Question 2. Part 1. Transfer pricing and IP

Transcription

1 Question 2 Part 1 Transfer pricing and IP Transfer pricing is the price charged in transactions between 2 related entities. It is important in the international tax context because the level of transfer price charged can have an impact on the taxable income for each of the related parties i.e. the tax base for the jurisdictions of each party. In the OECD model tax convention, the taxation of associated enterprises is principally governed by article 9. The key concepts revolve around that related parties sharing features of control (either common shareholder or one controlling another, in forms not limited just to shareholdings, but also voting powers, etc.), should transact with each other as two third parties would in similar circumstances setting out the basis of arm s length principle. The model commentary cross refers to the OECD Transfer pricing guidelines in this publication there s a dedicated chapter for the considerations regarding intercompany transaction related to intangible properties and resulting intercompany royalties. The third party French company paying ME UK royalty is it comparable with the royalty from MEA to ME UK? We need to consider the comparability factors. Economic circumstances France is an economically developed country whereas A is an Asian country (potentially a developing nation) and as mentioned, extremely competitive. The fact that France is a mature economy and A is not would impact on the business margin/profits in each state. E.g. France is richer, it can therefore afford more of the medical products from ME group, if A is much poorer, the turnover is clearly going to be less. If a third party knows it could have less turnover, then it is likely to demand a lower royalty rate (i.e. argument for at least a lower rate for MEA). Business strategy Following the above, if ME group is trying to break into A, then it might consider slashing the royalties to encourage sales (assuming the licensee could then sell at a lower price range to customers). Would they have the similar strategy with the French co? Contractual terms We don t have much information on whether the two agreements are the same (only indicated that the same patents are being licensed) we need to consider factors such as exclusivity, or rights to participate in further research and term of agreements etc. These could also have an impact. Product characteristics This should be less of a concern as the patents are the same. But we should also consider whether the French licensee uses the patent in the same way as MEA? The business rationale would have an impact on the royalty rates. Functional profiles

2 Following all the above, there should be analysis carried out to check whether the French co and MEA would have similar levels of assets and assume similar risks. If there are significant differences, then it would influence how third parties would be willing to pay the royalties. In third party circumstances, they would expect payment to be commensurate with the risks assumed. If MEA has guaranteed sales (market risks) to ME UK but the French co doesn t then MEA would expect an even higher rate in third party situations. CUP pros Same patents (product characteristics) Same royalty basis net sales CUP cons Different states of licensees one is developed one is developing different economics at play. ME UK provides marketing strategy to MEA but not the French third party co (so products licensed are actually slightly different). Other information required We need to look at the contracts to know more about the precise terms. We will need to undertake a functional analysis to evaluate MEA s contribution to the business. Overall, we will need to gather more facts before we can conclude on the usability of CUP for comparison of the two transactions. Part 2 MEA could also consider other transfer pricing methods such as transactional profit split method. Following the establishment of MEA and ME UK s functional profiles in the business operations, it could be possible to understand the contribution by each party in the overall business success for the group. In third party circumstances, entities would be able to obtain profits based on the elements they bring to the venture s success. In very intricate transactions, a total profit split may be used. In other cases where a more routine element could be identified, the remuneration for them could be dealt with first. In MEA s situation, the service transactions would appear to be simpler in nature, as well as the core distribution functions. Following that, it could be left with just a residual pot of profits, which could be split out based on the contribution of MEA and ME UK s to the business. Other than looking at just contribution, MEA could also consider the bargaining position of itself and ME UK. Or MEA could consider using the Transactional net margin method.

