Transfer Pricing Alert

Transcription

1 Transfer Pricing Alert July 2015 Journey to the future: BEPS and the fastevolving transfer pricing landscape in China On 6-7 July 2015, the Organisation for Economic Co-operation and Development (OECD) held a public consultation on transfer pricing issues in connection with the Base Erosion and Profit Shifting (BEPS) project. The consultation was hosted by OECD Working Party 6 (WP6), which is responsible for the OECD s work on transfer pricing matters. The BEPS project was originally launched in July 2013, when the OECD published its ambitious Action Plan to combat BEPS; the G20 officially endorsed the Action Plan soon after, in September The BEPS process is now rapidly approaching its conclusion: WP6 indicated that the transfer pricing guidance is intended to be finalized in September 2015 and published shortly before the G20 Finance Ministers meeting on 8 October As a member of the G20 and a long-standing consultant on OECD transfer pricing matters, China has been deeply involved in the BEPS process. It is understood that China s State Administration of Taxation (SAT) will soon be issuing comprehensive transfer pricing rules to replace Guoshuifa [2009] No. 2 Implementation Measures for Special Tax Adjustments (Circular 2). As developments in the BEPS project can be expected to have a significant influence on the SAT s work in this area, now is an appropriate time to take stock of the status of the BEPS project s transfer pricing guidance.

2 BEPS transfer pricing drafts The BEPS project s transfer pricing work comprises three substantive action items (actions 8, 9 and 10) and one documentation action item (action 13). The BEPS Action Plan identifies the overarching objective of the transfer pricing work as to assure that transfer pricing outcomes are in line with value creation. The BEPS Action Plan takes the view that existing transfer pricing rules, based on the arm s length principle and embodied in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), work well in many cases; the Action Plan raises the concern that in some cases multinationals have been able to use and/or misapply those rules to separate income from the economic activities that produce that income and shift it into low-tax environments. The goal of actions 8, 9 and 10 is to modify the OECD Guidelines to prevent BEPS: ideally, by clarification of the application of the arm s length principle, but by special measures that go beyond the arm s length principle if deemed necessary. There have been a number of discussion drafts on the substantive transfer pricing action items issued during the course of the BEPS project. This alert discusses three of the most significant ones: Report of 16 September 2014 titled BEPS Action 8: Guidance on Transfer Pricing Aspects of Intangibles (Intangibles Deliverable) Discussion draft of 19 December 2014 titled BEPS Actions 8, 9 and 10: Discussion draft on revisions to Chapter I of the Transfer Pricing Guidelines (including risk, recharacterization and special measures) (Risk Draft) Discussion draft of 4 May 2015 titled BEPS Action 8: Revisions to Chapter VIII of the Transfer Pricing Guidelines on Cost Contribution Arrangements (Cost Sharing Draft) 1. Source: &id=id&accname=guest&checksum=F1F8FC1D D10D69FB1976E96EAE466B69 Intangibles deliverable The Intangibles Deliverable was one of the BEPS project s first wave of deliverables in September It consists of amendments to the OECD Guidelines, many of which were issued in final form. However, key portions of the Intangibles Deliverable were grayed out to indicate that they remained in draft mode to be revised in coordination with the September 2015 finalization of the other transfer pricing work. From a mainland Chinese perspective, while Articles 21 to 27 of Circular 2 address transfer pricing methods for all types of related party transaction, Circular 2 does not provide any specific guidance relating to intangibles. Guidance from the Intangibles Deliverable can be expected to inform the revision of Circular 2. Finalized portions of the Intangibles Deliverable address the following issues 1 : Location specific advantages are recognized as comparability factors (but not as intangibles per se). This guidance is less detailed than that provided by the United Nations Practical Manual on Transfer Pricing for Developing Countries, to which China contributed substantially, so the latter is more apt to influence revisions to Circular 2 than the Intangibles Deliverable. A broad definition of intangible assets is offered and clarification is made that goodwill and going concern value should generally be compensable. Guidance is provided on the use of valuation methods (such as the income method) for determining the arm s length price for the transfer of intangibles. These methods supplement the five transfer pricing methods previously recognized and are considered to be useful in cases where the comparable uncontrolled price (CUP) method cannot be reliably applied. Draft portions of the Intangibles Deliverable include the following guidance: Legal ownership of intangibles by itself does not confer any rights to retain profits derived from exploiting intangibles. Further, mere funding of intangible development costs generally would entitle the funder to an appropriate rate of return on its financing costs. Although the Intangibles Deliverable provided that this should be a risk-adjusted rate of return, WP6 in the 6-7 July 2015 consultation indicated that this would normally be the risk-free rate. Intangible-related profits should rather flow to the related parties that perform and exercise control over development, enhancement, protection and exploitation (DEMPE) functions. 2

