Post on 18-May-2018
American Bar AssociationTax Section
2011 Midyear MeetingBoca Raton, FL
January 20-22, 2011
An Update on OECD Transfer
Pricing Developments and Proposals
for the Taxation of Intangibles
This presentation is offered for informational purposes only and the contents should not be construed as legal advice on any matter
January 21, 2011 2
Panelists
Moderator:
A. W. Granwell,DLA Piper LLP (US)
Washington, DC
Panelists:
David Ernick
Associate International Tax Counsel
Department of Treasury
Washington, DC
Daniel J. Frisch
Managing Director
Horst Frisch Inc.
Washington, DC
Michelle LevacTransfer Pricing Specialist
Canada Revenue Agency
Chair, OECD Working Party 6,
Paris, France
Ramon Lopez De Haro
Garrigues,
Madrid, Spain
Janice McCart
Blake Cassels & Graydon LLP
Toronto, Canada
January 21, 2011 3
Agenda
• Business Restructurings (OECD)
• OECD Intangibles Project
• US Transfer Pricing Proposals
January 21, 2011 5
Introduction
• Business Restructuring is a cross-border redeployment of
assets, functions and risks among affiliated entities of a
multinational group (“MNC”).
• Business restructurings can enable an MNC to compete more
efficiently, preserve profits or limit losses in the global
economy.
• Business restructurings may result in the erosion of the tax
base of the host countries in which the restructured
companies are resident and therefore are under active
scrutiny by high tax countries and the OECD.
January 21, 2011 6
Business Models
• Vertically integrated business model. Under this business
model, MNCs conduct full-fledged manufacturing, distribution
activities and associated services through separate locally incorporated entities (H Cos). Each H Co is treated as the
entrepreneur in its local country.
• Supply chain management business model. This business
model entails centralizing in one company (E Co), resident in a tax friendly jurisdiction, overall responsibility for managing
and conducting a business segment, including R&D,
manufacturing, distribution and associated services.
• These are endpoints on a spectrum. Intermediate cases of
various sorts are common.
January 21, 2011 7
Vertically Integrated Business Model
• MNC Group currently
conducts business abroad
through locally incorporated
legal entities (H Cos) that
manufacture and sell product
in their local countries.
– Each entity is a fully-functioning manufacturer and distributor and provides its own associated services.
– Each H Co is the entrepreneur with respect to its activities.
– Returns are commensurate with the benefits and burdens of the entrepreneur.
MNC
H Co 1 H Co 2 H Co 3
January 21, 2011 8
Supply Chain Business Model
• Management and conduct of a business segment is
centralized in an entrepreneur company (E Co) that is
responsible for the management and conduct of the business.
• Intangible assets and many functions and risks are
centralized in E Co.
• E Co. conducts manufacturing and distribution of product
through contract manufacturers and limited risk distributors
and provides associated services.
• E Co obtains the residual returns from the business, commensurate with E Co’s assets, functions and risks.
• Limited risk manufacturers and distributors receive routine
returns commensurate with limited functions, risks and assets.
January 21, 2011 9
MNC
Entrepreneur
Limited Risk
DistributorsContract Manufacturers
Supply Chain
Business Model
January 21, 2011 10
Restructuring
• The restructuring is achieved by “migrating” intangibles and
“stripping out” functions and risks from the H Cos and
centralizing these intangibles, functions and risks in E Co, which will function as the entrepreneur with respect to the
business segment that is the subject of the restructuring.
January 21, 2011 11
Migration of Intangibles
• Intangibles can be migrated through:
– Assignment.
– Licensing.
– Cost sharing.
– Transfer of employees.
– Virtual migration.
January 21, 2011 12
Manufacturing Operation Restructuring
• Manufacturing operations are restructured by converting full-
fledged manufacturers into contract or toll manufacturers.
• After restructuring, R&D is performed pursuant to a cost
sharing arrangement and/or on a reimbursable cost plus
basis.
January 21, 2011 13
Supply Chain Restructuring
• The supply chain is restructured by converting full-fledged
distributors into low-risk stripped distributors or
commissionaires, and the creation of central regional management logistics platforms and shared service centers.
