Performing a BEPS Diagnostic

Transcription

1 Performing a BEPS Diagnostic Jason Osborn Partner, Washington, DC (202) josborn@mayerbrown.com Kenneth Klein Partner, Washington, DC (202) kklein@mayerbrown.com

2 Agenda Typical US Multinational Company IP Planning Irish IPCo Case Study: L Corporation Proposal 1: Single Irish Structure Proposal 2: Double Irish Structure US and Foreign Tax Sensitivities The Country-by-Country Report as a Roadmap Beyond the CbC Report An in-depth assessment under BEPS Actions

3 Recent Tax Controversy Developments: and Tax Reform Typical US MNC IP Planning

4 Typical US MNC IP Planning Irish IPCo Irish Structure : Common IP planning technique for US MNCs, especially in the technology and life sciences sectors. A significant portion of the profits of most economic activities is attributable to IP, assumption of risk and capital. Ownership of IP and capital is more mobile and flexible than certain other components of profit. Risk can be assumed by contract. Planning objectives: Existing IP: Migrate to foreign IPCo in low-tax jurisdiction. Future IP: Ensure that IPCo is the developer and beneficial owner of the future IP from day one. Ensure that IPCo is well-capitalized and contractually assumes most of the risk of the business. 4

5 Recent Tax Controversy Developments: and Tax Reform Case Study

6 Case Study L Corporation 6

7 L Corporation Background Approximately 40% of L Corp s revenues are from non-us sources and that percentage is expected to grow significantly in coming years. L Corp is considering putting additional resources and infrastructure in Europe to support its growing international operations. In light of this consideration, the question has arisen as to whether a structure should be considered to lower L Corp s 39% effective tax rate. 7

8 L Corporation Two Restructuring Proposals Proposal 1: Creation of an Irish IP Co/Distributor ( Single Irish ). Proposal 2: Creation of an Irish non-resident IP Company and an Irish resident Distributor ( Double Irish ). 8

9 L Corporation Proposal 1 L Corp forms an Irish subsidiary ( L Ireland ). L Corp licenses or sells the non-us rights to the L technology to L Ireland (see infra re possible transfer of US rights); L Corp. and L Ireland enter into a cost sharing agreement to jointly develop the future enhancements to the L technology. L Ireland enters into a contract manufacturing agreement with a third party in Ireland under which the third party agrees to produce products for L Ireland. L Ireland forms subsidiaries in different jurisdictions to act as commissionaires on its behalf. A commissionaire sells product to customers in its own name. The principal is contractually bound to the commissionaire to deliver the goods to the customer and the commissionaire is contractually bound to the principal to remit the purchase price. The commissionaire never takes title to the product. Often used by US MNCs to avoid related party sales / subpart F income. 9

10 L Corporation Proposal 1 10

11 L Corporation Proposal 1 Tax Analysis Under Irish law, L Ireland s income would be subject to the 12.5% Irish corporate tax rate for active business income. L Ireland s sales do not create current taxation in the US under the subpart F regime: No related party sales because the commissionaire does not take title to the product. Additionally, L Ireland should benefit from the manufacturing exception to foreign base company sales income. No need to provide US tax on L Ireland s earnings if indefinitely reinvested outside the US (APB 23). 11

12 L Corporation Proposal 1 ETR Results FY 2016 Revenues $200 Pre-Tax Income $50 ($30 US 1 + $20 foreign) Provision for Taxes $14.2 ($11.7 US + $2.50 foreign) Effective Tax Rate 28.4% $30 of US income (i.e., combination of income from US rights and royalty income on non-us rights)* 39% US ETR 12

13 L Corporation Proposal 2 L Corp forms a non-resident Irish subsidiary managed and controlled from Malta ( NRI ); NRI forms an Irish subsidiary ( L Ireland ). L Corp licenses or sells the non-us rights to the L technology to NRI (see infra re possible transfer of US rights); L Corp. and NRI enter into a cost-sharing agreement to jointly develop the future enhancements to the L technology. NRI licenses the non-us rights to the developed L technology to L Ireland (and sublicenses the existing non-us rights, as applicable). L Ireland enters into a contract manufacturing agreement with a third party in Ireland under which the third party agrees to produce products for L Ireland. L Ireland forms subsidiaries in different jurisdictions to act as commissionaires on its behalf. 13

