Transfer Pricing Times: Volume XII, Issue 4
In this Edition: OECD Holds Public Consultation on Various Transfer Pricing Discussion Drafts.
On March 19 - 20, 2015, the Organization for Economic Cooperation and Development (OECD) held a public consultation on numerous discussion drafts dealing with transfer pricing issues. This brief summary focuses on the sessions on the Risk, Recharacterization, and Special Measures discussion draft and the Profit Splits discussion draft. Sessions were also held for the discussion drafts on low value-added services and commodity transactions.
With respect to the discussion draft on Risk, Recharacterization, and Special Measures, focal points of discussion included:
- The concept of “delineating” the transaction and the role of such delineation in determining the actual transaction relative to contractual arrangements. Business representatives largely came down strongly on the side of respecting the contracts except in extreme circumstances, while certain countries’ delegates signaled fairly strong skepticism towards intercompany agreements being viewed as anything beyond fiction created by tax departments.
- Risk identification and the importance of risk; reward to capital and reward to capability, and the allocation of risk and moral hazard. The important themes of this section included:
- Distinctions between compensable and non-compensable risks, and the definition of risk generally;
- The importance of recognizing that the allocation of risks to the contractual owner are real and very important, particularly as it relates to the bearing of fixed costs;
- Recognition that realized results relative to results that would be expected if risks were appropriately priced have proven immensely favorable to taxpayers; and recognition that disallowing risk shifts is one potential avenue to eliminating the resulting misalignment of profits and functions; and
- The role that moral hazard should play in the discussion – there was little support among the business commentators for the use of the moral hazard framework as an appropriate motivating factor within the discussion draft.
- The risk-return trade-off as presented in the discussion draft, particularly as it relates to the examples presented in paragraphs 89 and 90, and the guidance on non-recognition generally. Business commentators came down hard on any notion that risk shifting should lead to non-recognition in anything but extraordinary circumstances. The realistic alternatives principal featured heavily in this topic area.
- A discussion about the various special measures that were proposed at the end of this draft. Generally speaking, business commentators viewed all of the special measures unfavorably and felt that nearly all of the proposed special measures were outside of the arm’s length framework. Option 1 (which would provide for commensurate with income adjustments in certain circumstances) was the only proposed special measure that seemed to receive any support from the business community.
Also discussed were profit splits. There seemed to be a bit of support among some business participants for broadening the use of profit splits (certainly more so than any indication of support for the biggest changes reflected in the Risk, Recharacterization, and Special Measures draft). That being said, the majority of practitioners had a fairly unified message that:
Profit splits should be the exception and not the rule;
The guidance should be clear that profit splits should only apply when multiple parties are making valuable and unique contributions. This limitation is very familiar to US practitioners, but doesn’t really exist in the existing guidance or any proposed revisions;
When profit splits are applicable, the guidance needs to be clearer that its profit or loss splits. Many practitioners have experiences where high profits are expected to be split, but then tax authorities are unwilling to take any part in losses; and
Where profit splits are applicable, it should be residual profits that are being split (consistent with the logic of valuable and unique requirements).
The OECD is planning to make significant changes to its discussion draft on Risk, Recharacterization, and Special Measures following the public consultations in March. These changes will likely help to clarify the draft’s position on moral hazard, non-recognition of transactions, and conduct.
For more information on the OECD’s public consultations on these drafts, click here.
