Lifting the mist. Sustainable distribution models in the post-beps world

Transcription

1 Lifting the mist Sustainable distribution models in the post-beps world

2 Contents Introduction...1 Key BEPS changes impacting sales and distribution...2 Trends in sales and distribution activities in the European Union and how companies are reacting to BEPS...6 Implications for the design of tax and transactional models...9 Conclusions and observations...14 Tax and transactional models for sales and distribution activities...16 Contacts Lifting the mist Sustainable distribution models in the post-beps world

3 Introduction In October 2015, the Organisation for Economic Co-operation and Development (OECD) published the results of its Base Erosion and Profit Shifting (BEPS) project in the form of 15 actions. It is generally recognized that BEPS represents a fundamental change in the international tax environment facing multinationals; one which requires close alignment of value-adding commercial activity with the recognition of taxable profit. As local legislation is implemented throughout Europe, we are seeing different approaches and actions undertaken. Our focus will be on Europe as multinational companies often do, or would like to, view it as a single market. In addition, tax authorities in the region follow OECD Model Tax Conventions and guidance with some, but far from complete, consistency. 1 In other regions, there is more diversity in many markets and in the approach of tax authorities. In the first article, we explore the implications for one step in the value chain, sales and distribution: 1. We identify the key BEPS changes affecting sales and distribution BEPS Actions 7 (Preventing the Artificial Avoidance of Permanent Establishment Status) 2 and BEPS Actions 8 10 (Aligning Transfer Pricing Outcomes with Value Creation) 3 noting that they are making it riskier and more complex for business to adopt agency structures. 2. We outline some recent trends in the drivers of business operating models for sales and distribution and how companies are reacting to the BEPS changes. 3. We identify some important compliance requirements that are likely to be triggered if sales-related activities are found to result in the creation of a dependent agency permanent establishment (DAPE). 4. We present two case studies to illustrate the complexities introduced or augmented by BEPS. These illustrate how varying fact patterns influence the choice between alternative transactional and tax models for the relationship between a manufacturer or principal entity, and a local country sales and distribution entity (SalesCo), in a post-beps world. Joost Vreeswijk Operating Model Effectiveness Leader Europe, Middle East, India and Africa Victor Bartels Operating Model Effectiveness Partner The Netherlands Ernst & Young Belastingadviseurs LLP Thomas Ebertz Operating Model Effectiveness Partner Germany Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft 1. Even within Europe, countries take different approaches. North Europe countries tend to take an economic approach, i.e., a focus on activities rather than legal forms. Whereas, in South Europe countries, there is a tendency to see the existence of a permanent establish (PE) as requiring additional remuneration irrespective of whether the associated activities have already been adequately remunerated through transfer pricing. 2. Aligning Transfer Pricing Outcomes with Value Creation, Actions Final Reports, OECD, 2015 (Actions 8 10 Report) 3. Preventing the Artificial Avoidance of Permanent Establishment Status, Action Final Report, OECD, 2015 (Action 7 Report) Lifting the mist Sustainable distribution models in the post-beps world 1

