRS (i.e., separate from exam) that serves to settle tax disagreements without the need for litigation. The Administrative Appeals process is intended to provide a venue where disagreements concerning the application of tax law can be resolved on a fair and impartial basis for both the taxpayer and the government.
· Potential of more favorable settlement (Appeals has been able to settle 80 – 90 percent of the cases that come before it at significantly lower adjustments than those presented by exam)
· Sensible forum to resolve transfer pricing disputes
· Significant delays in moving a case from exam to Appeals are common
· Provision of “ammunition” to the IRS should a settlement not be reached and the case escalates to litigation (or other dispute resolution avenues)
Mutual Agreement Procedure (“MAP”)
The MAP is provided for in tax conventions (e.g., tax treaties) around the globe with the primary purpose of eliminating international judicial double taxation. These provisions are commonly known as MAP articles (and are typically found in Article 25 in most model tax conventions). In order for a MAP article to be invoked, there must be taxation, or the threat of taxation, “not in accordance with” the provisions of the applicable tax convention”. Taxpayers must direct their request for relief from double taxation to the appropriate “Competent Authority,” as defined in tax conventions.
· Relief from double taxation
· Agreed upon resolutions that are not subject to administrative or judicial review
· Ability to withdraw at any time
· Ability to pursue other dispute resolution alternatives if the resolution is not accepted / no resolution is made
· No binding clause on the Competent Authority to reach an agreement (hence the inclusion of mandatory arbitration clauses in many tax conventions – see below)
· Lengthy process (US MAP cases take on average 26 months to complete, with more complex cases taking up to 72 months to complete)
· Lack of transparency – Outcomes are the result of negotiations by the Competent Authorities that reflect many considerations unknown to the taxpayer (e.g., outcomes of other cases and positions)
· Costly, time consuming, and inefficient for multilateral cases – Taxpayers must approach multilateral cases through a series of separate bilateral MAPs
In addition to the four primary ADR alternatives described above, it is important to note that mandatory binding arbitration and mediation are also options for taxpayers. Mandatory binding arbitration is a fairly new dispute resolution technique that has recently been included as a clause in several US tax treaties (and we expect to see this trend continue). Mandatory binding arbitration is intended to force settlement of prolonged Competent Authority disputes without double taxation (i.e., the arbitration board’s decision is binding to both Competent Authorities and constitutes a resolution by mutual agreement under the treaty). (An important aspect of treaty arbitration is that the taxpayer has 30 days to accept or reject the board’s decision. If rejected, the decision would not be subject to further MAP consideration and the taxpayer can move forward with other dispute resolution measures.) Mediation, on the other hand, is available for certain cases in which a limited number of legal and factual issues remain unresolved following settlement discussions in the administrative appeals process. Post-Appeals mediation is a non-binding process which uses an intermediary to assist the taxpayer and Appeals reach a negotiated settlement.
There are several alternatives for dispute resolution available to taxpayers besides litigation, which should be an option of last resort or invoked only when it may lend a strategic advantage as it can be extremely time consuming and costly (with wildly uncertain results). Given the increased scrutiny and audit activity around transfer pricing, it is important for taxpayers to fully understand their options for dispute resolution and consider the benefits and drawbacks of each in order to maximize the probability of a favorable outcome.
More Global Transfer Pricing Developments
Summarized below are a few recent developments in transfer pricing and related tax regulations around the world.
Philippines Introduces New Transfer Pricing Rules8
Effective February 9, 2013, the Secretary of Finance issued Revenue Regulations No. 2-2013 (“Philippines TP Guidelines”), providing guidance in applying the arm’s length standard to both cross-border and domestic intercompany transactions in the Philippines. Consistent with prior transfer pricing guidance released for the Philippines, the new guidelines are primarily based upon the arm’s length methodologies of the OECD Transfer Pricing Guidelines. We highlight key components of these new guidelines below:
- No hierarchy of methods – The Bureau of Internal Revenue (“BIR”) explicitly states that there is no preference for any one method. Instead, the method that produces the most reliable measure of an arm’s length result should be utilized.
- Three-step approach to applying the arm’s length principle – In the application of the arm’s length principle, the following three-step approach may be observed: (1) Conduct a comparability analysis; (2) Identify the tested party and the appropriate transfer pricing method; and, (3) Determine the arm’s length results.
