OECD 2008 DISCUSSION DRAFT: TRANSFER PRICING ASPECTS OF BUSINESS RESTRUCTURINGS

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1 OECD 2008 DISCUSSION DRAFT: TRANSFER PRICING ASPECTS OF BUSINESS RESTRUCTURINGS Business Restructuring As A Taxable Event: Causing Realization OECD Consultation June 9-10, 2009 Steven P. Hannes McDermott Will & Emery LLC Washington, D.C. Linda Fernandez Eli Lilly Indianapolis, IN th Street, N.W. Washington, D.C (202) SHannes@MWE.com Representing The Transfer Pricing Discussion Group Boston Brussels Chicago Düsseldorf Houston London Los Angeles Miami Munich New York Orange County Rome San Diego Silicon Valley Washington, D.C. Strategic alliance with MWE China Law Offices (Shanghai) 2008 McDermott Will & Emery LLP. McDermott operates its practice through separate legal entities in each of the countries where it has offices. This communication may be considered attorney advertising. Previous results are not a guarantee of future outcome.

2 About The Transfer Pricing Discussion Group The Transfer Pricing Discussion Group consists of multinational companies based in the United States and other countries. The members are in the automotive, chemicals, consumer nondurable goods, durable goods, news, information and pharmaceuticals industries, among others. The Discussion Group serves as an information source for corporate practitioners who work on transfer pricing and related matters and who want to exchange views on these matters with their corporate peers. Also, the Group prepares comments on government proposals involving transfer pricing and related matters. In a letter from McDermott Will & Emery dated February 18, 2009, the Group offered comments to the OECD on its 2008 Transfer Pricing Aspects of Business Restructurings: Discussion Draft for Public Comment. The Group was organized by Steven Hannes of McDermott Will & Emery in Any inquires about the Group should be directed to Mr. Hannes. 2

3 Business Restructuring As A Taxable Event: Causing Realization INTRODUCTION The Transfer Pricing Discussion Group welcomes the opportunity to contribute to this Consultation The Restructurings Discussion Draft is a constructive document that heads in the direction of achieving OECD goals of reducing uncertainty and increasing guidance 3

4 Introduction (cont d) The Transfer Pricing Discussion Group endorses many substantive transfer pricing principles about business restructurings expressed in the Restructurings Discussion Draft. The Group also believes that the Restructurings Discussion Draft can be improved and has made specific recommendations along those lines As requested by the OECD, this presentation focuses on issues in the Restructurings Discussion Draft involving the standards that affect when a business restructuring of related parties involves the realization of income (or deductions), is a taxable event, and can be affected by transfer pricing standards, including reallocations of income between the related parties involved The Transfer Pricing Discussion Group addressed realization and other matters about the Restructurings Discussion Draft in the Group s letter to the OECD dated February 18,

5 Summary of Transfer Pricing Discussion Group Recommendations on Realization 1. There should be clear OECD explanations on different roles of domestic law, OECD Model and OECD TP Guidelines in determining whether income is realized due to a business restructuring Article 9 does not create the realization of income independent of local law but can prevent realization of income that local law might otherwise create 2. There should be clear OECD standards in OECD TP Guidelines and Commentary to Article 9 of OECD Model on whether and when, under these OECD documents, income can be realized due to a business restructuring 3. Under OECD standards, income should not be realized in a business restructuring unless there is a transfer of Property (as defined here) 4. Under OECD standards, income should not be realized merely because there is a perceived or actual transfer of profit potential or of a function 5

6 Summary of Transfer Pricing Discussion Group Recommendations on Realization (cont d) 5. Under OECD standards, the provisions of related party contracts, and the rights provided to the parties under commercial law, should be respected in determining whether there is a taxable transfer of Property (a realization) in a business restructuring. Thus, tax authorities should not read indemnification clauses or other compensation rights theoretically relevant to business restructurings into related party contracts (e.g., effectively trying to create the realization of income) 6. Under OECD standards, tax authorities can take into account the lack of rights to indemnification or other compensation for business restructurings in determining whether these omissions or exclusions increase the risks and the amount of compensation due at arm s length during the term of the contract for undertaking the business activities to which the contract applies and, if so, to propose an increase in income for those activities 6

