EU Transfer Pricing Report on Cost Contribution Arrangements

Volume 68, Number 2 October 8, 2012 EU Transfer Pricing Report on Cost Contribution Arrangements by Martin Lehner Reprinted from Tax Notes Int l, October 8, 2012, p. 201

EU Transfer Pricing Report on Cost Contribution Arrangements by Martin Lehner Martin Lehner is a research associate at the Johannes Kepler University School of Law in Linz, Austria. In June 2012 the EU Joint Transfer Pricing Forum (JTPF) released the final version of its report on Cost Contribution Arrangements [CCAs] on Services not creating Intangible Property [IP]. 1 The report supplements and completes the JTPF s work on intragroup services (IGS). In 2010 the JTPF released its Guidelines on low value adding intra-group services. 2 Further, the JTPF summarizes in an annex to the report the current state of play regarding CCA legislation or administrative guidance within some EU member states. 3 In the U.S. this issue is covered by the service regulations as part of the service cost method and labeled as shared services arrangements. 4 The JTPF is designed to clarify issues that are difficult to deal with for both multinational enterprises and tax administrations in applying article 9 of the OECD model tax treaty and the arm s-length principle. 5 The report is based on the OECD transfer pricing guidelines, especially on Chapter VIII, which addresses CCAs. 6 The JTPF assumes its recommendations will support evaluation and acceptance that the arm slength principle has been applied in the majority of the cases that fall within the scope of the report. 7 Scope According to the OECD transfer pricing guidelines, the most common type of CCA is the joint development of intangible property. 8 But CCAs could also exist for any joint funding or sharing of costs and risks, for developing or acquiring property, or for obtaining services. 9 While the OECD is currently involved in a project on the transfer pricing aspects of intangibles, the JTPF focuses its report on services not creating intangibles. 10 The report addresses all kinds of IGS without IP impact and is not limited to special activities. 11 For illustration purposes, a list of examples is provided, whereupon the following activities could be 1 For the report, see Doc 2012-16159 or 2012 WTD 147-18. 2 The report was part of a communication of the European Commission; for the communication, see Doc 2011-1611 or 2011 WTD 17-16. 3 See the Annex to the JTPF report on service CCAs. More detailed information provided by the tax administrations can be found in the materials of the 33rd EU JTPF meeting on March 8, 2012, available at http://ec.europa.eu/taxation_customs/ taxation/company_tax/transfer_pricing/forum/index_en.htm. 4 See Treas. reg. section 1.482-9(b)(7). 5 In order to facilitate the discussions within the EU, JTPF examples were provided both by the private sector and competent authorities; examples can be found in the materials of the (Footnote continued in next column.) 33rd EU JTPF meeting on March 8, 2012, and the 32nd EU JTPF meeting on October 26, 2011. 6 See JTPF report on service CCAs, para. 5. 7 Id. at para. 55. 8 See OECD transfer pricing guidelines, para. 8.6. 9 Id. at para. 8.7. 10 See JTPF report on service CCAs, para. 3. For the OECD intangibles project, see http://www.oecd.org/ctp/transferpricing/ transferpricingaspectsofintangibles.htm. 11 See JTPF report on service CCAs, para. 13. TAX NOTES INTERNATIONAL OCTOBER 8, 2012 201