- Further guidance anticipated for Advance Pricing Agreement (APA) and Mutual Agreement Procedure (MAP) processes – Although the Philippines Transfer Pricing Guidelines refer to their APA and MAP programs, the new regulations do not go into detail. Instead, the BIR comments that it intends to issue separate guidelines on the application of APAs and MAPs.
- Documentation requirements – The Philippines Transfer Pricing Guidelines require that taxpayers maintain contemporaneous transfer pricing documentation. The main purposes of keeping adequate documentation is for taxpayers to be able to (1) defend their transfer pricing analysis; (2) prevent transfer pricing adjustments arising from tax examinations; and, (3) support their applications
The new Philippines Transfer Pricing Guidelines provide some much needed guidance for taxpayers pricing their intercompany transactions in the Philippines. In addition, the new regulations serve as a guideline to the BIR in transfer pricing audits. As such, Philippine taxpayers should be ready with adequate transfer pricing documentation.
France Introduces new E-document Requirements
In an interview with Bloomberg BNA, Fidal Direction Internationale, France’s largest law firm, indicated that new French electronic documentation requirements scheduled to take effect in 2014 could cause tax audit problems for multinationals using foreign accounting standards (e.g., US generally accepted accounting principles, or “GAAP”). Although French companies are required to maintain accounting records in local GAAP, many large multinational firms prepare financial data according to a foreign accounting standard, such as US GAAP, for operational reasons.
However, changes to France’s article L-47 A-I of the Book of Tax Procedures will require all companies subject to French taxation to comply with French accounting standards. This means that during future audits, companies will be expected to provide electronic versions of the general account ledger in the French standard. Failure to comply with this requirement could result in fines up to 5 percent of a company’s revenues. In order to prepare for this change, companies should establish a process for converting their foreign-standard based accounting to a French-compliant general ledger or at the very least be able to explain their accounting entries and prove that they are well-maintained and able to be converted to the French standard upon request.
APA Developments around the Globe
We describe several recent APA developments below:
- Italy releases second APA bulletin – On March 20, 2013, the Italian Revenue Agency (“IRA”) released its second APA bulletin since the program’s inception in 2004. This bulletin provides key statistics of the program to date. As of December 31, 2012, there were a total of 56 APAs completed, with 54 additional applications currently in process, illustrating the growing acceptance of Italian APAs by taxpayers. In 2010, Italy began accepting both bilateral and multilateral APAs, which together represented approximately 25 percent of all applications made in 2012. Furthermore, taxpayers’ willingness to renew existing APAs with the IRA (all taxpayers that held an APA that expired have requested a renewal) indicates overall satisfaction with the program.
- Latvia now offers an APA program – As of January 1, 2013, local companies and Latvian subsidiaries of foreign companies may enter into an APA with the State Revenue Service (“SRS”) if the value of the transaction(s) in question exceeds one million lats per year (approximately 1.9 million in USD). Taxpayers may enter into an APA for a period of up to three years. The SRS will have one to three months to consider a taxpayer’s APA application, depending on the extent of information required. As of the program’s inception, there was a filing fee of 5,000 lats.
- Greece introduces a new APA program – As mentioned in our previous edition (see Transfer Pricing Times, Volume X, Issue 3), Greece introduced an option for companies to apply for an APA covering the transfer pricing methodology of specific future intercompany transactions. APA applications must be made to the General Directorate of Tax Audits and Collection of Public Revenue of the Ministry of Finance. An initial APA cannot last for more than two years, with an option of renewal for a further four years upon its expiry.
The initiation of new APA programs abroad dovetails with more efficient processing of APAs in the US under the new IRS structure.
1.National Institute of Standards and Technology, “The NIST Definition of Cloud Computing”, September 2011.
2.Treas. Reg. § 1.861-18(b)(2).
3.Treas. Reg. § 1-861-18(f)(1) – (2).
4 .Treas. Reg. § 1-861-18(c)(2).
5.Treas. Reg. § 1-861-18(f)(1).
6.Treas. Reg. § 1-861-18(f)(2).
7.Treas. Reg. § 1.482-1(c)(1).
8.For more information, please refer to the Revenue Regulations No. 2-2013, dated January 23, 2013: ftp://ftp.bir.gov.ph/webadmin1/pdf/68122RR%202-2013.pdf