Interaction of OECD & US Standards under US Tax Treaties:

Transcription

1 Interaction of OECD & US Standards under US Tax Treaties: Branch Profits Allocation & Intangible Property Transfer Pricing Issues for International Banks Andrew P. Solomon June 21, 2010

2 Outline of Today s Presentation Branch Profits Allocation OECD Method US Method OECD Method vs. US Method Adoption of OECD Method in Certain US Tax Treaties The Consistency Requirement Transfer Pricing Intangibles Key Target as Revenue Raiser Background The CWI Standard IRS Guidance AM The CWI Standard vs. OECD Guidelines Reading the CWI Standard into US Tax Treaties 1

3 Branch Profits Allocation 2

4 Branch Profits Allocation OECD Method ( Separate Entity Method ) Determines the taxable income of a branch of a foreign corporation on the basis of the income actually earned and expenses actually paid by the branch, including income and expenses resulting from arm s-length transactions between it and other branches of the foreign corporation OECD Model Treaty (Article 7): Profits attributable to a branch should be the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment 3

5 Branch Profits Allocation US Method for Allocating Income Divides international bank s income between an effectively connected (US taxable) portion and a non-effectively connected portion A foreign corporation s income that is effectively connected with a US trade or business carried on by such foreign corporation would be subject to US taxation on a net income basis A foreign corporation s income that is not effectively connected with a US trade or business carried on by such foreign corporation would not be subject to US taxation on a net income basis 4

6 Branch Profits Allocation US Method for Allocating Income Under US domestic tax law, internal transactions generally are not recognized because they do not have legal significance In other words, income and expense from inter-branch transactions would generally not be recognized for income allocation purposes 5

7 Branch Profits Allocation US Method for Allocating Income In order for a foreign corporation s income to be effectively connected with a US trade or business and thus taxable in the US on a net basis: If the income is US source income: Certain types of income are effectively connected if either: The income is derived from assets used in or held for use in the conduct of the US trade or business or The activities of such trade or business were a material factor in the realization of the income If the income is non-us source income: Certain types of income are effectively connected if attributable to an office or other fixed place of business within the US maintained by the foreign corporation Income is attributable to an office / fixed place of business if the activities of such office are a material factor in realizing the income and if the income is realized in the ordinary course of the trade or business carried on through that office In order to be considered a material factor, the activities of the office must provide a significant contribution to, by being an essential element in, the realization of the income but they need not be a major factor in the realization and do not have to be the sole or exclusive material factor 6

8 Branch Profits Allocation US Method for Allocating Income Material Factor Test In applying the material factor test, some items of gross income would be attributed to a US trade or business on an all-or-nothing basis (notwithstanding the material involvement of non-us personnel, etc.) simply because the US activities were material The effectively connected standard is at sharp variance from the functional analysis used under Section 482 and OECD transfer pricing methodologies generally Accordingly, the US material factor methodology may result in more income being attributed to a US trade or business than would be the case under Section 482 / OECD arm s-length transfer pricing principles 7

9 Branch Profits Allocation OECD Method vs. US Method Example: International bank lends money through a branch in one country and a branch in another country performs credit evaluation and other activities in connection with the loans US Method: All the profit from such a transaction would, in general, be attributed to the branch making the loan OECD Method: Profits would generally be split between the two branches 8

10 Branch Profits Allocation Adoption of OECD Method in Certain US Tax Treaties Applicable treaties include US treaties / protocols with Belgium, Bulgaria, Canada, Germany, Iceland, Japan, and the UK Under these treaties, profits are attributed to branch as if it dealt wholly independently or at arm s length with the enterprise of which it is a branch (and, under certain treaties, with other associated enterprises, or in the case of Canada, with any related person) 9

11 Branch Profits Allocation Adoption of OECD Method in Certain US Tax Treaties Under these treaties, in determining the attribution of business profits to a branch, the separate entity method will be used and the OECD Transfer Pricing Guidelines apply by analogy (because transactions between branches do not have independent legal significance, the Guidelines can only apply by analogy) In applying the Guidelines, the different economics that arise from operating through a single legal entity rather than through separate legal entities must be taken into account Example: Operating through branches requires lower capital requirements, and therefore, the benefits from such lower capital costs must be allocated among the branches 10

12 Branch Profits Allocation Adoption of OECD Method in Certain US Tax Treaties Consequences: This treaty provision could create transactions that would otherwise be disregarded in the US under US domestic law (wherein internal transactions are not recognized) Under this treaty provision, internal transactions may be used to allocate income in cases where the transactions accurately reflect the allocation of risk within the enterprise Example: Management offices would generally be considered branches for treaty purposes. Under US rules, little profit or income would generally be attributed to such an office on account of the performance of management functions. However, under these treaties, significantly more income or profits could be attributed to a management office under a functional analysis or other methodology under the OECD Transfer Pricing Guidelines. 11