14 L Corporation Proposal 2 14

15 L Corporation Proposal 2 Tax Analysis NRI s royalty to L Corp: not subject to withholding under Maltese domestic tax law. L Ireland s royalty to NRI: Irish Tax Perspective: Not subject to Irish income tax because NRI is not considered an Irish tax resident; and generally no withholding under Irish domestic law and EU Royalty Directive. Maltese Tax Perspective: Under Maltese domestic tax law, tax is only imposed if income is remitted to a Maltese bank account. US Tax Perspective: No subpart F income: (1) payment is disregarded; and (2) same-country exception. 15

16 L Corporation Proposal 2 Tax Analysis L Ireland s Sales Income: Irish Tax Perspective: Irish transfer pricing rules generally allow leaving a relatively small profit margin in Ireland (e.g., 10%, as a result of a significant part of the revenue being paid out as a deductible royalty to NRI). Thus, the group s foreign income would be subject to approximately a 1.25% effective tax rate (i.e., 12.5% Irish tax rate * 10%; 0% Maltese tax rate * 90%). US Tax Perspective (NRI s sales income): No subpart F income (see Proposal 1 Tax Analysis). 16

17 L Corporation Proposal 2 Etr Results FY 2016 Revenues $200 Pre-Tax Income $50 ($30 US 1 + $20 foreign) Provision for Taxes $11.95 ($11.7 US + $0.25 foreign) Effective Tax Rate 23.9% 1 $30 of US income (i.e., combination of income from US rights and royalty income on non-us rights)* 39% US ETR 17

18 L Corporation US Tax Sensitivities Tax-efficient repatriation of offshore cash. What if, in addition to the non-us IP rights, L Ireland acquired the US IP rights and sold products into the US? US taxable presence issue No treaty protection for NRI in Proposal 2. Can the effectively connected income rules be managed? Section 956(c)(1)(D) ( investment in US property ) issue Managerial and operational control - compare Treas. Reg. sec (d)(3)(iii)(B)(2) with BEPS control of risk framework discussed infra. Valuation of non-us IP rights transferred to L Ireland (in Proposal 1) or NRI (in Proposal 2): The Veritas and Amazon cases. 18

19 L Corporation Irish Tax Sensitivities Ensure L Ireland has enough substance on the ground in Ireland to secure the 12.5% tax rate for active business income: high/middle management on the ground; regular board meetings with substantive business discussions; leased space; ideally, some R&D activity in Ireland. 19

20 L Corporation ROW Tax Sensitivities BEPS Action 7: [I]t is clear that in many cases commissionaire arrangements and similar strategies were put in place primarily in order to erode the taxable base of the state where sales took place. Proposed changes to the definition of permanent establishment ( PE ) in the OECD Model Treaty PE triggered when the subsidiary habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the principal (even if the subsidiary does not have authority to bind the principal). U.K. Diverted Profits Tax The Dell case in Spain Mitigate risk by converting commissionaires to buy/sell distributors? If so, full-fledged or limited-risk distributors? 20

21 The Country-By-Country Report (CbCR) As a BEPS Roadmap On June 30, 2016, the US Treasury and the IRS published the final US country-by-country ( CbC ) reporting regulations. The regulations generally adopt the guidelines set forth under BEPS Action 13 and the template report therein. The regulations apply to tax periods of the ultimate parent entity that begin on or after June 30, Rev. Proc allows voluntary filing by US parent multinationals for tax periods that begin on or after January 1, The following slides show a hypothetical CbC report for L Corp. under two scenarios: (1) the Proposal 1 structure described above and (2) a revised Proposal 1 structure in which: R&D employees are relocated from the U.S. to Ireland; L Germany and L Japan are converted from commissionaire s to full-fledged distributors. 21