January 21, 2011 14
Attributes: The Entrepreneur
• E Co will incur the benefits and burdens associated with the
centralized activities and be allocated the residual income or
loss from such activities.
• E Co will have the requisite substance to function as the
entrepreneur.
• E Co will be adequately capitalized to perform its functions
and to bear the risks that it will incur.
• E Co will have the tangible and intangible assets necessary to
perform its functions.
• E Co will have its own employees capable of conducting the
business resident in its office in the tax-friendly jurisdiction.
January 21, 2011 15
Attributes: Possible E Co
Functions• License MNC’s intangibles (name, patents, trademarks, copyrights,
manufacturing know-how, etc.) or become a participant in a cost sharing
agreement through a buy-in arrangement.
• Fund and perform R&D and own newly developed intangibles.
• Determine product price lists and allowable discounts.
• Manage production scheduling and sales forecasting.
• Approve purchase and sales orders.
• Procure raw material and components for contract manufacturers.
• Act as principal in the contract manufacturing or toll manufacturing
arrangement.
• Acquire output of contract manufacturing affiliates for resale to distribution
affiliates.
• Manage logistics, quality control, credit approval, invoicing, account control,
inventory and back office support.
January 21, 2011 16
Attributes: Potential E Co Risks
• Licensee/cost sharing risks.
• Market risks.
• Procurement risks.
• Inventory risks.
• Currency and interest rate risks.
• Legal risks.
• Credit and collection risks.
January 21, 2011 18
Attributes: Limited Risk
Companies• Limited risk manufacturer for E Co
– Functions: manufacturing.
– Risks: commensurate with limited risk functions.
– Return: routine cost plus or ROCE.
• Limited risk buy-sell distributors for E Co
– Functions: market, solicit, negotiate orders and sell product tothird party customers.
– Risks: commensurate with limited risks functions.
– Return: routine operating margin.
January 21, 2011 19
OECD Project
• On July 22, 2010, the OECD published final guidance (Final
Guidance) on business restructurings in the new Chapter IX
of the OECD Transfer Pricing Guidelines.
• Chapter IX is the culmination of the project begun in 2005.
January 21, 2011 20
Issues Considered
• Final Guidance covers four issues:
– The allocation and transfer of risks among related parties.
– Whether the internal business restructuring transaction requiresarm’s length compensation or indemnification.
– The application of transfer pricing rules to the parties post-business restructuring.
– When can a tax authority disregard a business restructuring?
January 21, 2011 21
General Comments
• Final Guidance is a consensus document endorsed by all
OECD members.
• Final Guidance is a more balanced document than the
Discussion Draft as a result of clarifications and efforts to
make the wording less subjective.
• The OECD acknowledges that a certain level of subjectivity is
inevitable in transfer pricing determinations.
January 21, 2011 22
Arm's Length Compensation
for Business Restructuring• Central Issue:
– Is there a transfer of “something of value” (rights or assets) or a termination or substantial renegotiation of existing arrangements?
– Would that transfer, termination or substantial renegotiation have been compensated between independent enterprises in comparable circumstances?
• Transfer → Compensation
• Termination → Indemnification
January 21, 2011 23
Arm's Length Compensation
for Business Restructuring• Arm’s length principle does not require compensation for a
mere decrease in the expectation of an entity’s future profit.
• No presumption that all contract terminations or substantial
renegotiations should be indemnified at arm’s length.
• “Profit potential” should not be interpreted as the profit or loss that would occur if the pre-restructuring arrangement would
continue indefinitely.
– Profit potential refers to expected future profits.
– Profit potential is not a right or an asset per se.
January 21, 2011 24
Arm’s Length Compensation
for Business Restructurings• OECD does not agree with the suggestion that compensation would
be provided only with regard to transfers of narrowly defined property interests.
• Rather, the OECD uses the phrase “a transfer of something of value,” which is vague and broad.
