26th Annual Health Sciences Tax Conference

Transcription

1 26th Annual Health Sciences Tax Conference Base erosion and profit shifting and its impact on supply chains and intangible property December 6, 2016

2 Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This presentation is 2016 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP. This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 2

3 Presenters Doron Herman Teva Tel Aviv, Israel Jeff Holtz Johnson & Johnson New Brunswick, NJ Karen Holden Ernst & Young LLP New York, NY Sarah Churton Ernst & Young LLP (UK) London, UK Gerrit Groen Ernst & Young LLP New York, NY Page 3

4 Agenda Europe update and trends Timelines European Union and Switzerland UK base erosion and profit shifting (BEPS) implementation headlines Anti-Tax Avoidance Directive (ATAD) 1 and 2 Application of anti-hybrid rules on common supply chain structures Impact of BEPS on intangible property (IP) Timeline Changes to IP regimes Action 5 Harmful tax practices Action 8 Development, enhancement, maintenance, protection and exploitation (DEMPE) Appendix US case law review US tax reform Page 4

5 Europe update and trends Page 5

6 Timeline European Union Red = Reality Green = Very high likelihood Blue = Possibility Yellow = Uncertain 2016 State aid actions, targeting: Transfer pricing (TP), using new EU TP concept Mismatches (double nontaxation, deduction/no inclusion) Rulings and regimes Parent subsidiary directive changes Intra-EU antihybrid rule General antiabuse rule (GAAR) Old EU IP regimes No new entrants Phase out (July 2021) Exchange of ruling summaries started First exchange of ATAD: ATAD: CbC reports Country-by-country (CbC) reporting introduced in all EU Member States Exchange of tax ruling summaries UK anti-hybrid rules: Applies to interest royalties, service fees and cost of goods sold No deduction for payments made to disregarded havens; CV/BV and similar reverse hybrid structures and certain variants of Double Irish Publication of list of tax havens Interest limitation rules (30% earnings before interest, taxes, depreciation and amortization (EBITDA)) EU-wide controlled foreign company (CFC) rules EU GAAR ATAD 2: addressing mismatches with third countries (hybrids) EU-wide Common Corporate Tax Base (CCTB): Mandatory for groups with turnover of EUR 750m Broadly defined tax base (participation exemption, switchover rules, net operating loss carryforward, R&D deduction, notional interest deduction regime) TP (upward adjustments only) Includes ATAD and ATAD 2 s measures New exit rules Old EU IP regimes no longer applicable Common Consolidated Corporate Tax Base (CCCTB): Single tax return for all EU operations Taxable profits shared between Member States based on apportionment formula (1/3 sales, 1/3 labor, 1/3 assets (excluding intangible assets)) Page 6

7 Timeline Swiss corporate tax reform Approval by Parliament Public vote Entry into force Parliamentary debate Referendum period (100 days) Referendum Implementation into cantonal laws June 2016 Feb 2017 Jan 2019 Targeted entry into force: January 1, 2019 Current tax laws and practices remain applicable until entry into force of Corporate Tax Reform III (likely until December 31, 2018) Existing preferential tax regimes remain valid Rulings for preferential tax regimes are still available Page 7