PRACTITIONERS CORNER subject of a service CCA: information technology, logistics, purchasing, real estate, finance, tax, human resources services, accounting, payroll, and billing. 12 Concept Multinational enterprises use CCAs to jointly carry out activities. The economic objective is generally to profit from the economies of scale and scope or from sharing risks, skills, or resources. In the report, the JTPF provides guidance to distinguish the concept of a CCA from IGS. 13 While in a CCA the participants share costs, risks, and benefits of an activity, IGS are limited to the provision or acquisition of a service by the members of the MNE group. In a CCA the service typically is performed only by one participant so that in fact one member of the MNE group provides a service to other members of the group. For IGS, there is also one group member providing services to other group members. The most important difference between those situations is a profit element contained in the charge for IGS. In a CCA, the contributions are usually valued at cost because all participants are contributing to a common activity either in cash or in kind. By contrast the (direct or indirect) charge for IGS usually contains a profit element because the risk is borne only by the service provider. Not explicitly mentioned in the OECD transfer pricing guidelines are arrangements of IGS in which the charge contains no profit element. 14 Although those cost pools have the same effects as CCAs they are not based on the CCA concept. To help a reviewer to differentiate between the two concepts the report contains a table of major distinctions. 15 Consistency With Arm s-length Principle General Features In general, the report states that MNEs are free to organize their business operations as they see fit. 16 If the business operations are not in accordance with article 9 of the OECD model treaty, tax administrations may perform transfer pricing adjustments. 17 The JTPF provides the following list of general features a CCA on services not creating IP needs to be consistent with the arm s-length principle: 18 The arrangement should make business sense. 12 Id. at para. 14. 13 Id. at paras. 7-10. 14 Id. at para. 11. 15 Id. at para. 12. 16 Id. at para. 16 with a reference to para. 9.163 of the OECD transfer pricing guidelines. 17 Id. at para. 16. 18 Id. The economic substance should be consistent with the terms of the CCA. The terms of a CCA should be generally agreed to before the beginning of the activity. The terms of a CCA should be at arm s length, taking into account the circumstances known or reasonably foreseeable at the time of entry into the arrangement. Each participant should have a reasonable expectation of benefit. The participant s share of the costs should be consistent with its share of the expected benefits. Reasonable expected benefits can be assessed in terms of efficiency or effectiveness in quantitative or qualitative terms. Contributions by a participant can be in cash or in kind and therefore active participation is not a requirement. The level of influence on decisionmaking will vary depending on the type of CCA, the expertise of the participants, and the amount of costs being allocated to the respective participants. When a service subject to a CCA is also provided to or received from nonparticipants in the CCA, it must be valued at arm s length. If participants join or leave the CCA, shares should be adjusted/re-balanced in accordance with the arm s-length principle. In practice, the list is helpful because it gives an overview of the key elements of a CCA and de facto summarizes the requirements of a CCA on services not creating IP according to Chapter VIII of the OECD transfer pricing guidelines. CCAs are based on reasonable expectations, although the actual outcome may differ from the projected outcome. 19 In the context of transfer pricing adjustments, the JTPF emphasizes, with reference to the OECD transfer pricing guidelines, that only material differences require an adjustment and that tax administrations should refrain from marginal adjustments. 20 However, the JTPF does not determine or suggest safe harbor rules (for example, that a 20 percent deviation of the projected outcome does not require any transfer pricing adjustment). Instead, the JTPF refers to Chapter VIII of the OECD transfer pricing guidelines and repeats general principles, such as not making adjustments based on data only from a single year and the rejection of hindsight. 21 Since in a dispute the mutual agreement may involve more than two competent authorities of the EU, the JTPF recommends following 19 Id. at para. 17. 20 Id. at paras. 18 and 53. 21 Id. at paras. 19-21 with references to paras. 8.26-8.30 of the OECD transfer pricing guidelines. 202 OCTOBER 8, 2012 TAX NOTES INTERNATIONAL

