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1 transfer pricing insider onesource transfer pricing Volume 4, number 2 June 2010 Author: JORGEN JUUL ANDERSEN JORGEN JUUL ANDERSEN is a transfer pricing partner with PricewaterhouseCoopers, currently in San Jose, Calif. He is a State Authorised Public Accountant from Denmark with more than 20 years experience in transfer pricing and international structuring. Transfer Pricing Challenge of the Future Managing PE Risk Source: Journal of International Taxation (WG&L) The new process may appear to work well in theory, but the reality is often much more difficult to implement, especially when it comes to allocation for a PE for tax directors, this represents a significant challenge In trying to predict the future, it is tempting to look to the past for direction, but what happens when tried-and-true models and assumptions from the past change so dramatically that they make it impossible to envision what the future will hold? What if all of this happens in the current environment, where the global business community is changing rapidly all while the world endures a major financial crisis (although signs of recovery have been noticed)? This is the scenario for stakeholders who are tasked with managing permanent establishment (PE) risk following the recent release of new rules from the Organization for Economic Cooperation and Development (OECD) for allocating profit to a PE. The OECD released its first discussion draft on allocation of profit to a PE in early The original release was followed by numerous additional reports and revised versions, which, taken together, reflect the OECD s thought process for developing technical guidance regarding profit allocation for PEs. The length and depth of the process also indicate the complexity of an issue that is not subject to any type of quick fix. Transfer Pricing Challenge of the Future Managing PE Risk Differences Between New and Traditional Approaches Can a Dealing Exist? Does a Dealing Exist? Valuation Process Documentation Conclusion Footnotes About OneSource Transfer Pricing Tax & Accounting

2 transfer pricing insider June 2010 Two documents relevant to this discussion are the OECD s final report on attribution of profit to a PE (July 17, 2008) 1 and the OECD s revised discussion draft of new Article 7 of the OECD Model Convention With Respect to Taxes on Income and Capital ( OECD model tax treaty ) and commentary (November 24, 2009), 2 which, if adopted in final form, would fully implement the changes outlined in the report. The most significant change in the revised draft concerns the elimination of double taxation now built into paragraph 3 of proposed new Article 7. Article 5 in the OECD model tax treaty defines a PE. The amended commentary to Article 7 does not intend to change this definition, but the release of the OECD documents will likely increase the focus on PEs for years to come. A PE is associated with a fixed place of business. For example, is a business address available or do the local representatives work from home? Are their sales activities preparatory or auxiliary? Do they have business cards with titles suggesting sales activities? (It is important that there is a clear connection between tax and operation, hence, if the tax structure shows that there is no PE because no sales are concluded, it would be inappropriate if the people on the ground had business cards showing that they were sales directors or VP of Sales, as it clearly demonstrates a disconnect.) The traditional allocation of profit to a PE was based on an all or nothing approach: either there was a taxable presence, so an allocation should be made, or the activities did not meet the threshold for a PE and no allocation was made. The allocation was made based on revenue or profit without guidelines for doing so. The new commentary language in Article 7 changes the approach to PE profit allocation by assessing the value chain between the head office and the potential PE in its entirety. As a result of this change, the process for determining a profit allocation has become more complex, but likely also more accurate. Article 7 reengineers transfer pricing methodology as the tool to identify and qualify the value of the activities undertaken throughout the value chain between the head office and the potential PE and the performance of the proper allocation of profit. This new process may appear to work well in theory, but the reality is often much more difficult to implement. For tax directors, this represents a significant challenge. Despite the limited number of case law examples, decisions in India (Rolls Royce, Morgan Stanley), Italy (Phillip Morris), and France (Zimmer) offer some guidance. The cases are very different in content and nature, but the common denominator is that the PE challenge came as a surprise, i.e., documentation to sustain the tax position had to be produced after the transactions occurred, which always creates a procedural risk for the taxpayer. Obviously, tax directors may have relied on a PE analysis. When a PE did not exist or the activities were deemed preparatory and auxiliary, there was no need to start a process of allocating profit. The Article 7 approach, as reflected in the new draft commentary and profit attribution report, looks specifically at the allocation between the head office and the PE. It allocates assets based on the division of functions between the head office and the PE, and it allocates risks based on the allocation of assets. It then proceeds to allocate income between the head office and the PE based on transfer pricing principles, treating the PE as a notional separate entity. Differences Between New and Traditional Approaches As stated earlier, the new approach focuses on the value chain between the head office and the PE. The traditional transfer pricing approach is based on an analysis of the factual and functional arrangement. In addition, the contractual relationship is evaluated to determine the risk and assets deployed. Hence, in ordinary transactions between affiliates, it is possible to segregate functions, risks, and ownership to assets by virtue of the contractual relationship. This is the approach that tax authorities and professionals use when performing a functional and risk analysis. The arrangement between a PE and its head office is referred to as a dealing. Can a Dealing Exist? For multinationals working cross-border without established legal entities in host countries, the question can arise whether an arrangement may constitute a dealing. Typical examples are cross-border projects where people from the head office are on the ground for a long period; the head office makes decisions that significantly influence the outcome of the project; it engages in extended maintenance under warranty provisions; or all of the above. Many progressive companies are introducing virtual management models, where the skills and competencies of management rather than the geographic location of a manufacturing site or head office determine how the business is operated. For example, although a company s sales directors are located in the United States, they may have responsibility for sales in Asia. A U.K. production manager may have a global responsibility, but the head office might be in New York. Management meetings may be conducted through virtual technologies (e.g., instant messaging, video conferencing), and may even be conducted from a private residence to lower office costs. This type of business model creates a significant challenge, both in 2