8 UK BEPS implementation headlines Action 2 Neutralize hybrid mismatch arrangements 3 Strengthen CFC rules Relevant to clients with: Any UK operations (e.g., UK limited risk distributor (LRD), contract manufacturer) UK intermediate holding company Key impact for clients Disallowance of UK deduction for any type of payment where income is not fully picked up due to a hybrid or branch mismatch Need to look all the way down the transaction chain Timing of UK change January 1, 2017, with no grandfathering; enacted No UK action expected Not applicable 4 Limit base erosion via interest deductions 5 Counter harmful tax practices UK leverage Net UK interest restricted to a fixed ratio of 30% of EBITDA with a group ratio fall back ( 2m de minimis allowed) Carryforward of excess deductions and excess limitation UK IP hub/principal Nexus principle ensures patent box benefit is more closely linked to underlying R&D activity Tracking and tracing of relevant information needed from July 1, 2016 Election needed by 2018 to access grandfathering April 1, 2017; draft law expected December 2016 July 1, 2016, but grandfathering for pre- July 1, 2016, IP until June 30, Prevent treaty abuse UK company paying royalties indirectly to nontreaty IP owner (e.g., Bermuda, Dutch CV/BV) Many UK treaties already include a principal purpose test Domestic law changed so that treaty relief from UK withholding is denied for royalty payments made to connected persons under treaty avoidance arrangements March 17, Prevent artificial avoidance of permanent establishment (PE) UK commissionaires UK sales support UK regional management hubs If arrangements are in place to avoid a UK PE, Diverted Profits Tax (DPT) could apply to the diverted profits at a punitive rate of 25% Royalty payments attributable to avoided UK PEs also within the scope of DPT DPT effective from April 1, Transfer pricing for intangibles, risks and capital and other high-risk transactions Any UK operations (e.g., UK LRD, contract manufacturer, principal) Rewritten TP guidelines require profits to be aligned with people functions that control risk in relation to development, exploitation, maintenance, protection and exploitation of IP DPT creates punitive tax charge (25%) when profits and substance are misaligned and profit is diverted from the UK Already applying new guidelines to open audits/and advanced pricing agreement negotiations DPT effective from April 1, 2015 Page 8

9 Quick recap of the agreed-upon ATAD and latest intelligence on version 2.0 Page 9

10 EU ATAD Overview The ATAD contains five anti-avoidance measures: The ATAD provides a minimum level of protection so Member States could implement ATAD more strictly as well as additional anti-avoidance rules. Financing Interest deduction limitation rules Anti-hybrid rules Former drafts contained a switch-over clause, but this clause has been removed in the final version. There are several exceptions for financial undertakings given their specific characteristics. Potential consequences for US multinationals with operations in Europe could include: Higher effective tax rate (ETR), e.g., due to a cap on interest deductions and direct taxation of profits realized by foreign subsidiaries and branches More structures may be challenged as a result of the introduction of anti-hybrid rules and GAAR Holding Intangible property and supply chain General anti-abuse rule Controlled foreign company rules Rules on cross-border transfers of assets, businesses and tax residence Anti-hybrid rules Page 10

11 Introduction to ATAD Scope, timeline and effective date The ATAD lays down rules in order to strengthen the average level of protection against aggressive tax planning in the internal market. The first draft was published on January 8, 2016, and an agreement on a final Directive was reached on June 20, Member States must adopt this Directive by December 31, 2018, at the latest. As such, the rules should be implemented on January 1, 2019, at the latest. An additional year is provided for the implementation of the exit tax provisions (December 31, 2019). Member States that have (equally effective) national targeted rules for preventing BEPS risks may defer implementation of the ATAD interest limitation rules until ultimately January 1, On October 25, 2016, a draft proposal was published by the EU Commission, which seeks to address hybrid mismatches involving third countries (ATAD 2). The proposal will be submitted to the European Parliament for consultation and to the Council of the European Union for adoption. If the proposal is unanimously accepted by the Member States in its current form, Member States will have to implement it by December 31, 2018, and the provisions will apply from January 1, Page 11

12 Hybrid mismatch Proposed amendments under ATAD 2 The aim of the EU Proposal is to capture all hybrid mismatch arrangements where at least one of the parties involved is a corporate taxpayer in a Member State. The EU Proposal does not address situations in which little or no tax has been paid due to a low tax rate or the tax system of a jurisdiction. Timing differences should not be treated as giving rise to mismatches. The proposed amendments would expand the territorial scope to third countries and address the following hybrid mismatches: Hybrid entity mismatches (leading to a double deduction or deduction without inclusion) Financial instrument mismatches (leading to a deduction without inclusion) Hybrid transfers (leading to a deduction without inclusion or double tax credit) Hybrid PE mismatches (leading to non-taxation without inclusion, double deduction or deduction without inclusion) Imported mismatches (leading to double deduction or deduction without inclusion) Dual resident mismatches (leading to double deduction) Page 12