22 Proposal 1 Country-by-Country Report Name of the MINE group: L Corporation and Affiliate Fiscal year concerned: 2020 Currency used: USD (in thousands) Revenues Tax Jurisdiction Unrelated Party Related Party Tota l Profit (Loss) before Income Tax Income Tax Paid (on Cash Basis) Income Tax Accrued - Current Year Stated Capital Accumulated Earnings Number of Employees Tangible Assets other Than Cash and Cash Equivalents United States 12, ,500 5,000 1,750 1,750 1,000 15, ,000 Ireland 15, ,000 5, , Germany Japan

23 Revised Proposal 1 Conversion Of Commissionaire to Buy/Sell Distributor 23

24 Revised Proposal 1 Country-by-Country Report Name of the MINE group: L Corporation and Affiliate Fiscal year concerned: 2020 Currency used: USD (in thousands) Revenues Tax Jurisdiction Unrelated Party Related Party Tota l Profit (Loss) before Income Tax Income Tax Paid (on Cash Basis) Income Tax Accrued - Current Year Stated Capital Accumulated Earnings Number of Employees Tangible Assets other Than Cash and Cash Equivalents United States 12, ,500 5,000 1,750 1,750 1,000 15, ,000 Ireland 12,295 2,536 14,831 5, , Germany 1, , Japan 1, ,

25 Full-fledged V. Limited Risk Distributors Limited-risk distributor ( LRD ): LRD bears no (or very limited) market risk and inventory risk. Arrangements may be structured so that LRD bears customer credit risk. Full-fledged distributor: Full-fledged distributor bears market risk, inventory risk and customer credit risk. Full-fledged distributor may develop marketing intangibles. The use of limited risk distributors (as opposed to full-fledged distributors) may allow to reduce the profitability of the distributor and retain greater profits in the jurisdiction of the principal company (Ireland, in Structure 1; Malta, in Structure 2). 25

26 Recent Tax Controversy Developments: and Tax Reform Beyond the CbC Report An in-depth assessment under BEPS Actions 8-10

27 Beyond the CbC Report What s next for L Corporation? Assume that despite measures to mitigate its BEPS exposures and file more robust CbC reports, L Corporation is selected for a transfer pricing audit. What additional things could L Corporation and its subsidiaries do to further mitigate its exposure once the tax administrators move beyond the risk assessment stage to examine its transfer pricing in detail? Here, we turn to the substantive guidance in the BEPS Actions 8-10 Reports as our guide: BEPS Actions 8-10 is now part of the OECD Transfer Pricing Guidelines ( TPG ) and is currently effective. While the United States does not officially follow the TPG, US Treasury view is that the OECD TPG (including BEPS Actions 8-10) and section 482 regulations are consistent. Certain provisions of the section 482 regulations, discussed infra, seemingly foreshadow BEPS Actions

28 BEPS Actions 8-10: Its all About Risk The OECD s basic concern revolves around the presumption that greater risk should lead to greater reward. To justify higher returns under this presumption, members of MNE groups might assign risks to other group members that could not meaningfully control or financially assume that risk, at times without any change in the business operations. In effect, the concern is that such a risk assumption has no substance. When such a risk assumption without substance does occur, the new BEPS Actions 8-10 guidance would allocate that risk to the group member that can meaningfully control or financially assume that risk. 28

29 OECD BEPS Actions 8-10 Types of Risk Under BEPS Actions 8-10, not all risks are treated equal. Key focus is on economically significant risks, which can include: Strategic or Marketplace Risks: These are the systemic risks, which include economic, political, technological, and social change. Ex.: New geographical market. Infrastructure or Operational Risks: The report describes these risks as those associated with the company s business execution. Ex.: Delay in product shipment. Financial Risks: The subset of risks that relate to the company s cashflow, liquidity, and creditworthiness. Transactional Risks: Pricing and payment terms in a commercial transaction. Hazard Risks: Accidents and natural disasters. 29