3 As MEA appears to be a functionally simpler entity, it could be possible to establish how much third party companies solely undertaking activities similar to MEA would earn in similar conditions. This could be undertaken via a benchmarking study which can establish the profitability level of the third party companies via different profit level indicators. In MEA s context, the most appropriate PLI would appear to be operating profit margin. So in comparison, MEA should also be earning a similar profit level, with the residual profits all payable to ME UK for its patent usage. This can be recalculated to produce the corresponding royalty rate supportable from an arm s length perspective. Part 3 Royalty payments are not necessarily related to the profit making potential of an enterprise. A McDonald s franchise would still have to pay royalties even if no one is buying any fast food. Whether this is sustainable in a third party situation, this is actually the key question. A third party company would not be able to sustain operations in prolonged loss making position. Just because MEA is currently loss making, it could be that it is anticipating a profit making upturn in future the loss in MEA could be a temporary thing. The poor management decisions are hopefully not going to repeat in future. Fixed fee quotes will unlikely be charged in future to customers profitability could then potentially return. As ME UK charges a third party in France for same patents then it can be seen that such arrangements are in fact acceptable to third parties. As such the royalty payment shouldn t be immediately considered to be non-arm s length. There is also a lot of substance in MEA s operations in A without which ME s overall profitability could be affected consider MEA does a lot of client liaison to establish the quantum to import into A, and the logistics for such fragile medical products MEA s contribution is clearly significant in the group s strategy. Framing it as a routine service provider under TNMM would therefore ignore the substance of MEA in the business this would be non-arm s length (i.e. TNMM would not be the most appropriate method). Further, if MEA is to be characterised as a routine service provider and its remuneration is to be benchmarked with similar comparable companies (albeit in fact they won t match MEA s contribution to business to the same extent) under TNMM. Does that mean in future, when MEA is making a lot of profit, A would still be happy with just the mark up on MEA s costs? As mentioned, it is posited that MEA could be profit making in the long term, (loss is temporary) by allowing for a CUP based royalty payment, A s authority might have to suffer the lack of revenue until MEA begins to make profit. Then, A s expected tax revenue from MEA would actually be much higher under the royalty model than under TNMM consider if MEA is to opt for a sliding royalty scale, even if making little profit, A would have a tax income, if making a lot more profit, the royalty would likely still leave MEA with more profit than under TNMM (this requires more numerical analysis).

4 Question 3 Part 1 Transfer pricing and services Transfer pricing is the price charged in transactions between two related entities. It is important in the international tax context because the level of transfer price charged can have an impact on the taxable income for each of the related parties, i.e. the tax base for the jurisdictions of each party. In the OECD model tax convention, the taxation of associated enterprises is principally governed by Article 9. The key concepts revolve around that related parties sharing features of control, (either common shareholder or one controlling another, in forms not limited just to shareholdings, but also voting powers, etc.) should transact with each other as two third parties would in similar circumstances setting out the basis of arm s length principle. The model commentary cross refers to the OECD Transfer pricing guidelines in this publication there s a dedicated chapter for the considerations regarding intercompany services transaction. Services chargeability For intercompany services, the chargeability is impinged on two key issues whether a benefit has been provided, and if so, what level would third parties in similar circumstances remunerate for the services. MEA context Based on the info provided, MEA is engaged in the provision of an array of services, such as accounting and technical assistance. Centralised management accounting Centralised management accounting would appear to be a service provided for the parent entity for the whole group, as such would likely to be considered a shareholder activity. Whilst MEA is not the shareholder, (ME UK is assumed to be the ultimate parent co and key shareholder) as such the costs incurred (such as apportioned salary costs) should be passed on only back to ME UK, not the other subsidiaries under ME UK. A third party would not have happily incurred the cost without a profit element, so an appropriate mark-up should be applied to the cost in calculating the recharge due to ME UK. The typical TP methods would be either CUP, Cost plus or TNMM. CUP is assumed not applicable as MEA is unlikely to be doing the same for external entities. Cost plus might be difficult in identifying the mark up for the lack of info on internal or external comparable uncontrolled transaction. Although in applying the mark up to the cost to be charged to affiliates, this would typically be the method. For the identification of an arm s length mark-up, TNMM would usually be considered. (As it s unlikely to be asset intensive, or high turnover, then the profit level indicators are likely to be Operating profit margin or Net cost plus.)

