Interpretation
matters in all things. Critical tax minds
do not take the term ‘international rules/standards’ or ‘international
principles’ at its face value. The tax economist like the author have a
life-long mission to capture both hidden and unhidden intentions and to derive
their implications. The cost to the taxpayers of failing to see those
intentions or implications is not inconsiderable.
BEPS
(Basis Erosion and Profit Shifting) has been on the cross-hair for many tax
economists for quite some time. After almost three years of tinkering, OECD has
published final reports for the 15 action plans in the second week of October
2015. The single most important objective of the BEPS project in terms transfer
pricing was ‘the matching of value creation with transfer pricing outcome’; the
analyses and discussions, as will be reflected in the OECD Transfer Pricing
Guidelines (the “Guidelines”) are well explicated in the following reports: (i)
The recent OECD final reports on transfer
pricing, namely, ‘Aligning Transfer
Pricing Outcomes with Value Creation – Actions 8-10: 2015 Final Reports’
(“Report #8-10”); and (ii) ‘Transfer
Pricing Documentation and Country-by-Country Reporting – Action 13: 2015 Final
Reports’ (“Report #13”).
The
above objective is an ambitious one, because identifying where value is created
is one thing, but more challenging would be the task of making it consistent
with where the income is attributed.
Such task requires having a bird’s eye view on how the taxpayer’s entire
economic eco-system (value chain) functions and grasping how it relates to the
taxpayer, but doing so from a tax authority’s standpoint would in turn require
certain changes in how the principle of transfer pricing review should be
conducted. This report intends to
provide interpretation of how this change has taken place by way of the BEP
project and its implications on MNEs’ tax strategies.
Background
Hence,
OECD via BEPS action plan #8 through 10 has called for taking a ‘new
perspective’ or, a new way of looking at multinational emprises (“MNEs” or
“MNE” in singular) for transfer pricing purposes. This new perspective has
brought forth certain changes in the application of the arm’s length principle
(“ALP”).
By
conventional wisdom, ALP is the principle of hypothesis. It simplifies the way
a controlled transaction should be viewed by a taxing jurisdiction seeking to
tax its resident. It was both developed and taken as an international tax
principle in the 1930s, when the typical controlled transaction was not so
elaborate as nowadays: a simple movement of goods/services from one European
nation to another. The tax authorities then did not see their ‘transnational’ taxpayers
as capable of forming a complex cross-border, value-generating structure; they
thought those taxpayers may be taxed just as any other taxpayers engaged in the
same types of businesses within the domestic market.
However,
things have radically changed since then. Global ‘reshuffling’ of functional
units within a single business and thus the restructuring of capital movement began
to take place transnationally, thanks to the globalization of world economies in
the late 20th and early 21st centuries. MNEs began to
take advantages of diverse regional markets and resource centers to set up
their entities according to different functions and purposes for higher group-wide
efficiency and profitability. So from this point on, the notion of international
transaction has become substantially more than the simple notion of
geographical movement of capital. The tax authorities have begun to realize
that, in order to properly analyze an international transaction within a MNE,
they had to understand how different entities within an MNE interact with each
other or within the global value chain (“GVC”) prioritized by the same MNE.
That is the new perspective put forth by OECD.
So,
this ‘contextual’ approach to looking at an international transaction is
exactly what OECD has been struggling to ‘enforce’ and ‘institutionalize’ through the BEPS project. The way the ALP must apply now requires not
just considering each transacting party strictly on a standalone basis (or as a
separate entity), but on the premise that each transacting party serves its
purpose within the context of a GVC. Simply put, OECD is saying that one should never make the mistake of ‘not seeing
the forest for tree’. The emphasis now is on the entire forest whereas in the
past it was only on the individual trees involved.
At
any rate, such ‘new perspective’ now requires capturing and understanding the
dynamics within the GVC where the transacting parties are interacting, in order
to correctly verify the arm’s length nature of the intercompany transaction
under review.
New Guidelines to Applying the ALP
Both Report #8-10 and Report #13 provide revised
guidance to applying the ALP, based on the information to be furnished by way
of newly expanded documentation requirements. The whole idea gravitates on the
GVC- oriented analysis, as discussed below, not just on the related party
transaction per se:
·
Identification
of Commercial/Financial Relationship for Recognition of “Delineated”
Transactions: in practice,
transfer pricing reviews or audits usually started with a clearly recognizable
related party transaction(s), with all the factual and functional details in
place, thanks to such rules as contemporaneous documentation requirements. There
was a very little need even to attempt to discover any undisclosed transactions
or commercial dealings, except under very unusual circumstances where the
taxpayer’s intention of ‘caching’ such transactions was obvious.