– Final Guidance expands on circumstances where a transfer of going concern may arise, viz., it is necessary to have transferred a functioning integrated business unit (i.e., a transfer of assets bundled with the ability to perform certain functions and bear certain risks).
– No guidance is provided on workforce in place.
• Final Guidance does not deal with whether compensation that would be paid at arm’s length constitutes a taxable event.
• Potential conflict with legal and accounting treatment where no discernable asset transfer can be identified (despite recognition of taxable event).
January 21, 2011 25
Arm’s Length Compensation
for Business Restructurings• Final Guidance clarifies that rights under commercial
legislation and case law should be a relevant consideration,
but not the only one, in determining whether indemnification should be provided in connection with a restructuring under
the arm’s length principle.
January 21, 2011 26
Arm’s Length Compensation
for Business Restructurings• Indemnification concept only relates to:
– Compensation for detriments suffered by restructured entity (restructuring or reconversion costs and/or loss of profit potential).
– Relevance of financial risk borne by restructured entity upon investment made for assessing whether the terms of the arrangement are arm’s length.
January 21, 2011 27
Options Realistically Available
• Concept plays a key role in Final Guidance.
• The concept has its most important application at the individual entity level (i.e., the alternatives theoretically
available to each party should be taken into account in
determining appropriate levels of compensation to be paid).
January 21, 2011 28
Options Realistically Available
• Concept has primary application in transfer pricing decisions
rather than in recharacterising transaction.
• The OECD considers that the concept is relevant in applying
the arm’s length principle to a business restructuring, although
it is not necessary to document all hypothetical options
realistically available.
• The use of hindsight is prohibited.
January 21, 2011 29
Options Realistically Available
• Commentators have suggested that the concept appears to be premised on the economic theories of opportunity cost and rational decision making.
• The concept creates tension between MNE group reasons for a business restructuring versus reasons for restructuring among the constituent MNE group members.
– No clear guidance is provided on how to resolve tension (i.e., if
individual members are compensated for the restructuring, economic
efficiency sought to be achieved may be jeopardized).
• Query, option not to restructure?
• Final Guidance seems to require that the parties to the businessrestructuring need to assess their realistically available options.
January 21, 2011 30
Allocation of Risk
• The issue is closely aligned with potential disregard of
transaction.
– Two critical factors that may lead to either TP adjustment or disregard of risk allocation are:
• Assessment on whether conduct of associated enterprises
conforms to the contractual allocation of risks.
• Assessment on whether contractual risk allocation is arm’s length.
• Analytical framework to allocate risks between associated
enterprises under Article 9, OECD Model Tax Convention,
differs from AOA developed for Article 7 profit attribution.
January 21, 2011 31
Allocation of Risk
• Risk is defined as the ability to make key decisions (see the new Example
3) and the decision to put capital at risk.
• The notion of control over risk was placed in a more limited context in the
Final Guidance, although the OECD continues to believe that the capacity
to assess the outcome of risk monitoring and risk administration is a
necessary element of controlling risk.
• Location of control over risk is an important determinant for transfer pricing
purposes.
• Discussion of financial capacity to assume risk expanded and clarified.
• Risk assumption:
– Capacity to bear consequences of risk should it materialize.
– Mechanism to cover risk.
• If purported risk bearer does not have the financial capacity to assume risk,
risk may be borne by another party.
January 21, 2011 32
Allocation of Risk
• Determination of risk allocation:
– By comparable evidence of how third parties actually divide risk(although no requirement to search for comparables).
– If no comparable evidence, then by how third parties would allocate risk.
– The absence of comparables for a particular risk allocation does not necessarily mean that it is not arm’s length.
• Determination generally made by location of control over risk
and financial capacity to bear risk, although these factors are
not intended as standard.
– OECD continues to believe that capacity to assess the outcome of risk monitoring and risk administration is a necessary element of controlling risk.
January 21, 2011 33
Allocation of Risk
• Choice of transfer pricing method for setting versus testing the
price:
– The choice of a certain TP method within a contractual relationship for setting the price of a given transaction may affect the allocation of risks and determine a low risk environment.