13 Branch Profits Allocation Adoption of OECD Method in Certain US Tax Treaties Application to Intangible Property Transfers The analogous OECD Transfer Pricing Guidelines would include the transfer pricing rules that require arm s length compensation for one related person s use of intangible property developed or attributable to another related party US generally takes the view that such compensation must be commensurate with the income generated by the intangible in the hands of the related person and believes that its commensurate with income standard (the CWI Standard ) for intangibles is consistent with the general arm s-length standard. Under CWI standard, actual income from a transferred intangible is used as evidence as to whether or not the original transfer price was set reasonably (rather than relying only on information known at time of transfer) Under these treaties, the US could use the CWI Standard in order to make transfer pricing adjustments with respect to intangibles created by a US branch but used outside the US 12

14 Branch Profits Allocation The Consistency Requirement Rev. Rul : Holds that the PE and Business Profits articles of a US treaty must be applied consistently and that the IRC and a treaty cannot be used by a foreign enterprise to reach different results with respect to different parts of its US operations Technical Explanation of US Model Tax Treaty: Provides that a foreign bank or financial institution cannot use the risk-weighting rules of Business profits article to determine its US assets / deductible interest expense, unless it also uses the same rules to determine its dividend equivalent amount for branch profits tax purposes Technical Explanations of US Model Treaty and the Belgian and German treaties suggest that the use of the PE clause of a treaty precludes using Section 864(c) to eliminate US tax on foreign-source royalties attributable to a PE 13

15 Branch Profits Allocation The Consistency Requirement Potentially broad scope: Does the IRS interpret the consistency requirement so broadly as to require a taxpayer to choose between the PE article of a treaty and specific statutory provisions? E.g., 864(b) (safe harbor for trading in stocks, securities and commodities) Ambiguous because other, more recent US tax treaties and protocols that refer to the OECD Transfer Pricing Guidelines simply refer to Rev. Rul and do not go further Perhaps the IRS has reconsidered its interpretation of the consistency requirement 14

16 Transfer Pricing Intangibles 15

17 Transfer Pricing - Intangibles Key Target as Revenue Raiser Transfer pricing of intangible property transfers has become an area of significant interest to the IRS and has become a tool in the IRS arsenal for attributing additional income to US operations Issue has drawn the attention of the Obama administration, which as part of its budget proposals, has proposed to tighten the transfer pricing provisions applicable to the cross-border use of intangibles 16

18 Transfer Pricing - Intangibles Background: In 1986, Congress was concerned about related-party transfers of highprofit potential intangibles for relatively low lump-sum or contingent royalty consideration that effectively removed the future profits derived from the intangible from the reach of US taxation In order to avoid this perceived US tax evasion, in 1986, Congress added a second sentence to Section 482: In the case of any transfer (or license) of intangible property..., the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. (the CWI Standard ) The CWI Standard requires controlled taxpayers to price an intangible transfer consistent with reasonably projected profits anticipated from the use of the intangible and provides for the actual income from the transferred intangible to used as evidence as to whether or not the original transfer price was set reasonably (rather than relying only on information known at the time of the transfer) 17

19 Transfer Pricing - Intangibles Background: Legislative history explains the intent behind the new standard: Where taxpayers transfer intangibles with a high profit potential, the compensation for the intangibles should be greater than industry averages or norms...the committee does not intend, however, that the inquiry as to the appropriate compensation for the intangible be limited to the question of whether it was appropriate considering only the facts in existence at the time of the transfer. The committee intends that consideration also be given the actual profit experience realized as a consequence of the transfer. Thus, the committee intends to require that the payments made for the intangible be adjusted over time to reflect changes in the income attributable to the intangible. Compensation for intangibles should be greater than industry averages or norms when taxpayers transfer intangibles with a high profit potential 18

20 Transfer Pricing - Intangibles The CWI Standard: If an intangible is transferred under an arrangement that covers more than one year, the consideration charged in each year may be adjusted to ensure that it is commensurate with the income attributable to the intangible. The IRS may, in making periodic adjustments, adopt a form of payment that differs from the form adopted by the taxpayer. No periodic adjustment to be made if: Taxpayer established its initial transfer price relying on a comparable uncontrolled transaction involving the same intangible; Actual profits for the tax year are not less than 80% or greater than 120% of the projected profits; Actual profits are less than 80% or greater than 120% of the projected profits, but only due to unforeseeable events beyond the control of the taxpayer that could not reasonably have been anticipated; or For the first 5 years, actual profits are not less than 80% or greater than 120% of the projected profits 19