4 2 Key BEPS changes impacting sales and distribution 2

5 Key BEPS changes impacting sales and distribution Risks allocated for transfer pricing purposes to the entity that controls them The notion that a contractual assignment of risks might be disregarded for transfer pricing purposes was made explicit in the OECD 2010 Transfer Pricing Guidelines (this is referred to hereinafter as 2010 Transfer Pricing Guidelines ). 4 In the absence of comparables for the observed assignment of risks, the guidance stated that a risk should be allocated to the party controlling the risk, provided it had the financial capacity to bear the risk. The report on BEPS Actions 8 10 develops this guidance further and introduces a six-step analysis process to identify and attribute economically significant risks leading to the pricing of the transaction. The new transfer pricing guidance therefore confirms that, whichever tax and transactional model is planned, it is essential to determine which, if any, economically significant risks and assets are controlled by a SalesCo. This will have a significant impact on the selection and implementation of the transfer pricing method(s) adopted for the relevant transactions. The indications are that more granular analysis of risk is now necessary. In designing sales and distribution structures, analyzing the control of risks arising from the setting of marketing and sales strategies, inventory levels and composition in addition to credit risks should be considered. Lower threshold for existence of a DAPE Even before the BEPS project, more and more tax authorities were asserting that a PE had been created if a local commissionaire had been habitually entering into contracts that were binding on the foreign Principal. This assertion was made even if those contracts were not actually in the name of that Principal. 5,6,7,8,9 Action 7 widens the application of the existing Article 5(5) of the OECD Model; an enterprise will be deemed to have a PE in another country if it has a person acting there on its behalf and, in doing so, that person habitually concludes contracts or plays the principal role leading to the conclusion of relevant contracts that are routinely concluded without material modifications by the enterprise. In other words, if a Principal has an agent that is actively involved in generating sales locally and the agent s actions directly result in the conclusion of contracts by the principal, such activities would give rise to a PE of the Principal. In addition, the same facts could in some countries result in the local indirect tax inspector taking the position that a VAT-fixed establishment of the Principal exists because it intervenes in the transaction through its involvement in the sales process. 4 OECD Transfer Pricing Guidelines for Multinational Enterprises and Administrations, August 2010, OECD, Spain is the most obvious example with the Spanish Supreme and High Courts findings in favor of the Spanish tax authorities, in the Dell, Roche and Borax cases, that a PE was created notwithstanding the commissionaire arrangements in place. For further details on two of the Spanish cases, see Roche Vitamins and Dell Judgements Highlight PE Risks, Victor Bartels and Juan-Jose Terraza, International Tax Review, June And in common law countries, a PE would be created under the existing Article 5 if the sale is agreed locally, even if the contract is concluded in the name of the local sales company on behalf of an undisclosed principal. 7 Borax case, Audiencia Nacional, 9 Feb. 2011, Rec. No. 80/ Dell case, Audiencia Nacional, 8 June 2015, Rec. No. 182/2012 confirmed the earlier decision of Tribunal Económico Administrativo Central, 15 Mar. 2012, Rec. No. 00/2107/2007, Tax Treaty Case Law IBFD. 9 Roche case, Tribunal Supremo, 12 Jan. 2012, Rec. No. 1626/2008, Tax Treaty Case Law IBFD. Roche confirmed Borax decision. Lifting the mist Sustainable distribution models in the post-beps world 3

6 Restriction of activity exemptions for fixed place permanent establishments (FPPE) Another area affected by Action 7 that is of importance to sales and distribution is the use of facilities for the storage and delivery (or purchase) of inventory by a foreign Principal. Article 5(4) of the OECD Model specifically exempts certain activities from creating a PE where a place of business is used solely for activities listed in that paragraph. Action 7 modifies the wording of Article 5(4) so that each of the listed exemptions from PE status is restricted to either activities of a preparatory or auxiliary character. Or, when taking into account the nature of the Principal s business, the overall activity of the fixed place of business is of a preparatory or auxiliary character. The revised commentary includes the example of an enterprise that sells online, and maintains a very large warehouse with a significant number of employees in another country for the main purpose of storing and delivering goods. The commentary states that activity or activities of the warehouse will not benefit from the warehousing exception because it/they constitute an essential part of the enterprise s sale/distribution and do not have, therefore, a preparatory or auxiliary character. A PE may also now be found if as part of a multinational s distribution arrangements: A Principal owns consignment stocks outside of its home territory, and this stock is maintained in a warehouse of a local SalesCo in an independent local warehouse or even at customer premises. The stock is maintained in a separate part of the facilities to which the owner is allowed unlimited access. The maintenance of the stock is an essential and significant part of the activities. One example could be because a commitment to supply at short notice is an importance feature of the enterprise s business model. New commentary on the application of Article 7 As part of its BEPS follow-up work, the OECD is currently developing additional guidance on the attribution of profits to DAPEs, particularly sales agents and commissionaires, and FPPEs to which the Article 5(4) exemptions no longer apply. The work is ongoing. 10 There is no change to the Authorized OECD Approach (AOA) to profit attribution as set out in a 2010 report 11 (2010 AOA Report), i.e., hypothesizing the PE as a functionally separate entity to which risks and assets are attributed on the basis of their exercise of significant people functions and engaging in dealings with the rest of the enterprise that are priced on the basis of Article 9 principles and guidance. However, the new guidance is intended to apply irrespective of the approach to profit attribution followed. 12 As set out in the opening statements of the 2017 OECD Profit Attribution Draft, once a PE exists under Article 5(5) of the Model Tax Convention (MTC), one of the effects will typically mean the rights and obligations resulting from the contracts referred to in Article 5(5) will be properly allocated to the PE. This does not necessarily mean that the profits resulting from the performance of these contracts should be attributed to the PE. For example, when the accurate delineation of the transaction indicates that a dependent agent enterprise is assuming the risks of the transactions of the nonresident enterprise, the profits attributable to the DAPE could be minimal, or even zero. The 2017 OECD Profit Attribution Draft states that the MTC and its commentary do not explicitly prioritize the application of either Article 9 or Article 7 in cases where a DAPE is recognized as a result of the activities of the intermediary located in that country. It is mentioned, however, that many jurisdictions find it logical and efficient to first apply Article 9 and accurately delineate the actual transaction between the nonresident enterprise and the intermediary. The order in which these articles are applied should not influence the taxing rights of the source country. 10 A second and substantially revised OECD Profit Attribution Draft draft has recently been issued Public Discussion Draft: BEPS Action 7, Additional Guidance on Attribution of Profits to Permanent Establishments, 22 June 15 September 2017, OECD, This report is referred to as 2017 OECD Profit Attribution Draft Report on the Attribution of Profits to Permanent Establishments, July 2010, OECD, See Paragraph 7 of the 2017 OECD Profit Attribution Draft 4 Lifting the mist Sustainable distribution models in the post-beps world