5 As ME UK is the sole recipient of the benefits, a direct allocation could be applied. (No allocation key required) We need to consider whether ME UK duplicates this by doing management accounting separately also if affirmative, then the chargeability could be undermined. Also, we are assuming this is actually required by ME UK in its capacity as the parent company and need to account for the shareholder aspects of its business. (I.e. a benefit exists to ME UK) However, if this service is in relation to each subsidiaries (and provide benefits) then MEA should use the indirect method to recharge the marked up cost to them. (Description of this in the internal audit section below) Internal audit Internal audit would appear to be a service providing a benefit to all group subsidiaries. A benefit could be tested by checking if without this service, would the subsidiaries have to either do it themselves or pay someone else to do it. Again, a mark-up should be applied as no third parties would undertake this without a profit element. (Please see above comments re TP method and arm s length mark-up identification) Again, duplication of this activity needs to be verified. Duplication is only allowed if it s temporary (business transition phase) or it s for accuracy checks. (E.g. risk mitigation for business decisions) If duplicated, it s unlikely a third party would be happy to pay for it, and as such it couldn t be recharged. It would be difficult for MEA to identify the precise rechargeable amount to each recipient. As such the guidelines approve of approximation using allocation keys. (Indirect charge method) Important to ensure this follows reasonable accounting principles with safeguards against abuse. Typically this could be based on some key business metrics, such as headcounts, or turnover. Assuming all recipients are operating entities, allocating the fully loaded costs (i.e. apportioned salaries with overheads bills/rent, etc.) on the basis of turnover would appear to be what third parties would do. Overall the recharge should be reflective of the extent of benefits received. The preparatory of consolidated statutory accounts This would appear to be within the ambit of shareholder activities. Again as MEA is unlikely to be the shareholder, (ME UK is the shareholder) it is likely that this would be a benefit for ME UK. Is this for the benefit of ME UK, if so, then it should be recharged to ME UK similar to the centralised management accounting section. On call referral It would be important to check how often this service has actually been provided to recipients. If over long period of time this has been recharged on some basis but no actions actually undertaken, then the third party would unlikely have continued to hire such services.

6 If used, we also need to consider the extent of usage. If it s excessive to the extent that MEA becomes solely doing this, then there should be some additional remuneration for capacity usage as well. Assuming this is reasonably used by all recipients and providing a benefit to all of them, then a marked up costs should be recharged to all of them. (Even though they might not have used the service in the particular timeframe, if they have used it some other time, they should be recharged) The costs could be the capacity that MEA would have to set aside (e.g. man hours, etc.) to provide for such on call services. Recharge should be cost plus. (See above, and also on marking up) The allocation key should be something sensible, could be the number of calls received in the period, or the amount of clients served by each entity. Other considerations One needs to consider whether there are contractual agreements in place highlighting MEA s involvement of these services for recipients. Does MEA provide similar services to external parties? That could be useful for external CUTs. Part 2 Memo tax risk of management charges Date 12 June 2014 To Board directors The purpose of this memo is to set out the key transfer pricing risks as a result of the implementation of certain intercompany service recharge from MEA in state A. In a third party context a service would only be required if it actually confers a benefit to the recipient. The notion of benefit is therefore critical. For instance, ME UK s recharging MEA of the global CEO costs would appear to present no real benefits to MEA s business operations. In particular, the CEO and the other listed management personnel have visited MEA, it would. If ME UK charges MEA for such usage, it could be deemed non arm s length and transfer pricing adjustment might result. (Upward adjustment to MEA s profits on account of non-deductible costs. I.e. cost base challenges) Secondly, the 20% mark-up seems rather high. Would a third party be willing to pay for it? Whilst MEA is not in the EU, based on the comments from the EU Joint Transfer Pricing Forum, for routine activities the mark up should be about below 10%. It is understood that the management personnel might actually do something more substantial than just routine management judging from their high positions, nonetheless it would be necessary to check whether third parties would be willing to pay for it.

7 It would be unlikely that ME UK provides similar functions to third parties. Does ME UK have recharge info on similar services between third parties? If not, it is possible to resort to using a benchmarking study to check how third party companies engaged in similar activities would earn in profit level. All this should be taking into account of how sensitive A is as a jurisdiction. Is the effective tax rate in A much higher than the UK? If there s a big difference, then the tax authorities would have more reason to believe that ME UK is trying to extract profits from A via profit shifting techniques. Further, MEA is already paying ME UK for royalty for patent usage. We need to consider whether the agreement provision for the management aspects of the various group heads. In general there should be no double dipping. (I.e. MEA paying for royalty inclusive of the group head s functions, and pay ME UK for the recharge) In summary, service charge could be a difficult area with many risks involved. In view of the current tax climate and the recently published BEPS report targeting abusive behaviour from companies via profit shifting and base erosion, there should be careful considerations in ensuring ME is compliant in its related party transaction from an arm s length perspective.