21 Transfer Pricing - Intangibles 2007 Internal IRS Memorandum from Office of Chief Counsel regarding Cross-Border Related Party Intangibles Transfers (AM ) In this memorandum, IRS argues it alone has the authority to make hindsight adjustments to apply the CWI Standard Rationale: Because of information asymmetry, IRS is at a disadvantage in predicting what the profit potential of an intangible is, whereas the taxpayer is in the best position to predict the future profit of a given intangible In this memorandum, IRS addresses certain issues / questions that arise regarding the CWI Standard 20

22 Transfer Pricing - Intangibles AM (cont d) Can the taxpayer affirmatively assert the CWI Standard in a Section 482 transfer pricing adjustment? No. (But taxpayers could structure transaction upfront with contingent payment arrangement based on actual profit experience.) Does the income in CWI refer to past profits, projected profits, actual profits, or some other measure of income? Generally the operating profits the taxpayer would have reasonably projected at the time it entered into the transaction However, the IRS may treat actual profits as evidence of projected profits and make periodic adjustments accordingly Taxpayers may rebut this IRS presumption (for example, by showing that such results were beyond the control of the taxpayer and could not reasonably have been anticipated at the time of the transaction) 21

23 Transfer Pricing - Intangibles AM (cont d) Buy-in payments for qualified cost-sharing arrangements (CSAs) structured in the form of a royalty or other contingent consideration when the actual amount paid in a particular year differs from the amount estimated due Would a participant in a CSA be permitted or required to invoke the CWI Standard to make true-ups or true-downs to account for the difference? Yes, if the form of payment is consistent with economic substance. If taxpayer conscientiously agreed to and abided by a truly contingent form of payment, and subsequent events do not turn out as reasonably anticipated, IRS may not impose a true-up adjustment on the grounds that it is necessary to reach the originally projected present value. 22

24 Transfer Pricing - Intangibles AM (cont d) Hypothetical: Exam has made a Section 482 allocation being considered by Appeals. The underlying transaction is governed by a US Tax Treaty. May Appeals take into account the Treaty provisions or the OECD Transfer Pricing Guidelines in determining the appropriate allocation? Treaty provisions do not dictate the specifics or application of domestic law to the extent the domestic law reaches results consistent with the treaty obligations. The Treasury and the IRS consider section 482 and the regulations to be wholly consistent with treaty obligations and the OECD Transfer Pricing Guidelines. Outside of the competent authority process under a treaty, tax administrators, including Appeals, are bound to enforce compliance with section 482 and the regulations without reference to the OECD Transfer Pricing Guidelines. The purpose of the Guidelines is to provide a common reference point for resolution of transfer pricing disputes between treaty partners within the context of the competent authority process. Suggests that taxpayer can request simultaneous assistance from the US competent authority and Appeals to coordinate a tentative resolution to be presented to the foreign competent authority 23

25 Transfer Pricing - Intangibles The CWI Standard vs. OECD Guidelines: OECD Guidelines generally emphasize arm s-length standard and finding comparable uncontrolled transactions OECD Guidelines do not generally require parties to quantify the profits of the transferred intangible Even where post-transfer adjustments are warranted, OECD Guidelines suggest more conservative adjustments (e.g., adjusting only the royalty rate rather than the profit itself) 24

26 Transfer Pricing - Intangibles Reading the CWI Standard into US Tax Treaties Allocation of profits between related / associated enterprises under common control to be made in accordance with arm s-length standard / applicable OECD Transfer Pricing Guidelines In several US Treasury Technical Explanations of US Tax Treaties, the CWI Standard is explicitly stated to be consistent with OECD Transfer Pricing Guidelines / the arm s-length standard Examples: UK, Japan: It is understood that the [CWI Standard]...was designed to operate consistently with the arm s-length standard. The implementation of this standard...is in accordance with the general principles of paragraph 1 of Article 9 of the Convention [regarding transfer pricing adjustments with respect to associated enterprises], as interpreted by the OECD Transfer Pricing Guidelines. 25

27 Transfer Pricing - Intangibles Reading the CWI Standard into US Tax Treaties Examples (cont d): Germany: It is understood that the [CWI Standard] was designed to operate in such a way that it does not represent a departure in U.S. practice or policy from the arm s length standard. It merely suggests alternative approaches, beyond those spelled out in current regulations, for achieving appropriate transfer prices. It is anticipated, therefore, that the application of this standard by the Internal Revenue Service will be in accordance with the general principles of paragraph 1 of Article 9 of the Convention Netherlands: [T]he "commensurate with income" approach is to be applied consistently with the arm 's length standard. The commensurate with income approach recognizes that in certain cases it [m]ay be appropriate under the arm's length standard to make periodic adjustments to royalty rates between related parties. In particular, as noted in a 1992 OECD Report it is not always possible for the Internal Revenue Service to know what profits were reasonably foreseeable at the time that an intangible was transferred. In such cases and others periodic adjustments may be warranted. It is anticipated that the commensurate with income approach will be applied in a manner consistent with the principles underlying paragraph 1 of Article 9. 26

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