7 The OECD reiterates that any approach in the application of Articles 7 and 9 to cases of deemed PEs under Article 5(5) must ensure that there is no double taxation in the source country. The OECD also stipulates that countries may adopt mechanisms aimed at simplifying a taxpayer s compliance in relation to the existence of a PE in their country. Reference is made to countries that collect tax only from an intermediary even though the amount of tax is calculated by reference to the activities of both the intermediary and the DAPE. Four examples are included in the 2017 OECD Profit Attribution Draft, which illustrate the attribution of profits to PEs resulting from either the changed definition of a DAPE or the antifragmentation rule. The first two examples relate to the DAPE. The examples illustrate that the profits of such a PE, in the case of sales and marketing type activities, would generally be equal to the revenue from the sales of goods related to the intermediary s sales activities minus: 1. An arm s length purchase price of the goods from the DAPE s head office 2. Other expenses attributable to the PE 3. The arm s length remuneration of the dependent agent enterprise A complicating feature patchy implementation of changes to PE rules The changes to Articles 5 and 7 represent the international consensus developed through the OECD. Any changes requiring amendments to tax treaties take a long time to come fully into effect. For example, the Article 7 rules on profit attribution in many treaties are those in the pre-2010 version of the OECD MTC. For this reason, under Action 15, the BEPS outputs included a multilateral instrument (MLI) which provides countries with a framework for implementing changes to treaties agreed by both contracting parties. The plan is that this will lead to implementation from Essentially, this mechanism will apply to the changes to Article 5 where both contracting parties agree to them. The Article 7 changes will be implemented through a revision of the OECD s Model Tax Treaty Commentary. But the position is complicated by the fact that the changes to Article 5 (and 7) have not been accepted, even by all the world s largest economies. Many large exporting countries are concerned that the expansion of the DAPE concept through the changes to Article 5(5) will result in too great a burden on their multinationals and do not plan to amend their treaties via the Multilateral Convention, or otherwise, for the revisions to the Model Article As of June 2017, of 68 countries which had signed the MLI, 39 had opted out of the changes to Article 5(5) and 26 had opted out of the Article 5(4) changes altogether. Some countries opted for only partial implementation of the latter changes For example, Germany, Finland, the UK, Belgium and Switzerland have indicated that they will not use the multilateral instrument to implement the DAPE changes. 14 Signing by 68 jurisdictions of the Multilateral Convention to implement Tax Treaty Related Measures to prevent BEPS highlights impacts for business to consider, EY Global Tax Alert, 14 June Lifting the mist Sustainable distribution models in the post-beps world 5

8 3 Trends in sales and distribution activities in the European Union and how companies are reacting to BEPS 6