8 Question 5 Part 1 Transfer pricing and intercompany debt interest Transfer pricing is the price charged in transactions between 2 related entities. It is important in the international tax context because the level of transfer price charged can have an impact on the taxable income for each of the related parties i.e. the tax base for the jurisdictions of each party. In the OECD model tax convention, the taxation of associated enterprises is principally governed by article 9. The key concepts revolve around that related parties sharing features of control, (either common shareholder or one controlling another, in forms not limited just to shareholdings, but also voting powers, etc.) should transact with each other as 2 third parties would in similar circumstances setting out the basis of arm s length principle. Intercompany financing transactions between companies caught by the control clause of the article would therefore also be subject to the arm s length test. Transfer pricing adjustment might be allowed under the above provisions. Further, the taxation of interest arising from intercompany financing transactions are also governed by article 11 on interest. The article goes on about the key concepts such as beneficial ownership, withholding tax levels, and in the related party context, if a special relationship exists between interest payer and recipient, the interest amount subject to the restricted source taxation (WHT) will only be limited to the amount which 2 third parties would have been fine with. (I.e. excessive interest could potentially be denied deductibility and/or subject to domestic withholding rates) Whilst the article does not go on about the reclassification of interest, but the OECD transfer pricing guidelines outline certain situations when the taxpayer s intercompany transaction s validity could be challenged and therefore re-characterised. One frequently seen in the context of related party financing transaction is the substance over form argument where based on the borrowing entity s financial standing it could only have borrowed so much in the open market at certain rates. If the intercompany debt exceed that in either interest rate or amount, then the transaction could be recharacterised typically into a distribution event. (Dividends) Application to the XYZ group circumstances Based on X s balance sheet prior to the proposed financing, it was already showing a Debt-Equity level of 3:1. This is considered borderline high in many countries. In all the options below, it would be necessary to show either that company of similar financial footing could borrow USD 25m, or that X could indeed borrow that amount from a third party. Option 1 From company Y s perspective, the external loans with a Y state bank should not be caught by the arm s length requirement. (Assuming the bank is an unrelated party) But regarding the transaction with X, whist Y can extract more profits from state X, (thus increasing tax efficiency assuming X is a high tax state to Y) it might be that the deductibility of the interest might be subject to scrutiny.

9 From company X s perspective first of all the interest Y pays to the bank is half of that paid by X to Y. Y s borrowing from the bank could be considered an internal comparable uncontrolled transaction and could be used against the controlled X-Y transaction. Secondly, there might be issues about the beneficial ownership of the interest paid by X to Y if Y is mandated to pay the interest directly to the bank with limited say on the usage of the money, the substance could be such that Y could be deemed a conduit and X would be denied the restricted WHT rate of 10% and a 20% WHT might apply. Consider the Aiken Industries case where the Honduras Company was denied treaty WHT rates as the Cayman sourced interest was mandated to the US via itself. If Y would not provide a corresponding adjustment to company Y, double taxation (economic) might occur. It might be good to know if there are other comparable transactions that could support the X-Y deal terms, (assuming if different from the Y-bank deal) taking into account the characteristics of the loans (call/put features, subordination, seniority, issuer state.) and the economic circumstances of state X, (is state X in recession, is the similar industry in state X having a liquidity crisis?) and the business strategies, (is it aimed at maximising funding or obtaining cheapest funding) etc. It would be good to know if however, there are differences in terms/tenure between the Y-bank deal and the X-Y deal are there early repayment options? Are there rolled up interest provisions allowing interest to be accrued instead to the end? This would impact the comparability between the two transactions. We would also need to know the debt to equity ratio of company Y on a consolidated basis. Perhaps if the debt to equity ratio is much lower for Y then it might make sense for the Y-bank deal to be cheaper than the X-Y deal. (Considering X could be much more leveraged by comparison) If X represents the major business part to XYZ and therefore Y s balance sheet, then there might be issues about the substantial difference in rates. Option 2 From company X s perspective, the external loans with a Y state bank should not be caught by the arm s length requirement. (Assuming the bank is an unrelated party) There s no special relationship between X and the bank so should not be caught by the Art 11.6 provision or the Art 9 provisions. However, if company X s main business is to secure loan and if X agreed the loans in Y, then X might have a PE exposure. If option 1 is used, then state X might question why company X would go for a more expensive intercompany loan than a cheaper external alternative. Option 3 Prima facie the X-external bank deal is the same as in option 2, but the fact that Y provides the guarantee to allow X to obtain a lower rate means that there s an additional layer to consider the X- Y guarantee transaction.