– However, when testing the prices, it is the risk allocation among the parties that dictates the selection of the most appropriate transfer pricing method and not the contrary.
• The Final Guidance is much less definitive on the ability of a transfer pricing policy to demonstrate the risk profile of a
transaction.
January 21, 2011 34
Allocation of Risk
• As a general rule, tax administrations should seek to address
risk allocation issues through pricing adjustments and
disregarding or modifying risk allocations in taxpayer agreements should be limited to exceptional circumstances.
– For example, where risk is in one entity and control in another entity.
– Definition of “exceptional” as rare or unusual.
January 21, 2011 35
Remuneration of Post-
Restructuring Transactions• Discussion Draft discussion was shortened substantially, due
to discussions in updated Chapters I – III.
• Fundamental Principal: Transactions among controlled
entities occurring after a business restructuring should be
governed by the same transfer pricing rules as apply to
controlled transactions that do not follow from a restructuring.
• Final Guidance retains:
– Discussion about sharing of location savings.
– Helpful transfer pricing approaches for procurement structures.
• Final Guidance has dropped the argument for use of two-
sided tests and profit splits to determine post-restructuring
transactions.
January 21, 2011 36
Documentation
• OECD believes that the preparation by taxpayers of
appropriately comprehensive and contemporaneous transfer
pricing documentation is a good practice that can assist taxpayers in their compliance efforts and assist tax
administrations in enforcing transfer pricing laws.
• Documentation requirements remain onerous for business
restructurings, but given the emphasis on written contracts, documentation is necessary.
January 21, 2011 37
Recognition of Transaction
• General Rule: MNEs are free to organise their business
operations as they see fit.
• Tax administrations have the right to determine the tax
consequences of the structure put in place by an MNE.
• Significant redrafting was undertaken in Final Discussion to clarify the material issues in order to provide a clearer
discussion of the notions of economic substance and of
commercial rationality, of the determination whether a
transaction or arrangement has an arm’s length pricing
solution, of the relevance of tax purpose and of the consequences of non-recognition of a transaction.
January 21, 2011 38
Host Country Audit Challenges
• Sham restructuring transaction.
• Transfer pricing.
• Imposition of one-time “exit taxes.”
• Permanent establishment (“PE”).
• Other.
January 21, 2011 39
Recognition of Transaction
• Transaction will be disregarded only when exceptional (i.e., in
rare or unusual circumstances).
• Exceptional circumstances:
– Substance differs from form.
– Independent parties in comparable circumstances would not have characterized or structured their affairs in a manner similar to associated enterprises and an arm’s length price can not be reliably determined.
January 21, 2011 40
Recognition of Transaction
• Recognition of the economic effects of a transaction will not
be challenged merely because:
– Third parties would not have entered into a similar transaction.
– The transaction may have been motivated by tax reasons (i.e., toachieve tax benefits).
• The transaction must be evaluated based on “commercially rational” standards.
– Use “options realistically available” standard.
– “Practically impedes” test.
January 21, 2011 41
PE Attribution
• Host countries are utilizing PE issues as a tool to circumvent the limitations that are imposed by the current OECD transfer pricing guidelines. For example, countries assert that limited risk manufacturers or distributors create dependent agent PEs of the entrepreneur in order to apply the OECD’s new profit attribution principles and thereby effectively permit tax authorities to disregard contracts and reallocate profits from the transfer of risks and assets.
• In other words, although it is possible to separate functions and risks on one hand from personnel on the other hand under a separate entity approach under Article 9 (Associated Enterprises) of the OECD Model Treaty, that is not possible under Article 7 (Business Profits).
January 21, 2011 42
Can “Crown Jewels” be Transferred Among Related Parties
• Discussion Draft supported controversial position that high
value intangibles could not be transferred.
• Final Guidance deleted “crown jewels” reference in
controversial example and adopted position that any dispute
can be addressed through pricing adjustment.
January 21, 2011 43
Effective Date
• Final Guidance does not provide an express date.
• Query, whether countries will apply Final Guidance to resolve prior business restructuring controversies?
January 21, 2011 45
Why Now?