9 Trends in sales and distribution activities in the European Union and how companies are reacting to BEPS There are essentially four tax and transactional models for sales and distribution (outlined on pages 17 and 18): 1. Sales agency 2. Commissionaire 3. Buy/sell distributor including the limited risk distributor (LRD) 4. Sales branch Most multinationals operating in Europe adopted some form of sales agency/commissionaire or buy-sell distributor model. But, in the past decade or so, taking advantage of the opportunities presented by the EU s Single Market, enterprise management systems and digital sales platforms, multinationals have increasingly been centralizing sales and distribution (as well as other) activities. Three features of the business structures for sales and distribution are increasingly being seen, which are of particular relevance in the context of BEPS: Centralized sales governance, e.g., key account teams comprising individuals based in a number of countries reporting to a European sales director. Central customer service desks responsible for order entry and fulfillment. Centralized supply and demand planning, and management of inventory across the region. In addition, businesses with centralized sales and inventory management will often seek further cost benefits from a simplified transactional model, i.e., taking orders directly from customers to a regional sales entity without the interposition of national sales companies. As a result, for purely business reasons, some companies have been adopting the sales agent model to accommodate the sales and distribution activities which remain in country. However, notwithstanding a natural tendency to defend or enhance their existing transactional and operating models, faced with the changes outlined above, many taxpayers are reviewing sales agent models. We are already observing that their review is leading some taxpayers to the conclusion that sales agency or commissionaire structures pose an unacceptable level of tax risk, and they are converting their sales and distribution activities to either: A buy/sell distributor, Or a branch structure (and dealing proactively with PE issues) So, at a time when business is increasingly considering the adoption of agency structures for reasons of commercial efficiency, the BEPS changes are likely to make these structures more complex and risky from a tax perspective. Additionally, as discussed below, the existence of a DAPE for corporate income tax may lead local tax authorities to conclude that a fixed establishment for VAT has also been created. Implications on systems and compliance In the past, in civil law countries, there was often a good basis for taking the position that a sales agent or commissionaire did not create a DAPE. Likewise, pure warehousing activities or the holding of stock in another country did not usually create a FPPE. However, with the lowering of the thresholds for the creation of DAPEs and FPPEs, there will be additional PEs, which, of course, will mean more direct tax returns to file and potential audits to manage. But the implications go much further than this. A DAPE could also be a VAT-fixed establishment. If it is, the question is then whether the DAPE is intervening in the supply and creating a local supply, an additional VAT transaction and potentially an additional VAT registration for the Principal. If there is direct supply from outside the territory where the DAPE is located, as in Case Study 1, its existence should not be seen as creating a VAT fixed establishment. But this view is not accepted in all EU Member States. 15 Therefore, this would need to be carefully examined on a country-by-country basis. In some countries, e.g., Italy, a company registration may even be needed for a DAPE, automatically resulting in statutory reporting obligations. 15 Examples include Spain, Portugal and Italy, and potentially other EU Member States. Lifting the mist Sustainable distribution models in the post-beps world 7

10 The obligation to file accounts and tax returns for additional PEs and VAT-fixed establishments means that financial and management (Enterprise Resource Planning) systems must be put in place or updated. Moreover, it may well be necessary to ensure that systems support the creation of full profit and loss (P&L) accounts and balance sheets for a DAPE as a fictitious buy/sell entity for VAT purposes. So, the characterization of DAPEs and the associated implications for their positions in the transactional model are important issues. In case of a DAPE, the question is whether it should be functionally hypothesized as a buy-sell distributor or as an agent. The OECD Profit Attribution Draft seems to suggest that a DAPE should be functionally hypothesized as a buy-sell distributor, regardless of its functionality. But we think the position is not clear. What if the DAPE, viewed functionally, is best characterized as an agent? In any case, however reluctantly, companies must accept that there will be differences when a SalesCo is looked at from a corporate tax/transfer pricing/attribution of profits perspective compared with the VAT view and/or the finance and accounting view. These three views may be completely different, resulting in unwanted complexity and risks. In addition, there is an added layer of complexity. Some treaties will soon incorporate some or all of the Article 5 revisions - either bilaterally or through the medium of the Multilateral Convention, while other countries will retain the existing provisions. The combination of the already apparent differences in interpretation, as well as differences in Article 7 Models within treaties, will, apart from the inherent risk of double taxation, make all aspects of compliance more complex to plan and implement. 8 Lifting the mist Sustainable distribution models in the post-beps world