30 OECD BEPS Actions 8-10 Risks Related to Intangibles Certain risks are specific to the transfer and development of intangibles. Development Risk: The cost of R&D, the timing of the investment, and the risk that the entire project ends up being a commercial failure. Product Obsolescence: The chance that competitors will develop some technology that undermines the value of the intangible. Infringement Risk: The time and financial cost of defending the intangible in court, taking into account the possibility of losing in court. Product Liability: The risk of the product leading to legal liability. Exploitation Risk: The cost of variable, uncertain returns from the intangible. 30

31 OECD BEPS Actions 8-10 New Transfer Pricing Guidance on Risk: Control Controls BEPS Actions 8-10 provides a new, multi-step framework for analyzing risk in related party transactions Under this framework, related party contracts remain the starting point for analysis. However, if a related party that contractually assumes a risk does not exercise control over the risk or does not have the financial capacity to assume the risk, then the risk should be allocated to the enterprise exercising control and having the financial capacity to assume the risk Control framework applies equally to cost contribution arrangements (CCAs) as it does to other types of related party transactions involving intangibles. Thus, the notion of cost sharing as safe harbor is unequivocally dispelled. 31

32 OECD BEPS Actions 8-10 New Transfer Pricing Guidance on Risk: What is Control? For purposes of BEPS Actions 8-10, control means more than just oversight or rubberstamping: Control over risk involves (i) the capability to make decisions to take on, lay off, or decline a riskbearing opportunity, together with the actual performance of that decision-making function and (ii) the capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision-making function Further: Neither a mere formalising of the outcome of decision-making in the form of, for example, meetings organised for formal approval of decisions that were made in other locations, minutes of a board meeting and signing of the documents relating to the decision, nor the setting of the policy environment relevant for the risk..., qualifies as the exercise of a decision-making function sufficient to demonstrate control over a risk

33 BEPS Actions 8-10: DEMPE Functions and Control Much of the BEPS 8-10 attention has focused on so-called DEMPE functions (development, enhancement, maintenance, protection, and exploitation) related to intangibles An owner of an intangible must perform all of the functions, contribute all assets used and assume all risks related to DEMPE to be entitled to retain all of the returns from the exploitation of that intangible. See But, a related party need not perform DEMPE functions itself to enjoy returns from an intangible. Outsourcing of DEMPE functions to other related parties (e.g., R&D services) is sufficient to attribute intangibles-related profits, but only if the intangibles owner (or other principal) controls the DEMPE functions that are outsourced Bottom line: Adding employees to perform DEMPE functions may help, but adding control may help even more. 33

34 BEPS Actions 8-10: Control and the Return to Capital The BEPS Actions 8-10 Reports propose to substantially limit returns for providing capital or funding without more (e.g., bearing R&D costs under cost sharing). Effectively, there are three levels of returns for three levels of control. Cash Box - Entities that provide funding without exercising any control over the financial risk of providing funding (i.e., so-called pure cash boxes ) are treated as not assuming any risk at all. Accordingly, such related parties are limited to a risk-free return Smart Cash - Entities that exercise[] control over the financial risk associated with the provision of funding, without the assumption of, including the control over, any other specific risk (i.e., socalled smart cash providers) are limited to an appropriate risk-adjusted return and High functionality/substance Only entities that control additional risks e.g., the operational risks of the business and/or perform or control DEMPE functions are contemplated to earn premium returns greater than an appropriate risk-adjusted return on capital. 34

35 Control and Return to Capital an Example Example 6: The Development Agreement Companies A and B enter into a development agreement. Per the agreement, B performs all activities related to the development of the intangible. Also per the agreement, A funds the development and takes ownership of the intangible. Analysis finds that Company A contractually assumes the financial risk, has the financial capacity to assume that risk, and exercises control over that risk. After development, the intangible is assumed to lead to $550M in yearly profit. B licenses the intangible from A, and pays A for that right based on returns of comparable licenses. After such payments are made, B is left with $200M in profits. After review by Country B s tax administration, A, having only funded development, is found to have earned only a risk-adjusted rate of return (which is assumed to be $110M). B is then allotted the rest of the profit, here $440M, rather than the $200M previously. 35