• Intangibles are central in business and often account for a
significant proportion of the market value of a company.
• Intangibles transfer pricing issues are uncertain, contentious
and difficult to resolve.
• Tax authorities globally have increased their focus on the transfer pricing aspects of intangibles.
• Guidance in OECD Transfer Pricing Guidelines (Chapter VI
and VIII) may require updating as it dates back to 1995-1998.
• The OECD Business Restructuring project identified
intangibles as a major concern.
January 21, 2011 46
OECD Timeline
• OECD requested comments on scope of project (by 9/15/10).
• OECD received almost 50 comments (see www.oecd.org/ctp/tp/intqangibles).
• OECD conducted a consultation in Paris (11/9/10).
• OECD is in process of finalizing and approving the scope of
the project at the end of January 2011; substantive discussion
commence in March 2011.
• Additional business community input will be solicited.
• It is likely that the project will result in a revision of the OECD
Transfer Pricing Guidelines.
• A discussion draft is expected by the end of 2013.
January 21, 2011 47
Issues Raised in Comments
• General Comments:
– The scope of the project.
• Issues to be considered.
• Issues that need not be considered.
– Consistency with the OECD Transfer Pricing Guidelines (Chapters I-III and IX).
– The level of documentation and compliance burdens to be imposed on taxpayers.
– The involvement of non-OECD economies and the business community.
– The format for reflecting the final output of the project; most likely a revision of the OECD Transfer Pricing Guidelines, illustrated by examples.
January 21, 2011 48
Issues Raised in Comments
• Definitional Issues:
– How should one determine that an intangible exists:
• By reference to an analytical framework or a list.
– If an analytical framework, what are the relevant characteristics: viz, that the intangible has value, is identifiable, is legally protected, is separately transferable, produces non-routine profits?
– Classification and scope of:
• Manufacturing intangibles.
• Marketing intangibles (see slide 56).
• Goodwill (see 52 & 54).
• Going concern (see slide 53 & 54).
• Soft” intangibles (see slide 57 & 58).
• Operating intangibles (see slide 55).
• Know-how.
– Interaction between intangibles and services (see slide 59).
January 21, 2011 49
Issues Raised in Comments
• Transactional Issues:
– How should intangible transfers be identified and characterized.
• Transfers of intangibles through services.
– Return from Intangibles:
• Developer.
• Legal Owner.
• Economic Owner.
• Licensee.
• R&D center.
– Cost Sharing (Cost Contribution) Arrangements:
• Platform contributions and future iterations of existing intangibles.
• Cost contribution arrangements for services.
• Cost measure.
January 21, 2011 50
Issues Raised in Comments
• Other Issues:
– Loss-making activities.
– Site closure.
– What are the implications of a transfers of an intangible to a low-tax or a high tax country.
– Arm’s length pricing vs. formulary apportionment.
– Should guidance be industry specific:
• Pharma.
• Financial services.
• E-commerce.
January 21, 2011 51
Issues Raised in Comments
• Valuation Issues:
– Type of guidance to be developed by OECD.
– The application of the “options realistically available” concept.
– Accepted valuation methods.
– Relevance of standards developed by accounting and valuation bodies?
• Financial accounting vs. transfer pricing.
– Comparability issues.
– Relevant parameters in a valuation model.
– The role, if any, of retrospective analyses (hindsight).
– Value chain analysis.
– How bundled transactions (complex intangibles; intangibles bundled
with goods and services) should be treated.
– Depreciation of intangibles.
January 21, 2011 52
Goodwill
• The element of value that inheres in the fixed and favorable
consideration of customers, arising from an established, well-
known and well-conducted business and includes every positive advantage that has been acquired by the firm in the
progress of its business, whether the business was previously
carried on, or with the name of the firm or with any other
matters carrying with it the benefit of the business.
January 21, 2011 53
Going Concern
• The amount of enhanced value associated with assets
because those assets are combined in an on-going business.
It is the result of such factors as the existence of a network of regular customers, a staff of trained employees, an
established routine for supplying goods and services, a
product line ready for sale and equipment ready for immediate
use.