11 4 Implications for the design of tax and transactional models 9

12 Implications for the design of tax and transactional models In this section we explore the implications of the BEPS changes through two case studies, which are intended to illustrate two key points. Firstly, to caution against too rapid a conclusion that an agency model is necessarily unstable. And secondly, to illustrate the potential complexity of implementing or sustaining agency or commissionaire models when the SalesCo has functions that go beyond pure sales activity. Case study 1: Bulk Chemicals This example (see fact pattern below) has been constructed to explore the implications of the BEPS changes for a minimal SalesCo, i.e., a sales entity whose functions are purely related to local sales. It is assumed that the transfer pricing analysis for this fact pattern would show that all economically significant risks and assets are controlled by the Principal. The SalesCo only undertakes activities that are characteristic of a sales agent and hence, it does not control any significant risks (e.g., inventory or market risks) or assets (e.g., inventory, accounts receivable, marketing intangibles and customer lists). However, because the SalesCo habitually plays a leading role leading to the conclusion of the contract between the customer and the Principal, the Principal has a DAPE in Country B. As per the OECD Profit Attribution Draft, the hypothesized entity should be attributed Country B sales income, the sales commission paid to SalesCo and compensation to the Principal Home Office for its functions in relation to Country B. Based on these facts, the deduction of an arm s-length commission due to SalesCo in the income statement of the DAPE should result in no profit remaining left to be taxed in the DAPE. The key to this result is the recognition that the profit should be the same whether the functions are rewarded as those of an agent or as a very low risk distributor. On the basis of the above analysis, one option would be to not change the transactional operating model (as it has been selected for good operational reasons), but file a protective zero profit return for the DAPE and document the reasons for this position. In addition, potential indirect tax and/or accounting implications would have to be analyzed in each country. Bulk Chemicals case study fact pattern SalesCo undertakes sales agent activities (identifying customers and account management, including soliciting sales) on behalf of a sales principal (Principal) under the Principal s close control. Transactional model as set out in the first diagram on Page 17 with drop shipment to customers from overseas manufacturing, i.e., no local stocking locations. Principal owns inventory until delivered to customers. Small number of employees of each local sales agent entity. Centralized customer service (order taking and fulfillment, and invoicing) including decision to accept customers and orders Centralized credit control. Centralized pricing agent can only negotiate with customers within very narrow bands subject, even then, to active review and authorization by product management in the center. Treaty between SalesCo and Principal territories includes new Article 5 and Article 7 Centralized supply and demand planning. 10 Lifting the mist Sustainable distribution models in the post-beps world

13 If the existence of the DAPE is judged to impose unacceptable risks and compliance costs, the two alternative models sketched in this article could be considered, i.e., a distributor (LRD) model or branch model. In the case at hand, a low function sales agent and no inventory holding, an LRD model would eliminate the PE risk. However, it would introduce additional transactions (which would mean additional transactional complexity) and it would certainly result in the creation of a VAT presence and an additional domestic VAT transaction. The latter would also have a significant impact on the customer. A sales branch model, i.e., one in which the SalesCos become branches of the Principal, is increasingly considered by businesses that have a natural preference for direct sales or agency models, but are reluctant to accept the additional compliance cost and risk associated with DAPEs in agency structures. This is because a branch structure, with the right operational setup and governance model in place, may allow for a centralized transactional model (often referred to as one face to the customer ), while PE issues are proactively managed, given that there is no doubt about the existence of a PE of the Principal in the local country. Also, the PE profit attribution analysis appears to be more straightforward in a branch model compared with an agency model, as there is no agency entity locally and hence, the complex interplay between transfer pricing rules (Article 9 OECD Model Tax Treaty) and profit attribution rules (Article 7 OECD Model Tax Treaty) is not relevant. Key points arising from this case study 1. As the agent only undertakes activities consistent with its character, it can be argued that it is adequately rewarded by a commission determined on transfer pricing principles. 2. Similar results could be achieved by structuring the SalesCo as an (agent) company or as a branch. 3. It would be important to document the control of the Principal on two levels: The centralization of functions. That as a matter of implementation, the Principal is controlling pricing and other key decisions. 4. A zero profit tax return would need to be filed for the DAPE. 5. There is a chance that local tax authorities would claim (incorrectly, in our view) that the existence of the DAPE creates a VAT-fixed establishment and local transactional involvement. 6. In some countries, a full transactional accounting setup may be required for the DAPE, which may have significant IT systems implications. But, as our second case study illustrates, as soon as the DAPE undertakes additional functions leading to the attribution of risks or assets to it, the analysis becomes much more complicated. Assuming the facts are the same as above, the branch would be a PE, but one to which no assets or risks are attributed. The dealing between the branch and the parent might be characterized as a sales agency service and the financial results should in substance be the same as above But there is a chance that the tax authority would insist on treating it as a hypothetical buy/sell entity. Lifting the mist Sustainable distribution models in the post-beps world 11