Therefore, in practice, the tax authorities were
seldom required to actually ‘hunt’ for transactions or dealings out of thin air
that would need transfer pricing reviews based on completely disarrayed facts
and circumstances.[1]
However, Report #8-10 has coined in the term
“delineate” to make it official that applying the ALP now presupposes gathering
the factual and functional information for broad-based understanding (by such
means introduced in Report #13) and trying to ‘delineate’ or ‘portray’ any
transactions or economics dealings for transfer pricing reviews strictly based
on such ‘contextual’ understanding. In other words, a controlled transaction
has to be understood only in the context of having in perspective the entire
GVC of which the transaction is a part. Please refer to the following for
further details (para. 1.34 and 1.35 in Report #8-10):
“…the typical process of identifying the
commercial or financial relations between the associated enterprises and the
conditions and economically relevant circumstances attaching to those relations
requires a broad-based understanding of the industry sector in which the MNE
group operates (e.g. mining, pharmaceutical, luxury goods) and of the factors affecting
the performance of any business operating in that sector. The understanding is
derived from an overview of the particular MNE group which outlines how the
MNE group responds to the factors affecting performance in the sector,
including its business strategies, markets, products, its supply chain, and the
key functions performed, material assets used, and important risks assumed.
This information is likely to be included as part of the master file as
described in Chapter V in support of a taxpayer’s analysis of its transfer
pricing, and provides useful context in which the commercial or financial
relations between members of the MNE group can be considered.
… The process then narrows to identify how
each MNE within that MNE group operates, and provides an analysis of what each
MNE does (e.g. a production company, a sales company) and identifies its
commercial or financial relations with associated enterprises as expressed in
transactions between them. The accurate delineation of the actual transaction
or transactions between the associated enterprises requires analysis of the
economically relevant characteristics of the transaction. These
economically relevant characteristics consist of the conditions of the
transaction and the economically relevant circumstances in which the
transaction takes place. The application of the arm’s length principle depends
on determining the conditions that independent parties would have agreed in
comparable transactions in comparable circumstances. Before making comparisons
with uncontrolled transactions, it is therefore vital to identify the
economically relevant characteristics of the commercial or financial relations
as expressed in the controlled transaction.”
This implies that mere narrow understanding of
facts concerning the controlled transaction would now be insufficient for
transfer pricing analyses. The same transaction now needs to be ‘delineated’ or
‘portrayed’ based on the precise understanding of the ‘context’, that is, the nature
and value-creating mechanism of the GVC along which the transaction has taken
place.[2]
This ‘delineation’ process will be given more
weight than in the past in all transfer pricing reviews due to the newly
enhanced documentation requirements as will be implemented by BEPS Action Plan
13 from January 2016 globally.
·
Identification
of Profit Drivers along the GVC – Allocation of Human Resource: after
both delineation and recognition of a controlled transaction, one needs to
identify profit drivers along the GVC and their relationship with the
controlled transaction. Profit drivers may be understood as value drivers, responsible
for creating competitive advantages for the value chain within the market. This
terms could also be understood as ‘profit potential’ as used in Chapter 9
(Business Restructuring) of the Guidelines.
Profit drivers are closely related to the
economical allocation and exploitation human resource. In the free market
economy, ‘profit’ may be understood as ‘surplus value’ created in the course of
consuming both fixed and variable capitals. The creation of ‘surplus value’ ultimately
depends on the economical exploitation of workforce or human resource in the
day-to-day business operations. Within a MNE, human resource is allocated to
various functionalities across its GVC to assume business risks, and to generate
and maintain competitive advantages (e.g., market value of products/services,
cost advantages, etc).
As with many preceding OECD literatures, it is
not the first time the significance of human resource has been spotlighted.
However, diversion of income from human effort or activities underlying the
source of that income by means of, for instance, legal measures i.e., both the
creation and migration of the ownership of intangible property (e.g., patents,
knowhow, etc.), has been the typical tax planning plots for MNEs for years. This
is exactly what OECD wanted to ‘neutralize’ through the BEPS project; it
ensured that no legal forms or measures could be used as the basis of attributing
incomes generated by the value creating functions actually conducted by qualified
groups of employees or keys decision-making individuals on site.