3 More specifically, in the area of allocating returns associated with the intangibles, it would not be surprising that the SAT would continue to emphasize the need for analyses on value contribution of all participants in the supply chain as well as the location specific advantages, which can be observed from several high-ranking SAT officials' public speeches in recent years. Meanwhile, given that the increasing importance/complexity of IP related transactions, there is a possibility that further guidance on the use of valuation techniques (e.g., the cost method, market method and income method) for intangible assets may also be provided in the revised Circular 2. Risk Draft The Risk Draft covers three broad topics. First, it provides extensive guidance on how to evaluate the risks faced by a controlled group, how to assess the allocation of risks among members of the group, and how the allocation of risk affects transfer prices. Second, it describes circumstances under which transactions between related parties would be subject to nonrecognition or recharacterization by tax authorities. Third, it outlines potential special measures that might be necessary if it is found that clarification of the arm s length standard through revisions to the OECD Guidelines would not be sufficient to prevent BEPS abuses. At the 6-7 July 2015 consultation, WP6 indicated that there would be significant revisions to the new guidance on risk. The Risk Draft s guidance and likely modifications are discussed below. WP6 indicated that there would be extensive revisions to the guidance on recharacterization, which will not be discussed further here. The Risk Draft s discussion of potential special measures will not be covered here either because WP6 indicated that the OECD is comfortable at this stage that no special measures will be necessary. 2. Source: pricing/discussion-draft-actions chapter-1-tp- Guidelines-risk-recharacterisation-special-measures.pdf The Risk Draft s guidance on the evaluation of risks for transfer pricing purposes includes the following 2 : The allocation of risk is central to transfer pricing analysis because the related party that bears risks is expected to earn the return for such risks. Although the expected return would be greater as the level of risk increases, the actual return (including potential losses) may vary depending on whether the risks are realized. In the case of intangible property, the allocation of risks related to DEMPE functions is central to the expected allocation of intangible-related profits. Commenters from industry and consulting firms expressed concern that the Risk Draft did not pay adequate respect to the allocation of risk in contractual agreements between related parties. WP6 indicated that final guidance will provide greater clarity on the role of contracts. An allocation of risk to a particular related party will be respected if the party performs key control functions relating to the management of that risk. Otherwise, the risk will be allocated to the party having the most control over that risk. WP6 indicated that, in final guidance, outsourcing of risk management will be respected if the group company in control of the risk sets the objectives of the outsourced activities, assesses whether the objectives are met, and takes responsibility for hiring or firing the service provider. Mere formalizing of decision-making in the form of, for example, minutes of a board meeting and signing of documents would not be sufficient for this purpose. Commenters expressed concern that, given the broad definition of risk and the wide range of relevant risk control activities, transfer pricing analysis could become too theoretical and complex under the Risk Draft. For example, profit splits might be required in circumstances where other methods would be more appropriate. WP6 promised to provide more practical guidance, including setting a materiality threshold. It is possible that the Risk Draft will have an impact on the SAT s revision of Circular 2. Although Circular 2 currently emphasizes the importance of risk in determination of arm s length prices, it provides very little specific guidance on how risks should be evaluated. Although the SAT has been generally conservative in the recognition of value associated with risk and capital, the increasing Chinese outbound investment in recent years and the fact of 2014 becoming the first net capital outflow year for China should provide a good reason for the SAT to take a new perspective to embrace a more balanced technical view towards the value creation issue going forward. 3

4 Cost Sharing Draft A development cost sharing arrangement (CSA) is a contractual arrangement under which participants share the costs and risks of developing an intangible in exchange for defined ownership shares of the intangible. Cost sharing is covered by Articles 64 to 75 of Circular 2. Article 69, which addresses standards and procedures for tax authority review of a CSA, was recently modified by Announcement 45 Standardizing the Administration of Cost Sharing Agreement [16 June 2015]. However, the substantive guidance has not been revised. It is possible that the SAT will take the BEPS Cost Sharing Draft into account as it revises Circular 2, especially on the application of commensurate-with-benefit standard. Given the emphasis on the discussion of location specific advantages, there is also possibility that the SAT would provide further requirement on the considerations of local cost advantage when determining Chinese participant s contribution share and/or market premium when estimating Chinese participant s anticipated benefits. Key elements of the Cost Sharing Draft include the following: Participants in a CSA must have reasonable expectations of deriving benefits from the CSA activity and must exercise control over the risks associated with the CSA. Participants contributions to the CSA must be measured by value rather than cost. For example, if a participant performs R&D activities, its contribution to the CSA would be equal to the arm s length value of similar R&D services provided by a third party (e.g., cost plus an appropriate markup). A participant s share of the total contributions of all participants to the CSA must be consistent with that participant s share of expected benefits from the CSA activity. This share would not be adjusted for differences between benefits expected at the time development activities are undertaken and those actually realized at a later date from the CSA activity. Conclusions and Take-Aways The BEPS project represents the most dramatic and wide-ranging change in global norms of international taxation in more than half a century. Transfer pricing lies at the very heart of that change. The timing of this global upheaval coincides with changes in mainland Chinese tax law that are perhaps even more dramatic and severe, as China modernizes and expands its tax system to meet the demands of one of the world s most rapidly developing economies. The upcoming revisions to Circular 2 will be part of this dynamic. Multinationals would be well-advised to carefully evaluate their global transfer pricing strategy and the part that China plays in it, and should pay particularly close attention to the identification of global and local intangible property and the determination of how group companies are compensated for their DEMPE functions. EY China Transfer Pricing contacts Beijing Joanne Su joanne.su@cn.ey.com Leonard Zhang leonard.zhang@cn.ey.com Shanghai Travis Qiu travis.qiu@cn.ey.com Julian Hong julian.hong@cn.ey.com Kana Sakaide kana.sakaide@cn.ey.com Shenzhen Enoch Hsu enoch.hsu@cn.ey.com Lawrence F Cheung lawrence-f.cheung@cn.ey.com Jean N Li jean-n.li@cn.ey.com Hong Kong Martin Richter martin.richter@hk.ey.com Kenny Wei kenny.wei@hk.ey.com Mark Ma mark.ma@cn.ey.com Taipei George Chou Ext george.chou@tw.ey.com 4

5 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 Ernst & Young (China) Advisory Ltd. All Rights Reserved. APAC No ED None. 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/china