14 Case study 2: Medical devices Our second case study is at the opposite of the functional spectrum of SalesCos: one undertaking a wide range of distribution functions. This SalesCo is structured as a commissionaire. The fact pattern for this case study is set out in the box below. It contains elements of Examples 2 and 4 in the OECD Profit Attribution Draft. Medical devices case study fact pattern SalesCo is a commissionaire and receives a sales commission set to achieve 10% mark-up on its costs (equivalent to 2% of Principal s sales revenue). Transactional model: as set out in the second diagram on Page 17. Wide range of products. Customers are hospitals either directly or through buying groups. Principal secures product registrations. SalesCo advises on which products meet local country requirements (which are diverse across Europe). Account plans prepared by SalesCo; larger plans actively reviewed by Principal (European Sales Manager and six regional sales managers each responsible for one large and three to four smaller countries). Tenders let from time to time and bids prepared by SalesCo on behalf of Principal, subject to delegated authorities (minimum prices and maximum size); 60% of revenues derived from tenders specifically reviewed and authorized by Principal. Commissionaire is contracting party for sales but for the risk and account of the Principal. Customers place orders online. Service standard requires 98% of orders to be fulfilled within 24 hours. Principal-owned consigned stocks in network of regional warehouses managed by SalesCo with a value of one year s sales. SalesCo recommends and monitors inventory levels and places orders on factories behalf of Principal to ensure stocks remain sufficient to meet demand. SalesCo acts as contact point for customer queries on stock availability and quality issues subject to escalation. SalesCo technical salesforce supports customers in use of products, drawing on backup from technical specialists employed by the Principal. SalesCo invoices customers and acts as contact point for queries SalesCo receives and administers claims relating to adverse events, subject to close monitoring and scrutiny by Principal. SalesCo manages Principal s debtors subject to policies set by the Principal which reflect varying national payment norms. Treaty between SalesCo and Principal territories includes new Article 5 and 2010 Article 7. It is assumed for the purposes of the case study that the activities of the commissionaire create a DAPE for the Principal. The Principal might also have a PE because of its ownership of stock in warehouses operated by the SalesCo, if it has unlimited access. 12 Lifting the mist Sustainable distribution models in the post-beps world