13 Application of anti-hybrid rules on common supply chain structures Page 13

14 Anti-hybrid rules Application to common principal-type structures Irish nonresident CV Switzerland Royalty Royalty Sale of Circ 8 PE Ireland BV goods UK LRD Royalty/ cost of goods UK LRD Royalty/ cost of goods UK LRD Nonresident disregarded so hybrid Imported mismatch rules CV is US/NL hybrid Imported mismatch rules Switzerland is multinational company Direct mismatch IP or UK IP to non-hybrid IP company New non-hybrid holding company Royalty-free licenses Onshoring Waive Circ 8 ruling Cantonal tax Convert UK LRD Page 14

15 Royalty withholding tax Anti-treaty abuse Irish nonresident CV CV Royalty Royalty Royalty Ireland BV BV Royalty Royalty Sale of UK UK goods UK Page 15

16 Discussion What are companies doing in response to BEPS implementation? Page 16

17 Impact of BEPS on IP Page 17

18 Changes to IP regimes Timeline Early beginnings: First patent box regimes adopted in France and Ireland Growth: Introduction of Dutch innovation box followed by other jurisdictions (Belgium, Hungary, Luxembourg, UK, etc.) Opposition: USA and Germany as prominent IP source countries react negatively to rise of patent box regimes and shift of homegrown IP to patent box countries New order: Countries start amending their patent box regimes to comply with Action Plan (AP) s April: Harmful tax competition: an emerging global issue September: Interim BEPS report, including: Nexus approach for IP regimes Compulsory exchange of rulings related to preferential regimes February: Guidance on Harmful Tax Practices: Modified nexus approach further to joint German/UK proposal April: Commencement of Exchange of Tax Rulings Forum on Harmful Tax Practices (FHTP) created October: Final BEPS reports on all 15 focus areas, including: Harmful Tax Practices (AP 5) Aligning Transfer Pricing Outcomes with Value Creation (APs 8-10) October/November: Endorsement of The Organisation for Economic Co-operation and Development (OECD) BEPS project by G20 Page 18

19 Action Point 5: Harmful Tax Practices Framework AP 5 sets out the nexus approach (i.e., aligning taxation of profits with substance). The application of an IP regime should be dependent on the level of R&D activities carried out by the taxpayer. Review of 16 existing IP regimes (EU and non-eu) All 16 did not meet the substantial activity requirement of AP 5. Nexus ratio Qualifying expenditures incurred to develop IP asset Overall expenditures incurred to develop IP asset x Qualifying income from IP asset = Income receiving tax benefits Page 19

20 Action 8 OECD guidance: DEMPE functions and entitlement to intangible return Action 8 s focus is on DEMPE functions relating to intangible assets. Development of intangible asset Enhancing value of intangible asset Maintenance of intangible asset (e.g., quality control) Protection of intangible asset against infringement Exploitation Taxpayers are directed to review the allocation of profits for each DEMPE component with respect to the level and nature of activity undertaken. There is no automatic return on account of mere legal ownership of the intangible. There is a requirement to directly perform or to control the performance of DEMPE functions and related risks. The return retained by an entity in a group depends on the contributions it makes through DEMPE functions to the anticipated value of the intangible relative to contributions made by other group members. Page 20

21 DEMPE considerations When reviewing any supply chain structure, BEPS Action Items related to IP returns and the framework for determining risk-related returns must be considered. These Action Items are effected through a change in the OECD guidelines. The Action Items focus on the IP-owning entity having the appropriate functionality to be entitled to the risk and IP-related returns in connection with its IP ownership. Areas of focus Risk ownership and related returns IP ownership and related returns Key considerations Having 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 Having 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 Having access to funding to take on the risk or to lay off the risk to pay for the risk mitigation functions and to bear the consequences of risk materialization Controlling (the performance of) key IP functions and being the DEMPE of the IP, including related assets and risks Page 21

