The arm's length principle (ALP) is the cornerstone of transfer pricing (TP) rules as they appear in the OECD Model Convention and associated TP Guidelines. Actions 8 to 10 of the BEPS Action Plan aim to reinforce this principle by ensuring that the allocation of profits is correctly aligned with the economic activity that produced the profits.
The TP Guidelines were perceived to have an excessive emphasis on the contractual allocation of functions, assets and risks. This has proven vulnerable to manipulation, leading to outcomes which do not correspond to the value created by the economic activity carried out by the members of a multinational group. An example is capital-rich and low-functioning entities (so-called "cash boxes"), which are expected to be much less relevant in BEPS planning following the changes described below.
Accordingly, the BEPS Action Plan required the guidance on the ALP to be clarified and strengthened, focusing on three key areas:
- transactions involving intangibles;
- the contractual allocation of risks and the resulting allocation of profits to those risks, which may not correspond with the actual activities carried out. This includes the level of returns to funding provided by a "capital-rich" multinational enterprise (MNE) where those returns are not aligned to the level of activity undertaken by the funding company; and
- transactions which are not commercially rational for the individual entities involved (which will result in recharacterisation of the arrangements), the use of TP methods which result in diverting profits from the most economically important activities of the MNE group, and on the use of management fees and head office expenses charges as a base eroding factor.
It remains to be seen how the new minimum standard for access to the Mutual Agreement Procedure (MAP) provided by Article 25 of the OECD Model Treaty (to be introduced under Action 14) will help in situations where subjective interpretations of specific facts and circumstances may otherwise give rise to double taxation in respect of TP; for example, any dispute regarding a recharacterisation of a transaction or the value attached to the transfer of "hard-to-value" intangibles (HTVI).
Guidance on the application of the ALP
The amendments to the TP Guidelines address two main areas of concern.
Contractual allocation of profits
The Report states that the allocation of risks on paper (contracts) should not in itself shift profits. Instead, the parties' conduct should serve as the basis for delineating the transaction when the conduct and contractual terms differ.
The new guidance lays out a six-step process for the analysis of risk assumed in a transaction. In this process, assumption or control of a risk constitutes the ability to make, and the actual making of, decisions to take on, avoid or decline a risk-bearing opportunity, as well as the ability to make and take decisions on whether and how to respond to the risks associated with the opportunity. When the risk is assumed by someone other than the party to whom the contract attributes the risk, it should be reallocated to the party who actually does.
A direct consequence of this is that, when a party provides funding but neither controls operational risk nor has the authority and ability to control the risk of investing in a financial asset, it is entitled only to a risk-free return.
Underlying commercial rationality
Every arrangement must have an underlying commercial rationality that would be agreed between unrelated parties under comparable economic circumstances. If not, the arrangement should be recharacterised with the profits reallocated to the party actually assuming the risk or to the parties entering into the actual transaction.
The commercial rationality test entails that a controlled transaction must benefit each party in the light of the options realistically available. The mere fact that a transaction cannot be found in the market place does not mean that it should not be recognised.
The non-recognition of a transaction will be used only as a final resort to align the TP with the value creation, as there is a high risk of triggering double taxation in this way, particularly if the other tax administration(s) involved do not share the same view. In such cases, the structure that replaces the one chosen by the taxpayers should match as closely as possible with the facts of the actual transaction undertaken, while achieving a commercially rational expected result which leads to pricing acceptable to both parties.
Transfer pricing of intangibles
This is one of the most expected outcomes from BEPS: the report defines the term "intangible", addresses the issue of the returns from their use or transfer, the selection and application of the best method, as well as the thorny question of the valuation of HTVI.
A compensable intangible is a non-physical, non-financial asset which can be owned or controlled for commercial activities and that would require compensation if it were transferred between unrelated parties. It includes goodwill and going concern value (and other assets which may not be recognisable for financial accounting purposes) but not group synergies and market-specific characteristics.
Again, it is clarified that the entitlement to returns from the exploitation of intangibles belong to the entities that perform and control the functions, contribute the assets and assume the risks associated with the development, enhancement, maintenance, protection and exploitation of the intangible, and not necessarily to those which have their legal ownership.
As to the methods to be used to value the use or transfer of intangibles, the report is keen to the use of the CUP or the profit split method as best methods. When comparable uncontrolled transactions cannot be found in the marketplace, valuation techniques based on discounted cash flows may provide for the best method. The Report cautions that all methods have their own flaws and further specifies that an intangible's value should be determined from both the transferor and the transferee's perspectives, and that the arm's length price should fall between those values.
HTVI are those for which no comparables exist and profit projections are highly uncertain at the time of the transfer. For them, the new Guidelines allow tax authorities to consider ex post outcomes as presumptive evidence about the appropriateness of the ex ante pricing arrangements when the taxpayer cannot demonstrate that the uncertain item was duly factored into the pricing methodology adopted. This is on the basis of the "asymmetry" which exists between the level of information held by the taxpayer as compared to that of the tax authorities at the time of the arrangement.
"Rule of thumb" will not be adequate
The following new paragraph 2.9A is inserted: "The application of a rule of thumb does not provide an adequate substitute for a complete functional and comparability analysis conducted under the principles of Chapters I-III. Accordingly, a rule of thumb cannot be used to evidence that a price or an apportionment of income is arm's length".
This is self-explanatory and reminds of some of the issues at stake on the state aid files opened by the EU Commission against a number of MNE groups in several EU Member States.
Transfer pricing of intra-group services
The aim of the Report is to achieve a compromise between multinational groups and tax authorities on the tax treatment of low-value-adding intra-group services. By setting out a simplified methodology for such services, tax authorities will free up resources which can be assigned to examining transactions exhibiting a greater risk of BEPS.
The services contemplated under this approach must be supportive in nature and must not represent part of the group's core business, require or give rise to unique and valuable intangibles, or involve the assumption or creation of significant risks by the service provider. The taxpayers must identify the services cost pool for each category of qualifying services, allocate them among the recipients based on an appropriate allocation key, and apply a five per cent mark-up to the costs recharged, either under the cost-plus method or the transactional net margin method. The taxpayers will have to produce detailed documentation to demonstrate to the tax authorities all the above, thus showing transparency and fairness in the treatment of those costs among all the affected taxable entities of the MNE group.
A number of countries expressed concerns with the above approach, as they consider management fee charges to be one of the most important BEPS challenges. In order to give comfort to them, the new approach indicates that countries may combine it with the introduction of a threshold which, if exceeded, may trigger a full TP analysis by the tax authorities on these expenses in the corresponding jurisdiction. Follow-up work on the threshold, its design and implementation will have to be finalised before the end of 2016 so that as many countries as possible join this elective approach not later than 2018.
Next steps
Although ostensibly a final report, there remain areas where consensus has not yet been achieved, e.g. on the scope of application of the profit split method and on management fee charges.
Further work will be undertaken on these areas in 2016 with a view to finalising the revised TP Guidelines in the first half of 2017.
Please click on the links below for the other articles in the November 2015 tax newsletter:
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