15 Transfer pricing analysis The transfer pricing analysis identifies a number of risks which the SalesCo manages but, as a commissionaire, cannot assume. These risks include: The SalesCo plays an important role in local market product strategy. The SalesCo plays a role in pricing, particularly for smaller accounts. The SalesCo plays a major role in managing inventory risk. The SalesCo manages debtors. The SalesCo contributes to the management of claims arising from adverse events. It is likely, and assumed for illustrative purposes, that these risks would be assumed by the Principal under its agreement with the SalesCo. Before BEPS, we would have expected any controversy to focus on whether the comparables used to benchmark the commission remuneration included an adequate allowance for a contribution to managing risks. There might have been a challenge that such additional services should be rewarded by a cost-plus service fee adjustment, e.g., to the SalesCo costs associated with inventory management. Post-BEPS, the first question to be addressed is whether these risks are economically significant. While noting the list of risks is quite long but does not include any that relate directly to development, procurement or manufacturing, we will assume that the risks are economically significant. So, as noted above, it appears that the BEPS changes point to the need for a more granular transfer pricing analysis. The SalesCo s role in managing some, and possibly all, of the risks related to sales and distribution is supervised by the Principal and a detailed analysis might conclude that control of risk is shared. In addition, it is unlikely that the SalesCo would be capitalized with the level of financial resources necessary to finance these risks. These circumstances are provided for in Chapter 1 (paragraph 1.94) of the revised transfer pricing guidelines published in the Action 8 10 report 17, The guidelines state that in cases of joint control, a party contributing to control and assuming the risk under the agreement will be allocated the risk if it has the financial capacity to bear the risk. 18 However, there remains an obligation to set an arm s-length price for the contribution of the other party. 19 So, in this case, it would be necessary to determine arm s-length fees for controlling or sharing control of market, pricing, inventory, debtor and adverse event risks. This would not necessarily be a simple cost plus fee. Profit attribution analysis On the basis of the functional profile of the SalesCo, it would likely be found to be undertaking significant people functions in relation to product management, inventory management, credit risk management and adverse event management. If the SalesCo were in sole control of these risks, the analysis should, in our view, be very similar to that in the first case study. A profit and loss account for the DAPE would need to be constructed, but it would show zero operating profit after deducting the sales commission to the SalesCo, provided that the commission included an arm s-length reward for the SalesCo s contribution to the management of significant risks. However, the DAPE would earn a funding return on the assets attributed to it. However, this view might be challenged in Southern European countries. In our view, essentially the same result should apply if control of risks is shared between the Principal and the SalesCo. However, a full analysis based on the principles of the 2010 AOA Report would require: 1. Assigning capital necessary to bear market, debtor, inventory and product liability risks 2. Imputing (financing and risk) returns for these risks. 3. Determining and apportioning funding returns. 4. Apportioning inventory write-downs, bad debts and product liability costs. 5. Apportioning the risk fees paid to the SalesCo. The overriding additional message from this case study is the complexity that is introduced when it is determined that a SalesCo is undertaking risk management functions not adequately compensated by traditional transfer pricing benchmarking. Given the high complexity of the profit attribution analysis related to the DAPEs deemed to exist post-beps, those companies that have adopted an agency or commissionaire model pre-beps will have to consider converting to a distributor model. 17 See reference in footnote 2 above 18 This provision in the guidelines is referenced in the discussion of Example 4 in the OECD Profit Attribution Draft. 19 See Paragraph 1.99, Chapter 1 in the OECD Profit Attribution Draft. Lifting the mist Sustainable distribution models in the post-beps world 13

16 5 Conclusions and observations 14

17 Conclusions and observations The key messages emerging from this discussion include: There is a serious disconnect between the approach to the Single Market that business would like to take and BEPS developments, which are imposing an additional compliance burden on agency and commissionaire models, as well as considerable uncertainties relating to the profit attribution analysis, which means greater tax risks. There is also a potential disconnect between the corporate tax, accounting and VAT treatment of a DAPE or a branch, which could even result in complex ERP adaptations to overcome and streamline the financial reporting. The case studies illustrate a point often made about the BEPS changes: they make it even more important than it was previously to undertake a detailed factual (functional) analysis of sales and distribution within the context of the overall operating model, as a basis for the selection of the appropriate tax and transactional model. In particular, it is essential to understand the economically significant risks facing the business and how, and by whom, they are managed. With the right facts (centralized control of all areas and all aspects of sales and distribution, apart from sales activity itself), careful implementation and good documentation, an agency or branch model may be a better fit than a distributor model. Companies with a similar fact pattern to that illustrated in case study 1 may choose to protect their existing agency models by accepting the additional compliance obligations introduced through the existence of DAPEs next to the agent entities. But these additional compliance obligations may be viewed as less problematic compared to converting to an LRD model, as the latter may not be a good fit for a very centralized commercial operating model. But if an agency and/or branch manages risks not characteristic of a sales agency (as illustrated in case study 2), the profit attribution analysis can become very complicated and potentially controversial. This is why companies with the fact pattern of case study 2 may rather choose to convert to an LRD model or in certain cases, even a traditional full risk distributor model. Although the BEPS work on Articles 5 (BEPS Action 7) and 9 (BEPS Actions 8 10) is largely complete, considerable uncertainty about implementation remains, making planning difficult. Taxpayers need to carefully consider when it will be possible to seek guidance or assurance from tax authorities on future (changed or unchanged) structures, without prejudicing their current positions. Where the new Article 5 will be implemented, there will be more PEs, leading to more tax returns and greater potential for challenge on profit attribution with wider implications for VAT and for the systems needed to support compliance. Overlaying the changes with the likelihood of diverse approaches around Europe, the complexity of compliance will be substantially increased. Lifting the mist Sustainable distribution models in the post-beps world 15