22 The spectrum of risk and reward in the current tax environment High Offshore cash box IPCo Plus: Regular, substantive board of directors meetings Potential IP or risk management committee or branch operations Tax risk Funding of IP Decisions made remotely from IPCo Offshore IPCo with limited functions Onshore IPCo with limited functions Plus: Management of all relevant commercial risks, including DEMPE functions (see next slide) Plus: Tax-resident IP owner (e.g., entitled to amortization) Local management of certain functions, such as supply chain operations or regional sales Onshore IPCo with commercial risk management functions Low Low Post-BEPS profit attribution High The term Offshore IPCo refers to an entity that is located in a tax haven or otherwise not a tax resident. Page 22

23 Discussion Are companies changing approach to IP in response to BEPS? Page 23

24 Appendix Page 24

25 Recent US case law Page 25

26 US court cases 3M Co. v. Comm r Abbott Laboratories v. Comm r Altera Corp. v. Comm r Amazon.com Inc. v. Comm r Analog Devices Inc. v. Comm r Coca-Cola Co. v. Comm r Core Laboratories Holding v. Comm r Eaton Corp. v. Comm r Guidant LLC v. Comm r Medtronic Inc. v. Comm r Microsoft Corp. v. Comm r Henry Schein Inc. v. Comm r Zimmer Biomet Holdings Inc. v. Comm r Page 26

27 Medtronic Inc. v. Comm r Page 27

28 Medtronic Tax Court Memorandum (TC Memo) Medtronic licensed certain technology, IP, know-how and rights to MPROC, a Puerto Rican foreign controlled corporation, to manufacture devices and leads for the US and worldwide markets. MPROC existed for many years (under the Section 936 regime) and had state-of-the-art facilities and a highly trained workforce of over 2,000 people. Through the controversy, the Internal Revenue Service (IRS) contended that Medtronic was the owner of all the significant intangibles and that MPROC was simply a contract manufacturer not entitled to a residual profit. The Tax Court held that Medtronic met its burden of showing the IRS abused its discretion by making arbitrary and capricious Section 482 reallocations. The Tax Court further concluded that the IRS s use of the comparable profits method (CPM) was inappropriate. The Tax Court sided with Medtronic that the comparable uncontrolled transaction method was the best method, however: The Tax Court did not agree with either the IRS s or Medtronic s computation and undertook its own analysis in making adjustments to Medtronic s royalty rates, which were lower than the rates the IRS had sought but higher than those asserted by the taxpayer at trial. The Tax Court made adjustments for know-how, profit potential and scope of product. Lastly, the Tax Court rejected the IRS s alternative allocation that intangibles were transferred under Section 367(d). Page 28

29 Medtronic Tax Court s comparable uncontrolled transaction (CUT) analysis CUT issues: profit potential and the Tax Court s analysis The Tax Court first noted that Medtronic US s arm s-length royalty rates of 29% and 15% of net intercompany sales for devices and leads, respectively, came from several uncontrolled comparables, including the Pacesetter agreement, in which Medtronic US and Siemens agreed to cross-license certain intangibles. Medtronic US s expert failed to include a profit potential analysis, as is required under the Section 482 regulations. The Tax Court rejected Medtronic US s method and found that it had not met its burden of proving that its CUT methodology produced an arm s-length result. Since neither the IRS s nor Medtronic US s method was deemed reasonable, the Tax Court was left to its own devices, as it had little help from the parties to determine the proper method. The Tax Court rejected the IRS s contention that appropriate adjustments could not be made to the Pacesetter agreement. Accordingly, the Tax Court used the Medtronic US expert s analysis as a starting point, performed its own analysis and arrived at a royalty rate of 44% for device licenses. The Tax Court then deduced that because the devices business was significantly more profitable than the leads business, a royalty rate of 22% for lead licenses was reasonable. Page 29

30 Medtronic Biggest takeaways The Tax Court s opinion is heavily focused on the role of quality for medical devices, especially as these were implantable devices, where errors could mean lives lost (and market share). Value chain analysis matters The Tax Court rejected the CPM as the best method, and said that the CUT method should have been used. Also placed emphasis on meeting profit potential criteria Medtronic met its burden of proof that the CPM, as applied, was arbitrary and capricious and that MPROC was not a routine contract manufacturer. The Tax Court rejected the alternative Section 367(d) argument, which stated that if the Tax Court did not agree with the primary CPM analysis, then it must conclude that intangibles were transferred to MPROC and compensable under Section 367(d). Page 30

