BEPS Implementation and Transfer Pricing. GWU IRS 29 th Annual Institute on Current Issues in International Taxation. December 15, 2016 Washington, DC

Transcription

1 BEPS Implementation and Transfer Pricing GWU IRS 29 th Annual Institute on Current Issues in International Taxation December 15, 2016 Washington, DC 1 Panel Chris Bello, Chief, Branch 6, ACC(I), IRS John Hughes, Acting Director, APMA, IRS Michael McDonald, Financial Economist, U.S. Treasury Dept. Rocco Femia, Member, Miller & Chevalier Barbara Rollinson, Managing Director, Horst Frisch Bill Sample, Vice President Tax, Microsoft Corp. 2 1

2 Agenda Attribution of Profits to PEs Profit Splits Post BEPS Local Country Developments Legal developments Administration and enforcement Other Pending Items Hard to value intangibles Low value services 3 Attribution of Profits 4 2

3 Introduction Report on BEPS Action 7 (Preventing the Artificial Avoidance of PE Standard) recommended lowering of PE standard Expansion of dependent agent PE concept Narrowing of specific activity exceptions Anti fragmentation rule Report also concluded that additional guidance was needed as to the application of the Article 7 attribution of profits rules to PEs resulting from changes in the Report Discussion Draft issued for public comment on July 4, 2016 Public Consultations held October 11, Attribution of Profits In General 2010 Authorized OECD Approach Memorialized in 2010 OECD Model Treaty and Commentaries Included in relatively few treaties in force (2008 AOA is more common, even new treaties) Rejected by certain countries and UN Model Basic principles of 2010 AOA Hypothesize the PE as distinct and separate functional entity Allocate to the PE assets, obligations, and risks related to its significant people functions Identify and characterize dealings between the PE and the rest of the enterprise Characterization of dealings helps define the PE s business (e.g., distributor, contract R&D provider, contract manufacturer, etc.) and enable identification of potential comparable Dealings may include notional licenses of IP or advances of capital Price dealings with reference to transfer pricing principles Areas of disagreement or tension Deduction for notional royalties Whether to perform transfer pricing analysis at the hypothesized entity level (making comparables available) or based on significant people functions 6 3

4 Discussion Draft General Approach Guidance with respect to Dependent Agent PEs (DAPEs) Examples 1 4 Guidance with respect to PE arising from activities not covered by specific active exceptions Example 5 Questions related to coordination of Article 7 and Article 9 7 Example 1 Facts Country A Prima Services Country B Sellco Goods Customer Prima manufactures goods in A, its country of residence Prima engages Sellco, an affiliate, as its sales agent in B Sellco identifies customers and places customer orders with Prima. It provides local marketing services. Prima sets marketing strategy, reimburses Sellco for advertising. It is responsible for inventory management. It holds title to inventory, and bears credit risk with respect to receivables. It approves sales. 8 4

5 Example 1 Article 9 Analysis 200 Sales (40) COGS 160 Gross Profit (10) Commission (20) Other Opex 130 Op Profit Country A Prima Country B Sellco 10 Commission (8) Opex 2 Op Profit Customer Based on functional analysis, Prima is legal owner of inventory, marketing IP, and receivables; it controls and assumes risks with respect to those assets Sellco controls operational risk of performing services Sellco is owed a commission of 10, resulting in an operating profit of 2 9 Example 1 Article 7 Analysis Country A Country B Prima HO Sellco Sales DAPE 200 (190) COGS (to Prima HO) 10 Gross Profit (10) Commission to Sellco 0 Op Profit Assume activities of Sellco give rise to DAPE of Prima Based on functional analysis, DAPE is not attributed assets/risks of Prima because no significant people functions are performed by Sellco on behalf of Prima in Country B DAPE must compensate Sellco for its services, and must compensate Prima s head office for the goods Because the DAPE has no assets or risks, it is attributed no profits 10 5

