Transfer Pricing Times: Volume XI, Issue 4
Inside this Edition: US Senate Permanent Subcommittee report lists key recommendations for Caterpillar, Inc.
On March 30, 2014, the United States Senate Permanent Subcommittee on Investigations released a report entitled “Caterpillar’s Offshore Tax Strategy,” summarizing its conclusions from a nine-month investigation of Caterpillar Inc.’s corporate structure. The report cites Caterpillar’s transfer pricing documentation prepared by PricewaterhouseCoopers and uses details of the functional analysis contained therein to assess the structure set up by Caterpillar. The report states that as part of its tax strategy, Caterpillar US, in exchange for a royalty, transferred rights to its international parts distribution business to a wholly-controlled Swiss affiliate. As a result of this change, Caterpillar deferred $2.4 billion of US taxes from 2000 to 2012.
The Subcommittee report includes four recommendations:
Clarify IRS Enforcement - When reviewing transfer pricing transactions to evaluate their compliance with Section 482 of the tax code, the IRS should analyze, in accordance with 26 U.S.C. 7701(o), whether the transactions have economic substance apart from deferring or lowering a multinational’s US taxes. The IRS should also clarify what types of transfer pricing transactions, if any, are not subject to an economic substance analysis.
Rationalize Profit Splitting - The IRS transfer pricing regulations should require the US-based parent corporation to identify and value the functions of the related parties participating in a transfer pricing agreement and, in the agreement, identify, explain, and justify the profit allocation according to which parties performed the functions that contributed to overall profits.
Participate in OECD (Organization for Economic Cooperation and Development) Multinational Corporate Tax Effort - The US Treasury Department and IRS should actively participate in the ongoing OECD effort to develop better international principles for taxing multinational corporations, including requiring multinationals to disclose their business operations and tax payments on a country-by-country basis to stop improper transfers of profits to tax havens and/or avoidance of taxation in the countries in which they may have a substantial business presence.
Eliminate Auditing and Tax Consulting Conflicts of Interest - Congress and the Public Company Oversight Accounting Board (PCAOB) should prohibit public accounting firms from simultaneously providing auditing and tax consulting services to the same corporation, and prevent the conflicts of interest that may arise when an accounting firm’s auditors are asked to audit the tax strategies designed and sold by the firm’s tax consultants.
For additional detail, see the full text of the subcommittee’s report, available here.
US Tax Deferral and Cost Sharing Structure through an OECD BEPS Lens
The OECD is in the midst of an extensive review of the prevailing international tax framework, which is likely to impact taxpayers across the globe. One of the issues near the center of this debate is the accumulation of corporate profits in low or no-tax tax jurisdictions where some companies may have limited activities. While these corporate tax planning structures have come under increased scrutiny, they have, to a large extent, been found to be legitimate and legal. Specifically, much of this low-taxed offshore income is foreign-earned income of US-based multinationals that is legitimately deferred from US taxation under US tax law and regulations that effectively encourage overseas expansion.
In July 2013, working towards one of its “BEPS” (Base Erosion and Profit Shifting) initiative’s objectives to “assure that transfer pricing outcomes are in line with value creation” the OECD issued draft guidance on “Transfer Pricing Aspects of Intangibles.” The draft includes further guidance on the definition of intangibles and an understanding of which entities own or enhance the value of intangibles, or make other contributions as part of a full “value chain” functional analysis covering all significant activities, entities, and jurisdictions. The draft specifically highlights value-creating activities, especially the control and decision making around those activities, as a key factor in determining which parties should earn profits in a business. In the OECD’s mind this is potentially more important than legal arrangements and the returns to capital invested and risk. Importantly, the discussion draft recognizes that both independent and affiliated companies often delegate important value-creating activities (even day-day-day management of risks) to others with those capabilities, but asserts that an independent company would be unlikely to delegate the key decisions, controls, or aspects of oversight of these activities to other parties. It also alludes to the lack of comparables for benchmarking returns to critical or significant strategic activities when these are delegated. This discussion draft follows a theme introduced previously in the OECD Guidelines chapter on Business Restructuring, which also covers the difficulty around identification of similar value-add activities, the location of control and decision making, and the capacity to bear risk. 1 The framework for the OECD is one of comparable arm’s length compensation for value-add functions and risk bearing, or, where such compensation is not observable, to what independent parties would likely have agreed. The OECD acknowledges the subjectivity of such an exercise and provides some specific guidance on the types of control and decision making and capacity to bear risk that are indicators of the economic substance in the arrangements. 2
The OECD Guidelines then provide examples which highlight the types of “super” control activities that would be expected of an entity assuming significant risks, including decisions and monitoring of capital investments, programs of development, choice and hiring of service providers, budgets and performance, etc., in short, those strategic and tactical decisions that would normally be expected of an entrepreneur active in a business. Without this active management in operational arrangements, the existing OECD Guidelines and the draft discussion paper on intangibles envisage the possibility of adjustments to profits through the application of alternative methods, or in extreme cases for transactions without adequate substance, re-casting them by the tax authorities. Consequently, these activities take on a high degree of significance in operational, tax, and legal entity structuring in order to support the location of related risk-based investment returns where taxpayers would want them.