10 Is there actually a benefit provided to X by Y s guarantee? If yes, then fine, X should pay Y for the benefit to the arm s length level, if none, then the X shouldn t pay Y for such a guarantee. Other additional information It would be necessary to know whether there are safe harbours in X. It would be helpful to consider other ratios such as debt to EBITDA in companies X and Y separately maybe they can support different levels of rates/quantum. Overall, option 3 would present the cheapest of options prima facie whilst X could obtain cheap funding from external bank, (minimising compliance burden to show it is arm s length) it can also allow Y to extract profits from Y in the form of guarantee fee to reach potential added tax efficiency to the group. Part 2 A guarantee fee is considered within the OECD Transfer pricing guidelines chapter for services. The key questions are whether a benefit has been provided through the transaction and whether a third party would pay for it at similar level in similar circumstances. A Canadian case GE Capital v the Queen has highlighted the key considerations in intercompany guarantee. In the context of guarantee fees, we need to consider whether a benefit is indeed provided was the guarantor merely considered a guarantor on account of the borrowing entity pertain to the same group as the guarantor (incidental benefit of being in the same group i.e. passive association). Or, is the guarantee granted on the active promotion of the guarantor of the group s overall creditworthiness? In the GE case, the lower courts consider that the borrowing entity would have obtained the guarantee from the lender regardless of the parent s guarantee as the parent clearly wouldn t allow the sub to default. However, the higher courts consider that the borrowing entity should be considered on a case by case basis irrespective of corporate background. Secondly, it was argued that the guarantee would actually provide a benefit to the borrowing co, the parent s creditworthiness was above that of the borrowing sub. A third party s recovery prospect was enhanced, so the guarantee was allowed. One also needs to be able to quantify the difference in rates e.g. whether there are external quotes to evidence? Also some jurisdictions require the guarantee to be set down in a piece of formal letter. Is this available for the tested transaction? The contractual term would make an impact. In considering the guarantee fee level, the court contends that the fee should not be the total difference between what would have been under the interest rate without guarantee and that with

11 the guarantee. From the borrower s perspective, there can only be a benefit when there s a smaller difference. The court was happy to accept that 100 bps was a sufficient amount to present a benefit to the borrower whilst maintain the profitability of the guarantor.

12 Question 6 Part 1 Transfer pricing Transfer pricing is the price charged in transactions between 2 related entities. It is important in the international tax context because the level of transfer price charged can have an impact on the taxable income for each of the related parties i.e. the tax base for the jurisdictions of each party. In the OECD model tax convention, the taxation of associated enterprises is principally governed by article 9. The key concepts revolve around that related parties sharing features of control, (either common shareholder or one controlling another, in forms not limited just to shareholdings, but also voting powers, etc.) should transact with each other as two third parties would in similar circumstances setting out the basis of arm s length principle. The application of the arm s length principle is referred to in the model treaty commentary precisely OECD Transfer Pricing Guidelines. Comparability In order to establish whether the related party transaction is operating on the same footing as third party transaction in similar circumstances thus satisfying the arm s length principle, it would be necessary to undertake a comparability analysis. Typically the analysis would take into account functional profiles of each entities, economic circumstances, contractual terms, business strategies, and goods/services characteristics. However, in addition, the timing of the comparison is also critical. Having identified the comparable entities or transaction, the timing of the comparison would have an impact consider introducing an intercompany loan during the financial crisis in 2010 using the third party interest rate before the crisis in Even if the terms and particulars are the same, the timing of the comparison would clearly matter. The OECD TPG has discussed this in further details in Chapter 3.67 onwards. It outlines that ideally the comparison of related party transactions and third party transactions should operate on a contemporaneous basis, i.e. the same period as when the related party transactions took place. This would be critical in ensuring the comparability between the two. The key is also to consider how third parties would have acted in the similar timeframe. The practicality of this position depends on the transfer pricing methods adopted. If for instance, if a comparable uncontrolled price method is considered most appropriate and is to be used and an internal comparable uncontrolled transaction has been identified, then it is possible to apply the pricing information in the internal CUT with the tested transaction for a contemporaneous comparison. However, in practical terms this is rarely carried out if other methods such as transactional net margin method is applied. The application of TNMM relies on accounts info from third party companies which are then used to estimate the profitability of undertaking similar transactions/activities. Consider that the accounts of third party companies would typically not be submitted and published in the databases until a period after year end, in such case, a contemporaneous comparison would therefore not be possible.