There are many elements of profit potential
within a given GVC; the assumption of business risks and the
development/exploitation of intangibles are the major ones. The common
denominator for all such elements is that they all need to be underlain with
qualified people on site, as will be explained in following paragraphs.[3]
[Business Risks]
Assumption or partaking of risks for any
business enterprises is necessary for acquiring opportunities for making profits. Report #8-10 requires a bifurcated approach
to analyzing the MNE’s economic assumption of business risks: (i) the
identification of economically significant risks (“ESRs” or “ESR” in singular
form); and (ii) the analysis of how the MNE’s human resource is being allocated
to practically assume the ESRs identified. This approach may be summarized as
in the following table; no further elaboration of the details is necessary as
the general idea of the approach is consistent with the analytical approach
already introduced in the Guidelines and the PE Report[4]:
|
#
|
Steps
|
Description
|
|
1
|
Identify ESRs in
specificity
|
Identify and
analyze major categories of ESR[5]:
·
Strategic/market risks
·
Infrastructural/operational risks
·
Financial risks
·
Transactional risks
·
Hazard risks
|
|
2.
|
Determine how
ESRs are assumed contractually
|
Analyze how ESRs are
contractually allocated and assumed by the transacting parties
|
|
3.
|
Perform
functional analysis
|
Determine how ESRs
are controlled / managed / assumed by the transacting parties based on the
newly provided OECD definitions of[6]:
·
Risk management
·
Risk control
·
Risk assumption
·
Financial capacity to assume risk
|
|
4.
|
Draw
interpretation of data / information gathered from steps 1-3
|
Determine whether
contractual terms match with the economic assumption/management/control of
ESRs (e.g., whether the parties have financial capacity to assume ESRs)
|
|
5
|
Allocate ESRs based on step
4 (if inconsistency is found between contractual terms and actual
assumption/management/control of ESRs)
|
|
|
6
|
Derive transfer pricing
outcome based on steps 4 and/or 5
|
|
[Intangibles]
One of the major accomplishments of the BEPS
project in terms of transfer pricing was the development of the definition of
‘intangible’, which was made distinct from the conventional notion of
‘intangible asset’ or ‘intangible property’.
It is worth taking note of the OECD definition
before delving into further discussion:
“…the word “intangible” is intended to address
something which is not a physical asset or a financial asset, which is capable
of being owned or controlled for use in commercial activities, and whose use or
transfer would be compensated had it occurred in a transaction between
independent parties in comparable circumstances. Rather than focusing on
accounting or legal definitions, the thrust of a transfer pricing analysis in a
case involving intangibles should be the determination of the conditions that
would be agreed upon between independent parties for a comparable transaction…”[7]
The above definition is a clear breakaway from
the accounting and/or legal convention of intangibles. OECD made further
declarations in Report #8-10 that neither legal and contractual protection nor
transferability that was used to characterize an item as an intangible is not a
necessary condition any more for transfer pricing purposes.[8]
Why were all these changes necessary?
Most intangibles-related tax strategies employed
by MNEs were based on the transferability of the legal measures for the
protection of rights concerning intangibles (e.g., patents, copyrights, etc.)
and the separation of those measures from actual value-creating activities
performed by actual people. Such separation made possible the attribution of
returns (from exploitation and licensing of the rights mentioned) to the owners
of such measures rather than to those actually developing or exploiting the
intangibles concerned. That was the reason the use of IP centers in low tax
jurisdictions (e.g., patent box regimes) were so popular among MNEs during the
past several decades. The IP centers established in these jurisdictions,
however, have little to do with actual value-creation activities concerning the
intangibles parked there; mostly the functions of IP centers are those of patent
administrations, maintenance of bank accounts for pooling royalty incomes and
so forth.