7 Causing Realization: Roles of Domestic Law, OECD Model and Transfer Pricing Guidelines Restructurings Discussion Draft does not directly address the issue of what body of law or legal authorities (e.g., domestic law or OECD Model Article 9) can cause income to be realized in a restructuring of a business The OECD TP Guidelines do not currently provide needed guidance on this important legal question, either for restructurings or other circumstances. Both the OECD TP Guidelines and the Commentary for Article 9 should be revised to provide guidance as suggested here The Transfer Pricing Discussion Group s view is that, as a legal matter, Article 9 of the OECD Model should not create the realization of income separately from domestic law, although Article 9 can limit or prevent the realization of income that would otherwise occur under domestic law as to business restructurings (and more generally) 7

8 Causing Realization: Roles of Domestic Law, OECD Model and Guidelines (cont d) The 2008 Commentary for Article 7 of OECD Model Treaty helpfully states that before its principles can apply: income must be realized; realization is determined under a country s domestic law; and the standards for realization will vary from country to country 1 While Article 7 may permit a state to exercise domestic law to cause realization, or preclude such domestic law from applying, Article 7 does not itself trigger the realization of income where domestic law would not do so 2 1 Although the Restructurings Discussion Draft focuses on Article 9 of the OECD Model Treaty and the OECD TP Guidelines, these principles employed in Article 7 of the Model for permanent establishments are relevant here to separate legal entities. 2 Article 7 does not necessarily require realization in countries, such as the United States, that permit a taxpayer to choose the more favorable of its internal tax law or the provisions of a tax treaty and, likewise, do not allow the tax authority to impose treaty provisions that are unfavorable to the taxpayer compared to domestic law. 8

9 Causing Realization: Roles of Domestic Law, OECD Model and Guidelines (cont d) In Commentary to Article 7, OECD observes serious over-taxation problems due to differences in whether or when two countries view a transfer between a permanent establishment and another part of the same enterprise as a taxable event Similarly, an OECD goal under Article 9 should be to reduce conflicts between different countries domestic laws involving the existence and timing of the realization of income from business restructurings involving two or more legal entities; this matter is central to the Restructurings Discussion Draft 9

10 Causing Realization: Roles of Domestic Law, OECD Model and Guidelines (cont d) Thus, there should be one agreed clear OECD minimum threshold before realization and taxation can occur on a business restructuring under the OECD Model Treaty and OECD TP Guidelines If the final OECD work products on business restructurings (e.g., new paragraphs for the OECD TP Guidelines or the Commentary) refer to local views or laws concerning realization, then the OECD should explain whether they are consistent with the OECD s agreed minimum realization threshold for business restructurings 10

11 Causing Realization: Recommended Minimum Threshold Recommended OECD minimum realization threshold: If, but only if, domestic law requires realization of income for a restructuring, then in order for the restructuring to be taxable and income to be adjustable (e.g., by a reallocation) under Article 9 of the OECD Model Treaty or the OECD TP Guidelines, it must involve the transfer of Property Property should be defined in the Commentary to the OECD Model and in the OECD TP Guidelines to include only the following: Tangible assets; Intangible assets such as patents, trademarks, trade names, designs or models, as well as copyrights of literary, artistic or scientific work and intellectual property such as know-how and trade secrets that are legally protected and commercially transferable; and Contracts containing rights that are commercially enforceable 11

12 Causing Realization: Recommended Minimum Threshold (cont d) Thus, the change, transfer or loss of a function or of profit potential is not by itself a transfer of Property. Also, goodwill cannot be transferred absent the transfer of Property The Transfer Pricing Discussion Group agrees in this regard with the following statement in the Restructurings Discussion Draft: Profit/loss potential is not an asset, but a potential which is carried by some rights or other assets. The arm s length principle does not require compensation for loss of profits/loss potential per se 1 Other parts of Restructurings Discussion Draft should, however, be revised to conform with this statement: For example, Para may unintentionally suggest that a change in a business model can become a restructuring, triggering the realization of income, whether or not there is a change in commercially enforceable contract rights (e.g., whether or not the manufacturer has the exclusive right to operate on a fully fledged basis in a region for a term of years and to earn specified revenue or profits thereon) 1 (Paragraph 64). (Emphasis added.) It should be clarified by the OECD that assets do not include money (e.g., cash). Likewise, Property, as used in this document, does not include money. 12