6 Example 1 Alternative Article 7 Analysis Country A Prima HO 10 Country B Sellco 0? DAPE 200 Customer Analysis implicitly assumes that dealings between Prima HO and DAPE consist of transfer of goods (DAPE is characterized as a distributor) Alternative: DAPE provides services to Prima HO. Because DAPE performs no functions, is attributed no assets/risks, service fee = 0 2 nd Alternative DAPE is conduit for Sellco services Query whether it is appropriate to deem a PE to exist 11 Example 2 Facts Country A Prima Services Country B Sellco Goods Customer Same facts as Example 1, except Sellco is responsible for inventory management Sellco sets parameters for extending credit to customers, approves sales, and handles collection of receivables 12 6

7 Allocation of Risk OECD TPG Final Reports on Actions 8 10 provide significant guidance on Article 9 allocation of risk for purposes of allocating non routine returns to risk Analysis applies to operational and non operational risk Entitlement to non routine returns from assumption of operational risk requires: Assumption of risk Financial capacity to bear risks Control of risks Control of risks Must have in location capacity to identify risk, manage risk (including by choosing to face risk), and respond to changing risk conditions Must actually perform these functions 13 Example 2 Article 9 Analysis Country A 200 Sales (40) COGS 160 Gross Profit (30) Commission (7) Other Opex 123 Op Profit 2 Funding Return Prima 15 (net) 200 Country B Sellco 30 Commission (4) Bad Debt Losses (3) Inventory Losses (6) Warehousing (8) Other Opex 9 Op Profit (2) Funding return to Prima Customer Based on functional analysis, and application of post BEPS guidance on risk, inventory and credit risk, as well as associated costs, are allocated to Sellco Sellco is owed a higher gross commission of 30, but bears bad debt and inventory losses, and warehousing costs, of 13 Prima is owed funding return related to its legal ownership of inventory 14 7

8 Example 2 Article 7 Analysis Country A Country B Prima HO 170 Sellco 200 Assume activities of Sellco give rise to DAPE of Prima Based on functional analysis, DAPE is attributed ownership of inventory/receivables, and inventory/credit risks, due to significant people functions performed by Sellco (DAPE is implicitly characterized as a distributor) Profits related to these risks have already been allocated to Sellco (other than funding return related to inventory) 30 DAPE 200 Sales (170) COGS (to Prima HO) 30 Gross Profit (30) Commission to Sellco 0 Op Profit 2 Funding return from Sellco 15 Example 2 Alternative Article 9 / Article 7 Analysis Country A Prima HO 170 0? Country B Sellco DAPE Sales 170 COGS to Prima 30 Gross Profit (4) Bad Debt Losses (3) Inventory Losses (6) Warehousing (8) Opex 9 Op Profit (2) Funding return to Prima Article 9 analysis assumes inventory/credit assets and risks are allocated to Sellco, but continues to treat Sellco as an agent Alternative: Treat Sellco as a full risk buy sell distributor in accordance with its risk management and control functions Accordingly, Sellco performs functions for its own account, not on behalf of Prima Because DAPE performs no functions, and is attributed no assets/risks, service fee = 0 (alternatively, the combined profits of Sellco and DAPE should reflect functions, assets, and risks that have been attributed to Sellco under Article 9) 16 8

9 Example 4 Facts Country A Prima Services Country B Sellco Goods Customer Same facts as Example 2, except Sellco and Prima share responsibility for credit risk and where recovery problems arise, it may not be possible to determine whether the customer was evaluated/reviewed by Sellco or Prima Assume that arm s length return for credit risk is 5% of receivables, and arm s length fee for credit risk management is cost plus 10% Prima and Sellco have a contractual incentive fee arrangement providing fee to Sellco equal to 40% of the difference between the value of the credit risk and the bad debt write off (assumed to be arm s length) 17 Example 4 Credit Risk Profit Split Arrangement Discussion draft provides two tables illustrating operation of incentive fee arrangement to compensate Sellco for credit risk management services, one showing risk return in excess of bad debts (income), and one showing dad debts in excess of risk return (loss) In each case, Sellco is allocated 40% of the difference between the risk return and the bad debts, notwithstanding the fact that: Sellco incurs only 25% of the credit management functional costs Sellco s costs are reimbursed through a cost plus fee Although example assumes incentive fee is arm s length, it appears to result in an over allocation to Sellco, and the arrangement seems artificial given the relatively routine functions performed by Sellco 18 9