Government-to-government mechanisms for Country-by-Country reporting
The Guidance published by the OECD in January 2015 with respect to Base Erosion and Profit Shifting (BEPS) Action Item 13, on the implementation of transfer pricing documentation and Country-by-Country (CbC) reporting, envisages the distribution of CbC reports by the jurisdiction of the reporting entity of the multinational group to concerned jurisdictions in which the group operates by means of automatic exchange of information.Following the issue of this guidance, the OECD began the process of developing mechanisms to allow the competent authority of a jurisdiction implementing BEPS Action Item 13 to share, automatically and annually, CbC reports prepared by the reporting entity of a multinational group and filed with that jurisdiction’s tax authority and/or with another jurisdiction’s competent authority, provided the multinational group maintains a business unit in that other jurisdiction.Three draft model competent authority agreements are known to be in development as part of the implementation package for the exchange of CbC reports:
A bilateral competent authority agreement for exchanges under a Double Tax Convention (DTC) in place between the jurisdictions of the competent authorities signing the Agreement;
A bilateral competent authority agreement for exchanges under Tax Information Exchange Agreements (TIEAs); and
A multilateral competent authority agreement for exchanges under the Multilateral Convention for Mutual Administrative Assistance in Tax Matters (the MAAC).
We can expect that the model agreements will draw extensively, in terms of both structure and content, from the text of the model Competent Authority Agreement for exchanges under the Common Reporting Standard.
The agreements will propose timing for the government-to-government exchange of the CbC report from the date of receipt by the sending competent authority from the reporting entity. The exchange is anticipated to be within three months of receipt, and no later than 15 months after the end of the fiscal year of the reporting entity of the MNE group to which the CbC report relates.
As with the proposals for the Common Reporting Standard, it is expected that competent authorities will automatically exchange the CbC reports through a common schema in Extensible Markup Language (XML Schema). The XML Schema for CbC reporting will be developed by the OECD’s Working Party 10 (on exchange of information and tax compliance - WP10).
In line with paragraph 13 of the guidance, the model agreements will require that all information exchanged is subject to the confidentiality rules and other safeguards provided for in the main agreement (DTC, TIEA or MAAC), including the provisions limiting the use of the information exchanged. Jurisdictions will be required to use the information received through the CbC report solely for assessing high-level transfer pricing risk and other BEPS-related risks, and where appropriate for economic and statistical analysis. Jurisdictions will be required to not propose adjustments to the income of an entity on the basis of an income allocation formula based on the data from the CbC report and it will be mandatory that any such adjustments made by local tax administrations must be conceded.
Following review by delegates of Working Party 6 (on the taxation of multi-national enterprises - WP6) and WP10 in March, it is expected that the model competent authority agreements will be approved by WP6 in May 2015. The full implementation package, including all three agreements, will subsequently be submitted to the OECD’s Committee on Fiscal Affairs for approval.
The next meeting of WP10 is scheduled to take place in June 2015. Discussions will include the development of an XML Schema, a user guide for the exchange of CbC reports, and potentially a commentary to the competent authority agreements.
OECD Releases Discussion Draft on Strengthening CFC Rules
On March 4, 2015, the OECD relayed a discussion draft on controlled foreign company (CFC) rules in relation to the recent BEPS project. The general purpose of CFC rules is to prevent shifting of income from the parent jurisdiction to other jurisdictions. CFC rules work to balance the impact of taxing foreign income while still allowing the foreign companies to maintain competitiveness, as competitiveness may be eroded in jurisdictions with CFC rules if foreign subsidiaries owned by resident companies are taxed more heavily than locally owned companies in the foreign jurisdiction.The discussion draft works to break down the CFC rules into building blocks that are necessary for effective CFC rules. Specifically, the purpose of the discussion draft released by the OECD is to set forth recommendations for effective CFC rules that can be implemented in all jurisdictions in order to combat competitiveness concerns. Ideally, the recommendations would be consistent for the EU Member States and non-EU Member States, however, the OECD recognizes that modifications may need to be implemented to comply with EU law. In addition, the discussion draft also attempts to find effective rules that do not cause administrative burdens or compliance costs.The discussion draft identifies specific questions with a request for input from interested parties in order to advance the work on the CFC rules. Comments regarding the discussion draft must be submitted by May 1, 2015. A public consultation on this action item will take place at the OECD Conference Centre on May 12, 2015.To view the full discussion draft, click here.