Typical international operating and tax structures for a US corporation are usually arranged around an entrepreneurial business sub-group of foreign affiliates with the rights exploit the company’s products in defined foreign territories. These rights were obtained through arrangements which may include significant payments by the foreign group for the exploitation and use of existing products and technologies, as well as an on-going commitment to share intangible development costs in proportion to reasonably anticipated benefits. Within the core of this entrepreneurial foreign business group there may be a separate intangible holding company (“IPCo”) and an operating company (“OpCo”). The IPCo is the primary entrepreneurial entity which provides the capital for the foreign business operations, and makes the risky investment decisions to develop the foreign business, cost sharing future product or intangible development with the US, and pays for the contributions to the foreign business from other members of the group or third parties. It is also this entity that may be located in a low or no tax jurisdiction and which earns the risk-related rewards if things go well, or the losses if they don’t. The OpCo provides the resources and people required to operate the foreign business.
In a few cases where businesses have been very successful over time, these arrangements have led to significant low taxed foreign earnings which are deferred from US taxation. These are generally the businesses that finance ministers, tax authorities, and the public have been focusing on. However, the path to the deferral of these profits to US tax has usually been far from easy, and fraught with risks of failure. Further, the cash from any deferred foreign profits are often used to make expensive acquisitions to try and preserve their market position which can trigger additional payments and US taxation.
For younger or emerging companies, the initiation of these arrangements often leads to the recognition of significant US income for payments for initial contributions from existing affiliates and lost US deductions for cost shared R&D and intangible development costs attributed to the foreign business long before the foreign business is profitable.
Furthermore, in many cases, the returns to the capital at risk in these structures have not materialized at all or been muted by the additional costs of the structures and / or recessionary and competitive pressures. In summary, these arrangements are not for the faint of heart and carry considerable risk along with their potential rewards.
From the US perspective, often with the benefit of attribution, the core foreign business group either performs all the significant value add activities for the foreign business, or contracts with others for assistance and pays an appropriate service fee for those activities. Consequently, from a US perspective the structures and allocations of profit, even under the OECD lens, may look reasonable and appropriate assuming that the various payments in these structures are appropriately determined and supported and there is adequate support and evidence for the activities of control around the investment and operational risks in the foreign business.
From the perspective of the tax authorities in foreign countries, in which may reside certain affiliates that perform the various tactical or operational activities in the foreign business, these arrangements may look less robust. Specifically, the individual entities within the foreign business operations and the related control and decision making may seem dispersed. In particular, the IPCo with its agreements, capital, profits and risk, but potentially fewer employees and directors and lower levels of obvious business activity, may look like an attractive target for inquiry. Foreign taxing authorities might seek to locally tax US tax deferred profits under the existing tax and transfer pricing rules through claims of permanent establishment, adjustments to transfer pricing for non-routine contributions or special comparability factors, or use of profit split methods. In rarer cases, tax authorities have been known to try to collapse and re-characterize transactions and arrangements.
It is not yet clear where the OECD Guidelines or domestic and international legislation will settle and each taxpayer’s situation is different. Increased visibility and scrutiny of these structures, however, seems inevitable. That said, enough of a picture is available for taxpayers to review their arrangements and position them in a more supportable and favorable light. What is clear is that being able to provide evidence of the alignment of key control and decision making, if not direct performance of value-add activities, with the entities earning significant profits and bearing significant risks within the structure is going to be highly important to minimize or avoid the risk of tax controversies.
Takeaways from the OECD’s Presentation at TP Minds
Duff & Phelps’ transfer pricing professionals participated in the TP Minds Transfer Pricing 2014 International Summit held March 11-12th in the United Kingdom. Joseph L. Andrus, head of the transfer pricing unit of the OECD, discussed some recent developments at the OECD, including ongoing work on the “BEPS” initiative, specifically documentation and country-by-country (CbC) reporting (referred to as BEPS Action Item #13).
Mr. Andrus noted that the recent OECD draft on CbC reporting generated an overwhelming response, including feedback from over 1,300 non-governmental organizations (NGOs), the business community, and transfer pricing practitioners/advisors. Commentaries are itemized and available here.