18 6 Tax and transactional models for sales and distribution activities 16

19 Tax and transactional models for sales and distribution activities 1. Sales agent A sales agent identifies customers and solicits sales on behalf of its Principal. It refers potential sales to the Principal, which is responsible for negotiating and concluding sales contracts. Various countries Production entities Country A Countries 1 -n Master distributor (MD) Sales agent 1 DAPE 1 DAPE n Customer Customer 2. Commissionaire If sales and distribution activities are structured as a commissionaire arrangement, a person sells products in a given State in their own name but on behalf of a foreign enterprise that owns the products. Before BEPS Action 7, the view could be taken that a foreign enterprise was able to sell its products in a State without having a PE to which such sales were attributed for tax purposes, because the person that concluded the sales did not act on behalf of the foreign enterprise. This meant that it could not be taxed on the profits derived from such sales and could only be taxed on the remuneration that it received for its services (usually a commission). Various countries Country A Countries 1 -n Sales agent n Commissionaire 1 Customer Product invoice Physical delivery Production entities MD DAPE 1 DAPE n Commissionaire n Customer Product invoice Physical delivery Lifting the mist Sustainable distribution models in the post-beps world 17

20 3. Buy/sell distributor A buy/sell distributor buys from a Principal or manufacturer and sells to customers in its territory. The distributor may undertake a wide range of sales, marketing and logistical functions. A commonly adopted form of the buy/sell distributor model is the LRD. An LRD undertakes only operational or tactical sales and marketing activities. Its offshore Principal performs all the more strategic and value-adding activities. Typically, an LRD buys products on its own account from its overseas Principal for sale to local customers, on the basis that the principal will assume various business risks of the LRD and will guarantee its financial performance. The assumption of risks by the LRD is minimized through the careful design of transactional terms, for example, an LRD is likely to only: 4. Sales branch Under a branch structure, an entity directly undertakes (part of) its operations in one or more other countries, i.e., without establishing local subsidiaries. The commercial rationale is usually for the parent to gain greater control and thereby respond more effectively to market developments or opportunities; or to eliminate duplicative functions. A SalesCo established as a branch would be taxed as a PE on the basis of profitability determined on the basis of Article 7 of the relevant treaty. Various countries Country A Countries 1 -n Take flash title to the goods immediately before their sale to the customer, thereby reducing inventory financing costs and stock write-downs. Pay its (Principal) supplier in its own currency when it is itself paid by the customer, thereby reducing debtor financing, currency risk and bad debts. Production entities MD PE 1 PE n Customer Customer Product invoice Physical delivery Various countries Country A Countries 1 -n Production entities MD LRD 1 Customer LRD n Customer Product invoice Physical delivery 18 Lifting the mist Sustainable distribution models in the post-beps world

21 7 Contacts 19

22 Operating Model Effectiveness Contacts Joost Vreeswijk Switzerland Tel : Thomas Ebertz Germany Tel: thomas.ebertz@de.ey.com Victor Bartels The Netherlands Tel: victor.bartels@nl.ey.com Jean-Marc Girard Spain Tel: jeanmarc.girard@es.ey.com Marc Schlaeger Denmark Tel: marc.schlaeger@dk.ey.com Ai-Leen Tan Switzerland Tel: ai-leen.tan@ch.ey.com Mohi Khan United Kingdom Tel: mohi.khan@uk.ey.com Anastasia Salostey Germany Tel: anastasia.salostey@de.ey.com Stuart McDougall United Kingdom Tel: smcdougall@uk.ey.com Nathan Richards Switzerland Tel: nathan.richards@ch.ey.com 20 Lifting the mist Sustainable distribution models in the post-beps world

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24 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. 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 Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com EYGM Limited. All Rights Reserved. EYG No GBL EY indd (UK) 11/17. Artwork by Creative Services Group London. ED None In line with EY s commitment to minimize its impact on the environment, this document has been printed on paper with a high recycled content. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com