10 Example 4 Article 7 Analysis Article 7 analysis is provided to divide Prima profit/loss from credit risk between Prima HO and DAPE Discussion draft assumes that it is appropriate to split the profit/losses and Prima credit management functional costs in the following manner: 25% to Prima HO, 75% to DAPE Allocation of 75% to DAPE appears based on where decision to conclude sale is initiated (e.g., Sellco) But, Sellco has been reimbursed for its credit management costs AND has received an incentive fee that is assumed to be arm s length As a matter of principle, in light of post BEPS transfer pricing guidance that addresses risk, is it appropriate to attribute more profits to Country B under an Article 7 analysis on the basis of the risk management functions performed by Sellco? As a practical matter, could the results in Example 4 be defended? Because Sellco s costs are reimbursed at a cost plus, the source country is allocated 60%+ of the profits while bearing only 25% of the costs. 19 Attribution of Profits Concluding Observations Examples raise questions regarding scope of DAPE rules, particularly as new transfer pricing guidance is implemented to ensure appropriate compensation of source country entities Sequencing of Article 9 and Article 7 analyses can be significant Examples would benefit from: a better articulation of the dealings between the PE and the home office an explicit characterization of the hypothesized separate entity (e.g., as a distributor, contract R&D service provider, etc.) to enable the application of transfer pricing principles based on comparables Guidance does not account for limited adoption to date of 2010 AOA Administrative safe harbors should be considered to reduce costs of administration and compliance Tax on profits of DAPE (if any) should be collected from local country dependent agent enterprise 20 10

11 Profit Splits 21 OECD Document Trail: Transactional Profit Splits 1994 Transfer Pricing Guidelines Specified Other Method 2010 Transfer Pricing Guidelines Specified Method with expanded guidance 2015 Aligning Transfer Pricing Outcomes with Value Creation BEPS Actions 8 10 Expanded discussion of Functional Analysis, especially analysis of risk, applicable to all methods Outline revised guidance to be supplied on Transactional profit splits July 2016 Discussion Draft BEPS Actions 8 10 Revised Guidance on Profit Splits 22 11

12 Topics Addressed in Discussion Draft Most Appropriate Method discussion for profit splits involves consideration of the risk discussion in Chapter 1 of the 2015 guidance Profit Split based on Anticipated vs Actual Profits 23 Most Appropriate Method 2010 Guidelines Paragraph 2.2: Goal is to find the most appropriate method for a particular case. Consider strengths and weaknesses of the OECD recognised methods. In short, even though the focus of our discussion is the revised guidance on profit splits, we are not intending to imply that profit splits have more weight than other methods

13 2015 Aligning Transfer Pricing Outcomes with Value Creation Discussion of Risk Para. 1.61: Risk management comprises three elements: (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, (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 decisionmaking function, and (iii) the capability to mitigate risk, that is the capability to take measures that affect risk outcomes, together with the actual performance of such risk mitigation. Para. 1.63: Risk management is not the same as assuming a risk. Risk assumption means taking on the upside and downside consequences of the risk with the result that the party assuming a risk will also bear the financial and other consequences if the risk materialises. Para 1.65: Control over risk involves the first two elements of risk management defined in paragraph Contractual Assumption of Risk 2015 Aligning Transfer Pricing Outcomes with Value Creation para 1.78: A contractual assumption of risk constitutes an ex ante agreement to bear some or all of the potential costs associated with the ex post materialisation of downside outcomes of risk in return for some or all of the potential benefit associated with the ex post materialisation of positive outcomes. Importantly, ex ante contractual assumption of risk should provide clear evidence of a commitment to assume risk prior to materialisation of risk outcomes

