Transfer Pricing Times: Volume XI, Issue 3
Inside this Edition: Update on the OECD's BEPS/G20 Calendar Release.
On February 27, 2014 the OECD published a revised BEPS/G20 calendar for its joint project with the G20 focused on BEPS (base erosion and profit shifting). Specifically, the calendar outlines publication dates for discussion drafts and associated deadlines for stakeholder commentary, each of which relates to at least one BEPS action plan item. According to the calendar, the OECD plans to issue three discussion drafts and hold four public consultations this spring. Key deadlines within 2014 include the following: Addressing the tax challenges of the digital economy (BEPS action plan item #1): a discussion draft was expected to be published on March 24, 2014, associated comments from stakeholders will be due on April 14, 2014, and a public consultation will follow on April 23, 2014.
Neutralizing the effects of hybrid mismatch arrangements (BEPS action plan item #2): a discussion draft will be published on April 4, 2014, associated comments from stakeholders will be due on May 4, 2014, and a public consultation will follow on May 15-16, 2014.
Prevention of treaty abuse (BEPS action plan item #6): a discussion draft was expected to be published on March 17, 2014, associated comments from stakeholders will be due on April 11, 2014, and a public consultation will follow on April 14-15, 2014.
Re-examining transfer pricing documentation (BEPS action plan item #13): a public consultation on the discussion draft related to country-by-country reporting will be held on May 19, 2014. The draft was published on January 30, 2014 and written stakeholder comments were due by February 23, 2014. Working Party No. 6 will present a final version of the new guidance during the June meeting of the OECD's Committee on Fiscal Affairs.
OECD Publishes Paper on Data Comparability Issues
On March 11, 2014 the Organization of Economic Cooperation and Development (OECD) published a paper addressing concerns about the availability and quality of financial information on comparable transactions between unrelated parties and on comparable uncontrolled enterprises for use in applying transfer pricing methodologies effectively. Of particular concern is the availability and reliability of comparables data for companies in developing countries. Some of the reasons outlined for a possible shortage in information include 1) fewer organized players in developing countries, 2) incomplete information due to scarce resources and processes, and 3) the ability of “first movers” in a developing country to create high barriers to entry leaving an industry relatively underexplored and lacking comparable transactions.
These concerns were brought forth by the Group of Eight (“G8”) countries, which requested that the OECD find ways to address these concerns. In the paper, the OECD provides four potential solutions to address the concerns on the difficulty of obtaining comparable data in developing countries. They are as follows:
Expand access to data sources: In addition to increasing developing country access to commercial databases, steps could be taken to improve the range of data contained in these databases, particularly in regards to data on companies in developing countries.
More effective use of data sources: Use of these databases requires a certain amount of skill and knowledge. This action would work to provide guidance to developing countries on using these databases effectively as well as making adjustments to foreign comparables.
Use of alternative approaches- proxies: Use of approaches that identify arm’s length prices without reliance on direct comparables, such as the profit split method, value chain analysis, and safe harbors.
Use of advance pricing agreements and mutual agreement proceedings: This action would work to review developing countries’ experiences with these programs and provide guidance or assistance where necessary.
Some of these actions are already being worked on by the OECD and/or other stakeholders. As a next step, further prioritization of these actions will need to be carried out based on specific country needs and resource availability.
For additional detail, see OECD's article “Transfer Pricing Comparability Data and Developing Countries”, available at http://www.oecd.org/ctp/transfer-pricing/transfer-pricing-comparability-data-developing-countries.pdf
Swiss Federal Tax Administration Issues New Tax Practice for Swiss Principal Companies1
Earlier this year, the Swiss Federal Tax Administration (“FTA”) discussed internal guidelines with the cantonal tax authorities 2 clarifying existing guidelines governing the treatment of companies categorized as a Swiss principal (and therefore benefiting from the principal company tax regime under Swiss federal law) under Circular Letter Nr. 8, dated December 18, 2001 (“Circular Nr. 8/2001”). Previously, companies that qualified under Circular Nr. 8/2001 as a principal company could obtain a partial flat-rate reduction in their taxable base income.
Based on survey results and audits undertaken in 2012, the Swiss FTA determined that the existing guidelines under Circular Nr. 8/2001 have not been consistently applied. Thus, the Swiss FTA is promulgating several clarifications to the existing guidelines, related to the following:
- Exclusivity of distributors: The Swiss FTA clarified that commissionaires / stripped distributors must be exclusive and dependent upon the Swiss principal company in order to qualify for treatment under Circular Nr. 8/2001. This means that at least 90 percent of the commissionaire / stripped distributor’s profits must relate to its transaction with the Swiss principal company.