13 Instead, the TPG says it s possible to consider using 2 different approaches ex ante and ex post. Ex ante also known as the price setting the taxpayer can prepare documentation to support the arm s length nature of the tested transaction using information available to them up to that point. I.e. if the transaction is to happen in 2014, then using this approach, the arm s length nature of the transfer price could be upheld using data from 2010 to The benefit is that it can reflect the uncertain prospects of the tested transaction and marrying up with the latest financial performance in similar transactions. However, this may not necessarily reflect the profit levels of third parties in precisely the same time frame. (Contemporaneous) Ex post also known as the price testing the taxpayer can retrospectively use data available after the completion of the transaction (at year-end) for the testing of the controlled transaction s arm s length nature. The benefit is that it can ensure that the taxpayer had a similar profit level as third parties would in the similar timeframe. However this may not necessarily reflect the uncertain prospects faced by third parties when deciding on the price at the start of the time frame. (Contemporaneous) The usage of multiple year data in both instances can also remove the business cyclicality factors or market volatility elements and therefore make the transfer price (to be set or already set) more robust in face of challenges. As seen due to data insufficiency at times it would be impossible for groups to undertake a contemporaneous transfer pricing documentation exercise. In view of this, the TPG advocates restraints and appreciation from the tax authorities that the taxpayers have made best efforts to satisfy the arm s length principle and corresponding documentation requirements. Tax authorities should consider balancing the burden of proof re arm s length nature in tested transactions, and the cost it would present to taxpayers. In summary, I would therefore agree with the statement to some extent as comparability clearly should take into account the timing factor. Whilst the ideal would be contemporaneous documentation, in the operational aspects for businesses, the reality is such that this is not possible. Instead, it is equally possible to rely on the ex post or ex ante approaches to show that the transaction is broadly comparable. Part 2 From the tax authorities perspective, transfer pricing documentation from taxpayers would be a useful tool in many areas. The presented facts and analysis in the report can enable inspectors to undertake a high level review to understand the risk level of the taxpayer s transfer pricing position. Understanding the risk level as well as transactional quantum information would enable the authorities to decide whether resources should be diverted to the case for further investigation. In view of limited resources, having this information could potentially allow them to send resources to more at risk areas/transactions where the tax at stake could be much higher. Secondly it can enable them to appreciate the complexity of the taxpayer s affairs. Tax inspectors may not have insider information of how the industry functions and as such through the industry and

14 company analyses of the report, the inspectors can learn how the industry operates and therefore reduce the possibility of raising an enquiry on merely misunderstanding how the industry operates. Part 3 From the perspective of MNE groups, the documentation requirements would entail multiple concerns. The rules of each regimes are different for instance, there might be still a hierarchy of TP methods to be employed whilst some other might not allow such as TNMM. Some insist on using local comparables in TNMM benchmarking studies whilst some are restrictive on PLIs. Ensuring the transfer pricing policy and the documentation satisfy the local requirements could be difficult. The timing of yearends in each location could also be key. Some jurisdictions have a tight timeframe for documentation submission following yearend. Consider what if the other transacting party s yearend is not the same and the year-end adjustment hasn t been finalised. MNEs often operate in developing states, the lack of comparable data there might jeopardise the validity of comparison and therefore the documentation process would be made more difficult. Operating in multiple jurisdictions would also mean an increased costs in pulling together these documentation reports for each entity. Confidentiality should also be a concern in the current tax sensitive climate, taxpayers wouldn t want business secret information outlining the tax efficient structure to be published easily and compared with the likes of Starbucks or Amazon. It would have a negative impact on the public image of the MNE. The recently published BEPS report (targeted at increasing compliance and reducing abusive tax behaviours such as base erosion and profit shifting) has listed in action point 13 that increasing the transparency of documentation would be a priority and that MNEs could potentially need to deal with country by country report which would increase the compliance burdens for such taxpayers.