14 Actual vs Projected Profit Splits Para 3. irrespective of whether a transactional profit split of anticipated or actual profits is used, the basis upon which those profits are to be split between the associated enterprises, including the profit splitting factors and the way in which combined profits are calculated, must be determined ex ante on the basis of information known or reasonably foreseeable by the parties at the time the transactions were entered into. 27 Hypothetical Example Co A performs R&D and Manufacturing Co B performs Marketing, Selling and Distribution Projected Revenue 500 Projected Costs A 240 Projected Costs B 160 Projected Profit 100 Projected Relative contributions (in proportion to relative costs): Co A 60% Co B 40% Profit Split Case 1: Split based on actual relative cost and actual profit Case 2: Split based on projected profit, with payment set as fraction of % projected revenue, Co A receives 12%of actual revenue 28 14

15 Consider Four Potential Outcomes: Marketing Competitor R&D Campaign Unexpectedly Costs Unexpectedly Introduces Unexpectedly Projected Successful Product Low Revenue Co A Cost Co B Cost Profit Outcome of Case 1: Actual Profit Split Co A Calculation 60% x % x % x 50 53% x 160 Co A Profit Fraction of Total Profit 60% 60% 60% 53% Outcome of Case 2: Projected Profit Split Co A Calculation 12% x % x % x % x 500 Co A Profit Fraction of Total Profit 60% 26% 96% 38% 29 Explore these statements in light of the prior example: combining the profits of each associated enterprise under a transactional profit split of actual profits requires a high level of integration of activities. [para 6] a transactional profit split of anticipated profits does not require the level of integration or risk sharing required for a transactional profit split of actual profits. [para 20] 30 15

16 Further Discussion: Actual Profits Para. 9 Therefore, given risk discussion in Chapter I: using actual profits is only consistent with the actual transaction where the economically significant risks associated with the outcomes of the business activities are controlled, either separately or collectively, by the parties sharing in the actual profits, and each party has the financial capacity to assume its share of the risks. 31 What are the economically significant risks in this example? Does R&D risk only relate to the risks associated with technical success or failure of the product development, even though a perfectly developed product will fail if marketing is unsuccessful? Does Marketing risk only relate to the risks associated with success or failure of the marketing effort, even though a perfect marketing effort will fail if the product is technically deficient? Is there a third risk associated with this example, related to the interdependence of the R&D and marketing together in ensuring the success of the Product? (Commentators have labeled this as common risk or common business objective risk, or unanticipated returns risk). Alternatively, is this risk incorporated into each of the R&D risk and marketing risk? 32 16

17 Relevance (or lack of relevance) of Other Topics Considered in Draft Guidance Unique and Valuable Contributions Highly Integrated Operations Group Synergies Value Chain Analysis 33 Post BEPS Local Country Developments 34 17

18 Highlights of Legal Developments Countries going their own way UK Diverted Profits Tax (DPT) Australia DPT and Multinational Anti Avoidance Law India Equalization Levy Widespread proposal and adoption of numerous options from OECD work Increasing activity at the EU Anti Tax Avoidance Directive ATAD Public Country by Country Reporting 35 Administration and Enforcement Audit activity Rulings / APAs Competent authority 36 18

19 Pending Items 37 Hard to Value Intangibles 2015 Final Report includes section on HTVI that largely follows the discussion draft issued earlier in 2015 Guidance permits, in certain circumstances, use of ex post evidence as presumptive evidence on the appropriateness of the ex ante pricing arrangement Experience to date and possibility of future work 38 19

20 Low Value Services 2015 Final Report introduces an elective, simplified transfer pricing approach for low value added services Applicable only to back office services Permits countries to apply numerical thresholds above which access to approach could be denied Report recognized that the simplified approach would be useful only if widely adopted Report outlined multi step implementation process Follow up work on implementation issues to be undertaken and finalized before the end of 2016 A large group of countries would endorse the applicability of the approach in their countries before 2018 Further work would be undertaken to ensure other countries that the elective simplified mechanism will not lead to base eroding payments Status of this work and implications of lack of consensus 39 20