- Restrictions on remuneration to commissionaires / distributors: Commissionaire / stripped distributor company’s profits may not exceed a gross margin of 3 percent, unless such a gross margin would not be sufficient to cover all operating expenses (including tax and interest expense). If a commissionaire / stripped distributor company is found to make greater than a 3 percent gross margin (and such a margin would cover all operating expenses), the portion of profit that is in excess of such margin will be included in the distribution profit of the Swiss principal company for the purpose of computing the 50 percent profit allocation outside of Switzerland. In other words, the Swiss FTA would only leave a profit amount that would result in a 3 percent gross margin for the commissionaire / stripped distributor and allocate the excess profit to the Swiss principal. However, it is important to note that the 3 percent gross margin guidance should not be considered a safe haven. Instead, it is meant to be a threshold to measure a maximum acceptable profit margin for the commissionaires / stripped distributors when utilizing the allocation of profits outside of Switzerland under Circular Nr. 8/2001. The facts and circumstances of the transaction will still need to be considered to determine whether or not the pricing is arm’s length.
- Proof of Economic Substance: The Swiss FTA clarified that in order to have a sufficient level of economic substance to be considered a Swiss principal company, the key principal functions should be performed in Switzerland. While some functions (e.g., auxiliary functions such as financing) are acceptable, other functions (e.g., trading-related principal functions) are expected to be performed by the Swiss principal in order to benefit from the federal tax regime under Circular Nr. 8/2001.
- Effect on Mutual Agreement Procedures (“MAP”) and Advance Pricing Agreements (“APA”): The Swiss FTA clarified that corresponding adjustments made on the basis of a MAP or APA would not automatically result in a denial of the principal allocation for the respective income. If intercompany transactions with a foreign commissionaire / stripped distributor are subject to a profit adjustment and a corresponding adjustment is called for under a MAP / APA, it should not adversely affect the principal allocation under Circular Nr. 8/2001. However, the Swiss FTA indicated that the 3 percent gross margin cap discussed above is applicable regardless of MAP / APA.
The clarifications issued by the Swiss FTA to the cantonal tax authorities will become effective immediately.
Transfer Pricing Implications for Private Equity Funds
Given the continued globalization of the financial services industry and the increased attention focused upon transfer pricing issues from governments as well as global organizations (e.g., OECD), Private Equity (“PE”) Funds should understand the potential implications of transfer pricing on their operations, and just as importantly on the operations of their portfolio companies.
While specific transactions are unique to the facts and circumstances of each PE Fund, in general transfer pricing arrangements for PE Funds are becoming more complex as PE Funds expand operations in a globally integrated manner, with non-routine functions potentially spanning multiple jurisdictions. Further, there can be transfer pricing considerations not only within the PE Fund, but within the multinational portfolio companies, as well as between the PE Fund and its portfolio companies. As discussed below, transfer pricing can be an issue for a PE Fund at one or more of these levels.
Within a PE Fund with multinational operations, typical intercompany transactions include the provision of services, such as investment research and/or sub-advisory services for sourcing, qualifying, or managing investments provided by a related party to the fund manager, as well as corporate services provided to global affiliates (e.g., legal, human resources, IT, finance and accounting, etc.). Complexity of the transfer pricing arrangement may be increased when a multitude of services are performed , all of which may need to be priced using different methodologies depending on the nature of the services performed (e.g., routine vs. non-routine). As a fund’s business evolves, it is common that local affiliates assume high value non-routine functions either through local hires or the secondment of senior staff abroad. A business with highly integrated non-routine functions performed in multiple jurisdictions may lend itself to a profit split methodology in which allocation factors such as headcount, assets under management, and/or compensation can be used to determine the arm’s-length remuneration for each affiliate.
Within a multinational portfolio company, transfer pricing issues can relate to the intercompany transfer of intangibles, tangible goods, services, and financial transactions (e.g., loans). Assessing related transfer pricing risk is of ongoing importance, particularly prior to the acquisition or sale of a portfolio company by a PE Fund to mitigate risk.
Between a PE Fund and its portfolio companies, transfer pricing issues may also exist if a portfolio company is considered a “related party” to the fund itself or to any partners under the broad definition of “common control.” Other tax issues related to economic interest/ownership such as permanent establishment and tax liability risks may also exist, specifically in light of recent rulings in PE Fund-related court cases (e.g., Sun Capital Partners). In addition, while carried interest is characterized as an investment return and is not typically viewed as giving rise to an intercompany transaction, it has been scrutinized by local taxing authorities in certain transfer pricing audits.
Establishing and implementing supportable transfer pricing policies, as documented through a transfer pricing analysis, offer a PE Fund and its portfolio companies a first line of defense in the event of a tax audit, minimizing the risk of costly adjustments and penalties that can be imposed in most jurisdictions absent such documentation. Given the recent uptick in the frequency and scope of audits of PE Funds (e.g., the UK, Singapore) transfer pricing is becoming an increasingly important area of focus for PE Funds.
1As it is not expected for the Swiss FTA to officially publish the internal guidance given to the cantonal tax authorities, we highlight the key points of that guidance in this article.
2The cantonal tax authorities are responsible for enforcing federal income tax law in Switzerland.