January 21, 2011 54
Attributes
Goodwill and Going Concern• Goodwill is generally associated with the external competitive
position of a business in the marketplace.
• Going concern value is associated with the internal value a
business possesses by having its assets assembled in a
functioning unit.
• Significantly, goodwill and going concern represent the
residual value after all other tangibles and intangibles have
been identified and valued.
• Can these intangibles exist if there is no positive residual (and all transactions were at arm’s length)?
January 21, 2011 55
Operating Intangibles
• This encompasses IP of a type not ordinarily licensed or otherwise transferred for consideration in transactions with unrelated parties.
• These intangibles may be subdivided into three categories:
– Customer-based intangibles; i.e., any composition of market, market share, or
other value resulting from the future provision of goods or services pursuant to
contractual or other relationships in the ordinary course of business with
customers, such as customer lists or contracts to supply products.
– Supplier-based intangibles; i.e., goods or services that will be used by the
taxpayer in the ordinary course of business, such as favorable contracts for the
acquisition of components.
– Information-based intangibles; i.e., any customer-related information base
such as a list or other information with respect to current or prospective
customers, business books and records, operating systems and other
information bases. Other bases include technical manuals, training manuals, or
programs, data files, customer lists, subscription lists, lists of newspaper,
magazine, radio or TV articles.
January 21, 2011 56
Return from Intangibles
Marketing Intangibles• Query whether a high level of marketing expenditure alone is
sufficient for a distributor that does not own the trademark to obtain some interest in the trademark or other marketing intangibles?
• Where is the “bright line limit”?
• Would other factors be relevant such as the behaviour of the parties, e.g.:
– Whether the trademark owner had significant influence over marketing
expenditure;
– How marketing expenditure is spent; and
– What marketing expenditure is spent on?
• Would such marketing expenditure create an interest in the marketing intangibles where it is reimbursed indirectly, e.g., through the use of the TNMM to set transfer prices?
January 21, 2011 57
Soft Intangibles
• Query, how does one separate items which, while not
tangible, are not intangible assets?
• If such factors are not assets, or not separable assets, or
cannot be owned or transferred, they may simply be a
component of goodwill.
– For example:
• Work force in place.
• Network effects.
• Location savings.
• “Business opportunity” and “first mover advantage.” or
• Where commercial law protects a right that may not otherwise be
considered an intangible.
January 21, 2011 58
Return from Intangibles
Soft Intangibles• Experience reflects that tax authorities in a number of
jurisdictions sometimes assert a broad view of what might be
an intangible and then use that either to attempt to enforce an “exit tax,” transfer pricing adjustment or use of the profit split
method.
January 21, 2011 59
Differentiating an Intangible from
Services• Is a transaction that of a transfer of an intangible or a service?
– For example:
• Workforce in place.
• Agreement to undertake research.
• When intangibles may be associated or bundled with services?
• Examples:
– Whether a transaction which, for legal reasons, needs to be expressed
as a licence is, in economic terms, more akin to a sale of goods or
services (e.g., when certain types of software products are sold)?
– The transfer of an employee that uses intangible property in the
performance of services?
• Query, whether over time the license of an intangible can evolve to a service?
January 21, 2011 61
Administration’s Transfer Pricing
Proposals• Include workforce in place, goodwill, and going concern value in the
definition of intangible property for purposes of sections 482 and 367(d).
• In cases of multiple intangible property transfers, the Commissioner could combine the values of the properties on an aggregate basis to achieve a more reliable result.
• The Commissioner could also value intangible property taking into consideration the prices and profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.
• If a US person transfers an intangible from the United States to a related controlled foreign corporation that is subject to a low foreign effective tax rate in circumstances that evidence excessive income shifting, then an amount equal to the excessive return would be treated as subpart F income in a separate foreign tax credit limitation basket.
January 21, 2011 62
Circular 230
In compliance with US Treasury Regulations, please be
advised that any tax advice given herein (or in any
attachment) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax penalties or
(ii) promoting, marketing or recommending to another person
any transaction or matter addressed herein.