13 Causing Realization: Recommended Minimum Threshold (cont d) OECD TP Guidelines and OECD Model Treaty Commentary should state definitively that: (1) if, under the applicable contract law (commercial law), a particular business restructuring between affiliates would trigger a sustainable claim for damages, then there can be a realization of income (and deductions) and a reallocation under the OECD TP Guidelines and OECD Model Treaty if domestic tax law determines that realization has occurred; and (2) conversely, if such a business restructuring would probably not give rise to a sustainable claim for damages under applicable commercial law, then it is not appropriate for there to be a realization of income, deductions or a reallocation under OECD Model Treaty or OECD TP Guidelines whether or not domestic law determines that realization has occurred The Restructurings Discussion Draft should expand its analysis of the significant role of commercial law with respect to restructurings, using examples based on court cases decided under commercial law 13

14 Analyses of Realization in Business Restructurings Should Respect Contractual Rights of Related Parties With respect to whether business restructurings involve the realization of income, the OECD should maintain the long-standing and general position that tax authorities should respect the terms and conditions of a related party contract implemented consistent with its provisions Tax authorities should not read in to those contracts indemnification or other rights that the contracts (or the applicable commercial law) do not provide, or otherwise attempt to restructure the terms and conditions of a related party contract, or try to recharacterize such a contractual relationship, to cause the realization of income that would not otherwise occur Theories about how unrelated parties would have structured their contract cannot cause realization of income for related parties 14

15 Analyses of Realization in Business Restructurings Should Respect Contractual Rights of Related Parties (cont d) Of course, the amount of compensation under a related party contract should be at arm s length under the OECD TP Guidelines and the OECD Model Treaty when there is a restructuring that exceeds the agreed minimum threshold for realization Thus, if a related party contract does not contain an indemnification clause covering business restructurings, then the tax authorities can consider whether this omission increases the risks incurred by a party so that its compensation for the contracted activities might be increased accordingly during the term of the contract 15

16 Analyses of Realization in Business Restructurings Should Respect Contractual Rights of Related Parties (cont d) In summary, the general OECD rule of respecting the terms and conditions of related party contracts should be maintained and applied in determining whether a business restructuring causes the realization of income and a taxable event A possible narrow exception is where the tax authority presents empirical evidence, not hypothesis or theory, that third parties in similar circumstances consistently use contractual terms and conditions that require compensation for the restructuring in question This possible exception is very different from relying on the absence of reliable evidence of similar third party structures as a basis for not recognizing the related party agreement as it was structured contractually and implemented and to claim therefore that a related party business restructuring should involve realization and compensation even though it does not involve the transfer of Property 16

17 Profit Potential Without Property OECD Query: Can profit potential be transferred without a transfer of tangible assets, intangible assets or enforceable rights? Response: Yes, profit potential can be created or facilitated or even transferred without a transfer of Property. Examples: Setting up a shared service center for administrative services within the multinational group Setting up an affiliate to be a distributor, manufacturer, etc. Closing the distribution, manufacturing, etc. operations of one affiliate while allowing another affiliate to begin distribution, manufacturing, etc. Reassigning one or more employees from one affiliate to another or authorizing an affiliate to hire more people or to invest in more business equipment or other assets 17

18 Profit Potential Without Property (cont d) However, these sorts of situations, each of which can occur without interfering with any prior contractual obligations or transferring Property, should not result, under the OECD TP Guidelines or OECD Model Treaty, in the realization of income or become a taxable business restructuring for transfer pricing purposes 18

19 Are Only Legally Protected Intangibles or Other Property Compensated? OECD Query: At arm s length (i.e., between third parties), are only legally protected intangibles or other Property compensated? Response: Generally speaking, yes Compensation may change hands between third parties when one or both parties do not want to test (e.g., in court) the strength or value of their legal protections (i.e., compromise and settlement) Also, third parties may agree to amend rights that clearly are legally protected without money changing hands for the restructuring per se because of other benefits (e.g., helping a supplier continue in business by amending its contract to provide terms more favorable than what the contract previously provided) 19

20 Are Only Legally Protected Intangibles or Other Property Compensated? (cont d) If, notwithstanding these and other recommendations, the member states of the OECD want to leave the door open to requiring or allowing compensation for a business restructuring where there is no transfer of legally protected intangibles or other Property (as defined here), then there should be clear and consistent marketplace evidence supporting such a conclusion in a particular case In other words, if the OECD chooses to authorize a taxpayer or tax authority to have, or to require a taxpayer to have, compensation in a specific related party business restructuring case, even though there is no transfer of Property, then it should have the burden of establishing with empirical evidence by way of specific third party examples, not theory that third parties have consistently paid compensation in comparable circumstances *** WDC