36 Control and Return to Capital a Second Example Example 16: Sale of IP and R&D Services Parent company Shuyona and its group produce and sell consumer goods. In Year 1, Shuyona sells its IP (including rights to on-going research) to a new subsidiary, Company T. Company T establishes a manufacturing facility and begins to supply products to related parties around the world. Company T enters into two cost-plus R&D agreements: one with Shuyona and one its affiliate Company S. Under these agreements, Company S agrees to bear the financial risk of future R&D. Company T has no technical personnel capable of conducting or supervising the research activities. Parent company Shuyona continues to set research program, establish budgets, make decisions on particular R&D projects, etc. Tax authority in Company T s jurisdiction limits Company T to: (1) a manufacturing return, and (2) a risk-free return on its funding under the R&D agreements, on the ground that it exercised no control over the financial risks of the R&D. 36

37 BEPS Actions 8-10: Compare with Treasury Regulation sec Treas. Reg. sec (d)(3)(iii)(B)(2) [T]he allocation of risks specified or implied by the taxpayer's contractual terms will generally be respected if it is consistent with the economic substance of the transaction. Factors relevant to economic substance include: 1) Whether the pattern of the controlled taxpayer's conduct over time is consistent with the purported allocation of risk between the controlled taxpayers... 2) Whether a controlled taxpayer has the financial capacity to fund losses that might be expected to occur as the result of the assumption of a risk... 3) The extent to which each controlled taxpayer exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. 37

38 BEPS Actions 8-10 and IRC section 482 What s Next? While the regulation seemingly foreshadowed the BEPS control framework, note that financial capacity and control are merely relevant factors and not necessarily hard and fast requirements. Nevertheless, it seems that the IRC section 482 regulations and the BEPS Actions 8-10 reports can be applied consistently. If so, how should US-based MNEs structure their activities so as to prevent the unfavorable application of BEPS principles? 38

39 What can L Corp. do to manage its exposure? Consider ways to provide L Ireland (in Proposal 1) or NRI (in Proposal 2) with control over funding of R&D under the CSA. For example: Require L Corporation to submit quarterly budgets for L Ireland/NRI s approval (expenses in excess of approved budget subject to L Ireland/NRI s prior written approval). Require Corporation to provide monthly reports to L Ireland/NRI, including statements of incurred costs and description of material risks related to the R&D activity. Ensure that proposed budgets and reports are subject to substantive discussion at Board meetings prior to any approvals are granted; Board should scrutinize and propose changes to proposed budgets as appropriate. Document the Board s discussions, proposed changes to the budget and approvals in appropriately detailed minutes. 39

40 What can L Corp. do to manage its exposure? - continued Analyze and identify all economically significant risks faced by the L group s business beyond just the risks associated with funding R&D. Consider analogy of a public company identifying its risk factors for SEC reporting purposes. Consider how L Ireland/NRI can manage such risks in theory and in practice. Use this analysis of economically significant risks to guide the selection of Directors and prioritize which executives and functions should be placed in Ireland (see below). Consider including one or more top-level executives of L Corp. on the Board(s) of Directors of L Ireland and/or NRI. Need to define roles in a way that would avoid making L Ireland and/or NRI subject to tax in the United States. 40

41 What can L Corp. do to manage its exposure? continued Further consider hiring appropriately high-level executives resident in Ireland who: Have the capability to make decisions to take on, lay off, or decline risks; and Actually perform these decision-making functions on a day-to-day basis, within the parameters set by the Board(s) of Directors. Also consider whether a high-level executive resident in the US can also be an employee of L Ireland/NRI without making L Ireland/NRI taxable in the US. Take care not to create unintended exposures in L Germany or L Japan. Avoid having these entities perform DEMPE functions or exercise too much control in order to retain their status as routine buy-sell distributors. Economically significant risks specific to these local markets should ideally by managed and controlled by L Ireland/NRI. 41

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