Inside this edition of the Duff & Phelps Transfer Pricing Times:
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 U.S. Transfer Pricing Regulations do not provide specific guidance related to cloud computing resources, direction can be taken from Section 1.861-18 of the U.S. 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
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
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 method7 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.
Alternative | Description | Benefits | Concerns |
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. |
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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. |
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Administrative Appeals |
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. |
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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. |
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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:
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., U.S. 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 U.S. 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:
The initiation of new APA programs abroad dovetails with more efficient processing of APAs in the U.S. 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
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