Twenty-five Countries Seeking Consensus on Mandatory Arbitration
Recently, the OECD has been working to solve the issues of double tax disputes by promoting mandatory binding arbitration. The initial discussion draft from the OECD highlighted the fact that there is a wide range of countries being represented in BEPS negotiations and a universal approach to dispute resolution might not be the most effective or well received. Based on the public commentary received, the OECD has gone back to the drawing board and is working to create meaningful arbitration that may not cover everything but will allow progress moving forward. At the proposal of the United States, a coalition among the countries committed to arbitration is working to explore the potential use of a multilateral instrument to expand their network. The OECD is seeking to gain consensus around a framework for mandatory binding arbitration from this group of 25 countries.
UN Tax Committee to Issue Draft on Intangibles Next Year
It was recently announced that the United Nations’ (UN) Committee of Experts on International Cooperation in Tax Matters plans to issue a draft chapter on intangibles in 2016. The draft chapter is going to be considered for incorporation into the broader UN Practical Manual on Transfer Pricing for Developing Countries, which is being updated in 2016. The timing of the proposed draft allows the UN to finish the work on intangibles after the OECD’s BEPS project concludes its work on transfer pricing, and will permit the UN to use the BEPS project as guidance for the intangibles draft chapter. While the UN Tax Committee plans to review the OECD drafts on intangibles with the intent of maintaining a form of continuity in the transfer pricing world, the draft chapter on intangibles is not expected to follow the BEPS process exactly.The UN Economic and Social Council (ECOSOC) was scheduled to meet on April 22, 2015, to discuss international cooperation on tax matters with several panelists. Stay tuned for further developments resulting from this meeting.
Annual Report on US APA Statistics Released
Required to report annually to the public concerning advance pricing agreements (APAs), the United States Secretary of Treasury released its latest report on March 30, 2015. The report focuses on the Advance Pricing and Mutual Agreement (APMA) Program, as well as the statistics on APAs for 2014.The APMA program is comprised of 59 leaders, 22 economists, and 10 senior managers which form 10 different groups. These groups are organized by country with each group having responsibility for multiple countries in order to handle the large volume of cases. The APMA gathers data regarding the APAs that are filed globally. In 2014, there were 108 total APA applications filed: 31 unilateral, 74 bilateral, and 3 multilateral agreements. Although down slightly, the number of applications filed per year has stayed relatively stable from 2013 to 2014. Keeping consistent with prior years, the majority (55 percent) of the APAs executed in 2014 involved transactions between non-US parents and US subsidiaries. The types of tested parties in the APAs also remained similar as in prior years, with US Distributors making up 33 percent of the tested parties, followed by US Service Providers at 18 percent. The number of APAs executed during the 2012-2014 time period has been a substantial increase from prior years, leading to a significant increase in annual reports filed as part of the compliance requirements. This substantial increase in annual reports has created the issue of backlog, as only 641 of the 802 reports received in 2014 have been reviewed as of this report’s release date.For more information on the announcement concerning advance pricing agreements, please click here.
Vote on US Domestic Transfer Pricing Design Set for May 7, 2015
The Multistate Tax Commission (MTC), an intergovernmental state tax agency in the United States, has finalized its draft proposal for a state-level transfer pricing program called the Arm’s Length Adjustment Service (ALAS). The primary goals of the ALAS are to:
- Provide transfer pricing expertise to states and
- Enable states to share the costs of auditing related-party transactions.
Under the proposal, the program would have an annual budget of $2 million and an eventual staff of six full-time transfer pricing specialists, including a manager, an auditor, several economists and a staff attorney. However, in developing the program ALAS would initially rely on third-party consultants to provide economic expertise before eventually relying more on in-house economists. According to the proposal, the program could generate between $40 million and $60 million in revenues from transfer pricing adjustments in its third and fourth years of operations, respectively, creating a significant return on investment. The ALAS will be voted on at the May 7, 2015, meeting of the MTC's executive committee, and the program will ultimately require the participation of at least seven states in order to launch. As of April 16, only four states have expressed a willingness to commit to the project - Kentucky, North Carolina, Pennsylvania, and the District of Columbia.