the multilateral approaches in its EU code of conduct on the arbitration convention for triangular cases. 22 Corroborative Information Although the list of general features is helpful to design a CCA on services not creating IP, there are different approaches regarding what information is needed to understand and achieve confidence on several key issues. 23 The JTPF believes that in most circumstances MNEs should provide a narrative that includes the relevant information to confirm the consistency with the arm s-length principle. 24 However, most of the relevant information can already be provided by the written CCA. Key aspects are explanations of the reasonable expected benefits of each party and the fair allocation of the contributions in light of each participant s expected benefits. 25 The JTPF provides a list of corroborative information that should be provided in the majority of cases. 26 The list contains most of the elements also found in the list of recommended documentation in Chapter VIII of the OECD transfer pricing guidelines. 27 Specific Aspects In its report, the JTPF addresses some specific issues in which additional guidance might be needed. Expected Benefits Since the allocation of costs is based on the expected benefits of each participant, the expected benefit test is a key element of a CCA. 28 Benefits in this context means an increase in economic or commercial value such as cost savings in expenses or an increase of profits. 29 According to the JTPF, in most cases the expected benefit for each participant can be derived from the overall benefit of the CCA and the appropriateness of the allocation key chosen. In other cases, the individual benefit can be less clear and must be calculated differently. Depending on the facts and circumstances, the overall benefit of the CCA as well as each individual benefit may be evaluated directly or indirectly PRACTITIONERS CORNER that is, by using indirect indicators of the expected benefit such as turnover, number of employees, gross profits, and so forth. 30 Problems arise if the anticipated benefits deviate from the actual benefits. Independent parties might agree on a regular assessment whether expected benefits are in line with actual benefits and whether contributions should be changed in the future. 31 In the view of the JTPF, a retrospective adjustment would be an improper use of hindsight if the benefit projections are reasonable. 32 However, adjustments should be considered if unexpected or unforeseeable events or circumstances affect the initial benefit expectations. 33 Contributions of Each Participant Valuation of the shares in the expected benefits is an essential element in a CCA. 34 For guidance on the allocation key, the JTPF refers to paragraphs 48 to 55 of the IGS guidelines. 35 Concerning the valuation of the contributions in general, no specific result is provided in the report. There is no international consensus within the OECD. 36 The JTPF recommends a valuation at cost for CCAs on services not creating IP because in many cases there is only a small difference between pricing at costs and at market value. 37 However, in a related issue concerning the treatment of tax incentives and government subsidies, the JTPF has no recommendations and just makes a cross-reference to paragraph 8.17 of the OECD transfer pricing guidelines. 38 In this context the OECD transfer pricing guidelines do not provide a solution and simply note that it depends on what independent enterprises would do. Contributions in CCAs are in principle based on estimated costs. However, in CCAs on services not creating IP it may be practical to base contributions on actual costs instead. If an adjustment from estimated to actual costs is necessary, the JTPF suggests taking it into account in the following year if it can be considered as not having a major impact. 39 22 Id. at para. 54. The report on triangular cases was part of a communication of the European Commission; for the communication, see supra note 2. 23 Id. at paras. 22 and 23. 24 Id. at paras. 23 and 56. 25 Id. at para. 24. 26 Id. at para. 25. 27 See OECD transfer pricing guidelines, paras. 8.42 and 8.43. 28 See JTPF report on service CCAs, paras. 28 and 30. 29 Id. at para. 29. 30 Id. at para. 31. 31 Id. at para. 39. 32 Id. at paras. 40 and 41. 33 Id. at para. 42. 34 Id. at para. 32. 35 See JTPF report on service CCAs, para. 33. See supra note 2. 36 See OECD transfer pricing guidelines, para. 8.15. 37 See JTPF report on service CCAs, para. 34. 38 Id. at para. 38. 39 Id. at para. 35. TAX NOTES INTERNATIONAL OCTOBER 8, 2012 203

PRACTITIONERS CORNER To determine the relevant costs, the JTPF recommends that MNEs should be allowed to use the accounting standards that are generally used throughout the group. 40 However, in cases of permanent major differences with domestic accounting standards, a tax administration should nevertheless be entitled to require appropriate adjustments. 41 Participation As also mentioned in the OECD transfer pricing guidelines, an enterprise cannot participate in a CCA if it is taking its benefit solely or mainly from the performance of the CCA activity itself. 42 In those cases the activity performed would instead be an intragroup service. 43 Joining/Leaving a CCA Unlike R&D CCAs, IP issues on buy-in or buy-out payments are very limited (or nonexistent) in CCAs on services. 44 However, entry or departure of an enterprise will lead to an adjustment of the allocation key. 45 40 Id. at para. 36. 41 Id. 42 See OECD transfer pricing guidelines, para. 8.10. 43 See JTPF report on service CCAs, para. 43. 44 Id. at paras. 44 and 45. 45 Id. at para. 46. Documentation The JTPF refers to its code of conduct on EU transfer pricing documentation, which already states that MNEs should include CCAs in the master file. 46 More specifically, MNEs should prepare information of the nature of services covered, the terms of the arrangement, and the consistency with the arm s-length principle. 47 Regarding the consistency with the arm s-length principle, the JTPF considers a narrative concerning CCAs as an EU transfer pricing documentation requirement. 48 Final Remarks By giving guidance on how to distinguish between CCAs on services not creating IP and intragroup services, the JTPF addresses a major point not sufficiently covered by the OECD transfer pricing guidelines. Further, the report makes clear that in most cases a narrative on relevant information should be provided by MNEs to prove the consistency of a CCA with the arm s-length principle. 46 Id. at paras. 47-49. 47 Id. at para. 50. 48 Id. at para. 52. 204 OCTOBER 8, 2012 TAX NOTES INTERNATIONAL