Mr. Andrus noted that the OECD draft on CbC reporting was not a consensus document and acknowledged that at times the draft was over inclusive. He noted that in the immediate future, Working Party No. 6, the committee established by the OECD to investigate issues associated with the taxation of multinational enterprises, would need to address issues surrounding confidentiality, particularly in the context of how advanced pricing arrangements (APAs) or other rulings would be shared and how detailed requests (made under CbC framework) would be protected and stored. For example, the business community was specifically concerned that proprietary global organizational charts and/or detailed supply chain information that might be shared within and outside of OECD member countries.
Mr. Andrus noted that while sharing of APAs, mutual agreement procedures (MAPs), or other advanced rulings might be stricken from future CbC drafts, several tax authorities (particularly within the European Union) continue to want a global picture. As such, information pertaining to global value chain and consolidated financials (in addition to statutory, local GAAP financials) might be included.
He also indicated that there are continuing discussions with developing nations and certain NGOs pertaining to formulary apportionment since it has been noted that limited comparable data (and resources) are available for the developing world. Relatedly, Mr. Andrus sought commentary from the business community on the previously released discussion draft dealing with availability of comparables. This discussion draft on transfer pricing comparability data and developing countries is available here.
Finally, Mr. Andrus mentioned that the OECD is expected to release its final paper on intangibles in June 2014.
OECD Issues Two Public Discussion Drafts Related to BEPs in March
Hybrid Mismatch Arrangements
On March 19th, the OECD issued a public discussion draft addressing hybrid mismatch arrangements. The draft recommends that countries enact changes to domestic laws in order to neutralize the effects of hybrid mismatch arrangements. The discussion draft recommends adoption of a ‘linking rule’ which is intended to align the tax outcomes of the payer and payee of a given financial instrument.
The recommendations in the draft target three general categories of hybrid mismatch arrangements:
Hybrid financial instruments and transfers, which rely on tax treatment discrepancies resulting from the instrument having different characterizations in the respective jurisdictions of the payer and payee. For example, a deductible payment in one jurisdiction is not treated as taxable income under the laws of the counterparty’s jurisdiction.
Hybrid entity payments, which rely on tax treatment discrepancies resulting from the payer having different characterizations in its jurisdiction vs. that of its counterparty. For example, the characterization of the payer results in a deductible payment being disregarded as income, or worse triggering a second deduction, in the counterparty’s jurisdiction; and
Reverse hybrid and imported mismatches, which may cover payments made to an intermediary that are not taxable upon receipt. In addition, imported mismatches are engineered under the laws of a jurisdiction and subsequently imported into the jurisdiction of the payer.
For additional detail, see “BEPS Action 2: Neutralize the Effects of Hybrid Mismatch Arrangements,” available here. Comments on this discussion draft are due by May 2, 2014.
Tax Challenges of the Digital Economy
On March 24, 2014, the OECD published another discussion draft addressing Action Item #1 of the 15 actions covered in the OECD’s BEPS) Action Plan. Item #1 specifically addresses the challenges of the digital economy in international taxation.
The discussion draft highlights that in a digital economy, risks associated with BEPS can be exacerbated in certain instances. Specifically, many of the core elements of BEPS strategies arise from key features of the digital economy such as mobility and reliance on data. These features allow businesses to employ strategies to avoid a taxable presence in a country, minimize functions and risks, and establish business activities in a country solely to take advantage of favorable treaty arrangements. For example, businesses are increasingly able to centralize infrastructure and perform key functions outside of the jurisdiction into which they actually sell their goods or services. The digital economy therefore arguably allows companies to separate physical operations from economic substance. Some of the suggested ways to address these issues include effective rules to prevent treaty abuse, changes to the definition of a permanent establishment, and increased focus on the role and transfer of intangibles in the digital economy (see story above).
Building upon prior work done on e-commerce at a 1998 Ottawa Conference, the discussion draft outlines key issues and possible solutions to BEPS in the context of the digital economy along with broader tax implications presented by the digital economy.
For additional detail, see OECD's discussion draft on “Action 1: Tax Challenges of the Digital Economy”, available here. Comments on this discussion draft were accepted through April 14th.
1 OECD Transfer Pricing Guidelines for Tax Administrations and Multinational Enterprises, Chapter IX, section B.2.2 “Risk Allocation and Control”, para. 9.22 through 9.28.
2 OECD Transfer Pricing Guidelines for Tax Administrations and Multinational Enterprises, Chapter IX, section B.2.2 “Risk Allocation and Control”, para. 9.23 through 9.24.