31 Medtronic Implications What does the case mean? The language in the opinion suggests that results should be rooted in and reflective of the real world. The IRS provided no explanation why the taxpayer s method was inadequate; it simply applied its own method and adjusted the US parent s taxable income accordingly. How was the IRS wrong here? The IRS took an all-or-nothing approach to the CPM and essentially ignored Medtronic's CUT method in favor of the CPM. The opinion is yet another decision that is telling the IRS to bring facts, not theory. Not all practitioners agree with the decision. Among other concerns, one issue raised was whether the jurisdictions with true limited-risk contract manufacturers might use these theories to push for higher local returns. The Tax Court distinguished life-threatening manufacturing risk versus standard consumer product manufacturing risk. The OECD BEPS view reinforces the US Tax Court s acceptance of comparables. For example, the OECD directly acknowledges the ability to use comparable transactions for determining profit splits in the Discussion Draft on the Revised Guidance on Profit Splits. Page 31

32 Guidant LLC v. Comm r Page 32

33 Guidant LLC v. Comm r Cardiac medical device maker Guidant LLC is protesting total transfer pricing adjustments (covering tax years ) of $3.5 billion and tax deficiency of $1.2 billion Six consolidated cases by Guidant LLC and related parties Cardiac Pacemakers and Boston Scientific relate to technology licenses and manufacturing arrangements between the US companies and their Puerto Rican and Irish subsidiaries. The taxpayer says that the deficiency notice failed to specify the transactions that are the subject of the adjustments and did not specify the amount of the income adjustment attributable to transactions involving Guidant Puerto Rico vs. the amounts attributable to transactions involving Guidant Ireland. The taxpayer also notes that the IRS s rationale ignores the complexity and substance of the functions performed and risks assumed by the entities, their management of these risks and the intangibles they have developed and licensed. Status: Settled (final determination pending as the settlement is contingent on the IRS Office of Appeals applying the same terms to tax years ) Cases were set for trial starting July 25, 2016, and the settlement was announced on July 20, Total transfer pricing adjustment for tax years were $975m (net tax payment of $275m). $309m represents adjustments to the pricing of finished goods and the remainder reflects adjustments to royalties paid for intangibles used in manufacturing 21.7% rate five of seven product lines including pulse generators, leads and accessories, guide wires, cardiac surgery devices and endovascular devices; 35.2% stent delivery systems; and 38.6% dilation catheters produced in Ireland Page 33

34 Amazon.com Inc. v. Comm r Page 34

35 Amazon.com Inc. v. Comm r Amazon is challenging a $2 billion adjustment and resulting $234 million tax assessment under a cost-sharing arrangement in which IP was transferred to a subsidiary based in Luxembourg. A central issue in the case is the validity of the discounted cash flow (DCF) method used by the IRS to value intangibles transferred from Amazon to a Luxembourg affiliate under a restructuring that occurred in Amazon valued the transferred intangibles at $216 million; the IRS claimed they were worth $3.6 billion. The case is widely regarded as the agency s bid to retry the issues it lost in Veritas Software Corp. v. Commissioner. Status: The Tax Court trial was conducted under a protective order and concluded on December 24, 2014, in Seattle. Certain filings, redacted under the terms of the order, are now in the public record, and a British newspaper filed a motion seeking the release of 16 documents currently under seal. Page 35

36 US tax reform Page 36

37 Overview of potential Trump tax plan Corporate taxes Current law Trump Top corporate tax rate (now 35%) 15% Taxation of future foreign earnings (now worldwide) Immediate worldwide taxation, repeal of deferral Mandatory tax, untaxed foreign earnings 10% Inversions Lowering taxes is the only way to prevent inversions Expensing R&D (now 20% credit or alternative credit of 14% based on three-year average) Other business provisions Immediate expensing for manufacturing investments (but no interest deductibility with respect to such investments) Retain research credit Eliminates most corporate tax expenditures Page 37

38 Questions? Page 38

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