3 transfer pricing insider June 2010 identifying whether a dealing has actually taken place between the head office and a potential PE, and in allocating the appropriate profit. When conducting the analysis within this type of model, an organization s human resources department is often a good place to start, because it knows where staff is located and usually has determined that the company is in compliance with local tax and other laws. Identifying insurance policies taken out on people and projects is another helpful tool. Accounting records typically will not reflect the transactions corresponding to a dealing until the transactions have actually been identified and treated accordingly, i.e., when a transaction is not identified, no bookkeeping records are made and only when the transaction is recognized can the taxpayer start the bookkeeping. Does a Dealing Exist? Under the new process outlined in the commentary on Chapter 7, it is important that tax directors understand that they are probably the only people in the organization who can speak with authority about PE and PE-related issues. Hence, the tax director must understand what has been undertaken (and by whom) at each point in the value chain. The traditional function and risk analysis must be conducted with caution. If a dealing is found to exist, the allocation of profit is based on a division of function risks and assets between the head office and the PE but unlike the traditional functional analysis, risk and function cannot be separated by a legal agreement. The analysis further divides assets and liabilities between the head office and the PE using the capital employed for the underlying transactions. Tax directors will need to create a more intelligent reporting structure to accurately demonstrate whether a dealing exists. As always, the difficulty is in the details. The reporting structure should resemble that of a function and risk analysis, where the tax director seeks to obtain information from both the host and home country of the arrangement in question. A dealing should be documented similarly to a legal arrangement (i.e., establish the terms and conditions), although, by nature, it can not be legally binding on the parties. The documented dealing will ease the audit process. To complete the analysis, an allocation of capital (PE equity) should be made to assert the independence of the PE. Valuation Process It could be questioned whether a PE by nature would always assume to be a service provider and, therefore, appropriate to use a cost-plus remuneration. The answer would have to reflect the functional risk analysis between the head office and the PE and it may be found that a profit split is a more appropriate method for allocating the profit between the parties if the PE is hosting more of the significant people functions than the head office. In other situations, it may be found that cost plus is the right answer and, given the incremental nature of a cost-plus arrangement, the economic impact may be minor to the taxpayer overall. But the taxpayer would be able to make that judgement only on undertaking the underlying analysis of the dealing structure. What would be the point of undertaking the entire administrative burden of full implementation of the guidance for allocating profit to a PE? The answer is that cost plus may be the right approach, but it must be justified based on an actual factual and functional analysis any transfer pricing method represents a viable solution. Special care should be observed in handling significant people functions. In the PE context, capital follows risk, which follows assets, which follows functions. Hence, as noted above, execution of significant people functions in the host country may lead to the application of a profit split as a more reasonable method for allocating profit. But as in an ordinary transfer pricing study, setting the price will depend on the qualification of the transaction in conjunction with the functional risk analysis and ultimately should be supported by relevant benchmarking studies. If a PE is found to exist as part of the exercise, a compliance burden is automatically created and the filing of separate tax returns in the host country may be required. Documentation By analogy, the allocation of profit to a PE will also be subject to the documentation requirements in Chapter 5 of the OECD guidelines on transfer pricing documentation. At the time that profit from dealings is determined, taxpayers must make a reasonable effort to ascertain whether their approach to determining this profit is in accordance with the arm s-length principle. The OECD report highlights elements that can establish the existence of a PE s dealings: The documentation is consistent with the economic substance of the activities taking place, supported by a functional and factual analysis. The arrangement covered by the dealings does not differ from those adopted between unrelated parties in similar circumstances. The arrangement does not seek to separate risks from functions. In addition, it will be necessary to produce documentation to justify application of the arms-length principle for setting the price on the transactions subject to the PE s dealings. This documentation may be quite different from the 3

4 transfer pricing insider June 2010 documentation above. Dealings reflect that it is not possible to have a legal agreement in place between a head office and a PE, as one cannot make a legal agreement with one s self to be respected by third parties. However, to substantiate the relationship between a head office and PE, a dealing is created as an artificial legal arrangement that has no bearing towards third parties. Traditional transfer pricing documentation has not focused on or addressed a PE s dealings. Hence, the requirements in the OECD report will add an extra layer to a taxpayer s documentation burden. However, in the revised draft, the OECD introduced a limitation on the volume of documentation and resolution guidance to avoid double taxation in conflicts arising as a consequence of cross-border dealings. This is a very positive gesture by the OECD, but the reality may be very different when the taxpayer has to convince local tax authorities of the elements associated with PE dealings. Conclusion There is no doubt that the updated commentary to Article 7 on the allocation of profit to a PE has added complexity to a tax director s agenda. Tax authorities in local jurisdictions hosting limited-risk distributors or contract manufacturers might be tempted to compensate for declines in sales and idle capacity caused by the current economic downturn by arguing for the presence of a PE to hold on to a source of revenue, although, if the principal overall is incurring a loss, an interesting discussion of loss split may arise. There have already been instances where tax authorities have argued for the presence of a PE following a challenge to the transfer price or vice versa. The best way to avoid these discussions is by proactively establishing procedures for identifying existing PE dealings, performing additional detailed analysis, ensuring the proper allocation of profit, and creating proper supporting documentation. footnotes 1 Report on the Attribution of Profits to Permanent Establishments, July 17, 2008, dataoecd/20/36/ pdf. See BNA Daily Tax Report, July 21, 2008, page I-4. 2 Revised Discussion Draft of a New Article 7 of the OECD Model Tax Convention, November 24, 2009, to January 21, 2010, dataoecd/30/52/ pdf (comments to the revised discussion draft were to be submitted by January 21, 2010). See BNA Daily Tax Report, November 27, 2009, page I-1. 4

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