Based on this new OECD definition, the intangibles
will now be deemed worthless once they leave the hands of the actual people
that develop, enhance, maintain, protect and exploit them. OECD provides a new
set of criteria for the ownership of an intangible(s), that would re-connect
the rights of ownership with the actual people (or entity) that conduct economically
relevant functions, as follows[9]:
“…If
the legal owner of an intangible in substance:
·
performs and controls all of the functions…. related
to the development, enhancement, maintenance, protection and exploitation of
the intangible;
·
provides all assets, including funding,
necessary to the development, enhancement, maintenance, protection, and exploitation
of the intangibles; and
·
assumes all of the risks related to the
development, enhancement, maintenance, protection, and exploitation of the
intangible,
then
it will be entitled to all of the anticipated, ex ante, returns derived from
the MNE group’s exploitation of the intangible…”
[Miscellaneous]
There are other new elements of profit drivers
that would serve as the basis for transfer pricing; allocation of human
resource is the consistent theme here. One such element is called ‘assembled
workforce’ (“AWF”). AWF, according to Report #8-10 is referred to as the
assembling of a uniquely qualified or experienced cadre of employees. AWF may
be understood as including a team of in-house software developers or
researchers within a corporation, without whom profit generating intangibles
cannot be generated or exploited properly.
The concept of AWF may throw a lot of tax
managers off guard, because the concept is geared toward neutralizing the
deliberate isolation of valuable, qualified people from enjoying the returns of
their own valuable activities and other similar distortion of
value-generating-activities-to-income relationship. According to Report #8-10, the
transfer or secondement of the ‘unique’ employee(s) may result in the compensable
transfer of valuable intangibles. For
instance, suppose that Company A seconded to Company B one of its employees
with knowledge of a valuable intangible and that the same employee can make
that intangible available to Company B for commercial purposes. In this case,
Company B may have to compensate Company A for the use of the intangible.
Further, suppose that Company A transferred the ownership of certain other
intangible (e.g., software and such) to Company B whereas the latter does not
yet have any employees who can effectively exploit the transferred intangible.
If under any circumstances Company A’s employee with the technical knowledge of
using that intangible is seconded to Company B, which allows the latter to
generate value linking to its profitability, then Company A may charge the
arm’s length fees for such exploitation to Company B, separately from the
compensation made for the transfer of the concerned intangibles.
Conclusion
– BEPS Implications on Future Transfer Pricing Reviews
The new approach
to applying the ALP may be summarized as follows:
|
1.Understanding
of GVC
|
|||
Identification
of Commercial/Financial Relationship for Recognition of “Delineated”
Transactions
|
2.Understanding
of Relationship between Value Adding Functions and Profit Attribution
|
||
|
Identification
of Overall Profit Generation Structure along the GVC
|
3. Identification of Profit Drivers (Source
of Value)
|
||
|
Identification
of Profit Drivers along the GVC – Allocation of Human Resource
|
Business Risks
|
||
|
Intangibles
|
|||
|
Others
|
|||
In order to
derive reliable transfer pricing outcomes, the new approach requires
understanding of GVC exploited by a MNE as both the structure and mechanism of
how each of its constituents i.e., the affiliates of an MNE functions according
to its given role and interact with one another. Such understanding stems from capturing
the relationship between how value is added along the GVC and how fruits of
those value adding functions are attributed to each and every affiliate within
the MNE. That would start from identifying various profit drivers, which in
turn require understanding of how human resource is allocated to such factors
as business risks and intangibles.
How would this
new approach influence the way the transfer pricing policies are reviewed by
the tax authorities? Here are some forethoughts:
Intangible
Related Tax Planning - No Longer Viable: One of the most likely affected areas of BEPS
in terms of transfer pricing must be the way patent box regimes have been used
by MNEs. Patent boxes, or so called, “IP centers” were used to centralize the
ownership of various types of legally and contractually protected intangibles
such that the incomes from, for instance, licensing the rights thereof globally
may be pooled in a single location where the tax rate applicable for such
incomes is low. Such strategies now may need to be revisited for amending the
‘anchoring requirements’ for the IP centers based on the new definition of, and
the new standards of determining the ownership of intangibles. In other words,
MNEs may need to ‘beef up’ these entities with the economic substance they need,
i.e., allocating a sufficient level of qualified personnel that would support
undertaking of functions, assuming of risks and employing of assets concerning
the intangibles.
Report #8-10
provides many examples of transfer pricing outcomes under the new approach to
applying the ALP. If the IP centers described above fail to satisfy new
standards of determining the ownership of intangibles, the returns from
licensing or otherwise exploiting the intangibles accrued to such entities will
have to be either downscaled or even shared with other entities, as in the
example below[10]:
·
Company P,
a manufacturing entity established Country X is the ultimate parent of an MNE.
