Transfer Pricing Times: Volume XII, Issue 11
In this Edition: Patent Box: New BEPS-Compliant Regime.
The Organization for Economic Cooperation and Development (OECD) released its final tranche of BEPS (base erosion and profit shifting) reports on October 5, 2015, including a final report on Action 5, Harmful Tax Practices. Chapter 4 of the Action 5 report introduces new rules in respect to the substantial activity requirement in the context of intangible property (IP) regimes, specifically the introduction of the ‘modified nexus approach,’ gearing qualifying benefits to physical research and development activities.
On October 22, 2015, the United Kingdom’s tax authorities launched a public consultation on their proposed new regime with the aim of formulating proposed legislation for the 2016 Finance Bill. This should allow time to meet the Action 5 cut-off date of June 30, 2016, for withdrawal of old IP regimes to new entrants.
The consultation is available here.
On the same day, the Irish Financial Bill 2015 was published. This bill proposes incorporation of the ‘nexus approach’ applying the OECD’s nexus formula as part of the new Knowledge Development Box (KDB), which is currently set to become effective on January 1, 2016. In addition to the updates to the KDB - an IP tax regime with an effective tax rate of 6.25 percent, the bill also includes country-by-country (CbC) reporting and other updates on Ireland’s international tax strategy.
Finance Bill 2015 will now be debated in the Irish parliament and is expected to be passed, in some form, by year’s end. For more details on Finance Bill 2015, the press release from the Minister is available here.
Finally, with patent boxes in 11 European countries, Germany is now also considering the adoption of a patent box by the end of 2016 based on the ‘nexus approach’ outlined by the OECD.
Decisions Made by the EC in State Aid Investigations regarding Starbucks and Fiat
On October 21, 2015, the European Commission (EC) announced its final decision with regards to the formal state aid investigations into select advance pricing agreements (APAs). The EC found that two companies, Starbucks and Fiat, explicitly applied a method which allowed for their profit to be forwarded to the Netherlands (Starbucks) and Luxembourg (Fiat) in order to avoid paying tax in the countries where they earn the profit. Specifically, the EC concluded that the agreement between Starbucks and the Dutch government in 2008 which involved not collecting between €20 million to €30 million of tax from the high profile coffee chain was illegal. In addition, the EC concluded that Luxemburg allowed Fiat to pay artificially low taxes by employing “an extremely complex and artificial methodology” that “cannot be justified by economic reality.” Ultimately while the EC does not have direct control over national tax systems, the EC requires its member states to force companies to pay back any illegal tax reliefs granted over a period usually covering up to 10 years; something that could severely impact these corporations depending on the outcomes of any appeals.
Further, the EC’s decisions on Starbucks and Fiat, together with the OECD BEPS initiative, clearly indicate that the global environment for international tax has changed. The decision has caused consternation amongst multinationals including Apple, which is currently under scrutiny with respect to its relationship with the Irish government. In the case of Apple, the EC has commented that the Irish tax administration has been discretely granting Apple a selective advantage by reducing its tax burden below the level where it should technically be. A final decision from the EC on this investigation is expected before the end of 2015.
Chevron Australia Intercompany Interest Case Decision
On October 23, 2015, the Australian Federal Court released its decision in a case involving intercompany interest paid by Chevron Australia Pty Ltd (Chevron Australia) to its US subsidiary. The case considered the Australian Commissioner of Taxation’s disputed assessment that the interest rate paid under a Credit Facility Agreement by Chevron Australian exceeded an arm’s length consideration for the purposes of Australia’s former transfer pricing rules [Income Tax Assessment Act 1936, Division 13], and its recently-enacted retrospective transfer pricing rules [Income Tax Assessment Act 1997, Subdivision 815-A].
Over the period 2004-2008, Chevron US lent funds to Chevron Australia under a Credit Facility Agreement. The interest rate applied on the AUD-denominated borrowings (approximately USD 2.5 billion) was AUD LIBOR plus 4.14 percent, reflecting a significant mark-up on the US-sourced funds obtained by Chevron US from a third- party bank at an interest rate of approximately 1.2 percent. The Commissioner argued that the intercompany interest rate charged was unsustainable from the perspective of an independent third-party borrower and was not arm’s length. The judge found in favor of the Commissioner, and applied a 25 percent penalty on the tax shortfall.
It is likely that Chevron Australia’s transfer pricing approach for this transaction would have been accepted as adequate in 2003, when the Credit Facility Agreement was established. However, transfer pricing practices have evolved and such evolution coupled with Australian legislative and case law developments, ultimately cast a different light on this transaction. Further, the resulting tax benefits from Chevron likely tainted the pricing of the controlled financing transaction, as well as the Commissioner’s and Court's perceptions thereof.
The judgment is arguably dismissive of the taxpayer's benchmarking analyses, and of the limitations in the Commissioner's analyses that were raised by the taxpayer's expert witnesses. Ultimately, the court found that a key non-arm's length condition of Chevron Australia's Credit Facility Agreement was the lack of financial and operational covenants therein. However, this construct is common in intercompany agreements and adjustments during the benchmarking can account for this. The judgment arguably applies comparability standards too strictly, without regard to practical constraints on the availability of benchmarking data, as well as investment alternatives available to lenders.
Importantly, the Court held that “… [t]he correct perspective is that of a commercial lender. A commercial lender would not approach the question of the borrower’s creditworthiness in the same way as would a credit rating agency” (para. 503). Thus, the decision accepted that commercial lenders do not regard the views of credit ratings agencies, and that implicit parental support [upon which subjective notching is based] has "very little, if any, impact on pricing by a lender in the real world" (para. 606), in the absence of a binding parental guarantee. This aspect of the decision, if it survives appeals, will likely become embedded in the accepted transfer pricing precedents and practices specific to financial transactions.
Given the complexity of the case and the potential tax liability, approximately USD 322 million in penalties and unpaid taxes, it is generally expected that Chevron will appeal the decision.
For more information, a complete copy of the judgement is available here.
Country-by-Country (CbC) Reporting Legislation
Also topical in Australia, on August 9, 2015, the Australian Government released an Exposure Draft containing a new section 815-350 et. seq., and explanatory memorandum, pertaining to CbC reporting. Specifically, Australian CbC reporting requirements would be effective for fiscal years commencing on or after January 1, 2016. While the details of these reporting requirements have not yet been issued, the Australian Taxation Office (ATO) may require the provision of three reports – the Master file, the Local file, and a CbC report. The applicable revenue threshold for a group (defined in the legislation as a "significant global entity") will be AUD 1 billion, determined based on annual consolidated global revenue.
The CbC requirements are part of a broader piece of legislation, which was designed to combat multinational corporation’s tax avoidance. For more information on the specific changes related to CbC, click here.