Company S, on the other hand, is a fully owned subsidiary of Company P,
established in Country Y for the purpose of centralizing intangibles developed
by Company P. Company P had already developed a number of intangibles whose
ownership was entirely transferred to Company S upon its incorporation. Company
P also assigned to Company S the ownership of all future intangibles to be
developed by Company P. Then Company P has made a lump-sum payment for the
transfer of the ownership rights concerning the intangibles to Company S
immediately upon the conclusion of the relevant contract.
·
Company S
functions as an IP center whose role is mainly to register and to maintain all
patents developed within the group. Company S is currently run by three
employees who are all licensed attorneys. Company S does not engage in conducting
or controlling any R&D activities which are entirely undertaken by Company P.
All legal management or protection of patents are also supervised by Company P.
The above
description is how most IP centers typically operate within MNEs. In transfer
pricing, the typical area of contention between the taxpayers and the tax
authorities used to be the arm’s length nature of the royalty payments received
by S from P or from other affiliates licensed by S. However, based on the new
intangible ownership criteria under Report #8-10, S, the legal owner is
stripped of the economic ownership of the intangibles concerned. From P’s
standpoint, the sums of royalty payments previously made to S may be entirely
or partially disallowed, while the transfer pricing adjustment would only allow
S to claim just the modest compensations for its functions or ‘deemed services’
comprised merely of patent registration activities.
Quality
of Comparability Review Enhanced: the understanding of GVCs prioritized by various
MNEs will be deepened and shared among the tax authorities of various jurisdictions.
Such would provide a set of standards as to how the functional profile of a
resident taxpayer engaged in a related party transaction(s) is formed and
interact with that of others in the context of the GVC of which the taxpayer is
a part. Hence any irregularities found in the financial statements of the
taxpayer i.e., substantial level of marketing expenditure incurred by a limited
risk distributor with limited marketing functionalities, as opposed to
functionally comparable third-party businesses, may trigger transfer pricing
adjustments.
Impact
on financial services industry: the same may be said as in the above concerning the impact of BEPS on the
financial services industry: the tax authority’s enhanced understanding of GVC should
be the major area of concern for the taxpayers. Most financial services
transfer pricing cases, by large, fall in one of the following two categories:
(i) internal management of operational risk stemming from engaging in
transactions with third parties (e.g., trade financing, syndicated loans,
derivatives (for hedging of various financial market risks), etc.); and (ii) allocation
of costs incurred for management support services or other shared services.
The first
category, in most tax audit cases, was usually considered challenging because
the intercompany transactions involved mostly of intra-group absorption and
management of third-party induced risks by multiple related parties (e.g.,
full/partial/re-insuring of risks by multiple entities, loan guarantees
provided by a group of parent companies with higher credit ratings, a series of
derivatives trading to manage floating interest rate or forex risks, etc). The
functions were often so integrated and their structure, so sophisticated that
the application of the profit split method (“PSM”) or its equivalent was
necessary but perceived as not so reviewer-friendly by the tax authorities. The tax authorities often either lacked
reliable information at hand to determine, or simply didn’t have a good understanding
of how the entire GVC of a financial services MNE operates, which is deemed
essential for applying the PSM. However, now that the tax authorities shall
have all the ‘contextual information’ on the financial services firms by virtue
of the enhanced documentation criteria through BEPS i.e., masterfile and
country-by-country reporting (BEPS action plan #13), they will enjoy substantial upper-hand during the desk or
field audits on the financial services firms.
[1]
Section D of the current version of the Guidelines emphasizes, first and
foremost, the significance of comparability analysis for any transfer pricing
analyses (para. 1.33 and 1.63).
[2]
OECD published a report on “Attribution
of Income to Permanent Establishment” in 2006. In order to derive arm’s
length profit attributable to a permanent establishment, the report refers
several times to ‘hypothesizing’ a transaction between the PE and the company
of which it is a part based on the functional profile that would have been
assumed by the PE had it been an independent legal entity. The term
‘hypothesize’ was used in the same spirit as the term ‘delineate’ in Report
#8-10.
[3]
The inseparable correlation between human resource and intangibles, as
discussed here, is based the assertions made by Gary S. Becker, the economist
and the proponent in the field of the economics of human capital. According to
Becker, human being is the core element of human capital since the former
cannot be separated from the intangibles of his/her own creation i.e.,
knowledge, technology, health etc.
(source: http://www.econlib.org/library/Enc/HumanCapital.html)
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